K C Chakrabarty: Gearing up for the competitive impulse in the Indian
banking in its defining decade
Special address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at
BANCON 2011, Chennai, 4 November 2011.
* * *
Assistance provided by Dr Mridul Saggar in preparation of this address is gratefully acknowledged.
I: Introduction
Dear Shri Narendra, CMD, Indian Overseas Bank and host of Bancon 2011, Shri M.D.
Mallya, Chairman, Indian Banks Association and CMD, Bank of Baroda, Shri M.V. Nair,
CMD, Union Bank of India, Shri S. Raman, CMD, Canara Bank, CMDs and EDs of other
banks present here, fellow Bankers and all the delegates attending BANCON 2011,
representatives of the print and electronic media, Ladies and Gentlemen.
It is my pleasure and privilege to be here to share my thoughts on the theme of the
Conference. I would do this not from the policy perspective of the Reserve Bank as a
regulator of the banks. Having worked on either side of the regulatory fence, I would bring in
my understanding both as a bank executive and my present experience with the regulatory
policy to try to chart out some ideas that you may like to ponder upon and debate during the
Conference. I would be looking at Indian banking dispassionately and giving my frank views
on how I see the banking industry evolving and what we need to do right to tap opportunities.
The theme "Competing in the Defining Decade for Indian Banking" is in the form of a mission
statement. Banks in India need to imbibe it as their mission and develop a clear vision and a
strategy to achieve this objective. Why is this theme relevant now? Its immediate relevance
stems from the fact that financial sector reforms lost some of its pace in the face of the global
financial crisis of 2008 and is now starting to regain traction. So competition can hot up
again.
I.1 Large retirements provide defining moment for Indian banks
Why is the next decade likely to be a defining decade? In my view, in the coming years, the
Indian banking can unshackle several constraints that it faces today bringing about a
transformation into an era of globally competitive banking. The biggest of the constraint has
been the legacy of staffing that the public sector banks face. Indian banks employ about
1 million people, three-fourths of which are in public sector banks. It is estimated that about
55 per cent employees would be retiring in the next decade. This provides a defining moment
for these banks to transform by hiring the right talent, right-skilling its workforce and bring
about a cultural transformation in the functioning of the banks. There is an opportunity for
business process reengineering on the back of manpower transformation. It can bring in a
change in management as well as work ethos. While it may not be possible to quickly move
to a fully-flexible wage model, a lot could still be done to link monetary and non-monetary
incentives to productivity and efficiency.
As a large cohort of retirees leave, banks can start removing other constraints in Indian
banking. There are several drivers that would enhance competition and ensure
transformation of the Indian banking sector in the coming years. These include drivers which
are external to the bank, regulatory drivers and drivers which are internal to the bank.
External drivers include financial inclusion, growing pool of savings, consolidation,
globalisation and competition itself. Regulatory drivers include measures such as regulatory
focus on fair treatment to customers and stringent KYC norms, risk management guidelines
and reducing entry barriers through new licences to the banks. Internal drivers would be led
by manpower change opportunity that the retirements would bring. Banks would need to gear
up for winning the "war" for talent in a competitive market place. If they do so, other external
drivers such as newer technologies and newer operating models can follow, enabling banks
to improve efficiency. However as banks prepare to meet the challenges and opportunities
from these new drivers it is important that first and foremost, they place financial inclusion on
the top of their agenda.
II: External drivers to change the face of banking in India
II.1 Financial inclusion to lead transformation of economy and banking
Financial inclusion would need to be placed at the apex of the banking agenda over the next
few years, as it is an unfinished agenda of last four decades. It will change the way banking
for the masses would be done. By doing so banks would be addressing not only the banking
and several other financial services needs of the low-income population, but they also would
be increasing the base for value-added banking services in times to come. Partnering in
poverty and unemployment reduction and growth acceleration should not only be an altruistic
objective for the banks, but a self-serving one. It has to be done in a viable and profitable
manner and appropriate business and delivery models need to be evolved so that affordable
financial products and services could be provided to the customers. In doing so, they would
be paving the way for increasing the size of the banking market in years to come. Once
banks make progress on financial inclusion, they can then go on addressing other
constraints. With new human talent, a lot could be achieved in fields like customer service,
risk management, technology solutions and reap synergies through consolidation or
restructuring where possible. The important aspect is for bank managements to take up the
leadership for reorienting the entire organization by adopting an end-to-end approach. Banks
which lose this opportunity of transformation may be left a generation behind and may face
survival issues. Banks which show proclivity of change can not only seize expanding
business opportunities in India but can rub shoulders with the global giants.
