The Hindu Business Line : Banks have much to do if winning streak is to continue

Multiple dimensions of the reform model have improved the lot of banks. But achievement of competitive advantage requires continued accent on efficiency, productivity and profitability and up-scaling of technological upgradation on a much larger canvas.

CROSS-COUNTRY evidence clearly suggests that economic growth is positively related to the stage of financial development, usually defined in terms of the size of financial markets or outstanding bank assets relative to gross domestic product (GDP), both by facilitating better risk-sharing and mitigating informational problems.

In the pre-reforms phase, the Indian financial system suffered from `financial repression'. This was characterised by regulation of interest rates, statutory pre-emption of resources by government, cross-subsidisation of interest rates, high and mounting level of non-performing assets (NPAs), and so on. Post-1991, the liberalisation process attempted to transform the credit institutions into organisationally strong, financially viable and operationally efficient units by a process of well-sequenced and interconnected reforms in several segments.

Multiple dimensions of the reform model led to an increase in both operating and net profits, greater compliance to minimum capital adequacy norm and sharp reduction in the proportion of gross NPAs. But the impact of reforms on the banking industry has been uneven. Achievement of competitive advantage requires continued accent on efficiency, productivity and profitability and up-scaling of technological upgradation on a much larger canvas.

The major challenge for public sector banks (PSBs) relates to networking and providing core-banking solutions. Restructuring branches and manpower, downsizing, reducing operational risk and transactions cost by progressively greater use of the convergence of information and communication technology (ICT) and containing accretions under NPAs by checking additions to it and recovering critical amounts in incipient accounts and optimising efficiency have also emerged as key policy variables impacting the success of the winning formula.

In line with the improved performance of the economy, 2003 also marked a watershed for Indian banks, recording impressive performance in terms of several commonly accepted measures, such as profitability, capital adequacy, NPA levels, and so on. The improved performance of the banking sector is discernible not only in terms of the financial indicator of operational efficiency but also the quality of financial services provided. All these aspects are not just random or disconnected set of activities but constitute a `system', where different constituents form parts of an organic whole.

An analysis of the structure, content and performance of the banking system reveals the success in bringing about systemic reform over the long run. This thesis can be substantiated by the fact that all the 27 PSBs achieved capital to risk-weighted assets ratio (CRAR) above the prescribed minimum of 9 per cent, whereas 26 banks exceeded even 10 per cent by end-March 2003. The RBI's `Report on Trend and Progress of Banking 2002-03' shows that banks performed commendably in 2002-03.

With growth in trading profits likely to taper off because of the low interest rate scenario, the overall profits could be affected inasmuch as trading profits accounted for 44 per cent of operating profits of banks as a whole in 2002-03. But the significance of the trading profits varied sharply across bank groups. While old and new private sector banks (58 per cent and 63 per cent, respectively) formed one end of the spectrum, foreign banks (14 per cent) constituted the other. The position of the SBI group (30 per cent) and nationalised banks (56 per cent) was in the band set by the old and new private sector banks and foreign banks. PSBs, however, may not take a hit in the hypothetical situation of a rise in interest reducing yield on government securities.

This is because of the setting up of the proposed Investment Fluctuation Reserve to which the banks will contribute 5 per cent of their profits enabling them to hedge against interest rate movements. The higher profitability of the banks also emanated from their diversified business and reduced transaction cost. Non-interest income as a percentage to total income for nationalised banks rose from 10.55 per cent in 1996-97 to 16.68 per cent in 2002-03.

During 2000-03, PSBs enhanced their resilience to meet the challenges ahead by reducing their gross and net NPAs/assets' ratio from 6 per cent to 4.2 per cent and 2.9 per cent to 1.9 per cent. Lower additions to NPAs vis-à-vis recoveries in 2002-03 improved the overall position of the banks. This reflects the greater awareness of credit risk by banks and also the impact of bankers' resorting to effective action for rehabilitation, one-time settlement and filing of suits, taking advantage of Lok Adalats for recovery of NPAs for suits below Rs 4 lakh, taking advantage of the Securitisation Act, setting up of asset reconstruction companies (ARCs), enforcement of security interest without the intervention of courts, setting up of a Central Registry, developing a Credit Information Bureau and corporate debt restructuring.

Further reduction in gross NPAs necessitates an effective credit appraisal system, a risk-pricing methodology and real-time credit monitoring system. Legal reforms also need to be implemented to provide banks a free hand to recover bad loans.

The vastly improved profitability, productivity and efficiency of banks are also mirrored by the stock market. Given the inherently risky nature of the banking sector, it is essential to adopt a system-wide approach to plough back profits through reserves for expansion and provide for losses and expenses that are in the making or contingent, while meeting the emerging needs of its customers.

As the Narasimham Committee Report-II (1998) succinctly put it: "The process of strengthening the banking system has to be viewed as a continuing one. There is no finite end to improving the levels of efficiency and profitability. In fact the system has to cope constantly with changes in the broader environment in which it functions and face (new) challenges that those developments impose on it."

Strategic options and choices

Globalisation is not merely an inexorable process but a condition in which the traditional and familiar boundaries are increasingly becoming blurred. The efficient players in the financial system have been reorienting their policies and functioning in line with the ongoing reform process to make the high growth trajectory sustainable over the medium term.

