K C Chakrabarty: Banking and finance in India - developments, issues
and prospects
Inaugural address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at
the 62nd International Banking Summer School (IBSS), jointly organized by the Indian
Institute of Banking & Finance and Indian Banks' Association, New Delhi, 31 August 2009.
The assistance provided by Dr. Deba Prasad Rath and Mr. Sujit K Arvind in preparation of the address is
gratefully acknowledged.
* * *
Mr. M.V. Nair, Chairman IBA and Chairman and Managing Director of Union Bank of India;
Mr. Bhaskaran, Chief Executive Officer, Indian Institute of Banking and Finance;
Representatives from EBTN, Distinguished participants from different parts of the Globe,
invited guests, Ladies and Gentlemen:
I am delighted to be here amidst all of you at the 62nd International Banking Summer School
(IBSS) being organised by the Indian Institute of Banking and Finance (IIBF) jointly with the
Indian Banks' Association (IBA). I am thankful to the organisers and sponsors for providing
me an opportunity to share my views and interact with you at a forum which I personally rate
very high. Central bankers talk among themselves in various fora, it is high time that the
bankers talk with each other.
The School, open to senior bankers and financial professionals, as we are aware is a 10
days' brisk academic exercise that provides a platform for the practitioners of banking and
finance to learn and share the latest developments in the banking and finance field, best
practices and products available in today's fiercely competitive global banking arena. In the
present situation of global turmoil that we have been going through in the last two years, this
forum will provide opportunities to the bankers and finance professionals for understanding
each other better. The exchange of views and the ideas which are going to be generated
here during the next ten days will certainly throw useful insights and better understanding on
how to overcome such problems in future which will be of great relevance in shaping the
banking operations in future. I am saying so, as I am sure, in times to come, many of you are
going to occupy high positions in banks and Financial Institutions including positions of Chief
Executive Officers (CEOs). The takeaway from the School is, therefore, of great importance.
Considering the theme of IBSS this year and more focus on managing banks in the era of
turbulence, I think it would be appropriate if I share my views on a topic of contextual
relevance, that is, "Banking and Finance in India: Developments, Issues and Prospects" in
the backdrop of the global financial crisis.
A recent BIS report has stated that it is useful to think of the financial system as the
economy's plumbing. And like the plumbing in a house, the modern economic system
depends on a reliable flow of financing through intermediaries. Modern life requires the
smooth operation of banks, insurance companies, securities firms, mutual funds, finance
companies, pension funds and governments. These institutions channel resources from
those who save to those who invest, and they are supposed to transfer risk from those who
can't afford it to those who are willing and able to bear it (BIS, 2009). In India too, we have a
well-diversified financial system which is still dominated by bank intermediation, though the
size of the capital market has expanded significantly with financial liberalization in the early
1990s. Important components of the financial sector in India broadly fall into categories
namely; commercial banks, urban co-operative banks (UCBs), rural financial institutions,
non-banking financial companies (NBFCs), housing finance companies (HFCs), financial
institutions (FIs), mutual funds and the insurance sector. Commercial banks together with
cooperative banks account for nearly 70 per cent of the total assets of Indian financial
institutions.
Global banking trends and the crisis
Before I dwell on the developments in the Indian banking and financial arena let me first
touch upon briefly the global banking trends in view of the present crisis. The current global
crisis, as is well known by now, has its genesis in the imprudent practices of banks and
nonbank institutions worldwide, especially in the US. The fact that more than 80 banks have
failed in the US alone is a pointer to how deep and widespread the malaise was. Looking at
the past few years, it may be useful to divide the causes of the current crisis into two broad
categories: macroeconomic and microeconomic. The macro-economic causes fall into two
groups: problems associated with the build-up of imbalances in international claims and
difficulties created by the long period of low real interest rates. The microeconomic causes
fall into three areas: incentives, risk measurement and regulation (BIS, 2009).
The crisis is best regarded as the steep downside of an extraordinary global financial cycle
that was amplified by structural weaknesses. The financial imbalances that had built up
slowly but inexorably during the boom, on the back of aggressive risk-taking and leveraging,
had finally started to unwind. As elaborated in the BIS Annual Report (2009), financial cycles
are exacerbated by inherent difficulties in measuring risk and by distortions in incentives.
