TABLE OF CONTENTS

S.No. CONTENTS PAGE NO.

1. Abstract 5

2. Introduction 6

3. Literature Review 7

4. Overview 8

4. Concept of Universal Banking 10

5. Example of Universal Banks 11

7. SWOT analysis 14

8. Future Trend of Universal Banking in different countries

21

International Scenario 21

Universal Banking in India 32

9. Is Universal Banking good or bad for the country

38

10. What Universal Banking can result for India 42

11. Methodology 48

12. Results and Discussions 49

13. Findings 65

14. Considerations 66

15. Recommendations 67

16. Conclusion 68

17. Bibliography 69

18. Annexure- Questionnaire

ABSTRACT

Different types of financial products and services penetrate our daily activities. As a major

group of financial institutions, banks have been expanding their service scope, and hence,

universal banks, which provide a variety of financial products and services in one house,

have experienced growing popularity in some industrialized countries. In India, banking

institutions have assumed a key role in the simplistic financial sector. Commercial banks

have made effort to diversify their products and services, but a lengthy process is expected

for their transition into truly universal banks. It is argued that the current structure and

practices of the local market also contribute to this lengthy transformation . Thus, banks,

which assume a leading position in most financial systems, have to be prepared for the

growing need of their customers. Also, government should provide necessary assistance to

banks for aiding them to get converted into universal banking system for the benefit of Indian

customers.

2

INTRODUCTION

Banking institutions are dominant operators in modern financial systems and important

business entities in an economy. They are divided into two separate types of institutions,

namely commercial banks and investment banks in some countries, while in other countries

such division is vague or even non-existent. The so-called universal banks engage in all

forms of commercial and investment banking, not only including lending and deposit taking,

but also underwriting securities and securities trading. In particular, some universal banks

may own significant equity interests in companies with voting rights.

Germany is the typical example running the universal banking system. Canada and

Switzerland, among others, are noteworthy examples moving towards universal banking.

Despite the growing popularity of universal banks in a global context, the United States

continues to block commercial banks from engaging in securities transaction and

underwriting. Hence, it is argued that the practice of universal banking may not be suitable

for all financial systems.

This project is designed to discuss primary practices of universal banks and their relevance to

banking activities in India. The objective is to analyze whether the concept of Universal

Banking, if implemented by Indian banks, have potential for Indian market consumers.

3

LITERATURE REVIEW

Universal Banking is a multi-purpose and multi-functional financial supermarket (a company

offering a wide range of financial services e.g. stock, insurance and real-estate brokerage)

providing both banking and financial services through a single window.

As per the World Bank, “In Universal Banking, large banks operate extensive network 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”.

In a nutshell, a Universal Banking is a superstore for financial products under one roof.

Corporate can get loans and avail of other handy services, while can deposit and borrow. It

includes not only services related to savings and loans but also investments.

However in practice the term 'universal banking' refers to those banks that offer a wide range

of financial services, beyond the commercial banking functions like Mutual Funds, Merchant

Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans, Investment

banking, Insurance etc. This is most common in European countries.

For example, in Germany commercial banks accept time deposits, lend money, underwrite

corporate stocks, and act as investment advisors to large corporations. In Germany, there has

never been any separation between commercial banks and investment banks, as there is in the

United States.

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OVERVIEW

Universal banking is the opposite of narrow banking. Narrow banking legislation would

require banks to back their liabilities with safe assets, such as government securities. All

other bank lending functions would be transferred to mutual-fund-like institutions that were

not insured by the government. This arrangement would allow the government to base its

costly deposit insurance programs without jeopardizing the safety of the banks. Narrow

banking is the modern and more elaborated version of the “100 percent reserve banking”

principle, invoked by early economists to correct the inadequacy of money reserve against the

stock of banknotes in circulation. The benefits of narrow banking are:

First, by locking bank assets in high-quality instruments, narrow banking regulation would

minimize bank liquidity and credit risk.

Second, since narrow banks would be prohibited from supplying risky loans and would

collateralize deposits with high-quality assets, confidence in the value of their liabilities is

tend to be increased.

Third, with payment system access restricted to narrow banks, payment would be fully

secure, because payment-system participants would be protected against liquidity, credit, and

settlement risks, and because any shock to non-banks would be isolated, with no systemic

fallout.

In the early nineties, the forces of globalization were unleashed on the hitherto protected

Indian environment. The public sector banks, which had monopoly earlier, then started facing

problems with deteriorating performance. Therefore, the sector was opened up for the private

sector in line with Narsimham Committee’s recommendations. The protected environment

has given rise to several lacunae in the banking system. Most of the public sector banks were

inefficient in areas of liquidity management. In an administered interest regime, discretion of

management was limited and consequently, the risk parameters in these spheres were unclear 5

and not quantifiable. The share of private sector banks was not substantial while operations of

foreign banks were also restricted. Staff orientation especially at the branch level is a key

ingredient for success and neither the older private banks nor the nationalized banks were

successful in that respect. It would be pertinent to recapitulate that the nationalized sector had

outlived its utility; in fact they became burdened with unwelcome legacies; customer service

had become a casualty. Thus, there arose a need for computerization, including networking

among the vast branch network. Private banking in this context was viewed as an approach to

overcome the structural and operational shortcomings of the public sector.

The ICICI’s decision to turn itself into a universal bank ushered a new era in the banking

scenario. The second Narasimham Committee noted that the global trends in banking

industry towards consolidation and convergence led to the dismantling of boundaries among

suppliers of various financial products. The Khan Working Group also recommended a

progressive move towards universal banking and development of enabling regulatory

framework. It is contended that universal banking will result in greater economic efficiency

in the form of lower cost, higher output, and better products and therefore is believed to be

the panacea for beleaguered development financial institutions (DFIs).

There is a fear that such institutions, by virtue of their sheer size, would gain monopoly in the

market, which can have significant and undesirable consequences for economic efficiency.

Also, combining commercial and investment banking can give rise to conflict of interests.

Conflict of interests was one of the major reasons for introduction of Glass-Steagall Act of

1934 in United States. The Act prohibited commercial banks from collaborating with full-

service brokerage firms or participating in investment bank activities. The Glass-Steagall Act

was enacted during the Great Depression. It protected bank depositors from the additional

risks associated with security transactions. The Act was dismantled in 1999. Consequently,

the distinction between commercial banks and brokerage firms has blurred; many banks own

brokerage firms and provide investment services. Internationally, the concept was in the

financial segment. However, in India, the issue was more of access to short-term funds and

payment mechanism than access to long-term funds.

However, the enactment of the Gramm-Leach-Bliley Act (GLBA) in November 1999

effectively repealed the long-standing prohibitations on the mixing of banking with securities

or insurance businesses and thus permitting “broad banking”. The repeal of these prohibitions

6

are due to the increasingly persuasive evidence from academic studies of the pre Glass-

Steagall era, the recent favourable experience in the U.S. following partial deregulation of

banking activities, the experience of banking systems abroad with broader scopes for banking

activities, and rapid technological change in telecommunications and data processing.

THE CONCEPT OF UNIVERSAL BANKING

The entry of banks into the realm of financial services was followed very soon after the

introduction of liberalization in the economy. Since the early 1990s structural changes of

profound magnitude have been witnessed in global banking systems. Large scale mergers,

amalgamations and acquisitions between the banks and financial institutions resulted in the

growth in size and competitive strengths of the merged entities. Thus, emerged new financial

conglomerates, which could maximize economies of scale and scope by building the

production of financial services organization, called Universal Banking.

By the mid-1990s, all the restrictions on project financing were removed and banks were

allowed to undertake several in-house activities. Reforms in the insurance sector in the late

1990s, and opening up of this field to private and foreign players also resulted in permitting

banks to undertake the sale of insurance products. At present, only an ‘arm’s length

relationship between a bank and an insurance entity has been allowed by the regulatory

authority, i.e. IRDA (Insurance Regulatory and Development Authority).

Universal Banking, means the financial entities – the commercial banks, DFIs, NBFCs, -

undertake multiple financial activities under one roof, thereby creating a financial

supermarket.

The entities focus on leveraging their large branch network and offer wide range of services

under single brand name Universal banking generally takes one of the three forms: -

a. In-house Universal Banking. E.g. Germany

b. Through separately capitalized subsidiaries. E.g. England.

c. Operations carried through a holding company. E.g. USA. (Nair, 1998)

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EXAMPLES OF UNIVERSAL BANKS

In line with the growing popularity in merging investment banking, insurance and

commercial banking operations, the number of universal banks have gradually increased.

Universal banks can be broadly categorized in forms of full universal banks, universal-

subsidiary, and holding company

Germany is one of the most commonly cited countries with a full universal banking system.

German universal banks have prevailed before the Second World War. Cable (1985) has an

impressive analysis of the country’s banking system. German universal banks finance

enterprises mainly in two ways, i.e. current account credit and organization of issues of new

securities. External finance for investment is of great importance to German industrialization

since internal financial resources are obviously inadequate for the development of capital-

intensive industries. As a result, universal banks prove to be a major source of external

finance to enterprises.8

Edwards (1996) states that the supply of external finance in the model of universal banking

increases in line with the suppliers’ controlling power over their borrowers’ behaviours. In

the case of Germany, the representatives of universal banks on company boards of directors

increase profitability, as this arrangement makes the provision of external finance more

attractive. Edwards also argues that the universal nature enables German banks to improve

information flows within the economy. In other words, the contribution of universal banks to

the economy should not be only measured in terms of external funds they supply but also of

improved information flows as a result of banks’ improved capability to compare companies

within an industry and across industries within the whole economy.