Banks need to quickly move towards universal financial inclusion. This is both a national
commitment as well as a public policy priority. In order to achieve the ultimate objective of
reaching banking services to all the six lakh villages, financial inclusion has to become a
viable business proposition for the banks. There is little alternative to providing a solution
through regulated mainstream financial institutions and alternative banking structures,
including the MFIs, can only complement these efforts. We need to find profitable models for
financial inclusion through mainstream banking involving other layers as may be appropriate
to provide an added force multiplier.
For this to happen, the delivery model needs to recast from a cost-centric to a revenue
generation model. This will help in providing customers with quality banking services at their
door step and at the same time generating business opportunities for the banks. This is
sustainable only if delivery of banking services, at the minimum, includes the following four
products: (i) a Savings cum Overdraft Account, (ii) a remittance product for Electronic
Benefits Transfer (EBT) and other remittances, (iii) a pure savings product, ideally a recurring
deposit scheme and (iv) entrepreneurial credit in the form of Kisan Credit Card
(KCC)/General Credit Card (GCC).
Reserve Bank has been undertaking financial inclusion initiatives in a mission mode through
a combination of strategies ranging from provision of new products, relaxation of regulatory
guidelines and other supportive measures to achieve sustainable and scalable financial
inclusion. In India, the Reserve Bank of India (RBI) has initiated several measures to achieve
greater financial inclusion, such as facilitating "no-frills" accounts and "General Credit Cards"
for small deposits and credit. For paucity of time and my hope that this audience would be
well acquainted with these steps, I would not detail them here. But let me reiterate that the
Reserve Bank is very serious that all public and private sector banks implement a Board
approved three-year Financial Inclusion Plan (FIP). These plans and targets would be
monitored closely. In doing so banks should note that financial inclusion does not only means
mere opening of banking outlets. It is equally important to provide the financially excluded
people with products that are relevant. But, more importantly, it is the banks which have to
serious in delivering affordable products and services in a profitable and viable manner.
Recently the world population has crossed the seven billion mark and India accounts for 18%
of this share. With such huge population, we need to place financial inclusion highest on our
priority list. We cannot become big players in the global banking space if we leave out a large
segment of our own population out of their reach. We need to be worried about competition
and externalities, but not at the expense of prime motive of providing our products to all
those who need it.
II.2 Catalyzing economic growth by unlocking financial savings
Over the last two decades, there has been an increasing recognition that finance is important
for growth. Countries with better functioning banks and financial markets grow faster. The
degree to which a country's financial system is bank-based or market-based does not matter
much, but better-functioning financial systems promote growth by diminishing external
financing constraints that a firm faces. Finance also matters for income distribution, and
poverty alleviation as it reduces information and transactions costs. That finance matters for
growth should be intuitively obvious as economic growth depends on what one invests and
so is found to have a long-run relationship with savings. Bilateral causality exists between the
domestic savings growth and the economic growth. Higher growth raises savings, but higher
savings also raises growth.
India has been a bank dominated financial system, even as financial markets have
developed a great deal since the 1990s. Bank account for about 29% of the total financial
flows in the economy, but are now faced with increased competition from non-bank financial
intermediaries whose share increased rapidly to a significant 16% in 2007-08. Even though
51% of the household's financial surplus gets intermediated through banks, other financial
institutions account for a significant 41% share. India's high savings rate has been a crucial
driver of its economic boom, providing productive capital and helping to fuel a virtuous cycle
of higher growth, higher income and higher savings.