Episodic financial strains cannot be eradicated entirely; the market is not fully self-correcting.
But they can be mitigated or magnified by policy.
The crisis events can be traced to evidence of serious trouble emerging from when banks
became less willing to lend to each other, because they were no longer sure how to value the
assets held and the promises made - both their own and those of potential borrowers. For a
time, central bank lending was able to fill the gap. But from August 2007 the stress in the
financial system increased in waves. By March 2008, we are all aware, the crisis deepened
and Bear Stearns had to be rescued from failure; six months later, on September 15,
Lehman Brothers went bankrupt; and by the end of September, 2008 the global financial
system itself was on the verge of collapse.
Global crisis: US, Europe and emerging market economies
In the United States, the crisis was shaped by particular characteristics of the US financial
system such as a complex mortgage financing value chain with opaque securitization
structures, a large "shadow financial system" involving various poorly regulated
intermediaries (investment banks, hedge funds, structured investment vehicles - SIVs) and
instruments (credit default swaps), the important role played by government-sponsored
enterprises (Fannie Mae and Freddie Mac), as well as a fragmented supervisory
architecture.
The US financial system is in many aspects unique due to the high share of capital market
intermediaries and instruments. "Deposit money banks" account for a relatively low share of
financial system assets; the stocks of market instruments are significantly larger (including
private bonds), and the ratio of claims on the private sector to deposits is much higher.
Overall, these indicators reflect the much greater role played by large investment banks,
institutional investors, and other financial institutions, as well the extensive use of
securitization.
While financial institutions in the US are at the heart of the problem, European banks face
similar problems which shows how deeply interconnected national financial systems have
become. European banks have been hit nearly as strongly as their American peers by losses
from subprime mortgage investments, leveraged loans, failed financial hedges and a surge in
conventional credit losses. As per one study of June 2009, banks on both sides of the
Atlantic had to cope with combined write-downs of more than USD 1 trillion in this crisis -
and they may have to take USD 1.3 trillion more. Governments around the globe have had to
intervene to prevent a wholesale collapse of the financial system. They have injected more
than USD 200 billion in fresh capital into the top 20 banks alone; besides there are much
larger asset and debt guarantees.
Emerging countries have not developed the same complex financing structures as those in
the US, but several countries have already suffered from severe external imbalances,
caused by fiscal imbalances and/ or over-extended banking systems. These countries have
become particularly vulnerable, as the crisis is transmitted through financial and trade
channels. However, the specific channels of transmission may differ significantly across
countries. The basic structure of the financial system is, however, not expected to change
significantly, as banks still play a dominant role and capital markets are generally less
developed.
Hard-hit by the global financial crisis, the worldwide banking industry's future development
has now been sharply drawn into focus. Bankers and government officials will have to
grapple with important issues such as the best corporate governance model for the future of
an industry in which a number of banks have benefitted from government bailouts. Equally
important concerns such as the return of morality to the market, the definition of financial risk
and the tradeoff among innovation, self-discipline and regulation require the banking industry
to think outside the box. It has changed the face of Wall Street with lots of investment banks
changing their business models. What will the future holds for these financial institutions is a
subject being widely debated internationally to probe the future of the banking industry world
over. I am sure this school will devote some time for such discussions.
Role of banking/financial system in economy
In the analytical and empirical literature on the subject of finance and growth, there is a
consensus among economists that development of the financial system contributes to
economic growth (Rajan and Zingales, 2003). Financial development creates enabling
conditions for growth through either a supply-leading (financial development spurs growth) or
a demand-following (growth generates demand for financial products) channel. Empirical
evidence consistently emphasises the nexus between finance and growth, though the issue
of direction of causality is more difficult to determine. At the cross-country level, evidence
indicates that various measures of financial development (including assets of the financial
intermediaries, liquid liabilities of financial institutions, domestic credit to private sector, stock
and bond market capitalisation) are robustly and positively related to economic growth (King
and Levine, 1993; Levine and Zervos, 1998).