Supportive evidences show that the universal banking system in Germany benefits the

country’s industrial development. Stiglitz (1985) points out that default risk generally

decreases in the presence of banks’ control over enterprises but the concern of banks might

overshadow the profitability objective of enterprises. Banks’ prime concern is the repaying

ability of enterprises and not necessarily the maximization of enterprise profitability. As

Stiglitz emphasizes: “Lenders are only concerned with the bottom part of the tail of the

distribution returns. Thus, they may require that the firm undertakes projects with relatively

little (bottom-tail) risk, even though the expected return is much lower.” To conclude, Stiglitz

suggests that the effects of universal banks in boosting industrialization might be overstated.

On the other hand, the story can be rewritten in other way. The prudent governance of

universal banks is not solely for their own good. Shareholders of large enterprises are not

necessarily the managers because shares are usually widely held by an enormous number of

individuals or institutions. Most large enterprises will hire managers, who usually are

financial experts, to handle daily business activities. The underlying problem is that these

managers may be less concerned about long-run prospects of the company while short-run

profitability is of their first priority. Their over-aggressiveness in maximizing short-run

profits could increase the risk of bankruptcy. The representation of banks thus acts as a buffer

and promotes the long-term financial health of enterprises.

Universal banks play a dominant role in the German financial system. Yet not all financial

systems are as bank-oriented as the German’s. For example, the United States has a financial

system where markets are of great importance. Boyd et al. (1998) investigate whether the

United States should be transformed into a universal banking system. It is argued that one

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concern that could arise is the lack of control over moral hazard problems, which could easily

come up with the close relationship between banks and their borrowers. Furthermore, the

problems led by moral hazard might have negative impacts on the financial sector and also on

other economic sectors. As Boyd et al. (1998) argue, “…regulators have often expressed the

concern that the establishment of universal banking in the U.S. could extend the

‘governmental safety net’ far too broadly, that moral hazard problems could be exacerbated

as a consequence, and that they could, potentially, be transmitted beyond the financial

sector.” After investigating the severity of moral hazard problems in association with the

universal banking system, it is suggested that when banks are allowed to take equity positions

and participate in the decision-making process of the companies, their incentives to control

moral hazard problems could be attenuated seriously. In addition, banks with controlling

rights might sometimes lead enterprises to misallocate their funds for the sole benefits of the

banks.

Contrasts to the situation in the United States, universal banks are becoming more important

in the financial system of Switzerland. Rime and Strioh (2001) examine the production

structure of 290 banks from 1996 to 1999 through the performances of the following areas:

cost efficiency, profit efficiency, economies of scale, and economies of scope. However, their

empirical results indicate that around 40% of costs reflect cost inefficiency and about one-

half of potential profits are foregone because of profit inefficiency in their model, which

includes a “universal” measure of bank output. In addition, there is little evidence of

significant gains from either scale or scope economies for the largest banks in Switzerland.

The difficulty in monitoring large universal banks is also a major concern. The consequence

of inefficient monitoring could lead to financial instability. Benston (1994) states that

universal banks tend to be larger so that collapse of a single bank of this type could cause

substantial distress in the financial system. When several of those large universal banks are to

collapse, this will greatly increase the risk to the economy’s payments system. At the same

time, it is more difficult to regulate universal banks because of their close and complex ties to

businesses. Hence, financial regulators either have to regulate universal banks very tightly,

thus hindering economic efficiency, or be faced with the possibility of a taxpayer bailout.

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THE NEED BEHIND THE ADVENT OF UNIVERSAL BANKING

1. To make pace with the present need of corporate.

Now a day, there is a large market of General Insurance and Project Financing. As only a

bank is not able to fund it properly, due to insufficient asset base and net worth. So, to

overcome this, they form a consortium of lenders, for funding the Greenfield and Brownfield

projects. (In the month June a consortium of 20 lenders led by SBI has committed a 14 year

project finance term loan for a special purpose company promoted BPCL, which is starting a

Greenfield project in Madhya Pradesh) The point of consideration here is the consortium

partner – Bank of Baroda, Bank of Maharashtra, Central Bank of India, LIC, Indian Overseas

Bank. Most of the partners are nationalized banks.

It means there is a need of developing a strong domestic financial system to cater the need of

the corporate sector. It is possible if banks have strong capital/asset base. It fortifies the

importance of Universal Banking. Along with that, the ongoing clamor of Mergers and

Acquisitions in the corporate sector, this needs financial assistance as well as consulting.

More financial institutional investors entering in India and several Joint Ventures are being

started between domestic companies and global firms. A number of issues may crop up

between from the signing up of the sale purchase document and the deal actually coming up.

Near about 4% could be getting aborted (e.g.-the failure of Jet Airways and Air Sahara is one

of that. So, the corporate are in need of takers to insure the associated transactions of Mergers

and Acquisitions)

Now International insurers are offering cover in India against the loss arising out of Mergers

and Acquisitions and Breakups. (E.g.-Howden India leading International brokers, which has

introduced transactional insurance of M & A, is now finding takers for their insurance cover)

Indian banking, with the help of Universal Banking has technology edge and better business

11

models, compared to pre-liberalizations era, today they are able to attract and gain more

volumes simply because they meet their customers' requirements better than anyone else. If

the newer and foreign players can do that, then why can't bigger DFIs try their hands on it?

Liberalization and the banking reforms have given new avenues to Development Finance

Institutions (DFIs) to meet the broader market. They can avail the options to involve in

deposit banking and short term lending as well. DFIs were set up with the objective of taking

care of the investment needs of industries. They have build up expertise in Merchant Banking

and Project Evaluation.

So, saddled with obligations to fund long gestation projects, the DFIs have been burdened

with serious mismatches between their assets and liabilities of the balance sheet. In this

context, the Narsimham Committee II had suggested DFIs should convert into banks or Non-

Banking Finance Companies. Converting of these DFIs into Universal Banks will grant them

ready access to cheap retail deposits and increase the coverage of the advances to include

short term working capital loans to corporate with greater operational flexibility. At that time

DFIs were in the need to acquire a lot of mass in their volume of operations to solve the

problem of total asset base and net worth. So, the emergence of Universal Banking was the

solution for the problem of banking sector.

2. Funds Mobilization and Credit Rationing

The traditional activities of banks are deposit taking and lending. Deposits are liabilities of

banks, while funds extended by banks to borrowers are their assets. The fundamental function

of banks is to mobilize available funds from the surplus units to the deficit units. A “must”

technique when banks reallocate funds is credit rationing.

Bank credit is extended to the “good” ones, who are more likely to settle their debt principals

and interests. Default risk is a primary concern of banks when financing the deficit units.

Asymmetric or imperfect information is the factor behind default risk. In reality, financial

markets are not necessarily efficient under prefect information. Information is costly as well

as not available to everyone. Under this circumstance, banks with their advantages in

collecting information could minimize default risk to certain level. To a further extent, some

banks would insist to monitor their borrowers and take certain control over their borrowers’

businesses.

12

There are three basic mechanisms that banks apply in order to monitor their

borrowers. First, a bank can directly obtain information of the borrower’s cash flow when

the bank itself handles the borrower’s deposit account. The second arrangement is more

formal as restrictive covenants are stipulated in a loan contract. The borrower is required to

maintain a pre-set range of liquidity determined by the bank. Lastly, the bank is granted the

right to monitor the operation of the enterprises that borrow from them. Universal banks often

apply the last mechanism and maintain a close and extensive connection with borrowers.

Such connection will promise certain extent of lender control over those enterprises, and

hence, universal banks are argued to be in advantageous position to overcome the problems

led by the absence of reliable information and facilitate effective funds mobilization

13

A SOLUTION OF UNIVERSAL BANKING COUPLED WITH SWOT

The solution of Universal Banking was having many factors to deal with which further

categorized under Strengths, Weaknesses, Opportunities and Threats.

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

14

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

15

concerned, the prospect of the business, in which it is engaged, its track record, the quality of

the management, etc.

ICICI suffered the least in this section, but the IDBI has got worst hit of NPAs, considering

the negative developments at Dabhol Power Company (DPC)

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

16

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.

17

THE FUTURE TREND OF UNIVERSAL BANKING IN DIFFERENT

COUNTRIES

International Scenario

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 taking, 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-Stegall

Act, continues to be stiff.

18

The purpose of this project is to analyze the German and Swiss experience with regard to

universal banking. I attempt to show to what extent that experience supports or refutes the

arguments against universal banking frequently voiced in the Anglo-Saxon world.

Salient Characteristics of the German and Swiss Banking Systems

Popular discussions of universal banking are often flawed by misconceptions about the

characteristics of Continental European financial systems. The German system, in particular,

is frequently portrayed as being dominated by large oligopolistic universal banks with

branches all over the country. German banks are said to intermediate the bulk of financial

flows, while domestic capital markets remain underdeveloped. Furthermore, emphasis is

placed on the fact that German banks tend to hold equity stakes in industrial companies and,

therefore, yield considerable influence on their management.

