K C Chakrabarty: Indian banking sector - towards the next orbit
Inaugural address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at
the 9th Advanced Management Programme at IMI, Delhi, 13 February 2012.
* * *
Assistance provided by Smt. Theresa Karunakaran and Shri Sanjeev Prakash in preparation of this address is
gratefully acknowledged.
Dr. Pritam Singh, Director General, International Management Institute, Dr. Ahindra
Chakrabarti, Programme Director, participants from Reserve Bank of India and the
commercial banks.
It gives me great pleasure to be before you today as you embark on this journey of learning
here at IMI and later across Paris, Berlin and Milan to imbibe the culture of these countries
and the best practices. The Advanced Management Programme is the ninth in the series and
includes study visits to central bank/leading commercial banks of these countries and
interacting with their senior management, the objective being to enable the participants to
see world class banking systems, understand the strengths and weaknesses of the
European banking system and develop awareness and appreciation of the emerging
business environment. Lectures and interactions with some leading academicians and
management experts of the European business schools will give rare insights to the
participants on present status of the Eurozone economies. Apart from the structured
classroom learning, these kind of programmes offer a unique opportunity to the participants
for learning from each other and also understand the best management practices across
organizations. It is expected that the participants will try to develop further on these best
practices and implement them in their organizations in their own way. All these and more are
required as each one of you have a role to play in taking Indian banking to the next orbit.
Having said that, I have been asked to speak on "The Indian Banking Sector: Towards the
Next Orbit". I would like to begin with an analogy. A spacecraft needs to achieve a certain
momentum before it breaks free from the earth's gravitational pull, leaves behind the familiar
and comfortable and enters into the unchartered vastness of a new orbit. The success of the
mission and certainty of reaching its goals would lie in how effectively it has made its
preparation, the skills of its crew and its ability to manage the risk of turbulence and
overcome the snags and obstacles in its flight path. The banking system is no different. To
move into the next orbit, it is vital to understand the environment we are in, the inefficiencies,
the pitfalls that limit growth and build on synergies and innovation for catapulting it into the
future.
The outlook for the global economy remains uncertain with green shoots of optimism in the
US as fresh jobs were added, but the Eurozone remains embroiled in uncertainty of decision
making and lack of consensus with the battered economies unwilling to commit bailout funds
to the troubled nations. India has been more fortunate in that it has emerged virtually
unscathed from the global crisis. A combination of strong regulation and supervision and a
will to evolve policies that lean against the wind helped insulate the Indian financial system
from the crisis. It helped too that the Indian banks were not very sophisticated and
excessively leveraged. However, in a world where financial systems recognize no
boundaries and the fortunes of nations are intertwined, no nation can consider itself an island
and remain immune to the changes in the tides of the world economy for a prolonged period.
If the envisaged growth rate of 9 per cent per annum during the Twelfth Plan is to be
achieved and banks have to remain competitive and continue to improve their margins, they
would need to look at the new drivers of growth.
I. Key drivers for propelling Indian banking sector
A recent IBA-FICCI-BCG report, titled "Being five-star in productivity-Roadmap for excellence
in Indian banking" has projected that the domestic banking industry is set for an exponential
growth in the coming years with its asset size poised to touch USD 28,500 billion by the turn
of the 2025 from the current asset size of USD 1,350 billion (2010). It is fairly obvious to
presume that scope for such growth rates would inevitably usher in more competition for the
Indian banks aided in part by regulatory impulses and increased openness of the Indian
economy. Simultaneously, the reach and penetration of banking is going to increase
tremendously due to the policy spotlight on inclusive growth and financial inclusion. Aiding
the transition would be another fortuitous transformation in human resources area. Public
sector banks which account for nearly three fourths of the one million people working in
Indian banks face the prospect of retirement of nearly 55 per cent of their people in the next
decade. Thus, if ever there was a time for right sizing the organisation, hire the right talent,
the right skilling of the workforce and bring about a cultural transformation, the time is now.
