challenges before indian banking system

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CHALLENGES BEFORE INDIAN BANKING SYSTEM CHALLENGES BEFORE INDIAN BANKING SYSTEM Summary:  A spell of severe credit crunch, salary cuts, rehiring and a lot of news on loans going bad lead this paper to test the hypothesis that the Indian Banking Industry has been performing badly in contemporary times and was adversely impacted due to the continuing Global Financial Crisis. he methodology adapted to analyse the performance of all the !cheduled Commercial Banks of the Indian Banking Industry was to study the trend of the three most significant parameters"ratios applicable for Banking Industry.  Among the parameters of performance, the most significant ones comprise #et #on $erforming Assets as a percentage of #et Advances, Capital  Ade%uacy &atio and &eturn on Assets. A single composite weighted average of all #ationali'ed banks, $rivate sector banks and Foreign banks in India has been considered to (iew the trend in the period )**+*- to )***/. he analysis shows that the Indian Banking Industry is stable and still growing albeit at a slow pace. he enhanced role of the bank ing sector in the Indian ec onomy, the increasi ng levels of dere gulation alon g wi th th e incr easi ng levels of  competition have facilitated globalisation of the India banking system and pl aced numerous demands on banks. 0perating in this demanding environment has e1posed banks to various challenges. he last decade has witnessed ma2or changes in the financial sector new banks, new financial institutions, new instruments, new windows, and new opportunities and, along with all this, new challenges. 3hile deregulation has opened up new vistas for banks to augment revenues, it has entailed greater comp etition and cons e%ue ntly grea ter risk s. 4emand for new prod ucts, particularly derivatives, has re%uired banks to diversify their product mi1 and also effect rapid changes in their processes and operations in order to remain competitive in the globalised environmen t. KISHINCHAND CHELLARAM COLLEGEPage  1

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Page 1: Challenges Before Indian Banking System

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

CHALLENGES BEFORE INDIAN BANKING SYSTEM

Summary:

 A spell of severe credit crunch, salary cuts, rehiring and a lot of news on

loans going bad lead this paper to test the hypothesis that the IndianBanking Industry has been performing badly in contemporary times and

was adversely impacted due to the continuing Global Financial Crisis. he

methodology adapted to analyse the performance of all the !cheduled

Commercial Banks of the Indian Banking Industry was to study the trend of 

the three most significant parameters"ratios applicable for Banking Industry.

 Among the parameters of performance, the most significant ones comprise

#et #on $erforming Assets as a percentage of #et Advances, Capital

 Ade%uacy &atio and &eturn on Assets. A single composite weightedaverage of all #ationali'ed banks, $rivate sector banks and Foreign banks

in India has been considered to

(iew the trend in the period )**+*- to )***/. he analysis shows that

the Indian Banking Industry is stable and still growing albeit at a slow pace.

he enhanced role of the banking sector in the Indian economy, the

increasing levels of deregulation along with the increasing levels of competition have facilitated globalisation of the India banking system and

placed numerous demands on banks. 0perating in this demanding

environment has e1posed banks to various challenges. he last decade

has witnessed ma2or changes in the financial sector new banks, new

financial institutions, new instruments, new windows, and new opportunities

and, along with all this, new challenges. 3hile deregulation has opened

up new vistas for banks to augment revenues, it has entailed greater 

competition and conse%uently greater risks. 4emand for new products,particularly derivatives, has re%uired banks to diversify their product mi1

and also effect rapid changes in their processes and operations in order to

remain competitive in the globalised environment.

KISHINCHAND CHELLARAM COLLEGEPage 1

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

HISTORY:

he General Bank of India was set up in the year 5/-. #e1t came Bank of 

6industan and Bengal Bank. he 7ast India Company established Bank of 

Bengal 85/*9:, Bank of Bombay 85/;*: and Bank of <adras 85/;=: asindependent units and called it $residency Banks .

  $6A!7 II > #ationali'ation of Imperial Bank of India with e1tensive

banking facilities on a large scale specially in rural and semiurban areas. It

formed !tate Bank of India to act as the principal agent of &BI and to

handle banking transactions of the ?nion and !tate Governments all over 

the country. !even banks forming subsidiary of !tate Bank of India was

nationali'ed in 59-* on 59th @uly, 59-9, ma2or process of nationali'ation

was carried out. 5; ma2or commercial banks in the country wasnationali'ed .

 $6A!7 III> his phase has introduced many more products and facilities

in the banking sector in its reforms measure. In 5995, under the

chairmanship of < #arasimhama, a committee was set up by his name

which worked for the liberali'ation of banking practices.

3ithout a sound and effective banking system in India it cannot have a

healthy economy. he banking system of India should not only be hasslefree but it should be able to meet new challenges posed by the technology

and any other e1ternal and internal factors.

For the past three decades Indias banking system has several outstanding

achievements to its credit. he most striking is its e1tensive reach. It is no

longer confined to only metropolitans or cosmopolitans in India. In fact,

Indian banking system has reached even to the remote corners of the

country. his is one of the main reasons of Indias growth process.

he governments regular policy for Indian bank since 59-9 has paid rich

divedend 3ith the nationali'ation of 5; ma2or private banks of India.

KISHINCHAND CHELLARAM COLLEGEPage 2

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

NEW PHASE OF INDIAN BANKING SYSTEM WITH THE ADENT OF

INDIAN FINANCIAL ! BANKING SECTOR REFORMS AFTER 1""1#

The Bank of Bengal which later became the State Bank of India

$haseI

the General Bank of India was set up in the year 5/-. #e1t came Bank of 

6industan and Bengal Bank. he 7ast India Company established Bank of 

Bengal 85/*9:, Bank of Bombay 85/;*: and Bank of <adras 85/;=: as

independent units and called it $residency Banks. hese three banks were

amalgamated in 59)* and Imperial Bank of India was established which

started as private shareholders banks, mostly 7uropeans shareholders

In 5/-+ Allahabad Bank was established and first time e1clusively by

Indians, $un2ab #ational Bank td. was set up in 5/9; with head%uarters at

ahore. Between 59*- and 595=, Bank of India, Central Bank of India,

Bank of Baroda, Canara Bank, Indian Bank, and Bank of <ysore were set

up. &eserve Bank of India came in 59=+.

4uring those days public has lesser confidence in the banks. As an

aftermath deposit mobili'ation was slow. Abreast of it the savings bank

facility provided by the $ostal department was comparatively safer.

<oreover, funds were largely given to traders.

KISHINCHAND CHELLARAM COLLEGEPage $

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

P%a&e II

Government took ma2or steps in this Indian Banking !ector &eform after

independence. In 59++, it nationali'ed Imperial Bank of India with e1tensive

banking facilities on a large scale especially in rural and semiurban areas.

It formed !tate Bank of India to act as the principal agent of &BI and tohandle banking transactions of the ?nion and !tate Governments all over

the country.

!econd phase of nationali'ation Indian Banking !ector &eform was carried

out in 59/* with seven more banks. his step brought /*D of the banking

segment in India under Government ownership.

he following are the steps taken by the Government of India to &egulate

Banking Institutions in the Country>

59;9> 7nactment of Banking &egulation Act.

59++> #ationali'ation of !tate Bank of India.

59+9> #ationali'ation of !BI subsidiaries.

59-5> Insurance cover  e1tended to deposits.

59-9> #ationali'ation of 5; ma2or banks.

595> Creation of credit guarantee corporation.

59+> Creation of regional rural banks.

59/*> #ationali'ation of seven banks with deposits over )** crore.

 After the nationali'ation of banks, the branches of the public sector bank

India rose to appro1imately /**D in deposits and advances took a huge

 2ump by 55,***D.

P%a&e 'III

his phase has introduced many more products and facilities in the banking

sector in its reforms measure. In 5995, under the chairmanship of <

#arasimham, a committee was set up by his name which worked for the

liberali'ation of banking practices.

KISHINCHAND CHELLARAM COLLEGEPage (

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

INTROD)CTION:

THE MEANING OF BANK

From the Italian banca meaning bench, the table at which a dealer in

money  worked. A bank is now a financial institution which offers savingsand che%ue accounts, makes loans and provides other financial services,

making profits mainly from the difference between interest paid on deposits

and charged for loans, plus fees for accepting bills and other services.

0ther relevant legislation includes the Banks 8!hareholdings: Act and the

&eserve Bank Act. he &eserve Bank Act gives the &eserve Bank of 

 Australia  8the central bank: a wide range of powers over the banking

sector.

E Bank is an institution which trades in money, an establishment for the

deposits, custody and issue of money, as also for making loans and

discounts and facilitating the transmission of remittances from one place to

another.

Sa*+,g& Ba,-> &unning account for saving with restriction in number of 

withdrawal

Curre,. A//0u,.> &unning account without restriction on number of 

withdrawals

Term De0&+.> 4eposit of an amount for a fi1ed period where interest is

paid monthly"uarterly.

Se/+a Term De0&+.> 4eposit of an amount for a fi1ed period where

interest is compounded 8Capitali'ed: and paid on maturity.

Re/urr+,g De0&+.  > &egular 8<onthly: deposit of a fi1ed amount for a

fi1ed period

KISHINCHAND CHELLARAM COLLEGEPage 3

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

BANKING SYSTEM OF INDIA

<odern banking in India is said to be developed during the British era. In

the first half of the 59th century, the British 7ast India Company established

three banks H the Bank of Bengal in 5/*9, the Bank of Bombay in 5/;* andthe Bank of <adras in 5/;=. But in the course of time these three banks

were amalgamated to a new bank called Imperial Bank and later it was

taken over by the !tate Bank of India in 59++. Allahabad Bank was the first

fully Indian owned bank. he &eserve Bank of India was established in

59=+ followed by other banks like $un2ab #ational Bank, Bank of India,

Canara Bank and Indian Bank.

