INDIAS BANKING SECTOR REFORMS

Indias pre-reform period and financial reform:

Since 1991, India has been engaged in banking sector reforms aimed at increasing the profitability and efficiency of the then 27 public-sector banks that controlled about 90 per cent of all deposits, assets and credit. The reforms were initiated in the middle of a current account crisis that occurred in early 1991. The crisis was caused by poor macroeconomic performance, characterized by a public deficit of 10 per cent of GDP, a current account deficit of 3 per cent of GDP, an inflation rate of 10 per cent, and growing domestic and foreign debt, and was triggered by a temporary oil price boom following the Iraqi invasion of Kuwait in 1990. Prior to the reforms, Indias financial sector had long been characterized as highly regulated and financially repressed. The prevalence of reserve requirements, interest rate controls, and allocation of financial resources to priority sectors increased the degree of financial repression and adversely affected the countrys financial resource mobilization and allocation. After Independence in 1947, the government took the view that loans extended by colonial banks were biased toward working capital for trade and large firms (Joshi and Little 1996). Moreover, it was perceived that banks should be utilized to assist Indias planned development strategy by mobilizing financial resources to strategically important sectors. In the period 1969-1991, the number of banks increased slightly, but savings were successfully mobilized in part because relatively low inflation kept negative real interest rates at a mild level and in part because the number of branches was encouraged to expand rapidly. Nevertheless, many banks remained unprofitable, inefficient, and unsound owing to their poor lending strategy and lack of internal risk management under government ownership. Joshi and Little (1996) have reported that the average return on assets in the second half of the 1980s was only about 0.15 per cent, while capital and reserves averaged about 1.5 per cent of assets. Given that global accounting standards were not applied, even these indicators are likely to have exaggerated the banks true performance. Further, in 1992/93, nonperforming assets (NPAs) of 27 public-sector banks amounted to 24 per cent of total credit, only 15 public-sector banks achieved a net profit, and half of the public-sector banks faced negative net worth. The major factors that contributed to deteriorating bank performance included (a) too stringent regulatory requirements (i.e., a cash reserve requirement [CRR] and statutory liquidity requirement [SLR] that required banks to hold a certain amount of government and eligible securities); (b) low interest rates charged on government bonds (as compared with those on commercial advances); (c) directed and concessional lending; (d) administered interest rates; and (e) lack of competition. These factors not only reduced incentives to operate properly, but also undermined regulators incentives to prevent banks from taking

risks via incentive-compatible prudential regulations and protect depositors with a welldesigned deposit insurance system. While government involvement in the financial sector can be justified at the initial stage of economic development, the prolonged presence of excessively large public-sector banks often results in inefficient resource allocation and concentration of power in a few banks. Further, once entry deregulation takes place, it will put newly established private banks as well as foreign banks in an extremely disadvantageous position. Following the 1991 report of the Narasimham Committee, more comprehensive reforms took place that same year. The reforms consisted of (a) a shift of banking sector supervision from intrusive micro-level intervention over credit decisions toward prudential regulations and supervision; (b) a reduction of the CRR and SLR; (c) interest rate and entry deregulation; and (d) adoption of prudential norms.3 Further, in 1992, the Reserve Bank of India issued guidelines for income recognition, asset classification and provisioning, and also adopted the Basle Accord capital adequacy standards. The government also established the Board of Financial Supervision in the Reserve Bank of India and recapitalized public-sector banks in order to give banks sufficient financial strength and to enable them to gain access to capital markets. In 1993, the Reserve Bank of India permitted private entry into the banking sector, provided that new banks were well capitalized and technologically advanced, and at the same time prohibited cross-holding practices with industrial groups. The Reserve Bank of India also imposed some restrictions on new banks with respect to opening branches, with a view to maintaining the franchise value of existing banks. As a result of the reforms, the number of banks increased rapidly. In 1991, there were 27 public-sector banks and 26 domestic private banks with 60,000 branches, 24 foreign banks with 140 branches, and 20 foreign banks with a representative office.4 Between January 1993 and March 1998, 24 new private banks (nine domestic and 15 foreign) entered the market; the total number of scheduled commercial banks, excluding specialized banks such as the Regional Rural Banks rose from 75 in 1991/92 to 99 in 1997/98. Entry deregulation was accompanied by progressive deregulation of interest rates on deposits and advances. From October 1994, interest rates were deregulated in a phased manner and by October 1997, banks were allowed to set interest rates on all term deposits of maturity of more than 30 days and on all advances exceeding Rs 200,000. While the CRR and SLR, interest rate policy, and prudential norms have always been applied uniformly to all commercial banks, the Reserve Bank of India treated foreign banks differently with respect to the regulation that requires a portion of credit to be allocated to priority sectors. In 1993, foreign banks which used to be exempt from this requirement while all other commercial banks were required to earmark 40 per cent of credit were required to allocate 32 per cent of credit to priority sectors.