This characteristic of the German banking system is overly simplistic and fails to do justice to

the realities of universal banking. It is certainly true that in countries like Germany and

Switzerland large universal banks with nationwide networks of branches play an important, if

not dominant, role. However, this simplistic description omits crucial features of universal

banking that tend to get lost in the public debate. Three such features are worthy of note:

Even if legislation allows for universal banks, not all financial institution chooses to

offer the entire gamut of banking services. Only the largest institutions tend to be

truly universal banks, which coexist with smaller, specialized institutions. Moreover,

universal banking may take on a variety of institutional forms.

The importance of universal banks has tended to increase since the end of World War

II. But the techniques employed for promoting universal banking have varied. In

particular, there are substantial differences between Switzerland and Germany in this

regard.

Universal banking need not prevent capital markets from playing an important

supplementary role in financial intermediation. The German and Swiss experiences

also differ significantly in this respect.

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Universal Banking and Specialization

Table 1 provides information on the structure of the German and Swiss banking systems. In

both countries, financial institutions may be classified into broadly similar groups: big banks,

government-owned savings banks, regional banks, cooperative banks, branches of foreign

banks, and private banks. In addition, both countries feature one of two remaining groups of

diverse and highly specialized institutions.

The group of big banks comprises institutions with nationwide branch networks, as well as an

important international business. They are truly universal institutions involved in all aspects

of banking. They play a leading role in financing foreign trade and industry. They are also

heavily engaged in investment and trust banking. Most of the big German and Swiss banks

occupy an important position in domestic and international securities markets. They act as

leading underwriters of domestic and international securities issues. The big Swiss banks, in

particular, are also well known for their role as international portfolio managers.

The regional banks, as their name indicates, normally confine their activities to specific

regions. In Germany that group includes the subsidiaries of foreign banks. Regional banks

tend to be more specialized than the big institutions. The largest German regional banks,

however, have turned into truly universal institutions. They have spread to other parts of the

country and have also penetrated foreign markets. They now operate nationwide branch

networks, but remain "regional" in the sense that they continue to focus their business on

their home region. Many of the large German regional banks are also authorized to engage in

mortgage lending. In Switzerland most of the regional banks, in fact, are small savings banks

heavily engaged in mortgage lending. These banks do not play a significant role in

investment banking and they are not active abroad.

In both German and Switzerland, government-owned banks account for a substantial share of

total assets (Table 1). The majority of these banks were founded in the 19th century by

municipalities or districts in Germany and by cantons in Switzerland. The purpose of these

banks was, and is, to encourage saving by the local population. However, in contrast to

private-sector savings institutions, government-owned banks must accept certain public-

service functions, such as promoting the development of the local economy or assisting

disadvantaged groups. In Germany, these banks are chartered by the Lander (states) and can

only operate within their home-Land (state). Although the individual German government-

20

owned savings banks can hardly be regarded as universal establishments, they operate central

institutions (Landesbanken) placed at the level of the Lander and at the federal level. These

central institutions initially were set up to provide payments services to their members, but

later evolved into full-fledged universal institutions. Through these central institutions, the

individual savings banks are able to offer universal banking services to their customers.

Among the Swiss cantonal banks cooperation is less common. Only the largest cantonal

banks come close to resembling universal institutions. They do play a limited role in

underwriting domestic securities and in portfolio management, but are legally constrained to

engage in foreign business.

Cooperative banks, like government-owned savings banks, are institutions focusing on the

savings business. Although initially conceived as self-help organizations, which mainly

accepted deposits from and lent funds to members of the cooperative, they gradually evolved

into universal banks when they set up central institutions, as was done in Germany. In

Switzerland, by contrast, cooperative banks remained less important, as indicated by their

respective shares in total assets of the banking system (Table 1). Due to their small market

share, Swiss cooperative banks have not expanded into universal banking to any great extent.

The remaining banking groups in Table 1 largely consist of specialized institutions involved

in the most diverse lines of activity. In both Germany and Switzerland, private banks, whose

importance has shrunk considerably, are active in portfolio management. Branches of foreign

banks, though often part of a universal institution, typically also specialize. In Switzerland,

they tend to concentrate on underwriting and portfolio management. Finally, in Germany, the

category "other financial institutions" includes building societies, mortgage establishments,

and other specialized institutions. In Switzerland, the groups of "other banks" and "finance

companies," which include the subsidiaries of foreign banks, cover institutions involved in

various activities, such as commercial banking, underwriting, securities trading, and portfolio

management.

An analysis of bank earnings reveals further differences between the German and Swiss

banking systems. Table 1 shows the share of commission income in net revenue, broken

down by banking groups. Commission income covers fees obtained on such banking services

as payments services, guarantees, foreign exchange and securities trading, underwriting,

portfolio management, and financial derivatives. Aside from commission income, net

21

revenue includes interest income on the banks' assets net of interest paid on the banks'

liabilities. Therefore, institutions involved mainly in traditional commercial banking activities

display a low ratio of commission income to net revenue. Investment and trust banks, by

contrast, display a high ration, while truly universal banks occupy the middle range.

Table 1 point to two striking differences in the structure of German and Swiss banks'

earnings. First, German institutions, as a whole, resemble more closely traditional

commercial banks than their Swiss counterparts. In Germany, the average ratio of

commission income to net revenue is much lower than in Switzerland. The relatively high

Swiss ratio reflects the important role played by Swiss banks in underwriting, securities

trading, and portfolio management. Second, in Germany, that ratio displays a much smaller

variability across the various banking groups than in Switzerland. In Germany it fluctuates

between 12 to 30 percent as compared to a range of 9 to 80 percent in Switzerland. Thus,

while German banks, on average, are less universal than their Swiss counterparts, universal

banking in Germany is more evenly spread across the various groups of financial institutions

than in Switzerland.

A high ratio need not imply that the group concerned specializes in investment banking.

Unfortunately, the available data on Switzerland do not provide a detailed breakdown of

commission income by sources. There is little doubt that Swiss banks derive their

commission income mainly from four sources: foreign exchange trading, underwriting,

securities trading in the secondary market, and portfolio management. Separate data are

available on commission income gained from foreign exchange trading. They indicate that

big banks and branches of foreign banks are more heavily engaged in foreign exchange

trading than the other groups. However, the patterns revealed by Table 1 are not altered much

if the foreign-exchange component is eliminated, although the ratio of commission income to

net revenue, for the Swiss banking system as a whole, drops from 44 to 33 percent.

While some specialized Swiss institutions act as pure investment banks, they typically

combine investment and trust banking under one roof. Many of the specialized Swiss banks

operate as portfolio managers. They are members of the domestic stock exchanges and, thus,

provide both brokerage and portfolio management services to their clients. In most cases,

they do not participate to any great extent in underwriting, which is dominated by big banks.

Consequently, the strategy of specialization pursued by many of the smaller Swiss banks does

22

not fit the Glass-Steagall mould. Rather, it has resulted in a separation of traditional bank

borrowing and lending from investment and trust banking.

In summary, the German and Swiss experiences indicate that many banks choose to

specialize even if legislation does not place any constraints on universal banking. Specialized

banks tend to be small institutions coexisting and competing with big universal banks.

Although both the German and Swiss systems allow for specialization, there is little doubt

that since the end of World War II, market forces have served to enhance the importance of

universal banks and have permitted them to expand their sphere of influence.

Are the Objections to Universal Banking Justified?

There are four major objections to universal banking. In his study of the Glass-Steagall Act,

George Benston (1990) reviews critically these objections. In his view, the case for

separation of commercial and investment banking rests on weak foundations

1. Riskiness and Lender-of-Last Resort Problems

Are universal banks prone to incur excessive risks and, thus, to jeopardize the stability of the

financial system? Benston (1990) examines various studies that attempt to answer this

question by drawing on U.S. evidence. Most of these studies, he concludes, reject the view

that university enhances the riskiness of banking operations.

The available Swiss evidence leads to similar conclusions. As a result of the recent collapse

of the real estate market, many Swiss banks are compelled to make provisions against bad

23

mortgage loans. Regional and continual banks are particularly afflicted by these problems.

For this reason, the number of regional banks is shrinking substantially, mainly as a result of

mergers within that group or takeover by bigger institutions. The big banks, by contrast, are

weathering their real-estate problems without much difficulty, due to their ability to diversify

risk among a wide range of activities.

Since universal banks are better equipped to diversify their risk than the specialized

institutions, universality as such not complicates the lender-for-last-resort role of central

banks. However, problems may arise from the fact that universal banks are typically large. If

large institutions run into solvency problems, central banks may be confronted with the

dilemma of "too big to fail." In principle, these institutions should be closed, but such

closures might send shockwaves through the entire financial system and impair its stability.

Clearly, the "too big to fail" dilemma is not related to the universality of banks but not their

size.

2. Conflicts of Interest

Universal banking may give rise to conflicts of interest that need to be taken seriously. It

would not be difficult to find examples of conflicts of interest in the history of Swiss banking.

Nevertheless, two reasons lead us to believe that in Switzerland conflicts of interest today

create far less serious problems than in the past.

First, Swiss regulations of securities markets are being strengthened considerably. Insider

trading is now a criminal offense in Switzerland. Furthermore, the government is proposing

legislation that would guarantee transparency of stock exchange trading, as well as adequate

financial reporting by listed companies. A second reason is even more important than the first

one. Market forces themselves support the legislative efforts for diffusing conflicts of interest

and preventing other abuses in securities markets. For example, if universal bank attempts to

hide blunders in underwriting by shifting unsaleable securities to its trust department, its

customers are likely to be confronted with relatively low returns on their portfolio

investments. Competitors, including specialized banks, have an incentive to bid away

customers from the low-performing universal institution. Thus, market forces tend to induce

universal banks to eradicate conflict-of-interest problems.

