Universal Banking

Prepared By:
Priyanka Khandelwal
PG20095094
Universal banking can be defined as banking that includes not only services related to savings
and loans but also investments. This is most common in European countries as it is prohibited by
law in the United States. Although, in recent times there has been much market pressure in the
US for change. In universal banking, large banks operate extensive networks of branches,
provide many different services, hold several claims on firms (including equity and debt), and
participate directly in the corporate governance of firms that rely on the banks for funding or as
insurance underwriters.

Ever since the financial sector reforms were introduced in early 90’s the banking sector saw the
emergence of new generation of private sector banks. These banks gained at most popularity as
they have technology edge and better business models when compared to public sector banks
and the most important thing is they are able to attract more volumes simply because they meet
their customers’ requirements under one roof. If the newer players can do then so do the bigger
players like the Financial Institutions (FIs) can try their hands on it. Here comes the concept of
universal banking, its emergence, merits and related issues.

RBI states: “The emerging scenario in the Indian banking system points to the likelihood of the
provision of multifarious financial services under one roof. This will present opportunities to
banks to explore territories in the field of credit/debit cards, mortgage financing, infrastructure
lending, asset securitisation, leasing and factoring. At the same time it will throw challenges in
the form of increased competition and place strain on the profit margins of banks”

The evolving scenario in the Indian banking system points to the emergence of universal
banking. The traditional working capital financing is no longer the banks major lending area
while FIs are no longer dominant in term lending. The motive of universal banking is to fulfill
all the financial needs of the customer under one roof. The leaders in the financial sector will be
aiming to become a one-stop financial shop.

In recent times, ICICI group has expressed their aim to function on the concept of the Universal
Bank and was willing to go for a reverse merger of ICICI ltd. with ICICI Bank. But due to some
regulatory constraints, the matter seems to have been delayed. Sooner or later, the group would
be working towards its aim. Even some of the other groups in the financial sector like HDFC,
IDBI have started functioning on the same concept.

The main advantage of universal banking is that it results in greater economic efficiency in the
form of lower cost, higher output and better products. The spread of universal banking ideas will
bring to the fore issues such as mergers, capital adequacy and risk management of banks.
Universal banks may be comparatively better placed to overcome such problems of asset-
liability mismatches (for banks).However, larger the banks the greater the effects of their failure
on the system. Also there is the fear that such institutions, by virtue of their sheer size, would
gain monopoly power in the market, which can have significant undesirable consequences for
economic efficiency. Also combining commercial and investment banking can give rise to
conflict of interests.

SWOT analysis of Universal Banking in India

The solution of Universal Banking was having many factors to deal with which further
categorized under Strengths, Weaknesses, Opportunities and Threats (SWOT);

Strengths:

• Economies Of Scale: The main advantage of Universal Banking is that it results in

greater economic efficiency in the form of lower cost, higher output and better products.
Various Reserve Banks Committees and reports in favor of Universal Banking, is that it
enables banks to exploit economies of scale and scope. It means a bank can reduce
average costs and thereby improve spreads if it expands its scale of operations and
diversifying activities.

• Profitable Diversions: By diversifying the activities, the bank can use its existing
expertise in one type of financial service in providing other types. So, it entails less cost
in performing all the functions by one entity instead of separate bodies.

• Resource Utilization: A bank possesses the information on the risk characteristics of the
clients, which it can use to pursue other activities with the same client. A data collection
about the market trends, risk and returns associated with portfolios of Mutual Funds,
diversifiable and non diversifiable risk analysis, etc are useful for other clients and
information seekers. Automatically, a bank will get the benefit of being involved in
Research.

• Easy marketing on the foundation a of Brand name: A bank has an existing network of
branches, which can act as shops for selling products like Insurance, Mutual Fund
without much efforts on marketing, as the branch will act here as a parent company or
source. In this way a bank can reach the remotest client without having to take recourse
ton an agent.

• One stop shopping: The idea of ‘one stop shopping’ saves a lot of transaction costs and
increases the speed of economic activities. It is beneficial for the bank as well as
customers.

• Investor friendly activities: Another manifestation of Universal Banking is bank holding

stakes in a firm. A bank’s equity holding in a borrower firm, acts as a signal for other
investors on to the health of the firm, since the lending bank is in a better position to
monitor the firm’s activities.
Weaknesses:

• Grey area of Universal Bank: The path of Universal Banking for DFIs is strewn with
obstacles. The biggest one is overcoming the differences in regulatory requirements for a
bank and DFI. Unlike banks, DFIs are not required to keep a portion of their deposits as
cash reserves.

• No expertise in long term lending:In the case of traditional project finance an area where
DFIs tread carefully, becoming a bank may not make a big difference. Project finance
and Infrastructure Finance are generally long gestation projects and would require DFIs
to borrow long term. Therefore, the transformation into a bank may not be of great
assistance in lending long-term.