We are, therefore, on the cusp of a defining decade in banking history. What are the key
drivers that would propel the Indian banking sector into the next orbit? To answer this, I
would draw upon extensively from an address I delivered at BANCON 2011 where I have
identified three sets of drivers - external, regulatory and internal which will define banking in
the next decade.
i. External drivers
A. Financial inclusion
The overriding and most transformative driver would be the policy imperative to extend the
reach of banking services and to provide fair, transparent and affordable products and
services. To borrow from the spacecraft analogy given previously, the momentum to escape
to the next orbit will come from universal financial access. Apart from the potential to expand
banks' business manifold besides acquiring new customers for other value added services,
they would have the satisfaction of contributing immensely to higher inclusive growth. This is
an opportunity which will not present itself again. With the Government of India and the
Reserve Bank prioritising financial inclusion, banks have been encouraged to expand the
network through setting up of new branches and also through the Business Correspondent
Model. Resultantly, the population per bank branch improved from 14000 in 2009-10 to
13466 in 2010-11 while population per ATM from 19,700 to 16243 during the same period.
In June 2011, banks were advised to allocate at least 25 per cent of the total new branches
to un-banked rural centres. The number of branches opened in hitherto un-banked centres
has increased from 281 in 2009-10 to 470 in 2010-11, but the population per bank branch is
significantly higher than the national average in the North East, Eastern and Central Regions.
To strengthen the outreach of banking services, banks were advised to cover all villages with
more than 2000 population with at least one banking outlet by March 2012 and also
encouraged to cover peripheral villages with population less than 2000. Banks were also
required to put in place Board approved Financial Inclusion Plan (FIP) and the Reserve Bank
is monitoring the implementation of these plans. Significantly, the number of villages covered
by at least one banking outlet grew by 82 per cent in 2010-11 over the previous year,
besides 47 per cent of the villages covered under FIPs were villages with population less
than 2000. Almost 77 per cent of the villages covered were through business correspondent
model. The number of no frills accounts also grew by 50 per cent. While considerable
progress has been made, a lot more needs to be done to garner the savings of households.
The moderating of financial savings of households from 12.1 per cent of GDP in 2009-10 to
9.7 per cent in 20010-11 is an area of concern. Banks need to tap into the untapped
business opportunities for resources to power the growth engine. A GDP growth target of
9 per cent requires harnessing resources and fortune at the bottom of the pyramid. The small
customers are the key to big business opportunities waiting to be tapped. Improving the
quality of life of the people of our country by enabling them to have access to banking
services could be the next big game changer as it could unlock the vast potential of rural
India.
B. Competition, consolidation and globalisation
The past decade has virtually been a sellers' market in so far as the Indian banking sector is
concerned. The ability of the customers to choose the banking products and services were
severely restricted since they could hardly differentiate between the product and service
offerings of banks. The design of products and services was more bank-centric than
customer-centric. A bank would now need to convince a customer as to why he should bank
with them rather than another bank. While the lack of innovations by the banks could partially
be attributed to the extant regulatory regime, the banks on their part have also remained
largely unimaginative and lacked inspiration to experiment even after freeing of interest rates.
The recent regulatory initiatives like deregulation of savings bank interest rates, opening of
government business to more banks, etc. and some imminent steps such as licensing of new
banks and subsidiarisation of the foreign bank branches, on the one hand, and the changing
profile and simultaneously rising aspirations and expectations of the customers on the other,
should make the turf more competitive and increasingly, a buyers' market.
In view of the impending competition, banks would be forced to take a hard look at their
existing bouquet of product and service offerings and customer base so that they may
reposition themselves as "differentiated and niche" players. The increased competition could
also drive a spate of mergers among existing players and lead to consequent consolidation
within the sector. The entry of new players will also spur efficiency and productivity in the
system. While, at the moment, financial inclusion takes precedence, once financial inclusion
is substantially achieved, the banks may focus on consolidation. As the Indian banking sector
is propelled forward to a higher orbit, the banks would have to strive to remain "relevant" in
the changed economic environment by reworking their business strategy, designing products
with the customer in mind, focussing on improving the efficiency of their services and having
global ambitions. The mantra would be to "Innovate or perish".