24

3. Concentration of Power

Students of the German banking system frequently express concern about the concentration

of power in the hands of the big domestic universal institutions. In Switzerland, these

concerns are less pronounced even though the big Swiss institutions account for almost 50

percent of the domestic bank's aggregate assets. The intensification of competition and the

regulatory changes mentioned earlier have curbed the power of the big Swiss banks.

The Future of Universal Banking

We have argued that in Germany and Switzerland the importance of universal banking has

growth 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.

First, universal banks no doubt will continue to play an important role. They posses 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

25

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.

Second, although universal banks have expanded their sphere of influence, the smaller

specialized institutions have not disappeared. In both Germany and Switzerland, they are

successful 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 advantage in all areas of

banking. As a matter of fact, a substantial body of research indicates that most big banks have

already grown beyond the point at which further expansion in their market shares results in

significant returns to scale or scope. On the contrary, a continued expansion is often

detrimental to the banks' profitability as decision making within the institution becomes

bureaucratic and inflexible. Thus, even if legislation allows for universal banks, many

financial institutions will elect to specialize. However, the pattern of specialization generated

by market forces need not resemble the Glass-Steagall type of separation o commercial and

investment banking. German and Swiss experiences strongly suggest that banking activities

will be separated along different lines.

Third, universality of banking may be achieved in various ways. No single type of universal

banking system exists. We have shown that the German and Swiss universal banking systems

differ substantially in this regard. In Germany, universality has been strengthened without

significantly increasing their market shares of the big banks. Instead, the smaller institutions

have acquired universality through cooperation. They have set up central institutions

conducting those banking activities that are subject to significant returns to scale and scope.

In Switzerland, the cooperative approach has not worked as well as in Germany. The smaller

Swiss institutions find it difficult simultaneously to compete with one another in some areas

of banking and to cooperate in others. For this reason, in Switzerland the growth in

universality has been associated with a substantial increase in the market shares of the big

banks. It remains to be seen whether the cooperative approach will survive in an environment

of highly competitive and globalize banking.

26

TABLE 1

Banking Structure in Germany and Switzerland, 1991

Number of Banks

(End of Year)

Percentage Share of Banking

Group in Total Assets

(End of Year)

Germany

Big Banks

4 9

4 9

Regional Banks

198 14

198 14

Government-owned Savings

Banks

757 34

Saving Banks 746 20

Central Savings Banks

11 14

11 14

Cooperative Banks 3158 15

Credit Cooperatives 3154 11

Central Cooperative Banks 4 4

Private Banks 84 1

Branches of Foreign Banks 60 1

Other Financial Institutions 102 25

Total 4363 100

Switzerland

Big Banks 4 49

Regional & Savings Banks 189 8

Cantonal Banks 28 20

Cooperative Banks 2 3

Private Banks 19 1

Branches of Foreign Banks 16 1

27

Other Banks 222 16

Finance Companies 112 2

Total 592 100

Commissions as Percentage of Net Revenue

Germany

Big Banks 26

Regional Banks 21

Government-owned Savings Banks 14

Saving Banks 14

Central Savings Banks 12

Cooperative Banks 1 16

Credit Cooperatives 14

Central Cooperative Banks 30

Private Banks 29

Branches of Foreign Banks 29

Other Financial Institutions n.a.

Total 18

Switzerland

Big Banks 47

Regional & Savings Banks 19

Cantonal Banks 21

Cooperative Banks 9

Private Banks 80

Branches of Foreign Banks 34

Other Banks 54

Finance Companies 32

Total 44

Sources: Deutsche Bundesbank (1992a: Tables 13, 22a; 1992b:42-47), and Swiss National

Bank (1992: Tables III, 1, 1; 40.0-40-8).

28

UNIVERSAL BANKING IN INDIA

For determining the applicability of Universal Banking in India, first we must understand

what the present economic scenario in India is:

Indian Scenario

1. Commercial banks

29

In early 90's the financial sector in India was crying out for reforms. Ever since the process of

liberalization hit the Indian shores, the banking sector saw the emergence of new-generation

private sector banks. Public sector banks which played a useful role earlier on are now facing

deterioration in their performance. For very long, the banks in India were not allowed to have

access to stock markets. So their dealing in other securities were minimal. But the financial

sector reforms changed it all, Indian banks started to deal on the stock market but their bitter

experience with scams, they became averse to deal in equities and debentures. Off late,

commercial banks in India have been permitted to undertake a range of in-house financial

services. Some banks have even setup their own subsidiaries for their investment activities.

Subsidiaries include in the area of merchant banking, factoring, credit cards, housing finance

etc.

2. Financial Institutions

DFIs were traditionally engaged in long term financing, as their main objective was to take

care of the investment needs of industries and to contribute to a better industrial climate.

They had, over the time, built up expertise in merchant banking, project evaluation and also

started giving working capital finance. Recently, they were allowed to accept medium-term

deposits within the specified limits. Lots of changes have taken place in DFIs in the recent

past. Most of DFIs have floated banks, institutions and mutual fund subsidiaries. Ownership

changes took place, several institutions went public, organization structure itself got

transformed.

Indian Perspective on Universal Banking

Some argue that the approach is very slow, while some call for steady approach. The debate

of universal banking is very much on. Should India have universal banking and if so when?

Much has been written about it domestically; however the following are the issues which are

key in Indian context.

30

i. Regulatory burden

ii. Regulatory requirements

iii. Distinction between maturity and duration

iv. Optimum Transition path

i. Regulatory burden:

One of the major problems associated with universal banking is the issue of regulation. DFIs

in India are governed by separate Acts and banks are regulated by RBI and Banking

Regulation Act. DFIs in India have commercial banks as their subsidiaries, but due to the

separation of regulation, the DFIs cannot have direct access to the resource base of its

subsidiary bank. Without any doubt, the net regulatory burden for all participants in the entire

financial system should be equalized in order to ensure that no participant might end up

having a disadvantage relative to any other. The importance of this point can be highlighted

by citing the example of USA, Japan, West Germany and Britain where there was a

tremendous decline in the share of banks in composition of household financial assets and its

movement to mutual funds and insurance. The study revealed that the decline has been due to

very high net regulatory burden being imposed upon the entire banking system relative to that

on the mutual funds and insurance companies. In India there is an urgent need to reduce the

regulatory burden, particularly for banks vis-à-vis mutual funds and insurance companies, if

the banks are expected to compete in free market place.

ii. Regulatory requirements

Salient operational and regulatory issues of RBI to be addressed by the FI’s for conversion

into a universal bank

31

a)     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.

  b)     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..

  c)     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.

  d)    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.  

  e)    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.

  f)     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.

  g)     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

32

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.

  h)    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. 

  i)    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.  

  j)    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.

  k)    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.

  l)    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.   

  m)    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.  

33

  n)      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.

  o)       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.

  p)     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 .

q) 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.  

iii. Distinction between Maturity and Duration

This is the issue of debate between long term and short term. Somehow DFIs are the

suppliers of term finance, where the maturity is clearly specified which could be between 3

years to 7 years, where as banks are providers of short-term finance where in reality bank

finance in a way amounts to financing in perpetuity since there are in general no definite

maturity dates. Usually the deposit base of the banks have are short duration but with a

variably high interest rates but its not the case with DFIs. Their funds have a longer duration

with less interest rate.

The interim report of S H Khan committee has argued that the distinction between

commercial and investment banking have become increasingly blurred with banks providing

both working capital and term loans to corporates but DFIs can provide only term loans as

they cannot accept short term deposits. The committee further argued that DFIs should be

34

given banking licenses eventually and until then they should be allowed to establish 100

percent banking subsidiaries while they continue to play their present role.

iv. Optimal Transition path

Viable transition path is one of the major areas of concern for institutions which are desirous

of moving in the direction of universal banking. The transition path contains several

operational and regulatory issues for information and guidance of DFIs. The S H Khan

working group and the discussion paper on the subject prepared by RBI eventually felt that

DFIs should transform themselves into commercial banks but in a phased manner. The

committee also recommended that DFIs can have 100 percent owned banking subsidiaries

which would be extremely beneficial to them. If this happens, then it would allow DFIs to

gain expertise in the area of commercial banking which would in turn help the DFIs if they

are seriously looking at the prospect of converting into a commercial bank. Also the 100

percent subsidarisation allows banks to have a full access to capital base of DFIs and gain

substantial knowledge in the area of project financing.

The RBI has asked FIs, which are interested to convert itself into a universal bank, to submit

their plans for transition to a universal bank for consideration and further discussions. FIs

need to formulate a road map for the transition path and strategy for smooth conversion into a

universal bank over a specified time frame. The plan should specifically provide for full

compliance with prudential norms as applicable to banks over the proposed period.

In India Development financial institutions (DFIs) and refinancing institutions (RFIs) were

meeting specific sect oral needs and also providing long-term resources at concessional

terms, while the commercial banks in general, by and large, confined themselves to the core

banking functions of accepting deposits and providing working capital finance to industry,

trade and agriculture. Consequent to the liberalisation and deregulation of financial sector,

there has been blurring of distinction between the commercial banking and investment

banking.