• NPA problem remained intact: The most serious problem of DFIs have had to encounter
is bad loans or Non Performing Assets (NPA). For the DFIs and Universal Banking or
installation of cutting-edge-technology in operations are unlikely to improve the situation
concerning NPAs. Most of the NPAs came out of loans to commodity sectors, such as
steel, chemicals, textiles, etc. the improper use of DFI funds by project promoters, a
sharp change in operating environment and poor appraisals by DFIs combined to destroy
the viability of some projects. So, instead of improving the situation Universal Banking
may worsen the situation, due to the expansion in activities banks will fail to make
thorough study of the actual need of the party concerned, the prospect of the business, in
which it is engaged, its track record, the quality of the management, etc.

Threats:

• Big Empires: Universal Banking is an outcome of the mergers and acquisitions in the
banking sector. The Finance Ministry is also empathetic towards it. But there will be big
empires which may put the economy in a problem. Universal Banks will be the largest
banks, by their asset base, income level and profitability there is a danger of ‘Price
Distortion’. It might take place by manipulating interests of the bank for the self interest
motive instead of social interest. There is a threat to the overall quality of the products of
the bank, because of the possibility of turning all the strengths of the Universal Banking
into weaknesses. (e.g. the strength of economies of scale may turn into the degradation
of qualities of bank products, due to over expansion.) If the banks are not prudent
enough, deposit rates could shoot up and thus affect profits. To increase profits quickly
banks may go in for riskier business, which could lead to a full in asset quality.
Disintermediation and securitization could further affect the business of banks.
Opportunities:

• To increase efficiency and productivity: Liberalization offers opportunities to banks.

Now, the focus will be on profits rather than on the size of balance sheet. Fee based
incomes will be more attractive than mobilizing deposits, which lead to lower cost funds.
To face the increased competition, banks will need to improve their efficiency and
productivity, which will lead to new products and better services.

• To get more exposure in the global market: In terms of total asset base and net worth the
Indian banks have a very long road to travel when compared to top 10 banks in the
world. (SBI is the only Indian bank to appear in the top 100 banks list of ‘Fortune 500′
based on sales, profits, assets and market value. It also ranks II in the list of Forbes 2000
among all Indian companies) as the asset base sans capital of most of the top 10 banks in
the world are much more than the asset base and capital of the entire Indian banking
sector. In order to enter at least the top 100 segment in the world, the Indian banks need
to acquire a lot of mass in their volume of operations. Pure routine banking operations
alone cannot take the Indian banks into the league of the Top 100 banks in the world.
Here is the real need of universal banking, as the wide range of financial services in
addition to the Commercial banking functions like Mutual Funds, Merchant banking,
Factoring, Insurance, credit cards, retail, personal loans, etc. will help in enhancing
overall profitability.

• To eradicate the ‘Financial Apartheid’: A recent study on the informal sector conducted
by Scientific Research Association for Economics (SRA), a Chennai based association,
has found out that, ‘Though having a large number of branch network in rural areas and
urban areas, the lowest strata of the society is still out of the purview of banking services.
Because the small businesses in the city, 34% of that goes to money lenders for funds.
Another 6.5% goes to pawn brokers, etc. The respondents were businesses engaged in
activities such as fruits and vegetables vendors, laundry services, provision stores, petty
shops and tea stalls. 97% of them do not depend the banking system for funds. Not
because they do not want credit from banking sources, but because banks do not want to
lend these entrepreneurs. It is a situation of Financial Apartheid in the informal sector. It
means with the help of retail and personal banking services Universal Banking can reach
this stratum easily.

SALIENT OPERATIONAL AND REGULATORY ISSUES OF RBI TO BE ADDRESSED

BY THE FIs FOR CONVERSION INTO A UNIVERSAL BANK

• Reserve requirements: Compliance with the cash reserve ratio and statutory liquidity
ratio requirements (under Section 42 of RBI Act, 1934, and Section 24 of the Banking
Regulation Act, 1949, respectively) would be mandatory for an FI after its conversion
into a universal bank.
• Permissible activities: Any activity of an FI currently undertaken but not permissible
for a bank under Section 6(1) of the B. R. Act, 1949, may have to be stopped or divested
after its conversion into a universal bank..

• Disposal of non-banking assets: Any immovable property, howsoever acquired by an

FI, would, after its conversion into a universal bank, be required to be disposed of within
the maximum period of 7 years from the date of acquisition, in terms of Section 9 of the
B. R. Act.