Since the 1990s, the gross domestic savings rate has risen steadily from an average of 23%
to an estimated high of 36.9% in 2007-08 before it declined and was 33.7% in 2009-10. The
decline in savings in India has been due to public sector saving less as revenue deficits
widened, as also private corporate sector saving less as retained earnings could not keep
the pace of growth seen earlier. Household saving rate has stagnated and larger public
spending has not translated into higher savings by private agents. More importantly, financial
saving of the households has moderated to 9.7% of GDP in 2010-11 from 12.1% of GDP in
the preceding year. High inflation, low bank deposit rates, volatile equity markets and
increasing leverage by households affected the rate of financial saving. With construction
activity starting to slow down, the physical savings of the households could also be at risk.
Falling savings is a matter of concern if India is to grow at an envisaged rate of 9% per
annum during the Twelfth Plan. If ICOR remains unchanged from 4.5 that has been realized
so far in the Eleventh Plan, it would need an investment rate of 40.5%. Assuming current
account deficit (CAD) averages 2% of GDP in this period, as wider average CAD could risk
sustainability, then a saving rate of 38.5% becomes necessary. Banks need to play their role
in unlocking financial saving if we hope to step up the aggregate saving rate by 5 per cent
from the current level to realize this target. The current economic situation is putting pressure
on both corporate profitability and the public finances. As savings in these two sectors are
unlikely to grow as rapidly as in the past, household savings, especially its financial saving
holds the key to India's growth story. It is in the hands of the banks to live up to the challenge
and the opportunity they face from this macro-arithmetic.
Banks have large business opportunities. Of the 10.4 trillion households' saving pool in
financial 2010-11, nearly 42% was in the form of bank deposits. This pool could grow rapidly
allowing banks significant expansion opportunities in wholesale and retail banking. Also,
much of Indians' physical savings is still locked up in unproductive physical assets - such as
houses and gold and banks can help households slowly convert a large part of these into
financial assets. So while banks may be focusing on corporate banking to boost its asset
side, it should not miss the opportunities that the liabilities side of business provide and
should aggressively protect its turf by gearing up for competition from non-bank financial
institutions.
II.3 Competition, consolidation and globalisation to re-shape Indian banking
Competition in not a choice before the Indian banking. It would come naturally aided by
regulatory impulses and increased openness of the Indian economy. Not only will there be
increased number of players but the number and type of products and services will undergo
a change. With likelihood of an increasing competition over the next decade, there could be a
process of consolidation among banks as has been the case elsewhere in the world. It is
expected to be a market-driven process. Cost improvements in output efficiency are likely to
emerge from this process as banks seek to reap economies of scale and scope. Mergers
could be fruitful for smaller banks so they can increase their scale and expand into new
product lines.
The recent financial crisis has reopened debate on the scale and scope economies in the
context of big banks being too big to fail. For instance, Nobel laureate, John Vickers clearly
advocated splitting large UK banks to combat the problem of too-big-to-fail. In US too, some
regulatory features have been added through the Dodd-Frank Act to increase the social utility
of the largest, most complex financial firms.
In India, most banks that operate are as yet not of a global size. They are not big enough to
be competitive. So our problems are different. We need to develop a vision of banking over
next decade that incorporates not only M&A but changes in structure and in operational
framework. Banks will need to consider "end-to-end" operational changes that places
customer on the top of the pyramid and then redesign the processes. Our first priority is to
bring about universal financial inclusion. However, once financial inclusion is achieved,
banks can focus on consolidation.
Competition and consolidation, in turn, may prompt globalization of Indian banks. India is
viewed as one of the biggest growth stories among emerging markets. Trade in goods,
services and finance has exploded. Foreign banks are increasingly seeking to be present in
India. They could find easier entry through the wholly-owned subsidiary route. Indian banks
also have aspiration to turn global. Indian businesses are making overseas acquisitions even
as large inward FDI is taking place. This would impel banks to globalize to provide better
wholesale and corporate banking services. The focus of competition will, thus, be both on the
nature of institutions and products and services. The competition will be intense as there will
be diversity in terms of type of institutions as well as products and services. This will drive the
costs of products and services down, making it affordable to the entire segment of the
society.
