K C Chakrabarty: Indian banking sector - pushing the boundaries
Valedictory address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India,
at the 11th Advanced Management Programme "Towards the next orbit - Indian banking
sector", organized by the International Management Institute (IMI), New Delhi, 14 February
2013.
* * *
Assistance provided by Ms Dimple Bhandia in preparation of this address is gratefully acknowledged.
1. Dr Pritam Singh, Director General, International Management Institute (IMI),
participants from Reserve Bank of India and the commercial banks! It is a pleasure to be
amongst you today as you complete the first leg of the learning experience which is the
Advanced Management Programme. I believe that the programme is craftily designed with
an appropriate blend of lectures and interactive sessions with some leading academicians,
industry captains and management experts, both from India and from European business
schools. It is a rare learning opportunity for all participants - to understand and gain insights
into global banking systems and develop awareness and appreciation of the emerging
business environment. Apart from the opportunity to gain from structured classroom learning,
such programmes also offer a unique forum through which participants can learn from each
other and assimilate the best management practices across organizations. I hope all of you
will take advantage of this wonderful opportunity.
2. Being a part of the banking system, which forms the core of the financial
architecture of the economy, you have an inimitable opportunity to influence the economic
lives of the nation's populace. We all know that banking plays a silent, yet crucial part in our
day-to-day lives. The banks perform financial intermediation by pooling savings and
channelizing them into investments through maturity and risk transformations, thereby
keeping the economy's growth engine revving.
3. The central theme of the programme, as in the previous year, is: "Indian Banking
Sector: Towards the next orbit". The theme is, arguably, even more relevant today than a
year ago. While, on the one hand, the outlook for the global economy continues to be grim,
the outlook for the domestic economy is also far more subdued than the last year. Growth of
the Indian economy for 2012-13 is projected at 5 per cent - significantly below the 9 per cent
growth rate envisaged during the Twelfth Plan and well below our desired goal of double digit
growth rate. The Indian banking sector has also faced significant challenges. Asset quality of
banks has come under increasing pressure with rising NPAs and Restructured loans. The
Gross NPA ratio for the banking system, which was 2.4% in March 2011, increased to
3.6 per cent by September 2012. Going forward, the banking system will continue to face
a challenging environment given that its fortunes are closely linked with those of the
economy - domestic and global.
4. Having seen the challenges before the Indian banking system, what are our
motivations for discussing, today, the issue of taking the Indian Banking Sector towards the
next orbit? Our elementary knowledge of astrophysics would tell us that for being propelled
to the next orbit, a rocket needs to pull against the earth's gravitational force. For this, the
rocket needs to have the requisite fire power to generate the necessary "escape velocity".
Also, the rocket needs to be in a stable condition before the blast can propel it to a higher
orbit. In the absence of adequate propellant force, the rocket would fail to defy the force of
gravity and would crash land.
5. So, as we deliberate upon this issue today, are we comfortable with the dynamism
and stability that the Indian banking system possesses? What do we actually wish to achieve
by taking the banking sector to the next orbit? The issue which needs to be addressed is
whether we - from the regulatory community or as part of the commercial banking sector of
the country - are satisfied with the financial system as it exists today. The answer to this
question is not very comforting. Events in recent years have called to question the relevance
and purpose of the financial sector. Episodes like the "Occupy Wall Street" movement leave
little scope for doubt that the global financial crisis has left the financial sector discredited.
Thus, if the financial system has to play a purposeful and relevant role in the economy and if
it has to regain its credibility, it will have to develop the necessary fire power and stability and
move to the next orbit.
6. What are the key drivers for propelling the banking sector forward? Which are the
key factors that will determine whether the banking system is able to transform itself into a
relevant, purposeful and credible system? What are the major challenges and hurdles
ahead? What are the major goals that the banking sector has to achieve in the next few
years? I will spend some time in trying to answer these questions.
The key drivers and challenges for the banking system originate from different sources.
7. First, the regulatory environment in which banks in India are functioning is
undergoing a paradigm shift. In particular, with the implementation of the global reforms
agenda relating to Basel III, implementation of OTC derivative reforms, reducing reliance on
credit rating agencies, amongst others, the regulatory landscape of banks is set to change
forever, both domestically and in the global arena. This will, inter alia, require banks to fine
tune and refine their risk management systems.
8. Second, the growing global emphasis on fair treatment to customers, financial
inclusion and improved Know Your Customer (KYC) practices will require banks to reorient
their business models, their data and information systems, and, in fact, the very mindset of
banking, if banks have to remain relevant, going forward.