In 59-9, 5; ma2or banks were nationali'ed and in 59/*, - ma2or private

sector banks were taken over by the government. oday, commercialbanking system in India is divided into following categories.

Tye& 04 Ba,-&

Ce,.ra Ba,-

he &eserve Bank of India is the central Bank that is fully owned by the

Government. It is governed by a central board 8headed by a Governor:appointed by the Central Government. It issues guidelines for thefunctioning of all banks operating within the country.

Pu5+/ Se/.0r Ba,-& Among the $ublic !ector Banks in India, ?nited Bank of India is one of the

5; ma2or banks which were nationali'ed on @uly 59, 59-9. Its predecessor,

in the $ublic !ector Banks, the ?nited Bank of India td., was formed in

59+* with the amalgamation of four banks vi'. Comilla Banking Corporation

td. 8595;:, Bengal Central Bank td. 8595/:, Comilla ?nion Bank td.859)): and 6ooghly Bank td. 859=):.

!tate Bank of India and its associate banks called the !tate Bank Group )*

nationali'ed banks &egional rural banks mainly sponsored by public sector 

banks

KISHINCHAND CHELLARAM COLLEGEPage 6

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

Pr+*a.e Se/.0r Ba,-&

$rivate banking in India was practiced since the beginning of banking

system in India. he first private bank in India to be set up in $rivate !ector 

Banks in India was IndusInd Bank. It is one of the fastest growing Bank$rivate !ector Banks in India. I#G (ysya, yet another $rivate Bank of India

was incorporated in the year 59=*.

0ld generation private banks

#ew generation private banks

Foreign banks operating in India

!cheduled cooperative banks

#onscheduled banks

C0'0era.+*e Se/.0r 

he cooperative sector is very much useful for rural people. he co

operative banking sector is divided into the following categories.

S.a.e /0'0era.+*e Ba,-&

Central cooperative banks

$rimary Agriculture Credit !ocieties

4evelopment Banks"Financial Institutions

IFCI  #ABA&4

I4BI 71portImport Bank of India

ICICI #ational 6ousing Bank

IIBI !mall Industries 4evelopment Bank of India

I4BI!CICI #orth 7astern 4evelopment Finance Corporation

KISHINCHAND CHELLARAM COLLEGEPage 7

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

Figure 5> N0# 04 5a,-& +, ea/% /a.eg0ry 04 I,8+a, Ba,-+,g I,8u&.ry

LOCAL AREA BANKS

he ocal Area Bank !cheme was introduced in August 599- aimed atbridging the gaps in credit availability and enhancing the institutional credit

framework in the rural and semi urban areas and providing efficient and

competitive services. !ince then, five ABs have been established.

he review group, which was appointed by &BI in @uly )**) to study and

make recommendations on the ABs scheme, has in its report, drawn

attention to the structural infirmities in the concept of the ABs and

recommended that there, should be no licensing of new ABs. It has

pointed out several weaknesses in the concept of the ocal Area Bankmodel, particularly in regards to si'e, capital base and inherent inability to

absorb the losses in the course of business etc.Four AB! were functional

at endmarch )**+. hey were Coastal area bank ltd, (i2ayawada, Andhra

$radesh,Capital local area bank ltd,phagwara,#avsari,Gu2rat, rishna

KISHINCHAND CHELLARAM COLLEGEPage 9

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

bhima samrudhdhi local area bank limited , <ehboob #agar,!ubhadra local

area bank limited, olhapur.

CO' OPERATIE BANKS

he Cooperative banks have a history of almost 5** years. he Cooperative banks are an important constituent of the Indian Financial

!ystem, 2udging by the role assigned to them, the e1pectations they are

supposed to fulfill, their number, and the number of offices they operate.

he cooperative movement originated in the 3est, but the importance that

such banks have assumed in India is rarely paralleled anywhere else in the

world. heir role in rural financing continues to be important even today,

and their business in the urban areas also has increased phenomenally in

recent years mainly due to the sharp increase in the number of primary cooperative banks.

3hile the cooperative banks in rural areas mainly finance agricultural

based activities including farming, cattle, milk, hatchery, personal finance

etc. along with some small scale industries and selfemployment driven

activities, the cooperative banks in urban areas mainly finance various

categories of people for selfemployment, industries, small scale units,

home finance, consumer finance, personal finance, etc.!ome of the cooperative banks are %uite forward looking and have

developed sufficient core competencies to challenge state and private

sector banks.

hough registered under the Cooperative !ocieties Act of the &espective

!tates 8where formed originally: the banking related activities of the co

operative banks are also regulated by the &eserve Bank of India. hey are

governed by the Banking &egulations Act 59;9 and Banking aws 8Co

operative !ocieties: Act, 59-+.

REGIONAL R)RAL BANKS IN INDIA

KISHINCHAND CHELLARAM COLLEGEPage "

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CHALLENGES BEFORE INDIAN BANKING SYSTEM

&ural banking in India started since the establishment of banking sector in

India. &ural Banks in those days mainly focused upon the agro sector.

&egional rural banks in India penetrated every corner of the country and

e1tended a helping hand in the growth process of the country.

!BI has =* &egional &ural Banks in India known as &&Bs. he rural banks

of !BI are spread in 5= states e1tending from ashmir to arnataka and

6imachal $radesh to #orth 7ast. he total number of !BIs &egional &ural

Banks in India branches is )=;9 85-D:. ill date in rural banking in India,

there are 5;,;+ rural banks in the country of which )5)- 895D: are

located in remote rural areas.

INDIAN BANKS OPERATIONS ABROAD

 As on 0ctober )*,)**+,fourteen Indian banksnine from the public sector 

and five from the private sector had operation overseas spread across ;)

countries with a network of 5*5 branches,- 2oint ventures,5 subsidiaries

and representative offices.

64FC Bank

ICICI Bank!BI Bank

 AJI! Bank

Kes Bank

Indian 0verseas Bank

otak <ahindra Bank 

$un2ab #ational Bank

 Andhra BankCorporation Bank

 Allahabad Bank

arur (ysya Bank

Canara Bank

KISHINCHAND CHELLARAM COLLEGEPage 1;

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RESERE BANK OF INDIA

he &eserve Bank of India was established on April 5, 59=+ in accordance

with the provisions of the &eserve Bank 0f India Act, 59=;.he Central

0ffice of the &eserve Bank was initially established in Calcutta but waspermanently moved to <umbai in 59=. he Central 0ffice is where the

Governors its and where policies are formulated. hough originally privately

owned, since nationali'ation in 59;9, the &eserve Bank is fully owned by

government of India.

he $reamble of the &eserve Bank of India describes the basic functions of

the &eserve Bank as>

<###.0 regua.e .%e +&&ue 04 Ba,- N0.e& a,8 -ee+,g 04 re&er*e&

=+.% a *+e= .0 &e/ur+,g m0,e.ary &.a5++.y +, I,8+a a,8

ge,eray .0 0era.e .%e /urre,/y a,8 /re8+. &y&.em 04 .%e /0u,.ry .0

+.& a8*a,.age#

Orga,+&a.+0, ! Fu,/.+0,&

&eserve Bank of India 8&BI: is the Central Bank and all Banks in India are

re%uired to follow the guidelines issued by &BI.

 Financial !upervision

he &eserve Bank of India performs this function under the guidance of the

Board

for Financial !upervision 8BF!:. he Board was constituted in #ovember 5

99; as a committee of the Central Board of 4irectors of the &eserve Bank

of India.

C0,&.+.u.+0,he Board is constituted by coopting four 4irectors from the

Central Board as membersfor a term of two years and is chaired bythe Governor. he 4eputy Governors of the&eserve Bank are e1officio

members. 0ne 4eputy Governor, usually, the 4eputy Governor in charge of 

banking regulation and supervision, is nominated as the (iceChairman of 

the Board.

Curre,. F0/u&

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• supervision of financial institutions

• consolidated accounting

•legal issues in bank frauds

• divergence in assessments of nonperforming assets and

• supervisory rating model for banks.

• <ain Functions<onetary Authority>

• Formulates, implements and monitors the monetary policy.

• O5>e/.+*e: maintaining price stability and ensuring ade%uate flow of credit toproductive sectors.

• &egulator and supervisor of the financial system>

• $rescribes broad parameters of banking operations withinwhich the countrys banking and financial system functions.

• maintain public confidence in the system, protect depositors

interest and provide costeffective banking services to the public.• <anager of Foreign 71change

• <anages the Foreign 71change <anagement Act, 5999.

• 0b2ective> to facilitate e1ternal trade and payment and promote orderly development and maintenance of foreign e1change market in India.

• Issuer of currency>

• Issues and e1changes or destroys currency and coins not fit for 

circulation.• 0b2ective> to give the public ade%uate %uantity of supplies of currency

notes andcoins and in good %uality.• 4evelopmental role

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• $erforms a wide range of promotional functions to support nationalob2ectives.

• &elated Functions

•Banker to the Government> performs merchant bankingfunction for the centraland the state governmentsL also acts astheir banker..

.