III: Regulatory drivers can provide impetus of change
Banks may need to read the signal of change. Drivers of competition-driven change are
already emerging as a result of impetus being provided by regulatory changes. More
regulatory drivers could be in offing in coming years. Across the globe, the crisis acted as a
moderator in the area of financial innovations in the banking and financial services industry
(BFSI). Regulators' comfort with such innovation also dimmed. As the crisis unfolded, there
was a need for some regulatory forbearance. Regulatory reforms were back-peddled. At the
same time, the resultant economic downturn prompted developed country central banks to
adopt ultra loose monetary policies. Consequently, a regime of low interest rates helped
mask some of the risks that existed in the system. Banks started to shrink their balance
sheets adopting a risk-averse behaviour. All this reduced incentives for banks to innovate or
rather "finnovate", i.e. undertake financial innovation and compete. Some sort of
complacency set in. This behaviour was in evidence in India too.
III.1 Saving deposit rate deregulation is good for banks and the economy
However, competitive spirit is getting rekindled, at least in India, where financial sector
reforms are back on the forefront. The Reserve Bank in its October 2011 policy set the tone
for increased competition by deregulating the saving deposit rate. It has also charted out a
course for entry of new private sector banks and also given a clear indication that foreign
banks are encouraged to come by setting up a bank subsidiary. RBI has also given a carte
blanche to domestic scheduled commercial banks (other than RRBs) to set up new branches
in Tier 2 centres. While global financial system still faces considerable risk, I think the time
has come for banks in India to live with those risks by factoring those in and get to the task of
providing banking services.
Increased competition is desirable for banks as well as economy. Take the instance of the
long-awaited reform of deregulating saving bank deposit interest rates. The measure would
go a long way in encouraging thrift behaviour in the economy, helping it grow faster. It is
possible that it may temporarily affect banks' net interest margins, especially in case of the
high CASA banks. Yet, there is no reason to believe that these banks will not be able to
make the necessary adjustment by better asset-liability management, reducing
intermediation costs and providing more value added services to emerge stronger, resilient
and efficient banks. At the same time, the low CASA banks have an opportunity to grow and
improve their scale economies turning Indian banking into a more competitive space.
I have been told by some bankers that the time for deregulation was perhaps not right as the
NPA cycle is on the upswing. We all know the truth that there never will be a completely
appropriate time for such reforms. At least, today we have the comfort that banks have
substantially got rid of the asset-liability mismatches that were created earlier by credit
growth outstripping deposit growth. As regulators, our job is to support financial stability and
the health of the banking system, but not to unduly protect banking business at the cost of
welfare of those who consume financial services. Intermediation costs in Indian banking have
stayed high. We need to develop new paradigm for creating a competitive edge in the Indian
banking that drives down intermediation costs.
III.2 Reduced barriers to entry to spur competition
Banks already operating in India need to prepare themselves for competition from new
players as the barriers to entry are reduced. There is a need to extend the geographic reach
of banking in hitherto under-banked areas and improve access to banking services for those
who are hitherto excluded or inadequately served. The extant policy has been that industrial
houses are not permitted to promote new banks. This had good logic in restraining the risks
of connected lending that had created banking problems in a number of countries. In India,
individual companies, directly or indirectly connected with large industrial houses were
permitted to own only 10 per cent of the equity of a bank, but without any controlling interest.
However, the Reserve Bank has now guided a more open regime but this regime would need
to be developed with lots of checks and balances and not sacrificing the essential safeguard
principles. The Reserve Bank has also guided that it would be open to more foreign banks
coming into India through the wholly owned subsidiary route. Reduced entry barriers and
resultant increase in competition could be an important driver for existing banks to change.
III.3 Banks need to shift to customer-centric model
In recent period, the Reserve Bank has provided a regulatory impetus to improve customer
service in banks. This regulatory driver can change the operating models of banking in
several ways. Bank need to adopt more customer-centric models of growth and service.
Technology is not an end, but means of business and it must help reduce intermediation
costs. Bank need to be conscious of the fact that "lender liability" could become a reality and
banks can be held accountable if their lending practices dent a business. They also need to
be vigilant about depositor rights.