9. Third, impending developments in regulatory policies are likely to result in banks
facing a far more competitive environment in the coming years relative to what was, virtually,
a sellers' market so far. As banks' customers - both businesses and individuals - become
global, banks will also need to develop global ambitions. The challenge for banks will be to
develop new products and delivery channels that meet the evolving needs and expectations
of its customers.
10. Besides the formidable challenges that the evolving global regulatory and
supervisory landscape present for banks, the developments in the domestic business/
regulatory environment will also need to be factored in as banks set about recalibrating their
business plans. For instance, in line with global developments, India is also embarking upon
a project to develop a framework for assigning a unique Legal Entity Identifier for all
customers accessing the formal financial system. However, before attaining this goal at a
national or global level, we need to immediately ensure that within each institution a
customer is assigned a unique ID and that there are no instances of multiple customer IDs
for the same customer. This is important not just from the perspective of better management
of customer business, but also for an effective AML framework.
11. Similarly, frauds are a cause for concern within the banking system, particularly for
the public sector banks, which account for a large proportion of total frauds reported in the
banking system. Frauds do not just represent lost money; they also indicate serious gaps in
banks' systems and processes and in the internal control framework. Plugging these gaps
and institutionalizing a mechanism for identifying accountability and taking stringent action
against the perpetrators of the frauds is very important for tackling this menace.
12. The leveraging of the banking system by Multi-level Marketing (MLM) companies to
defraud common people of their hard earned money is another critical challenge that
financial sector supervisors are facing in various jurisdictions, including in India. It results in a
loss of confidence of customers in the formal financial system and could have severe
adverse implications, particularly at a time when we are putting all our energies into bringing
the marginalized groups within the fold of the banking system.
13. All these developments will present significant challenges for the banking system
and banks will need to face them head-on in the coming years. To gear up to these
challenges, banks will need to look inwards - at their human resource management, their
information systems and the technology at their disposal. Importantly, they will need to look
into the efficiency with which they perform their functions - that of credit intermediation and
the allocation of funds to the most productive sectors of the economy. These will be the key
internal drivers of change if banks are to gear up to the emerging regulatory and external
environment and move into the next orbit.
Let me now dwell on some of the major issues in a greater detail.
Risk management
14. The risk management challenge for banks has been steadily growing over the last
two to three decades. This can be attributed to several developments in the financial sector
over the last couple of decades. First, the deregulation of financial markets led to increased
volatility placing greater demands on banks to manage their risks. Second, banking activities
diversified from the traditional function of lending and borrowing to a larger set of activities
including, inter alia, custodial services, securities underwriting and corporate advisory. Third,
complex global financial institutions emerged leading to growing inter-connectedness of the
financial system. Fourth, the role of securities and derivative products in banking expanded
with increasing growth of complex financial products. The recent financial crises have further
reemphasized the importance of risk management frameworks for banks.
15. The question for the Indian banking sector is to what extent the risk management
framework in banks are oriented towards identifying risks and tracking the passage and path
of risks so as to be able to price the risks appropriately. My own view is that we in India are
still at a rudimentary stage and hence, the banking system needs to urgently work on
upgrading its risk identification, management and pricing abilities.
16. An associated issue arising in this context is the growing importance of stress
testing. Stress tests, typically, assess the resilience of banks to shocks in an extreme
adverse scenario as compared to a baseline scenario. It also provides banks' management
with a tool to improve their internal risk managements by identifying the stress points in their
operations. The relevance of stress tests for assessing banks' resilience to shocks lies in the
fact that these tests focus on the unexpected or "tail" events going beyond typical risk
management assessments. If banks are to meet the challenges of the emerging environment
and to move to the next orbit, it would be critical that the stress testing results be
incorporated in the business and capital assessment and planning exercise of banks. The
overall acceptable levels of expected and unexpected loss willing to be incurred by banks
should be a management decision driven based on rigorous and analytical assessment of
available information. While it is not expected that banks provide for unexpected losses in the
manner prescribed for expected losses, the "economic capital" which the bank seeks to
maintain must be driven by considerations which encompass such losses.
17. A risk management framework is incomplete without an effective system of internal
controls and methodologies. The first line of defense for risk management has to come from
bank managements and, especially, from bank boards. Unless the bank's management is
geared to internalize and institutionalize a risk and control culture in banks, any attempts to
increase the resilience of banks can be effective only to a limited extent. The management
has a critical role to play in ensuring the right balance between the business units and risk
management, both in times of stress and in good times, when there is a tendency for
misaligned incentives to emerge.