Financial deepening in India
In the Indian case, healthy growth of the assets of commercial banks in the recent period,
driven primarily by credit growth and sharp rise in credit-GDP, deposit-GDP and M3-GDP
ratios are reflective of significant financial deepening in India. For example, during the period
since 1980s, while bank assets-GDP ratio has tripled moving up from 31.4 per cent in the
1980s to 93.3 per cent in 2008-09, credit-GDP ratio has increased from 19.3 per cent to 52.2
per cent, deposits-GDP ratio has increased from 29.8 per cent to 72.0 per cent and M3-GDP
ratio has increased from 39.0 per cent to 89.5 per cent (Statistical Annex SA 1).
In a cross-country perspective, when measured by the ratio of bank assets to GDP, financial
depth in India was among the lowest in the world (Barth, Caprio and Levine, 2001).
Comparable cross-country data indicated that in 2001, this ratio, at 48 per cent for India, was
lower than those prevalent in Asian economies such as Indonesia (101 per cent), Korea (98
per cent), Philippines (91 per cent), Malaysia (166 per cent) and much lower than developed
economies, such as UK (311 per cent), France (147 per cent) and Germany (313 per cent).
In India, while the ratio of bank assets to GDP has increased significantly to a shade over 93
per cent in 2008-09 - a result of high credit growth in recent years - it is still lower than other
emerging countries. Financial deepening, hence, has been taking place on an accelerated
pace on a macro basis in recent years and banking productivity has improved significantly.
As per the data from India's national accounts, over the period since 1980s, banking and
insurance sector has witnessed a growth which is in excess of the overall GDP consistently
over the years. In the 1980s, the growth of banking and insurance sector was 10.6 per cent
vis-à-vis the GDP growth of 5.6 per cent - this increased to 15.4 per cent in 2007-08 vis-à-vis
the GDP growth of 9.0 per cent (Statistical Annex SA 2).
Another noteworthy feature discernible in Indian context is that the rise in indicators of
financial deepening takes place along with a noticeable rise in the domestic savings rate.
The rate of domestic savings has specially picked up in the recent period during 2003-04 to
2007-08 against the backdrop of financial sectors reforms, rise in total factor productivity and
investment boom, which had led to acceleration in the growth performance, while in the
developed countries like the US and Japan the rise in financial deepening has had a limited
effect on the savings rates of the economies. The results may seem contrasting; however,
the country specific reason such as the level of social security measures on welfare of
people, wealth effect in the period of rising assets prices and most significantly the
demographic profile which explain the Life Cycle Hypothesis (LCH) may have dampened the
savings propensity in a country.
A cautionary remark, however, I would like to make here. In the context of the
macroeconomic trend of high services sector growth which includes the banking sector growth, I
feel that the services growth needs to be well supported by growth from the real sectors of
the economy. Financial leverage cannot bring perpetual prosperity. Banks need to keep this
in mind, and I am telling this as a banker, as well as a central banker.
Indian banking trends
As you are aware, there is significant transformation of the Indian banking sector. The
financial sector reforms in the country were initiated in the beginning of the 1990s. The
reforms have brought about a sea change in the profile of the banking sector. Our
implementation of the reforms process has had several unique features. Our financial sector
reforms were undertaken early in the reform cycle. Notably, the reforms process was not
driven by any banking crisis, nor was it the outcome of any external support package.
Besides, the design of the reforms was crafted through domestic expertise, taking on board
the international experiences in this respect. The reforms were carefully sequenced with
respect to the instruments to be used and the objectives to be achieved. Thus, prudential
norms and supervisory strengthening were introduced early in the reform cycle, followed by
interest-rate deregulation and a gradual lowering of statutory pre-emptions. The more
complex aspects of legal and accounting measures were ushered in subsequently when the
basic tenets of the reforms were already in place.
Though public sector banks (PSBs) account for around 70 per cent of commercial banking
assets and 72.7 per cent of the aggregate advances of the Scheduled commercial banking
system (as on March 31, 2008), competition in the banking sector has increased in recent
years with the emergence of private players as also with greater private shareholding of
PSBs. Listing of PSBs on stock exchanges and increased private shareholding have also
added to competition. The new private banks which accounted for 2.6 per cent of the
commercial banking sector in March 1997 have developed rapidly and accounted for nearly
17 per cent of the commercial banking assets by end March 2008.