At the cost of repetition, let me reiterate the question I am often asked, "Why as a regulator,
are we concerned about customer care and protection? Why it is not left to the market forces
and competition to take care of? The answer to this lies in the fact that in any service industry
where market forces and competition play out freely, it may well have been the case, but
banking / financial services industry is a highly regulated service industry with stiff entry
norms and consumer protection cannot entirely be left to the market forces. Hence, the
regulator has a role. Availability of financial services / products, at affordable prices on an
uninterrupted basis is the purpose and result of financial sector stability.
Regulatory focus on customer services is ultimately in the interest of banks themselves.
Banking after all is about increasing business but that in turn is contingent upon better
customer service. Responsible marketing, responsible lending, responsible grievances
redress mechanism and responsible consumer protection are not mutually exclusive but are
inter-dependent. The public deposits and the funds available to the financial services industry
represent a nation's wealth. As such the least we can think of is protecting the owners of this
wealth not merely in terms of deposit insurance but also in terms of day to day transactions
and contractual relationships a consumer has with the banking and financial services
industry.
The second thought which I would like all the delegates to ponder on is to assess whether
we are competitive domestically? The degree of concentration in the banking market is not a
reliable proxy for the intensity of competition. The arrival of new entrants, technological
developments, the increasing role played by intermediaries and the varying corporate
strategies pursued by the suppliers of financial services continuously changed the
competitive environment of financial markets especially in relation to retail customers. The
bottom line of banks should reflect the opinion of the customer about pricing of products and
services. Customer opinion (measured as customer satisfaction) and behaviour (loyalty)
should form the dominant element in assessing the behaviour of banks, together with more
objective measures such as credit availability and pricing. It is increasingly becoming a
matter of debate between too big to fail versus too small to survive. Competition must create
a level playing field and the desired objective of consumer protection should be built into any
competition strategy adopted by the players in the industry.
A point that cannot be missed is about the changing face of competition and the role of
marketing. Banking has been and will always be a "People Business". Pricing is important
but there may be other valid reasons why people select and stay with a particular bank.
Especially in transparent situations with a high level of competitiveness, banks must try to
distinguish themselves by creating their own niches or images. They must articulate and
emphasize the core values to attract and retain certain customer segments. Values such as
"sound", "reliable", "innovative", "international", "close", "socially responsible", "Indian" , etc
need to be emphasized through concrete actions on the ground and these words should not
merely form a part of the ad campaign of banks.
Let me turn my attention to certain aspects concerning fair treatment of customers. There is
an imbalance of power as regards information and resources between consumers and
financial service providers. This could lead to market failure. Consumer protection financial
literacy promote efficiency, transparency and deepening of retail financial markets. It also
protects the financial sector from the risk of Government overreaction. However, market
forces and competition policy will not fully address the consumer protection issues. It is a
challenge to strike the right balance between regulation and market competition. The fair
practices code, code of commitment to customers etc. cannot be a substitute for regulation
but can be useful in improving business practices of banks. We need transparency,
nonexploitative pricing, fair and non-coercive selling practices, inexpensive and speedy
grievance redressal and respect for privacy on personal financial information.
Before I end talking on customer service, I would like to flag three important changes that are
expected to occur in the backdrop of the recommendations made by the Committee on
Customer Service in Banks (Damodaran Committee). The first one pertains to doing away
with foreclosure charges on home loans that are carrying floating interest rates. The second
one is concerning zero liability against loss in ATM and on-line transactions. Lastly, banks
should offer transparent and non-discriminatory pricing to customers. These changes could
alter the reach of banking and the customer welfare it provides.
III.4 KYC and integration of business in banking
Sound KYC policies are being advocated for a long time by the Reserve Bank. These
policies protect the integrity of the banking system by reducing the likelihood of banks
becoming vehicles for money laundering, terrorist financing and other unlawful activities. So
KYC in a sense has become public good. There are obviously private costs attached to this
as banks have to spend on ensuring KYC and customers too have to incur costs in time and
in meeting the requirements. Yet, it is not as if the gains are all public and costs are all
private so that meeting KYC becomes a tax on banks. There are private benefits to banks
too. These procedures are in the interest of banks themselves as they contribute to a bank's
overall safety and soundness. KYC reduces risks of defaults. It benefits banks as it reduces
default costs. It benefits customer by reducing risk premia in loan pricing. It also benefits
society by making it a safer place to live and do business.