The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to

RBI to discuss the time frame and possible options for transforming itself into an universal

bank. Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance,

35

its proposed policy for universal banking, including a case-by-case approach towards

allowing domestic financial institutions to become universal banks.

Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit

their plans for transition to a universal bank for consideration and further discussions. FIs

need to formulate a road map for the transition path and strategy for smooth conversion into a

universal bank over a specified time frame. The plan should specifically provide for full

compliance with prudential norms as applicable to banks over the proposed period.

IS UNIVERSAL BANKING GOOD OR BAD FOR THE COUNTRY?

Universal banking is being peddled as a panacea to most of the ills that plague the financial

system in India. The issue of whether it is good for our country, in the current stage of

development, is being sidelined.

Universal banking brings about convergence of financial services under one roof. The initial

impetus to the concept worldwide was the need to bring down the intermediation costs. But

this is surely not a driver for developments in India. It is being used as an instrument to move

into commercial banking as a source to raise low-cost funds and crowd out smaller players. In

the process, profit considerations over-ride the mandate with which institutions were

founded.

The real issue here is who will fill the void that these institutions are so eager to leave. Have

we built alternative systems that will take over the functions of industrial financing? Some

may argue that our industries have passed the stage where no more handholding is required.

But look at the continuous decline in manufacturing output and the virtual dearth of any new

investment, and you will know how misplaced this view is.

Indian industry now needs to compete with global capacities. An economic size of 15,000 mt

for which licences were issued during the licence-permit raj and were considered

economically viable capacities for financing by FIs, now have to compete with producers

with capacities of millions of tonnes. The stage is set for a concerted effort to make these

units survive. Some will say ‘let them vanish from the scene if they can’t compete’. Let us

36

import everything. Yes, we can, but how do we pay for the imports? Unless we have areas

where we build up, at least, certain segments in the industry where we can match the price

and quality, we will have no export earnings to pay for imports. Universal banking, which

may result in changed priorities of FIs, will seriously hinder our efforts to build a

manufacturing sector that can compete with the best on its own terms.

What FIs are today is on account of large amount of transfer of funds that came at the cost of

exchequer — through directed investments, tax shields and suppressed yields from

investments. Now that these sources are drying up, they are on to poach on the constituencies

nurtured by commercial banks, the retail and household sectors. Pundits of the financial

world may call it mergers.

37

UNIVERSAL BANKING: THE MEANS AND THE ENDS ARE

CONTROVERSIAL

The move towards universal banking has not been by choice and — whatever one might say

— has been dictated by the failure of the DFI model.

In India the growing literature on the subject, nearly all of it pro-universal banking, has been

overtaken by certain practical developments. Universal banking is about to become a reality.

On April 1, ICICI’s reverse merger with ICICI Bank was expected to be completed. Both in a

de jure and in a de facto sense universal banking would have arrived in India. However there

have been obstacles, mainly in the form of a legal challenge to the terms of the merger

between ICICI and ICICI Bank. The predicament of the ICICI's top management shows that

even the means to achieve the universal banking status can be controversial. Also, it should

not be forgotten that it is the inadequacy and irrelevance of the DFI model (which ICICI and

IDBI represent) that has pushed the universal bank model on to the centre stage. There has

been no evolution, as the RBI had hoped, but a sudden jump into a new territory.

For that reason at least the controversy over universal banking will not end. Among other key

issues waiting to be addressed is the role and efficacy of the regulator in the new set up. Even

more basically the consumers for whom the universal banking model is touted to be a big

virtue need to understand its rationale. In India, as in the U.S. and the U.K., commercial

banks have had a clear cut role earmarked for them by law and practice. As a financial

intermediary, banks accepted deposits which they lent and the difference between the interest

earned (from the borrowers) and that paid (on deposits) called the spread has traditionally

formed the major part of their income. All other income which came from say issuing a draft

or confirming a letter of credit have been called miscellaneous income, probably because

such business was originally considered to be incidental to the main banking activity of

deposit taking and lending. DFIs, on the other hand, have primarily been into project

financing for which they developed substantial expertise. They have been in the long end of

the banking business, granting term loans (project loans) while banks have been primarily

short-term lenders.

The difference between the two — banks and DFIs — is even more marked if one looks at

the liabilities side of their balance sheets. To fund their long-term lending activities, DFIs

38

looked to the government for cheap funds and tax breaks. Part of the SLR securities which

banks have been compelled to buy were instruments issued by one of the DFIs. Banks meet

their funding requirements by accepting deposits of less than three year duration.

Universal banking, involving manifold activities, can be successful only if there is no

mismatch between their resources and their lending/investments. And for managing their

risks better universal banks claim to undertake a wide variety of activities. To succeed

uniformly across a spectrum of financial products, these banks should also nurture and

develop a strong brand. Branding of financial products has become the new mantra. Any

institution whether fully integrated as ICICI would be (post merger) or operating through a

number of associates can be a "virtual" universal banking, offering a garland of financial

products under one brand.

Hence, according to one view, universal banking is already in vogue and that it has arrived

without the pains of a restructuring of a type attempted by ICICI. Interestingly, IDBI has also

contemplated a similar move to acquire the universal banking status.

In the recent budget, there are two concrete moves to convert it into a universal bank

eventually: legislative changes to "corporotise" it and conversion of certain long term loans to

"appropriate" long term instruments. Critics, however, point out that it is not much the

attractiveness of the idea as much as the sheer necessity of abdicating the DFI model that

motivates the drive towards universal banking. It has been admitted that DFIs have to move

on and into retail. But no thought has been given to the likely problems the banking regulator

will face. At a larger level there is always the need for setting up a level playing field for all-

former DFIs which have converted to universal banks as well the more established banks.

39

WHAT UNIVERSAL BANKING CAN RESULT FOR INDIA

Banking will never be the same again. With official committees recommending a move

towards universal banking, DFIs, led by ICICI, are getting set to storm the banking arena.

THE DOMESTIC banking sector is going through some interesting times -- not just

economically, but on the policy front as well. And the major policy shift was heralded by the

Narasimham committee's recommendation that development finance institutions (DFIs)

ultimately convert into either commercial banks or non-banking finance companies. This, in a

way, spelt the beginning of the end of specialized services from DFIs, and the introduction of

universal banks.

With universal banking, banks will offer a wide range of financial services, beyond solely

commercial banking or investment banking. The main advantage of universal banking is that

it results in greater economic efficiency and enables asset diversification, not only in the

nature of ventures financed but also in the age profile of assets. Additionally, it offers

reasonable protection from economic cycles. For FIs, moving towards universal banking will

mean the ability to raise short-term, low-cost funds.

In India, banks have traditionally been prime lenders for working capital loans and DFIs

financed term loans. Now, with DFIs told to move towards universal banking, banks have

been allowed to diversify into investments and long-term financing, and DFIs will lend for

working capital.

Starting trouble. In spite of the Narasimham committee's recommendations -- later endorsed

by the Khan working group -- the road to universal banking is proving far from smooth. One

major impediment for FIs is the fact that they have past liabilities on which reserve

requirements -- SLR, CRR and priority sector advances -- have not been met. Meeting this

requirement in its current form and level would require FIs to raise huge resources from the

capital market, which could give rise to liquidity concerns. Now, depending on the fiscal and

monetary situation, RBI is slated to reduce the CRR requirement to a minimum of 3 per cent.

40

It has been suggested that reserve requirements apply only to the incremental liabilities, but

this may not be a prudent move when the huge backlog of liabilities is not covered. The most

plausible solution would be to adhere to the reserve requirements over a period of time to be

specified by the FI. In fact, RBI has mentioned that DFIs would need to prepare a transition

path in order to fully comply with the regulatory requirement of a bank and such requests will

be considered on ‘case by case’ basis.

Services on offer ICICI IDBI SBI HDFC LIC

Insurance Yes No Yes Yes Yes

MF Yes Yes Yes Yes Yes

Banking Yes Yes Yes Yes Yes

Merchant banking Yes Yes Yes No No

Broking Yes Yes Yes Yes No

Retail finance

Housing Yes No Yes Yes Yes

Credit/debit cards Yes No Yes Yes No

Moving to universal banking may also create some pressure on the asset and liability side of

balance sheets. On the liability side -- sources of funds (at least for banks) -- there will be

increasing competition from investment alternatives such as MFs where schemes with similar

liquidity but a better return are available. On the asset side -- deployment of funds -- the

growth of capital markets, new players and efficient investment banking have enabled

corporates to raise funds directly from the market.

The new bankers. The shift from specialized to universal banks is not restricted to FIs -- SBI

and LIC can be considered universal banks. SBI deals with MFs and investment banking, and

41

its insurance initiative with Cardiff SA brings it closer to the universal bank objective. And

LIC's move to acquire a stake in Corporation Bank makes it a serious candidate.

ICICI, which will have to raise something like Rs 20,000 crore for reserve compliance, has

decided to join the few universal banks. It has begun reducing the number of its subsidiaries,

and is planning to merge with ICICI Bank, in a bid to turn into a universal bank in 12-18

months.