Da.e: 5*"*")*55

Ca&% Re&er*e Ra.+0 a,8 I,.ere&. Ra.e&

8per cent per annum:

I.em?Wee- E,8e8

2;1; 2;11

Se#2(

Aug#1"

Aug#26

Se# 2 Se# " Se# 16 Se# 2$

1 2 $ ( 3 6 7

Cash&eserve&atio 8per cent:85:

-.** -.** -.** -.** -.** -.** -.**

Bank&ate

-.** -.** -.** -.** -.** -.** -.**

Base&ate

.+*"/.**

5*.**"5*.+

5*.**"5*.+

5*.**"5*.+

5*.**"5*.+

5*.**"5*.+

5*.**"5*.+

4eposit -.+" /.+*"9. /.+*"9. /.+*"9. /.+*"9. /.+*"9. /.+*"9.)

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&ate .+ +* +* +* )+ )+ +

Call<oney&ate83eighted

 Average:8;:

-.5* .9/ .9- /.*5 .9= /.*= /.)+

85: Cash &eserve &atio relates to !cheduled Commercial Banks8e1cluding &egional &ural Banks:.8): Base &ate relates to five ma2or banks since @uly 5, )*5*. 7arlier 

figures relate to Benchmark $rime ending &ate 8B$&:.8=: 4eposit &ate relates to ma2or banks for term deposits of morethan one year maturity.8;: 4ata cover 9*9+ per cent of total transactions reported byparticipants. Call <oney &ate 83eighted Average: isvolumeHweighted average of daily call money rates for the week8!aturday to Friday:.

PRE'GLOBALI@ED SCENARIO OF BANKING IN INDIA

  BANKS SERICE C)LT)RE WAS ETREMELY DEMOTIATED> the

services offered by banks were not so good and it was demotivated

because there was no competition and no improvement in banking services

previous to globali'ation

DISINTERESTED EMPLOYER ! EMPLOYEE:. 4uring preglobali'ed

period the employee were totally disinterested they dont have any target to

achieve and there main motive is 2ust to earn livelihood for them no feeling

of competition was there and even there senior e1ecutive dont motivate

them to achieve some target.

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NON COMPETETIE ATTIT)DE.> preglobali'ation there were only

government banks who were ma2or players in the field of banking so there

is no way for competition so even staff attitude was completely non

competitive so no innovative service take place and even no innovation in

product line.

PROD)CT FOC)SED ! NOT C)STOMER SERICE FOC)SED: he

main focus of banks were selling of product not customers. like today bank

scenario customers are treated as lifeline of banking sector during pre

globali'ed time it was nothing so customers were given last priority.

CHALLENGES FACED BY BANK IN PRE'GLOBALI@ED SCENARIO

• 6A&4 0 &7AI# C?!0<7&>

• I##0(AI0# I# $&04?C I#7

• #73 7C6#00GI7!

• 47FF7&74 0KAK F&0< C?!0<7&!

• 7<7&GI#G 0F #73 BA#!

• $00& !I! 0F 7<$0K77!

• 6A&4 0 7!ABI!6I#G <A&7 F&I7#4K I<AG7

I#F&A!&?C?&7

THE PRESENT SCENARIO OF INDIAN BANKING SYSTEM

he current banking sector of India is Countrywide coverage even we can

found bank at small village level, district level and sate level also and

current Indian banking system involves arge number of players because

not only government banks take active participate in banking sector 

whereas there are private banks also, his sector is going through ma2or 

changes as a conse%uence of economic reforms. he changes affect the

ownership pattern of banks, availability of funds, the cost of funds as well

as opportunities to earn, range of services 8feebased and fundbased:,

and management of priority sector lending. As a conse%uence of 

liberali'ation in interest rates, banks are operating on reduced spread.

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4evelopment financial institutions would have a lesser impact on the Indian

economy. Consumerism is here to stay..

SOME FOLLOWING FEAT)RES OF C)RRENT INDIAN BANKING

SYSTEM

• Increasing use of technology in operations

• $oised to e1pand and deepen technology usage

• 4iversification

• 7mergence of integrated players

• 4iversifying capital deployment

• everaging synergies

• &obust regulatory system aligned to international standards

• 7fficient monetary management he landscape of the bankingindustry underwent considerable changes during the last

decade. he industry witnessed>• 4eregulation of lending and deposit rates.

• 7ntry of new private sector banks.

• 71tensive use of technology for product innovation

• 7mergence of retail banking and new derivative products.

• !tricter provisioning and asset classification norms.

• &aising capital ade%uacy re%uirements.

• .he freedom from administered policies and government

regulation in matters of daytoday functioning has opened a

new era of selfgovernance and need for selfinitiative

C)RRENT CHALLENGES BEFORE INDIAN BANKING SYSTEM

G05a+&a.+0, a /%ae,ge a& =e a& a, 00r.u,+.y .

T%e0ry: 

he enhanced role of the banking sector in the Indian economy, the

increasing levels of deregulation along with the increasing levels of 

competition have facilitated globali'ation of the India banking system and

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placed numerous demands on banks. 0perating in this demanding

environment has e1posed banks to various challenges. he last decade

has witnessed ma2or changes in the financial sector new banks, new

financial institutions, new instruments, new windows, and new opportunities

and, along with all this, new challenges. 3hile deregulation has opened

up new vistas for banks to augment revenues, it has entailed greater 

competition and conse%uently greater risks. 4emand for new products,

particularly derivatives, has re%uired banks to diversify their product mi1

and also effect rapid changes in their processes and operations in order to

remain competitive in the globalised environment.

 G05a+a.+0, a /%ae,ge a& =e a& a, 00r.u,+.y he benefits of 

globali'ation have been well documented and are being increasingly

recogni'ed. Globali'ation of domestic banks has also been facilitated by

tremendous advancement in information and communications technology.

Globali'ation has thrown up lot of opportunities but accompanied by

concomitant risks. here is a growing reali'ation that the ability of countriesto conduct business across national borders and the ability to cope with the

possible downside risks would depend, interalia, on the soundness of the

financial system and the strength of the individual participants

Ba&e ! Ca+.a A8eua/y:

 Amidst globali'ation Banking !ystem in India has attained vital importance.

4ay by day there has been increasing banking comple1ities in bankingtransactions, capital re%uirements, li%uidity, credit and risks associated with

them.

he 3orld rade 0rganisation 830:, of which India is a member nation,

re%uires the countries like India to get their banking systems at par with the

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global standards in terms of financial health, safety and transparency, by

implementing the Basel II #orms by )**9.

BASEL COMMITTEE> he Basel Committee on Banking !upervision

provides a forum for regular cooperation on banking supervisory matters.Its ob2ective is to enhance understanding of key supervisory issues and

improve the %uality of banking supervision worldwide. It seeks to do so by

e1changing information on national supervisory issues, approaches and

techni%ues, with a view to promoting common understanding. he

Committees !ecretariat is located at the Bank for International !ettlements

8BI!: in Basel, !wit'erland.

NEED FOR S)CH NORMS:

he first accord by the name .Basel Accord I. was established in 59// and

was implemented by 599). It was the very first attempt to introduce the

concept of minimum standards of capital ade%uacy. hen the second

accord by the name Basel Accord II was established in 5999 with a final

directive in )**= for implementation by )**- as Basel II #orms. Basel II

#orms have been introduced to overcome the drawbacks of Basel I Accord.

For Indian Banks, its the need of the hour to buckleup and practice

banking business at par with global standards and make the banking

system in India more reliable, transparent and safe. hese #orms arenecessary since India is and will witness increased capital flows from

foreign countries and there is increasing crossborder economic M financial

transactions.

Ta5e 1: 

 Analysis of Capital Ade%uacy &atio for the period year )**- to */

S#N0# Ca.eg0ry 04 I,8+a, Ba,-&

N0 04 Ba,-& +, ;6;7;9

Ca+.a A8eua/y Ra.+0

 As on <arch =5, In $er cent

2;;3';6 2;;6';7 2;;7';9

I #ationalised Banks 8)/,)/,)/: 5).) 5).) 5).*+

II $rivate !ector Banks 8),)+,)=: 55.5 5).9/ 5+.=

III Foreign Banks in India 8)9,)9,)/: ;5./; =9.)+ ;;.5

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  We+g%.e8 A*erage 04 I II a,8 III 22#27 22#;$ 2(#$9

!ource> 4erived from data of Indian Bankers Association and &eserve

Bank of India

)> Ca/ua.e8 Tre,8 & A/.ua 04 Ca+.a A8eua/y Ra.+0 04 I,8+a,Ba,-&#

http>""en.wikipedia.org"wiki"CapitalNade%uacyNratio

Capital ade%uacy ratios 8OCA&O: are a measure of the amount of a

banks core capital e1pressed as a percentage of

its assets weightedcredit e1posures.

Capital ade%uacy ratio is defined as

I7& 5 CA$IA A: 7%uity Capital, B: 4isclosed &eservesI7& ) CA$IA A: ?ndisclosed &eserves, B: General oss reserves, C:

!ubordinate erm 4ebts

where &isk can either be weighted assets 8 : or the respective national

regulators minimum total capital re%uirement. If using risk weighted assets,

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 P 5*D

he percent threshold varies from bank to bank 85*D in this case, a

common re%uirement for regulators conforming to the Basel Accords: is setby the national banking regulator of different countries.

wo types of capital are measured> tier one capital 8T 5 above:, which can

absorb losses without a bank being re%uired to cease trading, andtier two

capital 8T ) above:, which can absorb losses in the event of a windingup

and so provides a lesser degree of protection to depositors.