• Composition of the Board: Changing the composition of the Board of Directors might
become necessary for some of the FIs after their conversion into a universal bank, to
ensure compliance with the provisions of Section 10(A) of the B. R. Act, which requires
at least 51% of the total number of directors to have special knowledge and experience.

• Prohibition on floating charge of assets: The floating charge, if created by an FI, over
its assets, would require, after its conversion into a universal bank, ratification by the
Reserve Bank of India under Section 14(A) of the B. R. Act, since a banking company is
not allowed to create a floating charge on the undertaking or any property of the
company unless duly certified by RBI as required under the Section.

• Nature of subsidiaries: If any of the existing subsidiaries of an FI is engaged in an

activity not permitted under Section 6(1) of the B R Act , then on conversion of the FI
into a universal bank, delinking of such subsidiary / activity from the operations of the
universal bank would become necessary since Section 19 of the Act permits a bank to
have subsidiaries only for one or more of the activities permitted under Section 6(1) of B.
R. Act.

• Restriction on investments: An FI with equity investment in companies in excess of 30

per cent of the paid up share capital of that company or 30 per cent of its own paid-up
share capital and reserves, whichever is less, on its conversion into a universal bank,
would need to divest such excess holdings to secure compliance with the provisions of
Section 19(2) of the B. R. Act, which prohibits a bank from holding shares in a company
in excess of these limits.

• Connected lending: Section 20 of the B. R. Act prohibits grant of loans and advances by
a bank on security of its own shares or grant of loans or advances on behalf of any of its
directors or to any firm in which its director/manager or employee or guarantor is
interested. The compliance with these provisions would be mandatory after conversion
of an FI to a universal bank.

• Licensing: An FI converting into a universal bank would be required to obtain a

banking licence from RBI under Section 22 of the B. R. Act, for carrying on banking
business in India, after complying with the applicable conditions.
• Branch network: An FI, after its conversion into a bank, would also be required to
comply with extant branch licensing policy of RBI under which the new banks are
required to allot at least 25 per cent of their total number of branches in semi-urban and
rural areas.

• Assets in India: An FI after its conversion into a universal bank, will be required to
ensure that at the close of business on the last Friday of every quarter, its total assets held
in India are not less than 75 per cent of its total demand and time liabilities in India, as
required of a bank under Section 25 of the B R Act.

• Format of annual reports: After converting into a universal bank, an FI will be required
to publish its annual balance sheet and profit and loss account in the forms set out in the
Third Schedule to the B R Act, as prescribed for a banking company under Section 29
and Section 30 of the B. R. Act.

• Managerial remuneration of the Chief Executive Officers: On conversion into a

universal bank, the appointment and remuneration of the existing Chief Executive
Officers may have to be reviewed with the approval of RBI in terms of the provisions of
Section 35 B of the B. R. Act. The Section stipulates fixation of remuneration of the
Chairman and Managing Director of a bank by Reserve Bank of India taking into account
the profitability, net NPAs and other financial parameters. Under the Section, prior
approval of RBI would also be required for appointment of Chairman and Managing
Director.

• Deposit insurance: An FI, on conversion into a universal bank, would also be required
to comply with the requirement of compulsory deposit insurance from DICGC up to a
maximum of Rs.1 lakh per account, as applicable to the banks.

• Authorized Dealer's License: Some of the FIs at present hold restricted AD licence
from RBI, Exchange Control Department to enable them to undertake transactions
necessary for or incidental to their prescribed functions. On conversion into a universal
bank, the new bank would normally be eligible for full-fledged authorised dealer licence
and would also attract the full rigour of the Exchange Control Regulations applicable to
the banks at present, including prohibition on raising resources through external
commercial borrowings.

• Priority sector lending: On conversion of an FI to a universal bank, the obligation for

lending to "priority sector" up to a prescribed percentage of their 'net bank credit' would
also become applicable to it.

• Prudential norms: After conversion of an FI in to a bank, the extant prudential norms

of RBI for the all-India financial institutions would no longer be applicable but the norms
as applicable to banks would be attracted and will need to be fully complied with.
THE FUTURE TREND OF UNIVERSAL BANKING IN DIFFERENT COUNTRIES

Universal banks have long played a leading role in Germany, Switzerland, and other Continental
European countries. The principal Financial institutions in these countries typically are universal
banks offering the entire array of banking services. Continental European banks are engaged in
deposit, real estate and other forms of lending, foreign exchange trading, as well as underwriting,
securities trading, and portfolio management. In the Anglo-Saxon countries and in Japan, by
contrast, commercial and investment banking tend to be separated. In recent years, though, most
of these countries have lowered the barriers between commercial and investment banking, but
they have refrained from adopting the Continental European system of universal banking. In the
United States, in particular, the resistance to softening the separation of banking activities, as
enshrined in the Glass-Steagall Act, continues to be stiff.