ICICI will benefit

  ICICI ICICI Bank

CAR (%) 14.6 11.57

Net NPAs (%) 5.2 2.19

Cost of funds (%) 11.71 7.77

ROA (%) 0.79 0.82

Spread (%) 1.83 2.00

While this may be good news for customers, shareholders have reason to be wary. ICICI is

seen to benefit more from the deal (see table above) as ICICI Bank is the better placed

company on most counts. The better financials from ICICI Bank will aid in reducing the cost

of funds. And the bank's lower NPA, in view of the higher NPA provisioning by ICICI,

augurs well for the merged entity. The possibility of the swap ratio being skewed in favour of

ICICI in view of its 47 per cent holding in ICICI Bank cannot be ruled out. Investors should,

therefore, wait for clarity on the merger proposal before taking any decision to buy or sell.

42

THE ROAD AHEAD TO INDIA

Economic historians have long emphasized the importance of financial institutions in

industrialization. More recently, economists have begun more intensive investigation of the

links between financial system structure and real economic outcomes. In theory, the

organization of financial institutions partly determines the extent of competition among

financial intermediaries, the quantity of financial capital drawn into the financial system, and

the distribution of that capital to ultimate uses. The choice between universal and specialized

banking may affect interest rates, underwriting costs, and the efficiency of secondary markets

in securities. Furthermore, the presence or absence of formal bank relationships may affect

the quality of investments undertaken, strategic decision-making, and even the

competitiveness of industry.

Particularly since World War II, many economists and historians have argued that German-

style universal banks offer advantages for industrial development and economic growth.

Universal banking efficiency combined with close relationships between banks and industrial

43

firms, they hypothesize, spurred Germany’s rapid development at the end of the nineteenth

century and again in the post-World War II reconstruction. A corollary to this view holds that

countries that failed to adopt the universal-relationship system suffered as a consequence.

Adherents suggest that British industry has declined over the past hundred years or more, and

that the American economy has failed to reach its full potential, due to short-comings of the

financial system that lead to relatively high costs of capital.

In Indian context, the phenomenon of universal banking, as different from narrow banking,

has been in the news in the recently. With the last Narasimham Committee and the Khan

Committee reports recommending consolidation of the banking industry through mergers and

integration of financial activities, the stage seems to be set for a debate on the entire issue.

A universal bank is a one-stop supplier for all financial products and activities, like deposits,

short-term and long-term loans, insurance, investment banking etc. Global experience with

universal banking has been varied. Universal banking has been prevalent in different forms in

many European countries, such as Germany, Switzerland, France, Italy etc. For example, in

these countries, commercial banks have been selling insurance products, which have been

referred to as Banc assurance or Allfinanz. After the stock market crash of 1929 and banking

crisis of the 1930s, the US banned all forms of universal banking through what is known as

the Glass-Steagall Act of 1933. This prohibited commercial banks from investment banking

activities, taking equity positions in borrowing firms, selling insurance products etc. The idea

was to mitigate risky behaviour by restricting commercial banks to their traditional activity of

accepting deposits and lending. Research on the effects of universal banking has been

inconclusive as there is no clear-cut evidence in favour of or against it anywhere.

Nevertheless, the United States has once again started moving cautiously towards universal

banking through the Gramm-Leach-Bliley Act of 1999 which rolled back many of the earlier

restrictions. Some recent phenomenon, like the merger between Citicorp (banking group) and

Travelers (insurance group) confirmed the fact that universal banking is here to stay. Hence it

becomes all the more imperative to know whether we need universal banks in India and

whether it is a more efficient concept than the traditional narrow banking. The standard

argument given everywhere in favour of universal banking is that it enables banks to exploit

economies of scale and scope. What it means is that a bank can reduce average costs and

thereby improve spreads if it expands its scale of operations and diversifies its activities. By

44

diversifying, the bank can use its existing expertise in one type of financial service in

providing the other types. So, it entails less cost in performing all the functions by one entity

instead of separate specialized bodies. A bank possesses information on the risk

characteristics of its clients, which it can use to pursue other activities with the same clients.

This again saves cost compared to the case of different entities catering to the different needs

of the same clients. A bank has an existing network of branches, which can act as shops for

selling products like insurance. This way a big bank can reach the remotest client without

having to take recourse to an agent. Many financial services are inter-linked activities, e.g.

insurance and lending. A bank can use its instruments in one activity to exploit the other, e.g.,

in the case of project lending to the same firm which has purchased insurance from the bank.

Now, let us turn to the benefits accruing to the customers. The idea of one-stop-shopping

saves a lot of transaction costs and increases the speed of economic activity. Another

manifestation of universal banking is a bank holding stakes in a firm. A bank’s equity holding

in a borrower firm acts as a signal for other investors on the health of the firm, since the

lending bank is in a better position to monitor the firm’s activities. This is useful from the

investors point of view. Of course, all these benefits have to be weighed out against the

problems. The obvious drawback is that universal banking leads to a loss in economies of

specialization. Then there is the problem of the bank indulging in too many risky activities.

To account for this, appropriate regulation can be devised, which will ultimately benefit all

the participants in the market, including the banks themselves. In spite of the associated

problems, there seems to be a lot of interest expressed by banks and financial institutions in

universal banking. In India, too, a lot of opportunities are there to be exploited. Banks,

especially the financial institutions, are aware of it. And most of the groups have plans to

diversify in a big way. Even though there might not be profits forthcoming in the short run

due to the switching costs incurred in moving to a new business. The long-run prospects,

however, are very encouraging. At present, only an arms-length relationship between a bank

and an insurance entity has been allowed by the regulatory authority, i.e. the Insurance

Regulatory and Development Authority (IRDA). This means that commercial banks can enter

insurance business either by acting as agents or by setting up joint ventures with insurance

companies. And the RBI allows banks to only marginally invest in equity (5 per cent of their

outstanding credit). Development financial institutions (DFIs) can turn themselves into banks,

45

but have to adhere to the statutory liquidity ratio and cash reserve requirements meant for

banks. Even then, some groups like the HDFC (commercial banking and insurance joint

venture with Standard Assurance), ICICI (commercial banking), SBI investment banking)

etc., have already started diversifying from their traditional activities through setting up

subsidiaries and joint ventures. In a recent move, the Life Insurance Corporation increased its

stakes in Corporation Bank and is planning to sell insurance to the customers of the Bank.

Corporation Bank itself has been planning to set up an insurance subsidiary since a long time.

Even a specialized DFI, like IIBI, is now talking of turning into a universal bank. All these

can be seen as steps towards an ultimate culmination of financial intermediation in India into

universal banking.

METHODOLOGY

Data were colleted using questionnaires through personal interviews. Indian citizens

constituted the population. Convenience sampling method was used to select the respondents.

70 respondents from various regions in Delhi, Faridabad & Noida having sound banking

knowledge were interviewed. The questionnaire includes various dimensions related to

attractiveness of universal banking, its influence on customer’s product choice behaviour,

advantages of universal banking, the most suitable model and service provider in India which

can readily be converted into Universal Bank.

46

RESULTS AND DISCUSSION:

As the countries of Western Europe and other areas of the world move increasingly toward

universal banking, it is a useful time for India to examine how these institutions might affect

financial stability, economic development, and other financial institutions, concentration of

political and economic power, consumer choice, and conflicts of interest. Thus, through the

following research, I try to examine some of these parameters.

As per the responses of the respondents, the following results could be interpreted.

Are you aware about the concept of UNIVERSAL BANKING

Yes No

47

70

00

10

20

30

40

50

60

70

80

yes no

To

tal

no

. o

f re

spo

nd

ents

Series1

Since, I only approached those respondents who are aware about the concept of Universal

Banking. Therefore, the following stats show that everyone whom I approached replied in

affirmative.

Dimension 1: Attractiveness of Universal Banking to potential customers

Ques 1. Concept of Universal Banking attracts me

48

12

32

19

520

5

10

15

20

25

30

35

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

8

57

50 00

10

20

30

40

50

60

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

Thus, the above chart shows majority of respondents agree to the point that they are attracted

towards the concept of Universal Banking. And none of the respondents disagree with the

point that universal banking tends to be an attractive concept for them.

Ques 2. The concept can become very popular in India.

Thus, the above result shows that the majority of people agree that concept, if implemented in

India, can become very popular in India. Only few disagree with the following result.

Ques 3. Availability of all products information under one roof can make me pay more

attention to product details

49

20

36

7 700

5

10

15

20

25

30

35

40

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

Hence, above result can be examined in the respect that concept of ‘all products under one

roof’ can help people examine and analyse the product details with greater attention.

Dimension 2: Influence of Universal Banking on customer’s product choice behaviour

50

16

40

8 600

5

10

15

20

25

30

35

40

45

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

Ques1. Idea of ‘one stop shopping’ may help me to make my investing and financing

decisions more wisely.

Thus, the above result shows that majority of the respondents agree to the point that the idea

of ‘one stop shopping’ can help them make their investing and financing decisions more

wisely by availing more information about product attributes.

Ques 2. Availability of all products under one roof can help me remember the products with

their details

10

36

16

620

5

10

15

20

25

30

35

40

Strongly Agree Agree Uncertain Disagree StronglyDisagree

Total no. of respondents

Series1

Majority of the respondents feel that availability of all products under one roof can help them

remember much about the product and its details and thus can prove to be beneficial in

51

12

37

138

00

5

10

15

20

25

30

35

40

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

planning their financing activities. Very few are uncertain about the benefits they can avail

through the above concept.