Treating customers fairly
18. The touchstone of any successful business lies in the edict that "customer is king".
Serving customers is, essentially, the reason why the banks exist in the first place. But over
the years, I believe, the customer has become rather peripheral in the banks' scheme of
things. In my view, while for the private sector banks, shareholders have, perhaps, emerged
as the sole focus; for the public sector banks, employees and their well-being has become
the primary focus. In my opinion, neither approach is sustainable in the long run. Improving
bottom lines and preserving NIMs are the primary motives for the bank management, while
making banking services accessible and the transactions affordable, has reduced to being a
regulatory agenda.
19. Ensuring fair treatment for the customers has become a priority for financial sector
regulators globally and the regulatory framework is being tightened across jurisdictions. The
expectation from financial service providers is that they display high levels of transparency in
product design, pricing and financial disclosures. In addition, a credible, cost effective and
expedient grievance redressal mechanism has to be made available to all customers. Banks
must make use of technology to deliver banking products and services in a cost-effective
manner. Customer education is also critical so that the user can have the ability to choose
appropriate and need based products and services. Unless the banking system becomes
customer centric in all its dimensions, it would fail to attain sufficient momentum to gain
access to the next orbit.
Know your customer, his business and business risks
20. Across the world, greater emphasis is being laid by the financial service providers
on knowing their customers. It has important regulatory and business dimensions. From a
regulatory perspective, banks and other financial service providers are expected to
understand the business activities of their customers so that they do not, inadvertently, end
up being conduits for illegal activities such as terrorism, MLM, frauds, hawala transactions,
etc. From a business perspective, Know Your Customer (KYC), Know Your Customers'
Business (KYCB) and Know Your Customers' Business Risks (KYCBR) are important for
understanding the nature of the customer's business, which would help in offering suitable
products, managing credit exposure and generating early warning signals for potential
delinquency risks.
21. It is important that the emphasis on KYC compliance is effectively conveyed across
the organization by the top management, not just for meeting regulatory requirements, but as
an opportunity to understand the customer better and maximize the gains from the customer
relationship.
Human resource management
22. We must realize that the traditional factors of production named in economics
textbooks are no longer relevant in the banking industry. Land, labour, physical capital and
enterprise have given way to skills, technology and human capital as the prime factors of
production in the banking sector. Employees are no longer "labour", they are "people" who
ought to be nurtured and cared for. When I say "people", I mean the bank management and
all employees - officers, clerical staff and the sub staff. An organization's "people" are the
force that can, potentially, make the difference between success and failure. When the
marketplace has number of players with broadly similar product offerings, the ability and
motivation levels of employees could be the clinching factor when it comes to gaining an
edge over rivals. The challenge before management is to use the vast unused potential in
people and produce "leaders" out of "managers" who can not only work hard but also
motivate their co-workers for producing extraordinary results. The sector needs to recognize
the transformation in the factors of production in the banking industry early and aim to
effectively harness these new factors for its own betterment and, more importantly, in the
interest of the society. By effectively utilizing these new factors of production, the sector
could quickly bring in more and more financially excluded people under the ambit of the
formal banking system and help it to be seen as a relevant and purpose-oriented sector.
Promoting financial literacy
23. In today's digitized world, stating that information is power, is perhaps to state a
truism. Our economy is traversing towards being a knowledge economy. This is amply
demonstrated by the contribution of services sector in our economy. However, much as we
would hate admitting it, we are a financially illiterate society. And here, I am not talking about
the common man alone. The financial illiteracy is all pervasive - the banks, the regulators,
the policy makers - all suffer from some degree of financial illiteracy. Let me quote a few
examples to drive home my point. Take the recent instances where banks had sold forex
derivatives to their customers without proper understanding of their suitability and
appropriateness. Neither the customers nor the banks had an iota of understanding of the
quagmire that they were getting into while entering into these contracts. The subsequent
legal wrangling and losses suffered by some of the banks aptly demonstrate their financial
illiteracy. Take the case of the Benchmark Prime Lending Rate (BPLR), which was, till
recently, used by the banks for lending to their borrowers. My understanding of the BPLR is
that it is the rate at which the bank lends to its best borrowers i.e. those borrowers who are
least likely to default on their loans. However, for years together, the banks continued to lend
to their borrowers well below their BPLR until the regulator introduced the base rate regime.
Another conundrum that needs to be solved is one surrounding the gold import. Though
many of us have realized its implications for the Current Account Deficit, there have not been
very sincere efforts to check its imports. We need to examine why public money should be
utilized for importing gold by banks. I firmly believe that we need to begin a vigorous
campaign to educate the society about the myth of investment in gold as a "safe asset" and a
"hedge against inflation." I believe that the Indian banking sector cannot be propelled into the
next orbit unless all its stakeholders and the society as a whole, has attained basic financial
literacy.