Diversification of banking activities:

The second unique feature of Indias banking sector is that the Reserve Bank of India has permitted commercial banks to engage in diverse activities such as securities related transactions (for example, underwriting, dealing and brokerage), foreign exchange

transactions and leasing activities. The 1991 reforms lowered the CRR and SLR, enabling banks to diversify their activities. Diversification of banks activities can be justified for at least five reasons. First, entry deregulation and the resulting intensified competition may leave banks with no choice but to engage in risk-taking activities in the fight for their market share or profit margins. As a result, risk-taking would reduce the value of banks future earnings and associated incentives to avoid bankruptcy (Allen and Gale 2000). Second, banks need to obtain implicit rents in order to provide discretionary, repetitive and flexible loans. In addition; banks attempt to reduce the extent of information asymmetry by processing inside information on their clients and monitoring their performance. Such roles are unique to the banking system and important particularly for SMEs since information on them tends to be highly idiosyncratic. Without sufficient rents, however, banks are likely to cease providing these services and the implication for SMEs and economic development can be enormous. Thus, it is important for bank regulators to ensure adequate implicit rents to banks in order to encourage them to provide such unique services. Moreover, banks may lose an opportunity to collect implicit rents if their clients switch to capital markets once they become larger and profitable. Diversification of banking activities helps banks to mitigate the two problems raised above by providing them with an opportunity to gain non-interest income and thereby sustain profitability. This enables banks to maintain long-term relationships with clients throughout their life cycles and gives them an incentive to process inside information and monitor their clients. Third, banks can stabilize their income by engaging in activities whose returns are imperfectly correlated, thereby reducing the costs of funds and thus lending and underwriting costs. Fourth, diversification promotes efficiency by allowing banks to utilize inside information arising out of long-term lending relationships.8 Thanks to this advantage, banks are able to underwrite securities at lower costs than non-bank underwriters. Firms may also obtain higher prices on their securities underwritten by banks because of their perceived monitoring advantages. Further, banks can exploit economies of scope from the production of various financial services since they can spread fixed physical (i.e., branches and distribution channels) and human capital costs (Steinherr and Huveneers 1990). Fifth, diversification may improve bank performance by diluting the impact of direct lending (through requiring banks to allocate credit to priority sectors). Direct lending reduces the banks incentives to conduct information processing and monitoring functions. As a result, this not only lowers banks profitability by limiting financial resources available to more productive usages, but also results in a deterioration of efficiency and soundness by discouraging banks from functioning properly. These five advantages, however, can be offset by the following disadvantages.

First, public-sector banks engagement in the securities business may promote a concentration of power in the banking sector since the asset size of banks expands. This is partly because banks have a natural tendency to promote lending over securities, Second, the engagement of banks in underwriting services may lead to conflicts of interest between banks and investors. Banks may decide to underwrite securities for troubled borrowers so that the proceeds of the issue of securities can be used to pay off these banks own claims to the companies. Banks may dump into the trust accounts they manage the unsold part of the securities they underwrite. Further, banks may impose tie-in deals on customers by using their lending relationships with firms to pressure them to purchase their underwriting services (for example, using the threat of increased credit costs or non-renewal of credit lines). Banks may also use the confidential inside information that they possess when they underwrite firms securities in a way that the firms do not contemplate, such as disclosing the information directly or indirectly to the firms competitors. Third, diversification may expose banks to various new risks. For example, banks may end up buying the securities they underwrite. They may also face greater market risks as they increase their share of securities holdings and market-making activities. Further, derivatives involve higher speed and greater complexity, which may reduce the solvency and transparency of banking operations. The presence of these three potential disadvantages suggests that measures are needed to balance the advantages and disadvantages. The Reserve Bank of India tries to cope with the disadvantages by encouraging banks to engage in securities business through subsidiaries, thereby putting in place firewalls between traditional banking and securities services.10 The Reserve Bank of India also prohibits cross-holdings with industrial groups to minimize connected lending one of the causes of the East Asian crisis. To assess the overall impact of banks activities, this chapter examines whether diversification improves bank performance. In particular, the impact of disadvantages can be assessed indirectly by examining how soundness is associated with diversification. It is also important to examine whether diversification has led to even greater dominance of publicsector banks by examining whether banks asset portfolios differ between public-sector and private banks.