Financial health of the banking system
The implementation of reforms has had an all-round salutary impact on the financial health of
the banking system, as evidenced by the significant improvements in a number of prudential
parameters. Let me briefly highlight the improvements in a few salient financial indicators of
the banking system (Statistical annex SA 3 & 4). The average capital adequacy ratio for the
scheduled commercial banks, which was around 10.4 per cent in 1997, had increased to
13.08 per cent as on March 31, 2008. In regard to the asset quality also, the gross NPAs of
the scheduled commercial banks, which were as high as 15.7 per cent at end-March 1997,
declined significantly to 2.3 per cent as at end-March 2008. The net NPAs of these banks
during the same period declined from 8.1 per cent to 1.08 per cent. The reform measures
have also resulted in an improvement in the profitability of banks. The Return on Assets
(RoA) of scheduled commercial banks increased from 0.4 per cent in the year 1991-92 to
0.99 per cent in 2007-08. The Indian banks are well placed in this regard too vis-à-vis the
broad range of RoA for the international banks. The banking sector reforms also emphasised
the need to improve productivity of the banks through appropriate rationalisation measures
so as to reduce the operating cost and improve the profitability. A variety of initiatives were
taken by the banks, including adoption of modern technology, which has resulted in improved
productivity.
One area that needs to be watched continuously due to recent crisis is the off-balance sheet
(OBS) exposure of the banks. The spurt in OBS exposure is mainly on account of derivatives
whose share averaged around 80 per cent. The derivatives portfolio has also undergone
change with single currency Interest Rate Swaps (IRS) comprising 57 per cent of total
portfolio at end-March 2008 from less than 15 per cent at end-March 2002.
With regard to the assessment of the banking system in India we appear to be in a
comfortable position, as confirmed by the Committee on Financial Sector Assessment
(CFSA):
(i) Commercial banks have shown a healthy growth rate and an improvement in
performance as is evident from capital adequacy, asset quality, earnings and
efficiency indicators. In spite of some reversals during the financial year 2008-09, the
key financial indicators of the banking system do not throw up any major concern or
vulnerability and the system remains resilient; and
(ii) The single-factor stress tests carried for the commercial banking sector covering
credit risk, market / interest rate risk and liquidity risk have revealed that the banking
system can withstand significant shocks arising from large potential changes in credit
liquidity
quality, and conditions.
Lessons from India
The fact that India has not gone through any financial crisis as a result of financial
deregulation is not only remarkable, but a testimony to the correctness of the judgment that
reforms to global standards need to be adjusted to local conditions (Mohan, 2007). The need
of the hour is to have financial sector reforms in a recalibrated manner to address the issues
in light of the crisis. India has so far remained relatively insulated from the crisis that global
banking system has experienced in the course of the 1990s. Our exposure to troubled
subprime assets and related derivatives is negligible in comparison to many other economies.
The fact that, so far financial sector reforms have been calibrated with a progressive
integration into the world economy has paid us rich dividends. A key consideration in the
choice of pace and sequencing has been the management of volatility in financial markets
and implications for the conduct of monetary operations. The nuanced approach to financial
sector reform has served us well with an accent on conscious gradualism in the
implementation of coordinated and sequenced moves on several fronts. What have been
ensured are appropriate safeguards to ensure stability, while taking account of the prevailing
governance standards, risk management systems and incentive frameworks in financial
Overall, these progressive but cautious policies have contributed
institutions in the country.
to efficiency of the financial system while sustaining the growth momentum in an
environment of macroeconomic and financial stability. The policy challenge is, to continue to
ensure financial stability in India during this period of international financial turbulence, while
achieving high growth with price stability.
Some of the reasons for India's insulation as highlighted by Dr. Y.V. Reddy, the former
Governor of the Reserve Bank of India are: (1) The nascent stage of development of the
credit derivatives market; (2) Regulatory guidelines on securitisation do not permit immediate
profit recognition; (3) Perseverance of prudential policies which prevent institutions from
excessive risk taking and financial markets from becoming extremely volatile and turbulent;
and (4) Close co-ordination between supervision of banks and their regulation.
Future challenges to banking from the regulatory perspective
I would like to bring to the fore four issues that I consider very important for the future
regulatory reform process not only in Indian context but in the context of many emerging
markets as we move ahead. First is the issue related to "Know Your Customer (KYC)" in
banks; Second, from a central banker's perspective whether the banks are according "Fair
Treatment' to their Customers"
(FTC); Third, is the issue of "Risk Management" and its
proper understanding and Fourth is the Leveraging Technology for greater Financial
Inclusion. Let us discuss these four important issues in some detail now.