Bank need to prepare for a more stringent KYC regulatory regime. At the same time, costs of
KYC need not increase as better use of technology is possible, especially by integrating KYC
with UID. With such an integration, KYC can achieve some degree of portability with UID,
reducing incremental costs to a bank and affording customer to more freely choose between
banks. Bank in turn would need to do more on KYC. They should consider KYC as done only
if they know the "business" of their customers; (KYBC) and understand and assess the risks
associated with each of their customers' businesses (KYCBR). These would become an
integral part of elementary risk management process of the bank in years to come. But this
change also makes a good business sense. Thus, implementation of KYC in all the above
three manifestations and making banking more customer focussed and friendly will be
another driver for making the next decade a defining decade.
III.5 Towards global best practices in risk management
The world has started looking to India as an example for from which they can take some
positives while considering global best practices. Indian banks were one of the few which
emerged comparatively unscathed from the global financial crisis of 2008. Yet, risks in the
global financial system have increased once again. Though not on the scale of 2008 they
cannot be ignored with global economy expected to slow down ahead and with euro area
sovereign debt and banking problem still unresolved. At the same time with banks in India
expected to reap greater scale and scope economies through organic growth as well as
possible consolidation, they are likely to face new challenges in risk management. These
would require to be addressed through enterprise risk management.
Banks already have internal controls and risk management systems in place. The need is for
better enterprise-wide assessment of both quantity and quality of risks. The assessment
needs to be stress-tested adequately and appropriately. Portfolio aggregation of risk capital
becomes necessary and the economic equity - which is the result of the benefits of
diversification at the group level - needs to be considered so that capital charge can be
determined. Only through such an approach can the banks in India move to global best
practices in the risk management. A great deal of quantitative work needs to be done for the
purpose and banks need to attract talent which is skilled in economics, statistics, financial
econometrics and risk metrics for the purpose.
The key of the Risk Management is to ensure that banks have adequate capital and have a
framework for risk based pricing of products and services. While Basel guidelines will bring
out the challenges of capital planning, banks have to strive hard to meet the challenges of
capital requirement. More importantly, the challenge for Indian Banks going forward is going
to be in the area of risk based pricing. Banks have not been able to establish an
informationbased operational framework for pricing risk. The foundation for this has to be laid and
strengthened. There are three elements of this foundation a) an efficient and reliable
Transfer Pricing Mechanism (TPM), b) a cost-benefit framework for each product and service
which needs the specific presence of a scientific costing and pricing mechanism, and
c) introduction of the concept of profit accountability by banks over and above the existing
concept of risk accountability. Banks have to quickly move in this area if they have to meet
the challenges of capital as well as risk management.
Banks' risk management strategies could be build on three pillars. First, a risk-return
tradeoff for all its businesses need to be assessed and careful choices need to be made to
operate at the optimal point on the risk-return transformation frontier that ensures bank's
liquidity at almost all the times except in some tail risk or black swan events and bank's
solvency at all times. Second, a cost-benefit framework for all its products and services is
needed in the bank. This would help banks in strategic planning to reduce risks. Finally,
banks need to undertake profit accountability at all its functional and area units. Each unit
must understand not only cost of business but also the opportunity cost of not doing
business. Enhanced focus on risk management is all the more necessary as banks in India
prepare themselves for the "Basel III" regime. The Reserve Bank is planning to issues draft
guideline on this by the end of December 2011, so that the Basel III can be phased-in from
next year. Our assessment is that banks in India are adequately capitalized at system level,
as also in case of most banks and a smooth transition to Basel III should be possible even
though banks are entering into a relatively tougher environment of capital raising.
IV: Internal drivers an added force for change in banks
IV.1 Winning the "war" for talent in a competitive market place
Manpower transformation is the biggest transformative factor for banks in India. The
contribution of human capital to growth of economy or institution is often underestimated.
While physical capital attracts a lot of attention, human capital is often taken as given unless
the economy faces labour supply constraints. This anomaly is getting corrected as with
increased sophistication in banking, the quality of human capital is getting priced in labour
market with large differential returns at least in private and foreign banks. The public sector
banks are constraine