Globalisation of Indian banks could be a consequence of their customers becoming global
once increased competition and consolidation set in. Apart from banks' own global ambitions,
as Indian businesses turn global, their need for financial products and services would be
reason enough for banks to go global to service them. However, banking is a business of
size and more so for those that harbour global aspirations. Hence, consolidation is one way
to achieve the needed scale. Thus, the second set of external drivers that could propel the
Indian banking to the next orbit would be increased competition, consolidation and
globalisation.
ii. Regulatory drivers
The next set of drivers which would also be essentially external in nature would be those
provided by the regulator. Across the globe there is an increased convergence and
realisation that regulations would become more stringent especially in the areas of providing
fair treatment to customers, KYC norms and risk management.
A. Fair treatment to customers
In recent times, the provision of fair treatment to customers has gained prominence globally.
The writing is firmly on the wall that regulations in this area are likely to become stricter in
years to come. Banking/ financial services industry being a highly regulated industry with stiff
entry norms, regulators have a critical role in ensuring fair treatment to customers and it
cannot be left to the market forces alone. Banks need to price their products and services
fairly and competitively and ensure higher transparency in their products and pricing. Lack of
transparency in designing and pricing of products and services and selling them to
inappropriate customers could expose banks to litigation, reputational risks besides making
them liable for supervisory action. There should be no unreasonable post sale barriers if the
customers wish to change product or bank. Customer education is also critical to providing
appropriate and need based products and services and Indian Banks' Association may have
a critical role to play in this regard. The banking business would thus have to turn customer
centric in all its true dimensions.
B. Knowing your customer
A customer-centric business needs to know its customer, the nature of his business and the
inflows/ outflows into the accounts, if it is to provide customised business products and
solutions. But, banks need to understand the risks associated with customer's business to
manage risks arising from potential delinquency, fraud and consequent losses as also legal
and reputational risks arising from exposure to customers having links to Multi level
Marketing (MLM) business/terrorist activities/hawala transactions, etc. Know Your Customer
(KYC), Know Your Customers' Business (KYB) and Know Your Customers' Business Risks
(KYCBR) should be ingrained in the DNA of the bank's business. It should be understood
that it is not just procedural compliance, but that good KYC and KYCBR compliance are
good for the bank's business.
The banking system runs on information and data. Although financial data are made up of
innumerable complex components, one of the fundamental building blocks is reference data
about companies, organizations, firms and individuals customer. Reference data might
include a number of things, but an essential component is a systematic structure or code that
uniquely identifies each entity. Essentially a bank should have a Unique Customer
Identification (UCI) Code which helps it to identify a customer, track facilities availed, monitor
financial transactions in various accounts for compliance with KYC/AML regulations. A key
factor in ensuring KYC compliance is having a Unique Customer Identification Code which
may serve as a lynchpin for financial data and assist in improving regulation, risk
management and business processes. It would help the bank identify the customer, track
facilities availed, monitor financial transactions across accounts for compliance with
KYC/AML regulations. The UCI should eventually graduate to a Legal Entity Identifier (LEI)
which is a unique ID associated with a single corporate entity which assists in easy
identification of the same party across multiple financial market utilities and aids in tracking
settlement activity and exposures. The financial crisis clearly demonstrated the extreme
"complexity of interrelationships" and dependencies that exist between parties,
counterparties, issuers, guarantees, and guarantors and the domino effect that takes place
should one or more of the nodes within these horizontal or vertical relationships come under
pressure. Unique identification of each and every entity would be critical to unravelling these
linkages and (inter)relationships.
Some of the Indian banks have developed UCI numbers which enables them to track the
transactions of customers across the bank and monitor customer wise exposure limits,
account status and generate AML alerts/reports for FIU-IND filings etc. However, there is no
unique number to identify a single customer across the banking system based on a shared
database which provides an avenue for the customers to circumvent the risk profiling
guidelines and obtain multiple facilities across banks by opening several accounts. Even for
banks that have some form of unique customer identification, there is no guarantee that a
single customer does not hold multiple IDs.
The principles behind the Legal Entity Identifier (one entity - one identifier) could be
borrowed for shaping the KYC/ AML framework for the Indian banks. Towards this end, the
UIDAI initiative, Aadhaar, launched by the Government of India, which is envisaged to issue
a unique identification number to individuals that can be verified and authenticated in an
online, cost-effective manner for eliminating duplicate and fake identities, could be leveraged
upon by the banking system. It is heartening to note that UIDAI uses a state of the art
biometric technology (combining both - 10 Finger Prints and 2 Iris) and has achieved a high
degree of accuracy (99.96 per cent) in duplication detection.