Know Your Customer (KYC) in all its manifestations
First is the issue of KYC in banks and its importance in the overall enhancement in the
functioning of the banks. Sound KYC policies and procedures not only contribute to a bank's
overall safety and soundness, they also protect the integrity of the banking system by
reducing the likelihood of banks becoming vehicles for money laundering, terrorist financing
and other unlawful activities. There are three components here. "Knowing their customers" is
not enough for banks, they should also know the "business" of their customers; (KYBC) and
if the banks know the business of their customers, the banks must understand and assess
the risks associated with each of their customers' businesses (KYCBR). The banks should
realize that these parts of Know Your Customer in all their manifestations, viz. Know Your
Customer (KYC), Know Your Customers' Business (KYCB) and Know Your Customers'
Business Risk
(KYCBR) is not only an integral part of elementary Risk Management Process
but it also makes a good business sense. Regulatory intervention in this area is going to
increase in future.
Fair Treatment to Customers (FTC)
Second issue is with regard to affording Fair Treatment to Customers (FTC) by banks. This
requirement is key to the operation of an efficient retail market for financial services. FTC is
also central to consumers having confidence in the financial services industry. This principle
must be adopted and supported by the leadership of financial firms, and embedded
throughout a firm's operations and within its culture. Another important aspect related to FTC
is from the Regulator's perspective. One may ask why the regulator should at all be
concerned about customers not being treated fairly by banks. In this connection, it is
important to note that not all financial entities are accorded the status of the "Banks". The
banks raise deposits many times more than the capital resources they have and hence they
have a special responsibility to customers for providing fair treatment. Banks need to
respond to the challenge of restoring consumer confidence in the financial services industry
and ensuring that they treat their customers fairly.
In addition, in a competitive marketplace, FTC should be an important element (alongside
service levels, pricing and customer satisfaction) in determining the success of a bank in
acquiring and maintaining market share. However, in many markets for retail financial
products and services the incentive structure for firms to treat their customers fairly has not
always been robust enough to deter all firms from inadvertently or deliberately taking
advantage of the relative weakness of the financial services consumer.
There should be a blend of regulatory and market-based solutions to delivering fairness to
customers. The key issue is the balance between these two. The issue of addressing the fair
treatment of customers throughout the product life-cycle comprises:
•
Product design and governance;
• Identifying target markets;
•
Marketing and promoting the product;
•
Sales and advice processes;
•
After-sales information; and
•
Complaint handling.
These issues will create challenges for banks. They may have to adapt the management,
reward and operating systems they currently use and enhance the controls they have in
place to monitor whether they are meeting the FTC requirement.
Thus, there is a need to develop a better, and common, understanding of what FTC means
in practice. Banks need to examine what most effectively constitutes fair treatment of
customers. Banks' senior management needs to assess their current performance against
the requirement to treat customers fairly, identify possible areas for improvement and ensure
that the principle of fairness is embedded in their work-culture.
Risk management
The Third issue which has assumed critical significance now is "Risk Management" and its
proper understanding. We cannot view banks' risks at individual level in isolation all the time.
It has also been argued that the emphasis on micro-prudential regulation may have
contributed to the buildup of some macro risks. Collectively, the systemic risk is becoming
more and more prominent with the increasing complexities and the associated risk factors in
the banking activities. The banks have to have a proper understanding of all the risk factors
and at the same time they have to ensure that their customers also understand and
appreciate the associated risk. In the event of such banking activities leading to the
emergence of systemic risks, the central bank may intervene which might result in stricter
regulation and supervision.
The most critical issue is of liquidity risk management in the banks in the wake of the crisis.
We may have a situation where the liquidity may dry up and the banks and the financial
institutions would face severe liquidity crunch due to adverse market conditions. In this
scenario, the liquidity crunch might completely wipe out the capital of the bank as well
leading to its failure. Another case might be a scenario where plenty of liquidity in the market
may fuel inflation. Therefore, we have to be vigilant and monitor the market conditions more
vigorously.