Future direction of reforms:

If the financial sector reforms are viewed in a broad perspective, it would be evident that the first phase of reforms focussed on modification of the policy framework, improvement in financial health of the entities and creation of a competitive environment. The second phase of reforms target the three interrelated issues viz. (I) strengthening the foundations of the banking system; (ii) streamlining procedures, upgrading technology and human resource development; and (iii) structural changes in the system. These would cover aspects of banking policy, and focus on institutional, supervisory and legislative dimensions.

Although significant steps have been taken in reforming the financial sector, some areas require greater focus. One area of concern relates to the ability of the financial sector in its present structure to make available investible resources to the potential investors in the forms and tenors that will be required by them in the coming years, that is, as equity, long term debt and medium and short-term debt. If this does not happen, there could simultaneously exist excess demand and excess supply in different segments of the financial markets. In such a situation the segment facing the highest level of excess demand would prove to the binding constraint to investment activity and effectively determine the actual level of investment in the economy. Such problems could be resolved through movement of funds between various types of financial institutions and instruments and also by portfolio reallocation by the savers in response to differential movements in the returns in the alternative financial instruments. In this context, it is very important to identify the emerging structure of investment demand, particularly from the private sector, in order to reorient the functioning of the financial sector accordingly, so that investment in areas of national importance flows smoothly. A major area that needs to be focused in the context of the countrys development policy is investment in infrastructure. Financing of infrastructure projects is a specialized activity and would continue to be of critical importance in the future. A sound and efficient infrastructure is a sine qua non for sustainable economic development. A deficient infrastructure can be a major impediment in a countrys economic growth particularly when the economy is on the upswing. A growing economy needs supporting infrastructure at all levels, be it adequate and reasonably priced power, efficient communication and transportation facilities or a thriving energy sector. Such infrastructure development has a multiplier effect on economic growth, which cannot be overlooked. Infrastructure services have generally been provided by the public sector all over the world for a large part of the twentieth century as most of these services have an element of public good in them. It was only in the closing years of the century that private financing of infrastructure made substantial progress. It may be relevant to point out that infrastructure was largely privately financed in the nineteenth century. The twenty-first century would, therefore, be more like the nineteenth than the twentieth century.

Performance of Indian Public Sector Banks and Private Sector Banks:

PUBLIC SECTOR BANKS Public sector banks are the ones in which the government has a major holding. They are divided into two groups i.e. Nationalized Banks and State Bank of India and its associates. Among them, there are 19 nationalized banks and 8 State Bank of India associates. Public Sector Banks dominate 75% of deposits and 71% of advances in the banking industry. Public Sector Banks dominate commercial banking India. These can be further classified into: 1) State Bank of India

2) Nationalized banks 3) Regional Rural Banks NATIONALIZED BANKS In July 1969, 14 banks with a deposit base of Rs.50 crores or more were nationalized. Again in 1980, six more private banks were nationalized, bringing up the number to twenty. These Banks were: (1) Bank of Baroda (2) Punjab National Bank (3) Bank of India (4) Canara Bank (5) Central Bank of India (6) Indian Bank (7) Indian Overseas Bank (8) Syndicate Bank (9) UCO Bank (10) Allahabad Bank (11) United Bank of India (12) Oriental Bank of Commerce (13) Corporation Bank (14) Vijaya Bank (15) Dena Bank (16) Bank of Maharashtra (17) Andhra Bank (18) Punjab & Sind Bank (19 New Bank of India (20) Corporation Bank.

PRIVATE SECTOR BANKS Private sector banks came into existence to supplement the performance of Public sector banks and serve the needs of the economy better. As the public sector banks were merely in the hands of the government, banks had no incentive to make profits and improve the financial he Main difference is only that Public follow the RBI Interest rules strictly but Private Banks could have some changes but only after the approval from the RBI! Private sector banks are the banks which are controlled by the private lenders with the approval from the RBI their interest rates are slightly costly as compared to Public sector banks.