Ques 3. Universal Banking may increase acceptance of endorsed products.

Thus, the above result shows that the large number of respondents believe that the availability

of greater degree of information with much ease can increase their acceptance of products

being endorsed.

Ques 4. Universal Banking can enhance my awareness of available products

52

Thus the above stats shows, that the concept of all products under one roof can enhance the

awareness of the customers regarding products, its attributes and various other products being

offered by the service provider.

Dimension: 3 Advantages of universal Banking

1. Economies of Scale to bank

53

19

36

13

2 00

5

10

15

20

25

30

35

40

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

16

48

60 00

10

20

30

40

50

60

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

Majority of respondents agree that Universal Banking results in greater economic

efficiency in the form of lower cost, higher output and better products.

2. Profitable Diversions

10

44

14

2 00

5

10

15

20

25

30

35

40

45

50

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

The above result shows that 54 out of 70 respondents agree or strongly agree to the point that

by diversifying its activities bank can utilise its existing expertise in one type of financial

products for providing financial services in other type.

3. Resource Utilization

54

30 32

8

0 00

5

10

15

20

25

30

35

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

Approximately, all of the respondents being approached agree that Universal Banking can

help the bank in effective utilisation of their resource. A bank, possessing the information on

the risk characteristics of the clients, can utilize it to pursue other activities with the same

clients.

4. Easy Marketing on the Foundation of a Brand Name

23

42

50 00

5

10

15

20

25

30

35

40

45

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

A large number of respondents agree or strongly agree that Universal Banking concept can

help bank in easy marketing of their products as bank’s existing branch can act as a shop for

selling financial products, acting as a parent company or source, without requiring to spend

55

41

23

60 00

5

10

15

20

25

30

35

40

45

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

much effort on marketing. None of the respondents being approached disagree with the above

mentioned advantage.

5. One-stop shopping

Respondents agree to the point that the concept of ‘one-stop shopping’ can act as an

advantage both to the banks as well as customers as it can save lot of transaction cost and

speed up the economic activities.

6. Investor Friendly Activities

56

16

31

19

400

5

10

15

20

25

30

35

Strongly Agree Agree Uncertain Disagree StronglyDisagree

To

tal

no

. o

f re

spo

nd

ents

Series1

Majority of respondent agree that availability of greater details about the product can help

them in making their investing decisions more wisely. Only few disagree with the above

stated advantage.

Dimension 4: Applicability of Model

Acceptance of models

55%27%

18%

German

England

US

The above results shows that the acceptance of German banking system over others by Indian

customers. Thus the Indian service provider who wants to bring in Universal Banking, are

recommended to implement the system in line with German Universal Banking system for

achieving greater acceptability.

57

Dimension 5: Service provide which can readily be converted into Universal Bank

Service providers

40%

12%

32%

6%10%

ICICI

IDBI

SBI

HDFC

LIC

Thus, the above results shows that the ICICI bank has been voted by the respondents as the

most favoured service provider for Universal Banking services, closely followed by largest

public sector bank, SBI.

58

In addition to above results, to determine the applicability of Universal Banking model

in India, answers to following questions was also found out:

1.Do Universal Banks Increase the Risk of Financial Instability?

Universal banks tend to be large, so large that failure of even one such bank could bring the

entire system down or at least cause substantial distress. In addition, universal banks are said

to be particularly vulnerable, because of their close ties to business, particularly their role in

underwriting and distributing securities.

In this scenario, universal banking might result in a variety of negative consequences for the

economy. If one or several universal banks were to collapse, it might lead to a systematic

financial crisis, possibly including a risk to the economy's payments system. There is concern

that universal banks would be more difficult to regulate, because their ties to business would

be more complex. Furthermore, these banks' officers would realize that their banks were too

big to be allowed to fail. Hence, they might succumb to the temptation of taking excessive

risks. Government regulators, recognizing this threat, would either have to regulate universal

banks very tightly, thus hindering economic efficiency, or be faced with the possibility of a

taxpayer bailout.

However, the claim that universal banks are more risky than specialized banks, while

plausible in some ways, is not borne out by experience. Most recently, specialized U.S.

59

savings and loans failed in large numbers because their assets, liabilities, and operations were

not well diversified. This $150 billion-plus disaster is due largely to the fact that these

institutions specialized in fixed-interest long-term mortgages funded with short-term savings,

blend that took them into deep trouble when interest rates rose rapidly over the period of

1979-81. These risks are exacerbated by the U.S. prohibition against nationwide branching,

which has made depository institutions vulnerable to unexpected declines in natural resource

and farm-product prices, along with changes in regional real estate values.

Indeed, all except ten of the over 9,000 banks that failed during the Great Depression were

unit (single office) banks, most of which were located in small towns. In addition, specialized

depository institutions have been affected adversely by shifts in consumer preferences and

advances in technology. In contrast to the fragility of many specialized banks, failures among

the much better diversified universal banks are almost unknown. Even if, in a worst-case

scenario, several very large universal financial firms failed, it need not cause a failure of the

financial system. If the Federal Reserve maintains the money supply, there is no reason for

the financial system to collapse, even though some banks or other financial firms fail. In fact,

if the government wants to conduct economic policy through control of bank loans, such

control is likely to be more effective if relatively fewer firms made the loans. For this

purpose, specialized banking presents the government with a greater problem than universal

banking.

Neither theory nor evidence support the assumption that limitations on banking—like the

separation of commercial and investment banking—either were or are likely to be effective in

reducing risk-taking. Most of the activities in which universal banks engage are no more

risky than ordinary commercial bank activities. Empirical evidence on the combined risks of

various activities can be obtained from past experience and simulations. As noted above,

commercial banks that engaged in investment banking before passage of the Glass-Steagall

Act experienced relatively few failures. The expected effect of combining commercial and

investment banking on risks has been much studied. Most of commercial banks can take

interest rate risk with options and futures, by holding duration-unbalanced portfolios, and by

making loans that bear both high risk and promised fees and interest. Although, compared to

commercial banking alone, returns from combined commercial and investment banking (and

other activities, such as mortgage banking, insurance, and real estate investment) would be

significantly higher, and risk would be slightly higher.

60

In short, both theory and evidence support the expectation that risks are more likely to be

reduced than increased should banks be permitted to engage in securities, insurance, and

other products and services. Any remaining concerns about the failure of large depository

institutions should be dealt with not by restricting the size or scope of banks (whether

universal or specialized), but by allowing greater diversification, higher required levels of

capital, and explicit rules forcing banks to replace lost capital or be resolved (liquidated, sold

or merged) by the authorities before their economic (rather than book) capital falls below

zero.

2. Do Universal or Specialized Banks Enhance Economic Development More?

Some legislators and government officials believe that they can enhance economic

development by directing resources towards specific goals. Although subsidies could be

granted directly, governments often establish specialized institutions for this purpose. For

example, savings and loan associations are encouraged to make home mortgages to help the

home building. Some specialized lenders are created to avoid laws that legislators do not

want to repeal (for example, consumer finance companies were established as legal

exceptions to usury laws). Specialized institutions also allow the government to conceal

subsidies by allocating funds and other resources at less-than-market rates for distribution to

favored borrowers. But, the government never can be sure that borrowers will use loans as the

government wants. For example, home-buyers who receive mortgages at subsidized rates can

make smaller down-payments and use the funds saved to buy other assets, such as securities

or automobiles. Hence, a policy of directing resources towards specific ends is not likely to

be successful.

3. Will Universal Banks Deploy Capital as Efficiently as the Stock Market?

A key function of financial markets is to deploy capital as efficiently as possible. Economists

have long praised stock markets for fulfilling this role. Critics of universal banking worry that

such institutions will injure stock markets, because when universal banks trade and hold

equity securities, they are sometimes said to discourage the development of an active stock

exchange and independent stock brokers and dealers. One essential issue, then, is the role of

the stock market versus universal banks in facilitating the efficient deployment of corporate

resources.

61

However, the evidence that universal banks reduce stock market activity is actually quite

weak. In addition, without disparaging the importance of the stock market in monitoring

firms, there is good reason to believe that universal banks also have some strength in this

regard. Universal banks also have certain advantages in restructuring firms. The transactions

cost of takeovers and mergers are high in a stock market system. and might well be lower

with a universal bank If, instead [of being restricted to loans], a bank were to own the full

range of classes of both the firm's debt and equity, the bank could gain the control necessary

to effect reorganization much more economically. The covenants of the loans and other

liabilities can be designed to give the bank progressively greater authority to intercede in the

management of the firm as dividend and interest payment performance deteriorates.

Moreover, because the debt holder is also the equity holder, there are no conflicts between

holders of debt and equity securities to impede a needed reorganization. The result would be

fewer agency problems, lower costs in "work-outs" of financial problems, and a resultant

increase in organizational efficiency.

4. Will Universal Banks Crowd Out Other Financial Institutions?

Opponents of universal banks expect them to be large, bureaucratic and inflexible; hence,

they fear that such banks would tend to work primarily with large, established customers and

ignore or discourage smaller and newly formed businesses. Moreover, the indictment

continues, universal banks could use such tactics as limit pricing or predatory pricing (Limit

pricing refers to the strategy whereby prices are lowered to the point where entrants cannot

expect to offset the costs of entry with sufficient revenue. With predatory pricing, prices are

reduced to below competitors' marginal costs, until the competitors are driven out of

business, at which point the existing institution can exploit its monopoly position if it can

restrain reentry) to prevent smaller specialized banks from serving that market. These

problems will be especially salient if universal banks are more efficient, perhaps because of

economies of scale or scope, or for other reasons.