In Germany and Switzerland the importance of universal banking has grown since the end of
World War II. Will this trend continue so that universal banks could completely overwhelm the
specialized institutions in the future? Are the specialized banks doomed to disappear? This
question cannot be answered with a simple "yes" or "no". The German and Swiss experiences
suggest that three factors will determine future growth of universal banking.

• Universal banks no doubt will continue to play an important role. They possess a number
of advantages over specialized institutions. In particular, they are able to exploit
economies of scale and scope in banking. These economies are especially important for
banks operating on a global scale and catering to customers with a need for highly
sophisticated financial services. As we saw in the preceding section, universal banks may
also suffer from various shortcomings. However, in an increasingly competitive
environment, these defects will likely carry far less weight than in the past.

• Although universal banks have expanded their sphere of influence, the smaller
specialized institutions have not disappeared. In both Germany and Switzerland, they are
successfully coexisting and competing with the big banks. In Switzerland, for example,
the specialized institutions are firmly entrenched in such areas as real estate lending,
securities trading, and portfolio management. The continued strong performance of many
specialized institutions suggests that universal banks do not enjoy a comparative.

• Universality of banking may be achieved in various ways. No single type of universal

banking system exists. The German and Swiss universal banking systems differ
substantially in this regard. In Germany, universality has been strengthened without
significantly increasing the market shares of the big banks. Instead, the smaller
institutions have acquired universality through cooperation. It remains to be seen whether
the cooperative approach will survive in an environment of highly competitive and
globalized banking.

Universal Banking and Developmental Financial Model

The current banking model is in terms of intermediation between households and industries at
the short end of the spectrum. The DFI’s used to get Government funds at subsidized rates to be
lent for long. In the case of new model the entity is expected to be a one-stop shop. The
mobilization of funds could be focused on both long side and short side. The short end and long
term is combined in an institution, which needs to develop internal safe guards for asset liability,
mismatches. From the borrower side it is providing funds for fixed assets as well as current
assets and to do that extent safe guards can be built in rating. But if the corporate fail due to
working capital problems then the bank is hit twice.

FI’s can access relatively cheaper funds by becoming banks but given the CRR and SLR and
priority sector requirements, it is going to be difficult task to meet the term lending requirements.
One possibility is for the waiver of CRR/SLR requirements to these new entities but that would
be opening a Pandora’s box in our context.

Actually the spread plus other income less other expenses work out to be 1.03 for IDBI and 1.98
for ICICI. The comparable figure for Public sector Banks [PSB] is 1.34 percent. However the
provisions and contingencies at 1.25 percent for ICICI gives a net profit to asset ratio of 0.73.
For IDBI the number is 0.06 and PSB’s 0.42. It is possible that IDBI has under provider. At
present, the DFI’s are permitted an overdue period of 365 days for the principal and 180 days for
the interest. But once these are placed on par with those of Banks then, an asset will be treated as
nonperforming if interest or installment remains overdue for more than 180 days. Hence the
level of NPA’s and erosion of capital could be larger in these FI’s than what is presented. To that
extent the surmise that DFI’s move towards Universal Banking may be to overcome their NPA
problems.

One of the reasons for the decision to convert DFI’s to Universal Banks is because the
Government is not in a position to infuse additional capital to these entities. In a sense the
burden of bailing out these DFI’s will have to carry the burden of NPA’s of the DFI’s in addition
to their own. The gross NPA of ICICI bank as on 31 March 2010, amounted to nearly Rs.6000
crore of ICICI. In other words the decision by the Government is not out of love for Universal
Banking but out of concern about the situation of DFI’s. The capital markets are sluggish on the
whole and the position of Banks is also no better. In that context marrying the “sick man” hoping
the sickness will be cured after marriage to the “lame lady” may result in both becoming “Lame
and Sick”.

The options, [either in the case of DFI’s or the Universal Banks] which should be considered in
the context of changes both in domestic and global scenario, are as follows:

Grant them greater autonomy –only then will they be able to stand up to the competition from
domestic as well as international players.

Reduce government stake over period of time and make them private.
 • Make them more market driven .both from lending practices as well as compensation
packets.

• Allow for external experts to be inducted at senior levels.

• Introduce strict risk management practices and internal controls.

• Have to enter in to the global .financial system through more sophisticated financial
instruments.

• Last but not the least is a proper .succession planning, without leaving these institution
headless for months.

The form of organisation is only a minor part of the solution, the major issue is regarding
flexibility and autonomy given to these institution.

Some of the most successful entities have adopted the universal banking mode. But the success
or otherwise is not a function of the organizational structure but more due to management
practices. In other words universal banking per se is not a sufficient conditions for success.After
all individuals who are running them and not based on inanimate structure.

Thank You