E-DELIVERY CHANNELS IN BANKS-A FRESH OUTLOOK Use of Internet in banking Internet is a network of networks. It is not a single network, but a global interconnected network of networks providing free exchange of information. It implies the most pragmatic use of information technology as medium of universal communication. It has brought unprecedented changes in society. Spanning the entire globe, the net has redefined the methods of communication, work, study, education, interaction, entertainment, health, trade and commerce. The versatile facilities and opportunities provided by the Internet and World Wide Web led to the development of electronic commerce. This became possible

when the internet transformed from the ordinal system providing static web pages, into interactive two-way system. E-Commerce Electronic Commerce is a system, which includes transactions that centre on buying and selling of goods and services to directly generate revenue. E-commerce builds on the advantages of traditional commerce by adding the flexibility offered by electronic networks. E-commerce helps conduct of traditional commerce through new ways of transferring and processing information. E-Banking E-banking and electronically providing financial services are branches of electronic commerce. A significant development 20 SCMS Journal of Indian Management, JulySeptember, 2006. Published by School of Communication and Management Studies has been achieved in offering a variety of new and innovative E-banking services to customers today, which were not thought of before. Corporate Internet Banking (CIB) It facilitates banking from your desk. At the click of a mouse, we can access your accounts at any branch of the bank and also keep track of your accounts at its numerous branches. IT banking in rural areas IT has revolutionized the urban sector of banking manifolds but e-banking in rural areas has not taken much care of. If e-banking is implemented in the rural sector, it would be a great boon to the rural areas. If e-banking is implemented things would be much easier. In certain areas kiosks have been put up. Where extremely easy user interfaces are used so that even very less educated people can carry out transactions. This however is not very common. If ebanking becomes common in the rural areas, the much talked about corruption would end as it would be a direct communication between bankers and the people without the need of mediators who are responsible for all the corruption. It would lead to the commercialization of the rural sector, and would help bridge the divide between the technologically and economically rich urban sectors and would help in easy transfer of funds from the urban ector to the rural sector. The basic structure of the banks is increasingly in conflict with the changing product, delivery and service needs of the customers. The future belongs to financial service providers and not traditional banks. The vast majority of large banks will create value networks.

Information Technology and Bank Transformation

The second banking sector reforms gave much importance to the modernization and technology up gradation. The IT Act, 1999 started the speedy process of e-banking. E-Banking: Delivery of banks services to a customer at his office or home by using electronic technology can be termed as e-banking. The quality, range and price of these eservices decide a banks competitive position in the industry. The virtual financial services can be largely categorized as follows: Automated Teller Machines: - Cash withdrawals - Details of most recent balance of account - Mini-statement

- Statement ordering facility - Deposit facility - Payments to third parties EFTPoS: EFTPoS card used to initiate transactions: - Authorization and transaction capture processes take place electronically. - Transaction confirmed manually. - Funds not debited electronically.

Remote Banking Services: - Balance enquiry - Statement ordering - Funds transfer (payment) to third parties - Funds transfer between customers different accounts - Order travelers cheques and other financial instruments. Services Not Available Through Remote Banking: - Cash withdrawal - Cash/ cherub deposit - Sale of the more complex types of financial services such as life insurance mortgages and (pensions).

Smart Cards: (i) Stored value cards (ii) As a replacement for all types of magnetic stripes cards like ATM Cards, Debit/Credit Cards, Charge Cards etc. - One smart card to carry out all these functions - One smart card can contain the functionality of several different types of cards issued by different banks while running different types of networks. - Smart card a truly powerful financial token, giving user access

- STM - Debit facility - Charge facilities - Credit facilities - Electronic purse facilities at national and international level.

Internet Banking: The latest wave in IT is Internet banking. It is becoming more obvious
that the Internet has unleashed a revolution that is affecting every sphere of life. Internet is an interconnection of computer communication networks spanning the entire globe, crossing all geographical boundaries. Touching lifestyles in every sphere the Net has redefined methods of communication, work, study, education interaction, health, trade and commerce. The Net is changing everything, from the way we conduct commerce, to the way we distribute information. Being an interactive two-way medium, the Net, through innumerable websites, enables participation by individual in B2B and B2C commerce, visits to shopping malls, books-stores, entertainment sides, and so on cyberspace. Bank Transformation 1. The term transformation in Indian Banking Industry relates to intermediately stage when the industry is passing from the earlier social banking era to the newly conceived technology based customer - centric and competitive banking. The activities of banks have grown in multi-directional as well as in multi-dimensional manners. 2. During transformation, all known parameters of the earlier regime continuously change. 3. The current transformation process in the Indian Banking has many aspects. They pertain to: (i) Capital Restructuring (ii) Financial Re-engineering (iii) Information Technology (iv) Human Resource Development