Economies of scale and scope and efficiency indicate some advantage for universal banks

over specialized banks. However, considering that specialized banks are able to survive in

direct competition with universal banks (and vice versa), it does not appear that the efficiency

advantages of either form of banking are overwhelming. Data on the performance and growth

62

of banking in countries that have universal or specialized banking are so difficult to interpret

that not much can be concluded about the "revealed" efficiency of either banking

organization.

5. Will Universal Banks Reduce Consumer Choice?

Some critics fear that if universal banks were to dominate financial markets, there would he

fewer independent organizations and less choice for a more extensive discussion. Supporters

of universal banking argue against this scenario on two grounds. First, as noted above, the

German experience indicates that universal banking does not result in a few firms dominating

the market or the exclusion of other financial services firms. This situation is consistent with

the premise that universal banks have neither significant economies of scale or scope nor

great political power. Second, even if universal banks were to dominate financial markets,

consumers could still patronize one bank for loans, another for underwriting, and a third for

securities trading. Consequently, consumers' choices would not necessarily decline.

6. Can Universal Banks Give Impartial Investment Advice?

Having discussed the risk of tie-in sales, and the risk that universal banks might dominate the

financial or nonfinancial sector, one additional form of possible abuse remains: the fear that

universal banks will not advise their clients objectively on securities. The generic answer to

such problems is that if a banker is inclined to such conflicts of interest (and doesn't care

about the bank's reputation) and customers are blind to the possibilities, then such conflicts

can occur as easily under specialized as well as universal banking. Furthermore, many of the

possible conflicts specified either do not disadvantage consumers or would occur only if the

bank were operated contrary to the interests of its shareholders.

63

FINDINGS

After considering issues of financial stability, economic development, competition among

financial institutions, concentration of economic and political power, consumer choice, and

conflicts of interest, I find that universal banking can provide considerable benefits and

would pose few problems for the economy. It does not follow, though, that specialized

providers of financial services should not or would not also exist. Experience and logic

indicate that these companies can do many things better than can universal banks. In

particular, specialized firms are more likely to handle many important aspects of investment

banking. Takeovers, leveraged buyouts, mergers, spin-offs, and other capital restructurings

often must be completed quickly and imaginatively. Commercial banks, which tend to be

bureaucratically organized, often are not well-suited to this kind of activity. Furthermore,

companies not designated as "banks" and individuals provide a wide range and considerable

volume of financial services in countries characterized by universal or by specialized

64

banking. Thus, the adoption of universal banking is unlikely to result in these banks

dominating financial services.

There is room for disagreement over what form of universal banking makes the most sense

for India. The above research results in Germany making a most suitable model for India.

However, either approach would generate significant advantages over our present system of

specialized banking. We agree that the Glass-Steagall Act's separation of commercial and

investment banking and the Bank Holding Company Act's and other legislative restrictions

against banks offering a full range of financial services should be repealed. Restricting banks'

securities activities was either a misguided reaction to the financial crisis of the 1930s or a

means of enhancing the position of investment bankers (or punishing banks) at the expense of

the general public (Benston, 1990). The fact that the restrictions have not been repealed is

evidence of the power of well-focused suppliers to maintain their legal advantage over poorly

organized competitors and consumers.

Considerations

Though, the above research results in Universal Banking being beneficial for India customers

offering various advantages, still, caution must be applied in implementing Universal banking

because of the following considerations:

1. Dis-intermediation (i.e. replacement of traditional bank intermediation between savers and

borrowers by a capital market process) is only a decade old in India and has badly slowed

down due to loss of investors' confidence.

2. There is an ample room for financial deepening (by banks & DFIs) since loan market will

continue to grow.

65

3. DFIs as a folder of equity in most of the projects promoted in the past have never used the

tool advantageously.

4. DFIs are now only moving into working capital finance, an area in which they need to gain

lot of expertise and this involves creation of network of services (including branches) in all

fields like remittances, collections etc.

5. Reforms in the Indian capital market are still in the half way stage. The priority will be to

ensure branch expansions, financial deepening of credit markets, and creation of an efficient

credit delivery mechanism that can compete with the capital market.

Recommendations

The following are the steps suggested for successful implementation of Universal Banking in

India:

a. Equalise the net regulatory burden across the financial system (including banks, DFIs,

mutual funds, NBFCs and Insurance companies).

b. Lower the regulatory burden on the over regulated entities.

c. Promote and encourage strong competition.

d. Do not allow the merger of a weak bank with a viably strong DFI or vice-versa.

66

e. DFIs should be permitted to set up a 100 percent owned banking subsidiaries.

f. Need is felt to re-examine the minimum level of SLR requirement in order to meet the best

of international standards.

CONCLUSION:

Finance has very close ties with most people. Numerous financial products and services have

penetrated our lives. The globe is ever-changing and financial products and services have to

keep up with the pace of people’s demand. Banks, which assume a leading position in most

financial systems, have to be prepared for the growing need of their customers. In some

countries, universal banks, which offer a wide range of financial services, have proved

responsive to customer demand and helpful in facilitating economic developments.

India’s financial sector is relatively bank-oriented, and banks are the primary supplier of

financial services. With the regulatory allowance for universal banking, Indian banks 67

continue to expand its coverage of financial services in response to customer demand and

profitability concerns. In countries with universal banking system, banks usually serve as an

important source of external finance for enterprises.

India’s banking sector follows closely the global trend of financial developments. It is

believed that the concept of financial supermarkets could play a significant role in future

given that an increasing number of transnational companies have been set up in the region

and also by the opening of Indian Banking sector to foreign players.

BIBLIOGRAPHY

www.banknetindia.com/ banking /ubfeature.htm Universal Banking: introduction, RBI

rules and regulations, Universal Banking in India

www.answers.com/topic/ universal - banking : Universal Banking: definition

‘The Universal Banking’: introduction, concept, pros and cons. Journal of

Professional Banker, October 2006 pg 24-27

"Universal Banking by DFIs: Handy But no solution to NPAs" "Sanjiv

Sbankaran" “Business Line"

68

"Approach to Universal Banking" www.banknetindia.com

"Banking in the New Millennium"  "M. Guruprasad"     (Asst. Prof in Economics)

"Universal Banking: the Road Ahead"   Kamal Sehgal (IIFT)   www.

Indiainfoline.com

"Universal Banking – The Indian Perspective"   Chaitnya Krishna V.

"Consolidation of Indian Banks – challenges"   BNV Parthasarathi     "Professional

Banker"   (The ICFAI University Press) 

ANNEXURE

QUESTIONNAIRE

Objective:

To study the potential of universal Banking for Indian market consumers

CONCEPT: Universal Banking is a superstore for financial products under one roof. It is a

multi-purpose and multi-functional financial supermarket (a company offering a wide range

of financial services e.g. stock, insurance and real-estate brokerage) providing both banking

and financial services through a single window.

Instructions:

69

Questionnaire consists of three dimensions. Please tick the appropriate level of

agreement/disagreement in front of each question.

This research is for academic purpose. All information provides will remain strictly

confidential, will not be disclosed in any form to any organization and will be used only

for fulfilling research objective.

Are you aware about the concept of UNIVERSAL BANKING

Yes No

If yes, answer the questions under following dimensions:

Dimension 1: Attractiveness of Universal Banking to potential customers

Statements Strongly

AgreeAgree Uncertain Disagree

Strongly

Disagree

Concept of Universal Banking attracts

me

The concept can become very popular

in India

Availability of all products

information under one roof can make

me pay more attention to product

details

Dimension 2: Influence of Universal Banking on customer’s product choice behaviour

Statement Strongly

AgreeAgree Uncertain Disagree

Strongly

Disagree

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Idea of ‘one stop shopping’ may

help me to make my investing and

financing decisions more wisely.

Availability of all products under

one roof can help me remember

the products with their details

Universal Banking may increase

acceptance of endorsed products.

Universal Banking can enhance

my awareness of available

products.

Dimension 3: Advantages of universal Banking

No. ParametersStrongly

AgreeAgree Uncertain Disagree

Strongly

Disagree

1. Economies of Scale to bank

2. Profitable Diversions

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3. Resource Utilization

4.Easy Marketing on the Foundation of a

Brand Name

5. One-stop shopping

6. Investor Friendly Activities

Dimension 4: Applicability of Model

Amongst the three, two different model should not be voted on the same level of

applicability.

No. Model more suitable for IndiaHighly

ApplicableApplicable Inapplicable

72

1.

Germans Model, where commercial

banks accept time deposits, lends

money, underwrite corporate stocks,

and act as investment advisors to

large corporations.

2.

England Model, where securities and

other such activities are conducted in

separately capitalized subsidiaries of

banks.

3.

United States model, where there is

separation between commercial banks

and investment banks

Dimension 5: Service provide which can readily be converted into Universal Bank

Amongst the five listed, two different service providers should not be voted at the same level

of agreement/disagreement.

No. Name of service providers Strongly Agree Uncertain Disagree Strongly

73

Agree Disagree

1 ICICI

2 IDBI

3 SBI

4 HDFC

5 LIC

Name:

Age:

Occupation:

Contact Number:

74