Presently the Reserve Bank guidelines permit the use of Aadhaar as a KYC document for
small accounts. Since the coverage of the entire set of bank customers/potential customers
under Aadhaar would take time, in the interim, the banks should consider putting in place
unique identification numbers for each of their customers and filter out multiple banking
facilities availed by them through a de-duplication exercise. The banks could also work jointly
to set up a shared database which would enable them to securely see information on a
customer (KYC information and facilities availed from various banks etc.) based on a unique
identifier i.e. his Aadhaar ID. In the process, banks would be able to leverage upon the KYC
exercise already carried out by the previous bank and also benefit from consequent lower
customer acquisition costs, simplified account opening processes without repeated
burdensome procedures for the customers and also promote financial inclusion.
C. Risk management
The road ahead demands that banks further refine their risk management skills for enterprise
wide risk management. Globally, there is an inexorable move towards more advanced
approaches to risk management. However, we are still at a very rudimentary stage. As
capital comes always at a cost, banks need to have in place a fair and differentiated risk
pricing of products and services. This involves costing, a quantitative assessment of revenue
streams from each product and service and an efficient Transfer Pricing Mechanism which
would determine capital allocation. Each business unit in the enterprise would have to aim at
being a profit centre within the overall risk -return framework. In essence, it would mean
accountability for profit tempered by the discipline of risk-return within a deeply embedded
culture of good governance, the tone of which is set by the bank's Top Management. As an
illustration, the base rate is intended to serve as a benchmark for interest rates. Our past
experience has been of poor customers subsidising the rich borrowers. Also, there are
incidences of rampant mis-pricing of risks. From a business perspective, pricing of assets
should be non-discriminatory and in line with risk rating of the customer. A lower rated
customer should not get a better price than a higher rated customer. Once these basic
issues are addressed, other issues such as migration to advanced approaches etc. would
gain importance.
Migration to advanced approaches under Basel II
All the Indian banks have adopted the standardised approaches under the Basel II
framework in 2009, however, the pace of migration to the advanced approaches has
naturally been very slow. Though the Reserve Bank has set an indicative time schedule for
implementation of the Advanced Approaches, banks' response has been less than
encouraging so far. Migration to the Advanced Approaches is important for larger banks
because it involves adoption of more sophisticated risk management systems. Moreover,
there are reputational issues too if large banks continue with standardised approaches. Apart
from the fundamental issues mentioned above, much of this sluggishness could be attributed
to issues relating to development of human resource skills, technology upgradation, branch
interconnectivity, availability and management of historical data, robustness of risk
management systems, etc. within the banks. Even within the Reserve Bank, the supervisors
would have to make rapid strides to be able to appreciate the nuances associated with the
quantitative techniques and modelling.
Journey to Basel III regime
(a) Capital
An assessment of Indian banks' capital requirements under Basel III has revealed that,
notwithstanding some issues with a few individual banks, the system as a whole, is very well
capitalised and the transition to the revised capital norms of overall capital adequacy, Tier I
component or equity component would be smooth. The stress, however, could however arise
from a need for the banks to adjust the unamortized portion of Pension and Gratuity liabilities
in the opening balance sheet on April 1, 2013 on transition to IFRS.
(b) Addressing too-big to fail
The negative externalities associated with the large and complex financial institutions forced
the Central Banks/Governments the world over to bail them out during the financial crisis by
committing taxpayers' money. With an eye on reducing the probability and impact of failure of
such global systemically important banks (G-SIBs) as also to reduce the inherent competitive
advantages they enjoy in the funding markets, the standard setters have agreed on a
combination of capital surcharges, better resolution regimes, living wills, more robust
financial market infrastructures and a more intense supervision for these systemically
important financial institutions since then. Large size, excessive interconnectedness, reliance
on a single or few firms for the provision of key financial infrastructure, and complexity of
operations and cross-border activity have been identified as key indicators of systemic
importance of internationally active banks by the Basel Committee on Banking Supervision
(BCBS). Financial Stability Board (FSB) has since released the names of the 29 banks which
have been reckoned as G-SIBs based on the criteria laid down by BCBS.