Capital ade%uacy ratio is the ratio which determines the banks capacity tomeet the time liabilities and other risks such as credit risk, operational risk,

etc. In the most simple formulation, a banks capital is the OcushionO for 

potential losses, and protects the banks depositors and other 

lenders. Banking regulators  in most countries define and monitor CAR  to

protect depositors, thereby maintaining confidence in the banking system.

CA& is similar to leverageL in the most basic formulation, it is comparable

to the inverse of debttoe%uity  leverage formulations 8although CA& uses

e%uity over assets instead of debttoe%uityL since assets are by definition

e%ual to debt plus e%uity, a transformation is re%uired:. ?nlike

traditional leverage, however, CA& recogni'es that assets can have

different levels of risk.

!ince different types of assets have different risk profiles, CA& primarily

ad2usts for assets that are less risky by allowing banks to OdiscountO lower

risk assets. he specifics of CA& calculation vary from country to country,

but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a *D

Orisk weightingO that is, they are subtracted from total assets for purposes

of calculating the CA&.

T+er 1 /a+.a  is the core measure of a banks financial strength from

a regulator s point of view. It is composed of core capital, which consists

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primarily of common stock and disclosed reserves 8or retained

earnings: but may also include nonredeemable noncumulative preferred

stock. he Basel Committee also observed that banks have used

innovative instruments over the years to generate ier 5 capitalL these are

sub2ect to stringent conditions and are limited to a ma1imum of 5+D of totalier 5 capital.

  Capital in this sense is related to, but different from, the accounting

concept of shareholders e%uity. Both ier 5 and ier ) capital were first

defined in the Basel I capital accord and remained substantially the same in

the replacement Basel II accord. ier ) capital represents Osupplementary

capitalO such as undisclosed reserves, revaluation reserves, general loan

loss reserves, hybrid 8debt"e%uity: capital instruments, and subordinated

debt.

7ach countrys banking regulator, however, has some discretion over how

differing financial instruments may count in a capital calculation. his is

appropriate, as the legal framework varies in different legal systems.

he theoretical reason for holding capital is that it should provide protection

against une1pected losses. #ote that this is not the same as e1pected

losses, which are covered by provisions, reserves and current year profits.

In Basel I agreement, ier 5 capital is a minimum of ;Downershipe%uity but investors generally re%uire a ratio of 5*D. ier 5 capital should

be greater than +*D of the minimum re%uirement.

1#2 OPERATIONAL RISK

 An 0era.+0,a r+&- is, as the name suggests, a risk arising from e1ecution

of a companys business functions. It is a very broad concept which

focuses on the risks arising from the people, systems and processes

through which a company operates. It also includes other categories such

as fraud risks, legal risks, physical or environmental risks.

 A widely used definition of 0era.+0,a r+&- is the one contained in

the Basel II  regulations. his definition states that operational risk is the

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risk of loss resulting from inade%uate or failed internal processes, people

and systems, or from e1ternal events.

he approach to managing operational risk differs from that applied to other 

types of risk, because it is not used to generate profit. In contrast, creditrisk is e1ploited by lending institutions to create profit, market risk is

e1ploited by traders and fund managers, and insurance risk is e1ploited by

insurers. hey all however manage operational risk to keep losses within

their risk appetite the amount of risk they are prepared to accept in pursuit

of their ob2ectives. 3hat this means in practical terms is that organisations

accept that their people, processes and systems are imperfect, and that

losses will arise from errors and ineffective operations. he si'e of the loss

they are prepared to accept, because the cost of correcting the errors or 

improving the systems is disproportionate to the benefit they will receive,

determines their appetite for operational risk.

4etermining appetite for operational risk is a discipline which is still in its

infancy. !ome of the issues and considerations around this process are

outlined in this !ound $ractice paper published by the Institute for 

0perational &isk in 4ecember )**9Q

Ba/-gr0u,8

!ince the mid599*s, the topics of market risk and credit risk have been the

sub2ect of much debate and research, with the result that financial

institutions have made significant progress in the identification,

measurement and management of both these forms of risk. 6owever, it is

worth mentioning that the near collapse of the ?.!. financial system in

!eptember )**/ is a clear indication that our ability to measure market and

credit risk is far from perfect.

Globali'ation and deregulation in financial markets, combined with

increased sophistication in financial technology, have introduced more

comple1ities into the activities of banks and therefore their risk profiles.

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hese reasons underscore banks and supervisors growing focus upon the

identification and measurement of operational risk.

7vents such as the !eptember 55 terrorist attacks, rogue trading losses

at !ociRtR GRnRrale, Barings, AIB and #ational Australia Bank serve tohighlight the fact that the scope of risk management e1tends beyond

merely market and credit risk.

he list of risks 8and, more importantly, the scale of these risks: faced by

banks today includes fraud, system failures, terrorism and employee

compensation claims. hese types of risk are generally classified under the

term operational risk.

De4+,+.+0,

he Basel Committee defines operational risk as>

Ohe risk of loss resulting from inade%uate or failed internal processes,

people and systems or from e1ternal events.O

6owever, the Basel Committee recogni'es that operational risk is a term

that has a variety of meanings and therefore, for internal purposes, banks

are permitted to adopt their own definitions of operational risk, provided that

the minimum elements in the Committees definition are included.

S/0e e/u&+0,&

he Basel II definition of operational risk e1cludes, for e1ample, strategic

risk the risk of a loss arising from a poor strategic business decision.

0ther risk terms are seen as potential conse%uences of operational risk

events. For e1ample, reputational risk 8damage to an organi'ation through

loss of its reputation or standing: can arise as a conse%uence 8or impact: of operational failures as well as from other events.

Ba&e II e*e,. .ye /a.eg0r+e&

he following lists the official Basel II defined event types with some

e1amples for each category>

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I,.er,a Frau8  misappropriation of assets, ta1 evasion, intentional

mismarking of positions, bribery

E.er,a Frau8 theft of information, hacking damage, thirdparty theft and

forgeryEm0yme,. Pra/.+/e& a,8 W0r-a/e Sa4e.y  discrimination, workers

compensation, employee health and safety

C+e,.& Pr08u/.& ! Bu&+,e&& Pra/.+/e market manipulation, antitrust,

improper trade, product defects, fiduciary breaches, account churning

Damage .0 P%y&+/a A&&e.&  natural disasters, terrorism, vandalism

Bu&+,e&& D+&ru.+0, ! Sy&.em& Fa+ure&  utility disruptions, software

failures, hardware failures

Ee/u.+0, De+*ery ! Pr0/e&& Ma,ageme,.  data entry errors,

accounting errors, failed mandatory reporting, negligent loss of client

assets

D+44+/u.+e&JIt is relatively straightforward for an organi'ation to set and

observe specific, measurable levels of market risk and credit risk because

models e1ist which attempt to predict the potential impact of market

movements, or changes in the cost of credit. It should be noted however 

that these models are only as good as the underlying assumptions, and a

large part of the recent financial crisis arose because the valuations

generated by these models for particular types of investments were based

on incorrect assumptions.

By contrast it is relatively difficult to identify or assess levels of operational

risk and its many sources. 6istorically organi'ations have accepted

operational risk as an unavoidable cost of doing business. <any nowthough collect data on operational losses for e1ample through system

failure or fraud and are using this data to model operational risk and to

calculate a capital reserve against future operational losses. In addition to

the Basel II re%uirement for banks, this is now a re%uirement for 7uropean

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insurance firms who are in the process of implementing !olvency II ,the

e%uivalent of Basel II for the banking sector 

Me.%08& 04 0era.+0,a r+&- ma,ageme,.

Basel II and various !upervisory bodies of the countries have prescribedvarious soundness standards for 0perational &isk <anagement for Banks

and similar Financial Institutions. o complement these standards, Basel II

has given guidance to = broad methods of Capital calculation for 

0perational &isk

Basic Indicator Approach  based on annual revenue of the Financial

Institution

!tandardi'ed Approach  based on annual revenue of each of the broadbusiness lines of the Financial Institution

 Advanced <easurement Approaches  based on the internally developed

risk measurement framework of the bank adhering to the standards

prescribed 8methods include I<A, 4A, !cenariobased, !corecard etc.:

he 0perational &isk <anagement framework should include identification,

measurement, monitoring, reporting, control and mitigation frameworks for 

0perational &isk.