In recent times increase in the banks' dependence on bulk deposits to fund credit growth has
assumed significance as this could have liquidity and profitability implications. An increase in
growth in housing loans, real estate exposure as also infrastructure has resulted in
elongation of the maturity profile of bank assets. There is growing dependence on purchased
liquidity and also an increase in the illiquid component in banks' balance sheets with greater
reliance on volatile liabilities, like bulk deposits to fund asset growth. Simultaneously, there
has been a shortening of residual maturities, leading to a higher asset-liability mismatch.
There is a need to strengthen liquidity management in this context as also to shore up the
core deposit base and to keep an adequate cushion of liquid assets to meet unforeseen
contingencies. What needs to be borne in mind is that while at an individual customer level,
retail deposits may be volatile, but for the bank and the banking system as a collective lot, it
provides solid foundation for the banks to fund their long term assets like infrastructure and
similar business activities. How do we cultivate this aspect in our business model and Risk
Management Process is a great challenge.
Inclusive growth: financial inclusion through leveraging technology
Coming to Fourth issue, let me remind that, in the history of human civilization it has always
been the technology which has led to mass availability of products and services. Same is the
case for banking services. We are in the midst of the most exciting period of human
civilization when two billion of population is expected to move "up" from below poverty line to
above poverty line (BPL). Majority of these will be in this sub-continent and banks will have
an opportunity to participate in this process, which will bring sustainable peace and
prosperity to the mankind.
For achieving the goal of Financial Inclusion, experts have recommended the Business
Correspondent/Facilitator (BC/BF) model. However, some recent studies have pointed out
that the BC model at the initial stage, may not be commercially viable due to a high
transaction cost for the banks and customers. Here, the appropriate use of technology can
help in reducing the transaction cost. The need of the hour is to develop and implement
scalable platform independent technology solutions which, if implemented on a larger scale,
will bring down the high cost of operation. Technology, thus, really holds the key for financial
inclusion to take place on an accelerated scale.
The need of the hour is leveraging technology in Indian banking for providing affordable and
cost-effective banking services to the masses through multi-delivery channels. All of us know
that apart from traditional business, banks nowadays provide a wide range of services to
satisfy the financial and non-financial needs of all types of customers from the smallest
account holder to the largest company and in some cases of non customers. The range of
services offered differs from bank to bank depending mainly on the type and size of the bank.
The key enabling factor has been the adoption of technology. Banking industry is fast
growing with the use of technology in the form of ATMs, on-line banking, Telephone banking,
Mobile banking etc., plastic card is one of the banking products that cater to the needs of
retail segment has seen its number grow in geometric progression in recent years. The
internet banking is changing the banking industry and is having the major effects on banking
relationship. Retail banking in India is maturing with time; several products, which further
could be customized are in the retails segments of housing loan, personal loan, education
loan, vehicle loan, etc.
Being convinced that technology is the key for improving in productivity, the Reserve Bank
took several initiatives to popularize usage of technology by banks in India. Periodically,
almost once in five years since the early 1980s, the Reserve Bank appointed Committees
and Working Groups to deliberate on and recommend the appropriate use of technology by
banks given the circumstances and the need.
Even as global financials face growth and asset-quality issues, Indian banks continue to offer
a healthy growth trajectory with minimal balance-sheet risks. Despite the high growth rate of
the past decade, penetration for most financial products/services in India remains low. Indian
banks can sustain their structural high growth trajectory, driven by an under-penetrated
financial-services sector, a conducive economic environment and a supportive regulatory
regime. Financial penetration holds the key to financial inclusion and inclusive growth.
Favorable demographics would be a facilitating factor. Way forward, financial penetration is
expected to rise as banks expand into new areas, focus on building their retail business and
strengthen their risk-management system.
Conclusion
To sum up, while global banking developments have offered innumerable perspectives,
important perceptions are emerging from the Indian banking developments. Given the long
term objective of achieving 9.0 per cent of GDP growth, we need to understand that there are
significant challenges for Indian banking. Of these, the major challenge would be to achieve
financial inclusion through improved financial penetration in hitherto uncovered areas, which
in turn would enable inclusive and sustainable growth for the economy. We all have to put
our minds together and continually strive towards achieving this in the days ahead.
what will
The question currently on top of the minds of most bankers present here would be:
be the shape of banking in days to come? Will banks do business differently? What are the
changes that are likely to take place? The answer to these questions may come out from
some serious deliberations in the next few days and bef