Improving efficiency
24. What are the attributes of an efficient financial system? To my mind, efficiency of
any system may be gauged in terms of its ability to not only deliver products and services in
a cost-effective and affordable way, but also in an inclusive manner. Neither of these two
traits characterizes our present banking and financial system. A wide section of the
population remains excluded from the formal financial system even years after "growth with a
human face" has been the clichéd socio-political agenda of the policy makers. Moreover, the
operating cost of banking system remains at an elevated level which renders the banking
transaction costs unaffordable for the common man. The dream of financial inclusion cannot
be realized unless the banking transaction costs are brought down substantially. This would
need a collective effort from the policy makers, bank managements, regulator and the
employees. Effective use of the new factors alluded to above- skills, technology and human
capital- would help in increasing the productivity and, thereby, lowering the transaction costs.
For the realization of this dream, the banking system would need to acquire allocational and
operational efficiency:
•
Allocational Efficiency: This requires banks to ensure that the precious societal
resources are allotted to the most productive activities and that the interests of the
vulnerable sections of the society are also taken into account.
•
Operational Efficiency: Operational Efficiency requires banks to provide financial
products and services to its customers in a safe, secure and speedy manner and to
ensure that the cost of financial intermediation is minimized.
25. As you all gain knowledge and exposure through this Advanced Management
Programme, I expect you to deliberate and introspect on how your banks and the banking
system as a whole can improve on both- allocational and operational efficiency parameters-
so that the financial intermediation function is efficiently performed. You must realize that
banks would need to "perform or perish." This will be an important takeaway for all of you
from the programme and will determine whether banks can, indeed, regain the trust and
confidence of the common man on the street and retain their pivotal position in the emerging
financial order.
Challenges before regulator/supervisor
26. Though the Indian banking system remained largely unaffected by the global
financial crisis, we cannot pat ourselves on the back, for it was much to do with lack of
product innovation and a comparatively lesser degree of integration with the global markets.
The coming years, however, will pose big challenges for the supervisors as well. The
significant rise in interconnectedness of financial markets across jurisdictions, the growing
complexities of banking products and services, introduction of newer delivery channels and
the need for emphasizing on inclusion of the vulnerable and marginalized groups has
significantly increased the challenges presented before the financial sector regulator/
supervisor.
27. The supervisory processes within the Reserve Bank are changing so as to make
them more forward looking and geared to assess the risks that the supervised entities pose
to the supervisory objectives. The processes are being re-oriented to move away from
transaction based to risk based and from incidence based to theme based supervision. An
effective supervisory regime must facilitate good business and must obstruct bad business.
Supervisory practices will also need to imbibe additional lessons from the financial crisis
which are emerging in the form of new regulatory and supervisory benchmarks like Basel III,
revised Core Principles for Effective Bank Supervision, increased focus on systemically
important banks, etc., if they are to remain robust and relevant in a changing banking
environment.
28. The decks for banking systems' flight to the next orbit cannot be clear unless all
necessary safeguards have been validated by the regulators/supervisors. The latter have a
key role in overseeing the banks' transition to the next orbit for it has to ensure that the
banking system smoothly settles into the next higher orbit without crash landing. Some of the
major safety checks that the regulator and supervisors need to perform are related to the "Fit
and Proper" assessment of the senior management, adequacy of the management
information systems, risk management processes, internal audit, grievance redressal
system, compliance to regulatory guidelines and prescriptions, etc.
Conclusion
29. We are all living in exciting times - times which offer as many opportunities as it
offers challenges. While the global and domestic economic environment might, presently,
give little cause for cheer, one needs to look at the opportunities available and also seek to
strengthen our systems and processes by institutionalizing the lessons learnt during this
period. This will help in strengthening the financial system so that it sees through these
challenging times and is ready to thrive, as the economy sets on its recovery path.
30. In this process, while the bankers have to act as change agents within their
institutions, supervisors have a critical role to play in ensuring that they are equipped with the
necessary skills to deal with a rapidly expanding, increasingly complex and global banking
system. The financial system the world over has come under increased public scrutiny. Both
supervisors and supervised entities are increasingly accountable for their actions. We need
to collectively and decisively act in the interests of the economic system.
31. Perhaps, the greatest opportunity that exists is the vast mass of financially excluded
people who are waiting to be touched by the formal financial system. The potential benefits
to the banking system and to the economy from financially including this segment would be
enough to galvanize the economy and restore it back to the high growth trajectory.
32. Each one of us assembled here today has to walk the extra mile to ensure that the
Indian banking system acquires the necessary "escape velocity" to catapult itself to the new
orbit. I wish you all the very best of learning in the remaining part of your programme. Thank
You!