1#$ Re/a+.a+&a.+0, 04 Pu5+/ Se/.0r Ba,-&

$ublic sector banks performance is important. $ublic banks still dominate

the banking systems serving the ma2ority of people in developing countries,

despite the rash of privati'ations of the last 5* years. In )**), public sector 

banks represented -* percent or more of the banking systems assets in

 Algeria, Bangladesh, China, 7gypt, 7thiopia, India, Iran, and (ietnam. InIndonesia, public banks, including those under control of the Indonesian

Bank &estructuring Agency, held over -* percent of the banking systems

assets, up from about ;+ percent before the 7ast Asian crisis. In Bra'il,

despite closure, conversion into agencies or privati'ation of most provincial

banks, including the massive !tate Bank of !ao $aulo in )**5, federal

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banks, including the federal development bank 8B#47!:, held about 5"= of 

bank assets and dominate lending for agriculture, housing and longer term

pro2ects

5.;: Fre&% Ca+.a 40r Pr+*a.e Ba,-& he standardi'ed re%uirements in place for banks and other depository

institutions, which determines how much capital is re%uired to be held for a

certain level of assets through regulatory agencies such as the Bank for 

International !ettlements,Federal 4eposit Insurance Corporation or Federal

&eserve Board. hese re%uirements are put into place to ensure that these

institutions are not participating or holding investments that increase the

risk of default and that they have enough capital to sustain operating losses

while still honoring withdrawals. Also known as Oregulatory capitalO.

he Basel Accords, published by the Basel Committee on Banking

!upervision housed at the Bank for International !ettlements, sets a

framework on how banks and depository institutions must calculate

their capital. In 59//, the Committee decided to introduce a capital

measurement system commonly referred to as Basel I. his framework has

been replaced by a significantly more comple1 capital ade%uacy framework

commonly known as Basel II. After )*5) it will be replaced by Basel

III Another term commonly used in the conte1t of the frameworksis E/0,0m+/ Ca+.a, which can be thought of as the capital level bank

shareholders would choose in absence of capital regulation. For a detailed

study on the differences between these two definitions of capital, refer to

he /a+.a ra.+0 is the percentage of a banks capital to its risk

weighted assets. 3eights are defined by risksensitivity ratios whose

calculation is dictated under the relevant Accord. Basel II re%uires that the

total capital ratio must be no lower than /D.

he + Cs of Credit Character, Cash Flow, Collateral, Conditions and

Capital have been replaced by one single criterion. 3hile the international

standards of bank capital were laid down in the 59// Basel I accord, Basel

II makes significant alterations to the interpretation, if not the calculation, of 

the capital re%uirement.

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71amples of national regulators implementing Basel II include the F!A in

the ?, BaFin in Germany, 0!FI in Canada, Banca dItalia in Italy.

perceived credit risk associated with balance sheet assets, as well as

certain offbalance sheet e1posures such as unfunded loancommitments, letters of credit, andderivatives and foreign e1change

contracts. he riskbased capital guidelines are supplemented by

a leverage ratio re%uirement. o be ade%uately capitali'ed under federal

bank regulatory agency definitions, a bank holding company must have

a ier 5 capital ratio of at least ;D, a combined ier 5 and ier )

capital ratio of at least /D, and a leverage ratio of at least ;D, and not be

sub2ect to a directive, order, or written agreement to meet and maintain

specific capital levels. o be well-capitalized  under federal bank regulatory

agency definitions, a bank holding company must have a ier 5 capital ratio

of at least -D, a combined ier 5 and ier ) capital ratio of at least 5*D,

and a leverage ratio of at least +D, and not be sub2ect to a directive, order,

or written agreement to meet and maintain specific capital levels.

T+er 1 /a+.a

ier 5 capital, the more important of the two, consists largely of 

shareholders e%uity and disclosed reserves. his is the amount paid up to

originally purchase the stock 8or shares: of the Bank 8not the amount thoseshares are currently trading for on the stock e1change:, retained profits

subtracting accumulated losses, and other %ualifiable ier 5 capital

securities 8see below:. In simple terms, if the original stockholders

contributed S5** to buy their stock and the Bank has made S5* in retained

earnings each year since, paid out no dividends, had no other forms of 

capital and made no losses, after 5* years the Banks tier one capital would

be S)**. !hareholders e%uity and retained earnings are now commonly

referred to as OCoreO ier 5 capital, whereas ier 5 is core ier 5 together with other %ualifying ier 5 capital securities.

T+er 2 &ueme,.ary /a+.a

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ier ) capital, or supplementary capital, comprises undisclosed reserves,

revaluation reserves, general provisions, hybrid instruments and

subordinated term debt.

?ndisclosed reserves are not common, but are accepted by someregulators where a Bank has made a profit but this has not appeared in

normal retained profits or in general reserves. <ost of the regulators do not

allow this type of reserve because it does not reflect a true and fair picture

of the results.

Re*aua.+0, re&er*e&

 A revaluation reserve is a reserve created when a company has an asset

revalued and an increase in value is brought to account. A simple e1ample

may be where a bank owns the land and building of its head%uarters and

bought them for S5** a century ago. A current revaluation is very likely to

show a large increase in value. he increase would be added to a

revaluation reserve.

Ge,era r0*+&+0,&

 A general provision is created when a company is aware that a loss may

have occurred but is not sure of the e1act nature of that loss. ?nder pre

IF&! accounting standards, general provisions were commonly created toprovide for losses that were e1pected in the future. As these did not

represent incurred losses, regulators tended to allow them to be counted as

capital.

Hy5r+8 8e5. /a+.a +,&.rume,.&

hey consist of instruments which combine certain characteristics of e%uity

as well as debt. hey can be included in supplementary capital if they are

able to support losses on an ongoing basis without triggering li%uidation.

Su50r8+,a.e8'.erm 8e5.

!ubordinated debt is classed as ower ier ) debt, usually has a maturity

of a minimum of 5* years and ranks senior to ier 5 debt, but subordinate

to senior debt. o ensure that the amount of capital outstanding doesnt fall

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sharply once a ower ier ) issue matures and, for e1ample, not be

replaced, the regulator demands that the amount that is %ualifiable as ier 

) capital amortises 8i.e. reduces: on a straight line basis from maturity

minus + years 8e.g. a 5bn issue would only count as worth /**m in capital

;years before maturity:. he remainder %ualifies as senior issuance. For this reason many ower ier ) instruments were issued as 5*yr noncall +

year issues 8i.e. final maturity after 5*yrs but callable after +yrs:. If not

called, issue has a large step similar to ier 5 thereby making the call

more likely.

D+44ere,. I,.er,a.+0,a Imeme,.a.+0,&

&egulators in each country have some discretion on how they implement

capital re%uirements in their 2urisdiction.

For e1ample, it has been reportedQ-T that Australias Commonwealth Bank is

measured as having .-D ier 5 capital under the rules of the Australian

$rudential &egulation Authority, but this would be measured as 5*.5D if the

bank was under the 2urisdiction of the ?s Financial !ervices Authority.

his demonstrates that international differences in implementation of the

rule can vary considerably in their level of strictness.

1#3 CREDIT RISK

Cre8+. r+&- is an investors risk of loss arising from a borrower who does

not make payments as promised!uch an event is called a default. 0ther 

terms for credit risk are default risk and counterparty risk.

Investor losses include lost principal and interest, decreased cash flow, andincreased collection costs, which arise in a number of circumstances

 A consumer does not make a payment due on a mortgage loan, credit

card, line of credit, or other loan

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 A business does not make a payment due on a mortgage, credit card, line

of credit, or other loan

 A business or consumer does not pay a trade invoice when due

 A business does not pay an employees earned wages when due

 A business or government bond issuer does not make a payment on

a coupon or principal payment when due

Tye& 04 /re8+. r+&-

here are three primary types of credit risk4efault risk when the borrower 

fails to make contractual payments

Credit spread risk risk due to volatility in the difference between interestrates on investments and the riskfree rate of return

Cre8+. a,ay&+& a,8 /0,&umer /re8+. r+&-

!ignificant resources and sophisticated programs are used to analy'e and

manage risk!ome companies run a credit risk department whose 2ob is to

assess the financial health of their customers, and e1tend credit 8or not:

accordingly. hey may use in house programs to advise on avoiding,

reducing and transferring risk. hey also use third party providedintelligence. Companies like !tandard M $oors, <oodys Analytics, Fitch

&atings, and 4un and Bradstreet provide such information for a fee.

<ost lenders employ their own models 8credit scorecards: to rank potential

and e1isting customers according to risk, and then apply appropriate

strategies. 3ith products such as unsecured personal loans or mortgages,

lenders charge a higher price for higher risk customers and vice versa.

3ith revolving products such as credit cards and overdrafts, risk is

controlled through the setting of credit limits. !ome products alsore%uire security, most commonly in the form of property.

Credit scoring models also form part of the framework used by banks or 

lending institutions grant credit to clients. For corporate and commercial

borrowers, these models generally have %ualitative and %uantitative

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sections outlining various aspects of the risk including, but not limited to,

operating e1perience, management e1pertise, asset %uality, and leverage

and li%uidity ratios, respectively. 0nce this information has been fully

reviewed by credit officers and credit committees, the lender provides the

funds sub2ect to the terms and conditions presented within the contract 8asoutlined above:.

Credit risk has been shown to be particularly large and particularly

damaging for very large investment pro2ects, socalled megapro2ects. his

is because such pro2ects are especially prone to end up in what has been

called the Odebt trap,O i.e., a situation where H due to cost overruns,

schedule delays, etc. H the costs of servicing debt becomes larger than the

revenues available to pay interest on and bring down the debt.

S0*ere+g, r+&-

!overeign risk is the risk of a government becoming unwilling or unable to

meet its loan obligations, or reneging on loans it guarantees. Q9T he

e1istence of sovereign risk means that creditors should take a twostage

decision process when deciding to lend to a firm based in a foreign country.