While none of the Indian banks feature in this list of 29 G-SIBs, the BCBS and FSB are
already working towards laying down a criterion for identification of domestic SIBs which
would need to be subjected to additional capital and liquidity requirements on the lines of that
applicable to the G-SIBs. The industry may argue that the Indian banks are very well
capitalised and no additional capital may be necessary on account of the SIFI-ness of the
banks. As part of the superequivalence to Basel III banking reforms, under which the national
regulators prescribe a much higher regulatory capital ratios as compared to the Basel
norms,, the Swiss banking regulator has already set much more stringent capital
requirements for the largest Swiss banks and the United Kingdom is expected to follow suit
based on the report of the Independent Banking Commission.. The readiness of banks to
these evolving regulatory requirements would very critically determine whether they can
successfully transit to the next orbit.
iii. Internal drivers
A. Managing human resources
An organisation can only be as good as its people. They are the force behind innovation,
business process re-engineering and making the difference between success and failure. A
committed and highly motivated work force can make the difference in winning and retaining
customers as banking is a people oriented business. Banks have to be knowledge
organisations, able to attract and retain talent. HR policies should look at right size, right fit
and career growth with market related compensation. Increasingly, there is a going to be an
intense competition for the right kind of talent as they are likely to be in short supply. The
demand will not only stem from domestic institutions but it will also be from foreign
institutions and countries. The challenge before Indian banks is therefore to revitalise
themselves by hiring the right talent, investing in training and bringing about a vibrant
transformation in their DNA, in effect doing what Sumantra Ghoshal, the management guru
and Founding Dean of the Indian School of Business, called changing the "Smell of the
Workplace". Successful organizations, he felt, exude a vibrancy which uniquely defines the
"Smell of the Workplace". Ghoshal describes the smell of the air in the forest of
Fontainebleau, 40 miles south of Paris, the vibrancy which spurs the casual walker to run,
jog or do something, and is in essence revitalising. He compares it to downtown Kolkata in
summer which is hot and drains energy and vitality. Most large companies in India and
abroad, he felt end up creating downtown Kolkata in summer inside themselves. The smell of
the workplace then becomes encapsulated in an environment of constraints, where
jobs/relationships are only contracts and actions are defined by control and compliance. As
opposed to it, successful companies promote stretch, which means doing more with self
discipline, as opposed to control there is support and enhancing collaboration across the
organisation through combination of support on the one hand and trust on the other. The real
source of competitive advantage in organizations is not merely in technology but in the
behaviour of individuals in the organisation where each one of them takes initiative,
collaborates, has self confidence, has commitment to himself, to their teams, to their units,
and to their organisation. The challenge before management is to use the vast unused
potential in people and make ordinary people produce extraordinary results thereby changing
the smell of the workplace.
B. Leveraging technology
A recent article in the Economic Times dated December 27, 2011 detailed how e-governance
initiative helped check grass root pension fraud. In Keregodu village in Karnataka's Mandya
district, senior citizens, all 65-plus, face an endless wait in front of the local post office for
their pension money orders. Hours later they are told by a post office official - "the money
had already been collected by someone". In this south-eastern district of Karnataka,
thousands of pensioners haven't received their pension and entitlements for months - it is
siphoned off in transit. Even worse, out of the 2,95,525 pensioners in the district - whose
allowances get released from the state treasury every month - names of 37,000 are missing
- causing a monthly loss of nearly Rs 1.48 crore to the exchequer (or Rs 17.76 crore a year).
The state also suffers on account of distribution and delivery losses for pensioners whose
name exists but still do not get their money. But the situation in Mandya, a thriving
agricultural town till the late 1980s, is set to change with the state government along with an
IT services firm digitising the entire pension records and issuing smart cards to pensioners to
plug the leakage. It is perhaps one of the biggest financial inclusion projects where
technology can come to the aid of thousands of old and poor farmers, widows and other rural
pensioners. But that's only the first part. For the last-mile authentication and financial
transaction, the state government has tied up with a Karnataka-based bank. A bank
correspondent will now be sent to each pensioner's house with a card-reader where the
pensioner would swipe his smart card and give his thumb impression. Once the bank
receives the data at its central server, the amount would be credited to the pensioner's bank
account. The system is expected to fight ground-level corruption by cross-checking the
pensioner's identity against multiple databases, making it difficult for any single agency or
person to log false information. This would make a huge difference to the lives of the
pensioners. Technology, the will and desire to make a difference to the lives of the rural poor
living on the fringes of financial exclusion are the change agents.