This paper is divided into six sections. After a brief introduction second section reviews some related studies. Third section describes objectives, hypothesis, and database and research methodology. The fourth section describes the process and contents of bank transformation. The fifth section analyzes the performance of the selected banks whereas sixth section discusses general challenges faced by the banks and available opportunities. Last part concludes the paper. The present paper analyzes the impact of IT on the transformation of

banks during the second phase of banking sector reforms. The specific objectives of the paper are: To study the process and contents of bank transformation in the regime of post-second banking sector reforms. To analyze the comparative performance of public sector banks, new private sector banks and foreign banks in pre and post e-banking period. To study the challenges and opportunities for the banking industry particularly to the public sector banks.

Few value-added services being offered by banks are:

Free collection of specified member of outstation instruments per month. Instant credit of outstation cheques. Concession in commission / exchange for issuance of pay orders of demand drafts. Issuance of free cheque books. Concession in commission / demand drafts. Issuance of free ATM Cards. Waiver of credit card issuance fees. Issuance of free Add-on cards to members of the Card holders family. Execution of standing instructions of customer. Free investment advisory services. Payment of utility bills like Electricity, Telephone and Water Bills on due dates. Payment of monthly / quarterly education fees of children. Payment of insurance premium on due dates. Demoting of shares, debentures and bonds. Selling of insurance products. Housing finance etc.

E-Banking Services i) ii) iii) iv) v) vi) vii) viii) ATM (Automated Teller Machines) Any where Banking Debit Cards / Credit Cards / Smart Cards Internet Banking ECS (Electronic Cleaning Systems) EFT (Electronic Funds Transfer) Electronic Data Inter Change INFINET (Indian Financial Network)

ix) x) xi) xii) xiii) xiv)

On-Line Banking x) SPNS (Shared Payment Network System) Tele Banking Universal Banking xiii) 24 Hours Banking xiv) Corporate Banking Terminals

TECHNOLOGY IN BANKING

1 Technology will bring fundamental shift in the functioning of banks. It would not only help them bring improvements in their internal functioning but also enable them to provide better customer service. Technology will break all boundaries and encourage cross border banking business. Banks would have to undertake extensive Business Process Re-Engineering and tackle issues like a) how best to deliver products and services to customers b) designing an appropriate organizational model to fully capture the benefits of technology and business process changes brought about. c) how to exploit technology for deriving economies of scale and how to create cost efficiencies, and d) how to create a customer - centric operation model.

2 Entry of ATMs has changed the profile of front offices in bank branches. Customers no longer need to visit branches for their day to day banking transactions like cash deposits, withdrawals, cheque collection, balance enquiry etc. E-banking and Internet banking have opened new avenues in convenience banking. Internet banking has also led to reduction in transaction costs for banks to about a tenth of branch banking.

3 Technology solutions would make flow of information much faster, more accurate and enable quicker analysis of data received. This would make the decision making process faster and more efficient. For the Banks, this would also enable development of appraisal and monitoring tools which would make credit management much more effective. The result would be a definite reduction in transaction costs, the benefits of which would be shared between banks and customers.

4 While application of technology would help banks reduce their operating costs in the long run, the initial investments would be sizeable. IT spent by banking and financial services industry in USA is approximately 7% of the revenue as against around 1% by Indian Banks. With greater use of technology solutions, we expect IT spending of Indian banking system to go up significantly.

5 One area where the banking system can reduce the investment costs in technology applications is by sharing of facilities. We are already seeing banks coming together to share ATM Networks. Similarly, in the coming years, we expect to see banks and FIs coming together to share facilities in the area of payment and settlement, back office processing, data warehousing, etc. While dealing with technology, banks will have to deal with attendant operational risks. This would be a critical area the Bank management will have to deal with in future.

6 Payment and Settlement system is the backbone of any financial market place. The present Payment and Settlement systems such as Structured Financial Messaging System (SFMS), Centralised Funds Management System (CFMS), Centralised Funds Transfer System (CFTS) and Real Time Gross Settlement System (RTGS) will undergo further finetuning to meet international standards. Needless to add, necessary security checks and controls will have to be in place. In this regard, Institutions such as IDRBT will have a greater role to play.