Firstly one should consider the sovereign risk %uality of the country and

then consider the firms credit %uality.Q5*T

Five macroeconomic variables that affect the probability of sovereign

debt rescheduling are> De5. &er*+/e ra.+0

• Import ratio

• Investment ratio

• (ariance of e1port revenue

• 4omestic money supply growth

he probability of rescheduling is an increasing function of debt serviceratio, import ratio, variance of e1port revenue and domestic money supply

growth. Frenkel, arman and !choltens also argue that the likelihood of 

rescheduling is a decreasing function of investment ratio due to future

economic productivity gains. !aunders argues that rescheduling can

become more likely if the investment ratio rises as the foreign country could

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become less dependent on its e1ternal creditors and so be less concerned

about receiving credit from these countries"investors.Q5)T

C0u,.erar.y r+&-

Counterparty risk, known as default risk, is the risk that an organi'ationdoes not pay out on a bond, credit derivative, credit insurance contract, or 

other trade or transaction when it is supposed to. Q5=T 7ven organi'ations

who think that they have hedged their bets by buying credit insurance of 

some sort still face the risk that the insurer will be unable to pay, either due

to temporary li%uidity issues or longer term systemic issues.Q5;T

arge insurers are counterparties to many transactions, and thus this is the

kind of risk that prompts financial regulators to act, e.g., the bailout of 

insurer AIG.

0n the methodological side, counterparty risk can be affected by wrong

way risk, namely the risk that different risk factors be correlated in the most

harmful direction. Including correlation between the portfolio risk factors

and the counterparty default into the methodology is not trivial, see for 

e1ample Brigo and $allavicini

M+.+ga.+,g /re8+. r+&-

enders mitigate credit risk using several methods>

R+&-'5a&e8 r+/+,g> enders generally charge a higher interest rate to

borrowers who are more likely to default, a practice called riskbasedpricing. enders consider factors relating to the loan such as loan

purpose, credit rating, and loantovalue ratio and estimates the effect on

yield 8credit spread:.

C0*e,a,.&> enders may write stipulations on the borrower,

called /0*e,a,.&, into loan agreements>

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$eriodically report its financial condition

&efrain from paying dividends, repurchasing shares, borrowing further, or 

other specific, voluntary actions that negatively affect the companys

financial position&epay the loan in full, at the lenders re%uest, in certain events such as

changes in the borrowers debttoe%uity ratio or interest coverage ratio

.T+g%.e,+,g> enders can reduce credit risk by reducing the amount of 

credit e1tended, either in total or to certain borrowers. For e1ample,

a distributor  selling its products to a troubled retailer  may attempt to lessen

credit risk by reducing payment terms from net 30 to net 1 .

D+*er&+4+/a.+0,> enders to a small number of borrowers 8or kinds of borrower: face a high degree of unsystematic credit risk, called

/0,/e,.ra.+0, r+&-. enders reduce this risk by diversifying the borrower 

pool.

De0&+. +,&ura,/e> <any governments establish 8e0&+. +,&ura,/e to

guarantee bank deposits of insolvent banks. !uch protection discourages

consumers from withdrawing money when a bank is becoming insolvent, to

avoid a bank run, and encourages consumers to hold their savings in the

banking system instead of in cash.

Cre8+. r+&- rea.e8 a/r0,ym&

ACPM Active credit portfolio management

EAD 71posure at default

EL 71pected lossERM 7nterprise risk management

LGD oss given default

PD $robability of default

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INCREASING ROLE OF INS)RANCE COMPANIES 

he Insurance sector in India governed by Insurance Act, 59=/, the ife

Insurance Corporation Act, 59+- and General Insurance Business

8#ationalisation: Act, 59), Insurance &egulatory and 4evelopment Authority 8I&4A: Act, 5999 and other related Acts. 3ith such a large

population and the untapped market area of this population Insurance

happens to be a very big opportunity in India. oday it stands as a business

growing at the rate of 5+)* per cent annually. ogether with banking

services, it adds about per cent to the countrys G4$ .In spite of all this

growth the statistics of the penetration of the insurance in the country is

very poor. #early /*D of Indian populations are without ife insurance

cover and the 6ealth insurance.

his is an indicator that growth potential for the insurance sector is

immense in India. It was due to this immense growth that the regulations

were introduced in the insurance sector and in continuation

EMa%0.ra C0mm+..ee was constituted by the government in 599= to

e1amine the various aspects of the industry. he key element of 

the reform process was $articipation of overseas insurance companies with

)-D capital. !ince then the insurance industry has gone through many

sea changes .he competition IC started facing from these companieswere threatening to the e1istence of IC .since the liberali'ation of the

industry the insurance industry has never looked back and today stand as

the one of the most competitive and e1ploring industry in India.

$#1 RISE OF INS)RANCE SECTOR

he business of life insurance in India in its e1isting form started in India in

the year 5/5/ with the establishment of the 0riental ife Insurance

Company in Calcutta. !ome of the important milestones in the lifeinsurance business in India are given in the table

Ta5e 1: m+e&.0,e& +, .%e +4e +,&ura,/e 5u&+,e&& +, I,8+a

 Year M+e&.0,e& +, .%e +4e +,&ura,/e 5u&+,e&& +, I,8+a

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595) he Indian ife Assurance Companies Act enacted as

the first statute to regulate the life insurance business

59)/ he Indian Insurance Companies Act enacted to enablethe government to collect statistical information about

both life and nonlife insurance businesses

59=/ 7arlier legislation consolidated and amended to by the

Insurance Act with the ob2ective of protecting the

interests of the insuring public.

59+- );+ Indian and foreign insurers and provident societies

taken over by the central government and nationalised.IC formed by an Act of $arliament, vi'. IC Act, 59+-,

with a capital contribution of &s. + crore from the

Government of India.

 $#$ +,&ura,/e &e/.0r gr0=.

he General insurance business in India, on the other hand, can trace its

roots to the riton Insurance Company td., the first general insurance

company established in the year 5/+* in Calcutta by the British. !ome of 

the important milestones in the general insurance business in India are

given in the table ).

Ta5e 2: m+e&.0,e& +, .%e ge,era +,&ura,/e 5u&+,e&& +, I,8+a

 Year M+e&.0,e& +, .%e ge,era +,&ura,/e 5u&+,e&&

+, I,8+a

 

59* he Indian <ercantile Insurance td. set up, the first

company to transact all classes of general insurance

business

59+ General Insurance Council, a wing of the Insurance

 Association of India, frames a code of conduct for 

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ensuring fair conduct and sound business practices

59-/ he Insurance Act amended to regulate investments and

set minimum solvency margins and the ariff Advisory

Committee set up.59) he General Insurance Business 8#ationalisation: Act,

59) nationalised the general insurance business

in India with effect from 5st @anuary 59=.

5* insurers amalgamated and grouped into four 

companies vi'. the #ational Insurance Company td.,

the #ew India Assurance Company td., the 0riental

Insurance Company td. and the ?nited India Insurance

Company td. GIC incorporated as a company.

 

(#Tra+,+,g .%e HR

6uman resource training and development 86& M4: in manufacturing

firms is a

critical aspect of the development of a knowledgeworkforce in <alaysia.

he ob2ective of this study is to e1amine challenges to the effective

management of 6& M4 activities in manufacturing firms in <alaysia. In

order to achieve this ob2ective, indepth interviews were conducted with +/

6& managers managing employees training and development, employing

a purposive or 2udgmental sampling techni%ue. he study revealed three

ma2or challenges to the effective management of 6& M4. hese include a

shortage of intellectual 6&4 professionals to manage 6& M4 ctivities,

coping with the demand for knowledge workers and fostering learning and

development in the workplace. It is hoped that the findings of this study will

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provide 6& professionals with a clear understanding and awareness of the

various challenges in managing effective 6& training and development.

6ence, relevant and appropriate policies and procedures can be developed

and implemented for an effective management of 6& M4.

(#1Te/%,00gy A+e, HR:

 Ac%uiring the technical e1pertise should be the focus of future human

resource management given the changing paradigm of banking sector

regulations. For instance, the implementation of the new Capital Accord

8Basel II: whereby capital ade%uacy re%uirements have been made more

riskoriented by linking capital to operational risk and changing the risk

measurement approaches for credit and market risks. 6owever, its

implementation is not going to be an easy task especially in countries

8including $akistan: where risk management systems are at nascent stage.

his is because of one of the prere%uisite for Basel II implementation which

re%uires that the banking institutions should have a robust risk

management setup which is capable of effectively managing all ma2or risks

that an institution is e1posed to.

!imilarly, the banking institutions are also re%uired to carry out stress

testing, a techni%ue used around the globe by financial institutions toassess risk e1posures across the institution and to estimate the changes in

the value of the portfolio, if e1posed to various risk factors. Initially,

although, !B$ has advised banks to carry out the simple Usensitivity

analysis keeping in the view the varying levels of skill and available

resources among banksL however, going forward more sophisticated

techni%ues will be adopted. Certainly, this process would re%uire technical

e1pertise at least in three areas> identifying, analy'ing and proper recording

of the assumptions used for stress testingL ad2usting the situation or shocks

applied to the data and interpreting the resultsL and an effective

management information system that ensures flow of information to the

senior management to take proper measures to avoid certain e1treme

conditions. herefore, going forward, the focus of human resource

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management should be to ac%uire technical e1pertise if the institutions

intend to go along with the changing regulatory environment.