Most banks are already on Core Banking Systems (CBS) which covers banking operations
pertaining to deposits, withdrawals, credit delivery, back-office operations etc. Banks need to
look beyond Core Banking to harness the benefits of technology. CBS could provide inputs
for developing customised products based on customer data base. It would help in planning
product delivery and service at multiple/selected delivery points and better Customer
Relationship Management and building lasting customer relationships which will translate
into higher revenues. Technology needs to be more customer focussed than employee or
vendor focussed. The costs of banking transactions need to be dramatically reduced just as
in so many other fields such as telecom after the advent of technology. In case of glitches,
the rectification must be swift to instil faith and confidence in the system. It is only the more
agile and innovative players who will stay ahead in the game. Along with IT solutions arise
allied issues such as IT security, governance and audits. Gaps in IT security could make
banks vulnerable to data piracy, fraud and operational risk leading to reputation risk and
erosion of customer confidence.
C. Improving managing information systems
MIS is an inseparable part of bank's decision making process. The integrity and timeliness of
data is critical in formulating the bank's capital planning, business strategies, reviewing
achievements vis-a-vis targets, formulating course correction exercises where required,
feeding data into stress tests and importantly taking action on the outcomes. This brings us
to technology support for decision making. Banks have made huge investments in
technology, which should be translated into better MIS as decision support systems and yield
returns on investment by providing economical, affordable and customised customer centric
banking solutions. The use of technology should not be seen as an end in itself but as a
means to an end.
D. Business plan, strategy and vision
The role of banks' Boards would become increasingly crucial in the next decade in view of
the looming competition. The Board would need to have a clear vision for the bank, a
strategy to achieve its objectives, both medium and long-term and a well laid out long-term
plan. The banks would need to look beyond their existing customer base and large
corporates and reach out to rope in the vast number of small, retail and the SME clients
which are presently deprived of bank credit. Alongside extending the reach of their banking
services there would be a need to improve the products offered to customers and the quality
of services. They need to have proper business model and delivery model.
II. Managing change in the emerging regulatory and supervisory landscape
It has become fashionable to attribute any adverse feature to the economic downturn.
Perhaps, we need to draw the right lessons, learn from it and move ahead so as not to
repeat it in future. As an example, the 2011 financial results of most banks show a growing
increase in NPAs. While some slippage in an economic downturn is inevitable ,it does not
absolve banks from quick mortality/slippage due to adverse credit selection, lack of critical
credit appraisal and due diligence, laxity in monitoring end use of funds and performance of
the account. I am reminded of a story in the times of the Great Depression.
A man stood at the street corner every day selling hamburgers. He was cheerful and whistled
a tune as he sold his tasty hamburgers. His cheerful demeanour and modestly priced
hamburgers had a brisk sale. He had through his trade managed not only to do well but also
put his son through University. One day when the son came home on a holiday and saw his
father plying his trade as usual he was surprised. "Dad", he said, "You shouldn't be making
so many hamburgers as we are going through the Great Depression". And then the boy
proceeded to educate his father on the finer details of the Depression. The father thought
over what his son said and made fewer hamburgers. At work he was preoccupied and less
cheerful each day. Soon sales dwindled. Returning home one day with his products unsold,
he said to his son: "Son, you were right about the Great Depression. That's the advantage of
a university education!"
The stable funding profile of commercial banks - strong retail franchise and relatively less
dependence on wholesale funding is a comforting factor. Even under a worst case scenario
wherein the quarterly growth rate of September 2011 in gross NPAs and gross advances
continues for the next two quarters and GNPA ratio reaches 3.74 per cent; the system would
remain resilient as per the results of the credit risk tests mentioned in the latest Financial
Stability Report (FSR). The report goes on to predict that even under a worse case scenario
when NPAs are assumed to grow by 150 per cent and th