This is, by no means easy, but synchronised measures relating, inter alia, to customer orientation, market focus, innovativeness, efficient credit dispensation and monitoring, besides building up sound financials, can help banks to surmount emerging obstacles and script a new growth chapter. Transcending of the regular banking operation of `house-keeping', to accent on corporate banking, merchant banking, investment banking and treasury and forex functions is needed to translate this economic optimism into fruition.

The ongoing financial and banking sector reforms have brought to the fore the issue of generating and sustaining profits all along the line. This requires a sharper focus on the issues of declining spread, unduly high exposure to government securities, high operating cost, stiff competition, transformed economic environment and new prudential regulations.

The intensified challenges and increased complexities of contemporary Indian banking make it necessary to put in place measures, such as, spread management, rapid technological upgradation, product innovation, business process reengineering (BPR), check on transaction cost and reduction of impaired assets to make the growth in profits sustainable over the long haul.

Banks need to put in place a comprehensive business model to promote real time simulation for a healthy, efficient, sound and internationally competitive banking system.

Looking ahead

Banks face stiff competition from non-bank finance companies, primarily on the lending side and from mutual funds and other similar institutions on the deposit side. New private sector banks with improved technology and skilled manpower have also intensified competition for PSBs. Hence, the move towards universal banking would help banks to expand and diversify more effectively into franchise and fee-based and non-traditional income.

The larger Indian banks are strategically positioned in terms of adequate infrastructure, an elaborate network of branches and qualified personnel. Banks now need to develop dedicated outfits and specialised cadres for adequately managing niche areas by effectively leveraging their core strengths, including their existing customer base, the deep spread of their collections franchise from their commercial accounts-clearance business and their historical trade financing business.

The liberalisation of the financial sector and the increased freedom to combine banking with other financial services grounded both in economic theory and fact facilitated consolidation and convergence globally. While the Indian banking system weathered the shocks reasonably well, structural issues urgently need to be systematically addressed to in the present transitional phase of development.

Here synergy-based mergers and acquisitions in the industry and weeding out of weak players could play a critical role.

The process of convergence also needs to be carefully pursued by banks through changes in products, technology, structure, processes and introduction of advanced management concepts and practices to successfully introduce new financial instruments and strategies, and new and cheaper delivery, trading and settlement mechanisms.

The traditional face of banks as mere financial intermediaries has altered and risk management has emerged as their defining attribute. Appropriate risk management architecture is a function of the size, complexity of business, risk philosophy, market perception and the level of capital of banks.

Competition needs to foster convergence towards best practice in risk management because of growing role of market forces, need for internationally consistent prudential norms and a high-quality financial infrastructure and interdependence of prudential standards. Hence, risks need to be mitigated by improving integrated risk management mechanisms, streamlining systems and procedures and honing the skills of the operating staff.

Viewed against the background of a battle within (high transactions cost, high NPAs and low customer satisfaction, for example) and a war outside (phenomenal growth in capital inflows, global financial integration, and so on), there is an imperative need for a strong and resilient financial system and the orderly evolution of financial markets.

Consequently, the strategy for change management requires accent on 24-hour banking, tele-banking, Internet banking, corporate banking, merchant banking, investment banking, treasury and forex functions, internal checks and controls and transparency.

Some of the critical success factors also relate to enhanced organisational effectiveness of banks by management of deregulated interest, judicious asset-liability management (ALM), realistic market segmentation, product differentiation, technology upgradation and corporate governance.

Reducing the transaction and overall intermediation cost, improving yield of assets and slashing both gross and net NPAs would be helpful in bringing about a structural transformation in line with best practices. All these are areas where sustainability must essentially be viewed in the context of long-term issues.

In the context of winds of change sweeping the country, manifold and multi-dimensional challenges of stepping up income, curbing interest expended and operating expenses, credit risk, diversification in banking activities, portfolio investment, payments and settlements systems, and so on, have come to the fore. Such unsettled issues and cognisable dilemmas need to be resolved on the basis of resource-mix, investment opportunities, demanding standards of customers and patterns of shifting value to streamline the banking system as an integral part of the blueprint of development.

The ongoing financial sector reforms have also brought about a major cohesiveness in the three markets — bank credit, money and security markets at the domestic level. The changed financial architecture has significant implications for corporate strategy, organisation and performance necessitating a move for banks to become `one-stop financial shops'.

Eight commercial banks have recently come under the purview of the RBI's risk-based supervision (RBS), as part of a larger roadmap, to move the banking system towards the New Basle Capital Accord.

Some of the key drivers of Basel II relate to technological advances leading to emergence of new financial products (through risk unbundling and re-bundling) and new ways of delivering them (e-finance), progressively larger deregulation, particularly in emerging market economies, demographic changes and the nexus of increased competition, enhanced search for shareholder value and spread of financial safety nets.

These forces and their interactions have been reflected in securitisation (commoditisation of credit, and its associated risks and their sale and purchase in the marketplace), globalisation and consolidation in the financial services industry. But Basel II Accord is an evolving process to handle financial innovation and increasing cross-border flows triggered by rapid technological advancements. Systemic reform of the banking system necessitates streamlined risk management, adequate capital provision, sound supervisory and regulatory practices, transparency and macroeconomic stability.

(The author is chief economist, Canara Bank, Bangalore.)