EMERGING CHALLENGES BEFORE INDIAN BANKING SYSTEM

CONS)MER>he biggest challenge for the Indian banking system today is

the Indian consumer. 4emographic shifts in terms of income levels and

cultural shifts in terms of lifestyle aspirations are changing the profile of the

Indian consumer 

CHANGES IN BEHAIOR>In the post(&! scenario, banks have beenable to bring down their operating costs without upsetting their 

business .6owever, the average age profile andt he skill sets of employees

continue to remain unfavourable to meet the challenges of change. he

ne1t five years would see the average profile of staff worsening particularly

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with banks going slow on fresh recruitment. <anpower planning would be a

ma2or challenge before banks

Targe. mar-e.e a/e> he challenge before the Indian retail banking

industry is twofold> focus and e1ecution. 7ach bank must sharply focus onits target marketplace and rapidly e1ecute its services

A+/a.+0, 04 a8*a,/e8 .e/%,00gy>echnology is a key driver in the

banking industry, which creates new business models and processes, and

also revolutionises distribution channels. Banks which have made

inade%uate investment in technology have conse%uently faced an erosion

of their market shares. he beneficiaries are those banks which have

invested in technology. Adoption of technology also enhances the %uality of 

risk management systems in banks. A further challenge which banks facein this regard is to ensure that they derive ma1imum advantage from their 

investments in technology and avoid wasteful e1penditure which might

arise on account of uncoordinated and piecemeal adoption of technologyL

adoption of inappropriate" inconsistent technology and adoption of obsolete

technology.

C)STOMER ORIENTED SERICES  >In India, currently, there are two

types of customers one who is a multichannel user and the other who still

relies on a branch as the anchor channel. he primary challenge is to giveconsistent service to customers irrespective of the kind of channel they

choose to use. he channels broadly cover the primary channels of branch

8i.e., teller, platform, A<: phone banking, 8i.e., call centre, interactive voice

response unit:, and internet channel 8i.e., personal computer, browser,

wireless:. A retail customer selects a bank based on two criteria H

convenience and relationship and would continue with a bank if it provides

good service.

Regua.0ry a,8 Suer*+&0ry C%ae,ge& +, Ba,-+,g

 As the financial landscape in the last few years has changed significantly,there has been rethinking on several aspects of regulatory and supervisorypractices" framework"structure among the regulators and supervisors allover the world. In some countries such as ?, supervision has been hived

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off from the central bank to avoid perceived conflict of interest withmonetary policy. In response to blurring of distinctions among providers of financial services and emergence of financial conglomerates, a singleregulator approach has been adopted in some countries. he fast evolvingfinancial sector and the ever e1panding rule books of the regulatory bodieshave made some countries such as ? to adopt principlesbasedsupervision.

he Indian banking sector is faced with multiple and concurrent challenges

such as increased competition, rising customer e1pectations, and

diminishing customer loyalty. he banking industry is also changing at a

phenomenal speed. 3hile at the one end, we have millions of savers and

investors who still do not use a bank, another segment continues to bank

with a physical branch and at the other end of the spectrum,

F)T)RE SCENARIO OF INDIAN BANKING SYSTEM

iberali'ation and deregulation process started in 59959) has made a

sea change in the banking system. From a totally regulated environment,

we have gradually moved into a market driven competitive system. 0ur 

move towards global benchmarks has been, by and large, calibrated and

regulator driven. he pace of changes gained momentum in the last few

years. Globali'ation would gain greater speed in the coming years

particularly on account of e1pected opening up of financial services under 

30. Four trends change the banking industry world over, vi'

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Consolidation of players through mergers and ac%uisitions, Globalisation

of operations, 4evelopment of new technology and ?niversalisation of 

banking. 3ith technology acting as a catalyst, we e1pect to see great

changes in the banking scene in the coming years. he Committee has

attempted to visuali'e the financial world +5* years from now. he picture

that emerged is somewhat as discussed below. It entails emergence of 

an integrated and diversified financial system. he move towards universal

banking has already begun. his will gather further momentum bringing

nonbanking financial institutions also, into an integrated financial system.

he competitive environment in the banking sector is likely to result in

individual players working out differentiated strategies based on their 

strengths and market niches. For e1ample, some players might emerge as

specialists in mortgage products, credit cards etc. whereas some could

choose to concentrate on particular segments of business system, while

outsourcing all other functions. !ome other banks may concentrate on

!<7 segments or high net worth individuals by providing specially tailoredservices beyond traditional banking offerings to satisfy the needs of 

customers they understand better than a more generalist competitor.

&etail lending will receive greater focus. Banks would compete with one

another to provide full range of financial services to this segment. Banks

would use multiple delivery channels to suit the re%uirements and tastes of 

customers. 3hile some customers might value relationship banking

8conventional branch banking:, others might prefer convenience banking8ebanking:.

0ne of the concerns is %uality of bank lending. <ost significant challenge

before banks is the maintenance of rigorous credit standards, especially in

an environment of increased competition for new and e1isting clients.

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Eer+e,/e %a& &%0=, u& .%a. .%e =0r&. 0a,& are 04.e, ma8e +, .%e

5e&. 04 .+me&#  Compensation through trading gains is not going to support

the banks forever. argescale efforts are needed to upgrade skills in credit

risk measuring, controlling and monitoring as also revamp operating

procedures. Credit evaluation may have to shift from cash flow based

analysis to Eborrower account behaviour, so that the state of readiness of 

Indian banks for Basle II regime improves.

F)T)RE CHALLENGES :

THE FOLLOWING ARE MAOR CHALLENGES THAT ARE LIKELY TOBE FACED BY INDIAN BANKING IND)STRY IN COMING FEW YEARS:'

Ma,ag+,g Re&0ur/e M05++a.+0, :

Gr0=.% 04 De0&+.& T+ ,0=: he deposit growth of !CBs in the post

nationali'ation period could be analysed broadly in four phases. In the first

phase 859-9/;: beginning immediately after nationali'ation of banks in@uly 59-9, deposit growth accelerated sharply as the rapid branch

e1pansion. enabled banks to tap savings from the rural areas. In the

second phase 859/+9+:, deposit growth decelerated as banks faced

increased competition from alternative savings instruments, especially

capital market instruments 8shares"debentures"units of mutual funds: and

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nonbanking financial companies. his was the phase of disintermediation

as savings instead of being deployed in bank deposits, were increasingly

deployed in alternative financial instruments. 4eposit growth decelerated

further during the third phase 8599+)**;: in the wake of competition from

post office deposits and other small saving instruments, which carriedsignificantly higher ta1ad2usted returns than bank deposits. efforts by

banks to meet the increased demand for credit. As a result, the share of 

bank deposits in the financial savings of the household sector increased

sharply.

Fu.ure /%ae,ge& 40r re&0ur/e m05++a.+0, : Banks have a ma2or role

to play in meeting the resource re%uirements of Indias fast growing

economy. Although bank deposits have all along been the mainstay of thesaving process in the Indian economy and banks have played an

increasingly important role in stepping up the financial savings rate,

physical savings, nevertheless, have tended to grow in tandem with the

financial savings. A ma2or challenge, thus, is to convert unproductive

physical savings into financial savings. Also, in view of the shrinking share

of household sector deposits in total deposits, banks need to e1plore ways

of broadening the depositor base, especially in rural and semiurban areas

by offering customised products and features suitable to individual risk

return re%uirements.

T%u& =e /a, &um u &ay+,g .%a. 8espite India having a reasonably high

and growing savings rate, there is a need to increase financial savings.

Ehe substitution of unproductive physical savings in favour of financial

savings can generate large resources for investment. here is an

enormous untapped saving potential in rural and semiurban areas. For 

this purpose banks are in a better position to develop innovative and cost

effective products due to their Eoutreach as also special features of deposits, vi', safety and li%uidity.

Ma,ag+,g Ca+.a a,8 R+&- ? Imeme,.a.+0, 04 Ba&e II ,0rm& >

W%y .%ere +& ,ee8 40r Ma,ag+,g Ca+.a a,8 R+&- > he importance of 

maintaining bank capital in line with the risks involved in the banking

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business has assumed greater significance in view of the need for 

maintaining the safety and soundness of the financial system. he Basel I

framework was adopted in over 5** countries. 6owever, over the years,

several deficiencies of Basel I surfaced partly due to its inherent features

and partly due to rapid financial innovations. he ma2or limitation of BaselIwas its onesi'efitsall approach. he inade%uacies of Basel I also

became evident following the recent financial turmoil as it failed to capture

offbalance sheet e1posures. he Basel II framework, finali'ed in @uly

)**-, attempts to align regulatory capital more closely with the inherent

risks in banking by using enhanced risk measurement techni%ues and a

more disciplined approach to risk management. In addition, Basel II has in

place a variety of safeguards, which also have the benefit of reinforcing

supervisors ob2ective of strengthening risk management and marketdiscipline.

C%ae,ge& +, Imeme,.a.+0, 04 Ba&e II ? Ma,ag+,g Ca+.a a,8 R+&-  >

In keeping with the international best practices, India also decided to

implement Basel II. Foreign banks operating in India and Indian banks

having operational presence outside India have already adopted the

standardised approach 8!A: for credit risk and the basic indicator approach

8BIA: for operational risk for computing their capital re%uirements with effect

from <arch =5, )**/. All other commercial banks 8e1cluding local area

banks and regional rural banks: are e1pected to adopt Basel II not later 

than <arch =5, )**9. he parallel runs for these banks are in progress. A

significant improvement in risk management practices, assetliability

management and corporate governance in Indian banks under regulatory

pressure to adopt Basel II framework has been observed.

.

3hile the Basel II framework, by making the capital re%uirements risk

sensitive, would enhance the stability of the financial system, its

implementation also raises several issues"challenges. India follows a three

track approach with commercial banks, cooperative banks and regional

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rural banks having been placed at different levels of capital ade%uacy

norms.

Le,8+,g a,8 I,*e&.me,. Oera.+0,& 04 Ba,-&

GROWTH OF CREDIT TILL NOW> Credit e1tended by scheduled

commercial banks from the early 599*s witnessed three distinct phases.

Bank credit growth was erratic in the first phase 8from 599*95 to 599+9-:.

In the second phase 8from 599-9 to )**5*):, credit growth decelerated

sharply and remained range bound due to the industrial slowdown, high

level of #$As and introduction of prudential norms, which made banks risk

averse. he third phase 8from )**)*= to )**-*: was generally markedby high credit growth attributable to several factors, including pickup in

economic growth, sharp improvement in asset %uality, moderation in

inflation and inflation e1pectations, decline in real interest rates, increase in

the income levels of households and increased competition with the entry

of new private sector banks.

 Although the share of credit to industry in total bank credit declined in the

current decade, the credit intensity of industry increased sharply. A cross

country survey suggests that the reliance of industry on the banking sector 

in India was far greater than that in many other countries. Credit growth to

the !<7 sector, which slowed down significantly between 599-9 and

)**=*;, picked up sharply from )**;*+. 6owever, the share of the !<7

sector in the total nonfood bank credit declined almost consistently from

5+.5 per cent in 599*95 to -.+ per cent in )**-*. his suggests that it is

the large corporates that have increased their dependence on the banking

sector. he share of retail credit comprising housing loans, credit to

individuals, credit cards receivables and lending for consumer durables, intotal bank credit increased sharply from -.; per cent in 599* to )+.; per 

cent in )**.

CHALLENGES FOR INCREASING CREDIT> #otwithstanding some pick

up in credit growth to the agriculture and !<7 sectors in recent years,

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there is need for more concerted efforts to increase the flow of credit to

these sectors given their significance to the economy. Creating enabling

conditions, i!e!" providing irrigation facilities, rural roads and other 

infrastructure in rural areas, is necessary to augment the credit absorptive

capacity. 4evising products to suit the specific needs of the farmers iscritical. here is also a need for comprehensive public policy on risk

management in agriculture. Computerisation of land records can go a long

way in smoothening the flow of credit to agriculture. !imilarly the credit

assessment capabilities of banks need improvement to ensure flow of 

credit to !<7s. here is need to increase the use of cluster based lending

and credit scoring, which has proved %uite effective in many countries as

also in India. In view of the increased e1posure of banks to infrastructure

and retail credit segments, banks need to guard against e1posures toattendant risks. he corporate sector needs to gradually reduce its

dependence on the banking sector and move towards tapping the capital

market so as to enable the banking sector to meet the growing

re%uirements of agriculture, !<7s and other small and tiny enterprises,

which are unable to tap funds from other sources

CHALLENGES FOR FINANCIAL INCL)SION> 3hile there has been a

significant improvement in financial inclusion in recent years, moving ahead

several challenges remain to be addressed. A proper assessment of the

problem of financial e1clusion is necessary. here is, therefore, a need to

conduct specific survey for gathering information relating to financial

inclusion"e1clusion. here is need to reduce the transaction cost for which

technology can be very helpful. &&Bs and cooperative banks, are

e1pected to play a greater role in financial inclusion in future. here would

be need to design appropriate products tailor made to suit the re%uirements

of the people with low income supported by financial literacy and credit

counselling. here is also a need to improve the absorptive capacity of financial services by providing the basic infrastructure. Investment in

human development such as health, water sanitation, and education, in

particular, would be very helpful.

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C0me.+.+0, a,8 C0,&0+8a.+0, +, Re/e,. Year& : here has been a

significant increase in the number of bank amalgamations in India in the

postreform period. 3hile amalgamations of banks in the pre5999 period

were primarily triggered by the weak financials of the bank being merged,

in the post5999 period, mergers occurred between healthy banks, drivenby the business strategy and commercial considerations. !ignificantly,

despite increase in the number of bank mergers and ac%uisitions, the

Indian banking system has become less concentrated during the post

reform period. In fact, the degree of concentration in the Indian banking

system, based on the concentration ratio and 6irschman6erfindhal Inde1,

was one of the lowest among the select countries studied for the year 

)**-. he level of competition declined somewhat in the initial years of 

reforms, but improved significantly thereafter. Based on the empiricalevidence, the Indian banking industry could be characterised as a

monopolistic competitive structure, as is the case with most other advanced

countries and 7<7s

he empirical analysis also suggests that mergers andamalgamation had a

positive impact on efficiency both in terms of increase in return on assets

and reduction in cost, when the transferees were public sector banks

CHALLENGES OF COMPETITION AND CONSOLIDATION> heownership of public sector banks is not an issue from the efficiency

viewpoint as public sector banks in India now are as efficient as new

private and foreign banks, as revealed by the various measures.

6owever, the operating environment for banks has been changing rapidly

and banks in the changed operating environment need fle1ibility to respond

to the evolving situation. Another issue that needs to be considered is the

funding of capital re%uirements of public sector banks given the present

floor of minimum +5 per cent on Government e%uity in public sector banks.In the medium term, this can become an issue hampering the growth of 

public sector banks if Government is not able to provide ade%uate capital

for their e1pansion.

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he roadmap of foreign banks is due for review in )**9. his would involve

several issues. he increased presence of foreign banks, by intensifying

competition, may accelerate the consolidation process that is underway.

6owever, at the same time, this may also raise the risk of concentration if 

mergers"amalgamations involve large banks. he e1perience of some other countries also suggests that the emergence of large banks due to

consolidation has resulted in reduced lending to small enterprises

significantly. All these issues would need to be carefully weighed at the time

of review. he policy relating to ownership of banks by commercial interests

may have to take full account of international practices, given the issues

relating to potential conflict of interests, increased potential of contagion

effects and increased concentration.

EFFICIENCY PROD)CTIITY AND SO)NDNESS OF THE BANKINGSECTOR IN INDIA:9#1 PAST TRENDS : he efficiency and productivity of scheduled commercial banks 8!CBs: in India was analysed empirically,using both the accounting and economic measures.. he most significantimprovement has occurred in the performance of public sector banks andhas converged with those of the foreign banks and new private sector banks. Intermediation cost as also the net interest margin declined acrossthe bank groups. 4espite this, however, profitability of the banking sector improved. Business per employee and per branch also increased

significantly across the bank groups.

he improvement of various accounting measures, however, varied acrossthe bank groups. In terms of cost ratios 8operating cost to income: foreignbanks, and with regard to labour productivity, foreign and new privatebanks were ahead of their peer groups. In terms of net interest margins andintermediation cost, new private sector banks and public sector banks,respectively, were more efficient than the other bank groups. he cost of deposits of foreign banks was the lowest in the industry. 6owever, this was

not passed on to the borrowers, leading to higher net interest spread. heempirical e1ercise suggested that the operating cost was the main factor affecting the net interest margin. #oninterest income and the asset %ualitywere the other determinants of net interest margin.

  CHALLENGES:  . !imilarly, there is a need for increased absorption of 

enhanced technological capability 8innovation: by several banks to further 

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augment productivity of the banking sector through changes in processes

and improvement in human resource skills.

he recent events in global financial markets in the aftermath of ?!

subprime crisis have evoked rethinking on several regulatory andsupervisory aspects of the banking industry, #iz ., how to cope with li%uidity

stresses under unusual circumstancesL whether Uprocyclicality of capital

re%uirements is one of the factors with inherent tendency that escalate the

impact of booms and busts. &egulation of comple1 products and monitoring

of derivatives is becoming an important issue. Further, a %uestion has been

raised whether institutions should be allowed to become so big and so

comple1 that their problems can have systemwide repercussions.

OERALL ASSESSMENT :

he &eport has attempted an indepth analysis of various aspects of the

banking sector in India against the backdrop of the evolution of the Indian

banking sector beginning the 5/th century with a focus on the post

independence period. he analysis suggests that the Indian banking sector 

has witnessed several structural changes from time to time. India now has

a welldeveloped banking infrastructure, conducive regulatory environment

and sound supervisory system. Banks have become efficient and soundand compare well with banks around the world. Banks in India have

benefitted from the robust growth in the last few years, which enabled them

to produce strong financial performance

 An important lesson emerging from the recent financial market

developments is that the focus should not be on how the turmoil should be

managed, but on what policies could be put in place to strengthen the

financial system on a longerterm basis regardless of specific sources of 

disturbances. hese issues point towards the challenges that lie ahead topreserve the safety and soundness of the financial

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CONCL)SION

 A robust banking and financial sector is critical for facilitating higher 

economic growth ainth 8)**/:. he analysis of the Indian Banking

Industry shows stability and growth.

he Government of India and the &BI have attempted to implement a

proactive and responsive monetary policy and fiscal policy with timely,

targeted, and temporary measures. 3hile the &BI has reversed its earlier 

stance of a tight monetary policy, the government recently announced a

fiscal stimulus package to push overall economic activity. Indian Banks

have put in place a constellation of measures both on interest rates and

li%uidity to ward off the impending crisis.

 As a result Indian Banks have been able to perform well globally. Certainaspects and learnings from the Indian Banking Industry can be adopted as

best practices by other financial crisis affected countries.  

he global challenges which banks face are not confined only to the global

banks. hese aspects are also highly relevant for banks which are part of a

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globalised banking system. Further, overcoming these challenges by the

other banks is e1pected to not only stand them in good stead during difficult

times but also augurs well for the banking system to which they belong and

will also e%uip them to launch themselves.

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