Karnataka Bank Founder’s Day Lecture
Challenges Before the
Indian Banking System
by
It gives me great pleasure to be in your midst this evening and to deliver the Founders’ Day Lecture of the Karnataka Bank in this beautiful city of Mangalore. Established in 1924, Karnataka Bank over the last 82 years has grown from a tiny beginning to become a Bank of respectable size with a customer-friendly face. This is an appropriate occasion to express our gratitude to the Founders of the Bank whose vision successive managements have tried to fulfill. The financial position of the Karnataka bank is strong. Its capital adequate ratio is well above the norm prescribed by the Reserve Bank of India. Through maintaining a reasonable level of profitability, it has stood well by its shareholders. The Bank has built up a good technology platform. The Bank is known for its emphasis on customer service. Its credit portfolio is well balanced with a significant rural orientation. I wish to congratulate the Chairman and his colleagues on the excellent performance of the Bank.
In any
economy, the financial sector plays a major role in the mobilization and
allocation of savings. Financial institutions, instruments and markets which
constitute the financial sector act as a conduit for the transfer of financial
resources from net savers to net borrowers, i.e. from those who spend less then
they earn to those who earn less then they spend.
The financial sector performs this basic economic function of intermediation essential through four transformation mechanisms:
liability
asset transformation (i.e. accepting deposits as a liability and converting
them into assets such as loans);
size
transformation (i.e. providing large loans on the basis of numerous small
deposits);
maturity
transformation (i.e. offering saver alternative forms of deposits according to
their liquidity preferences while providing borrowers with loans of desired
maturities); and
risk
transformation (i.e. distributing risk through diversification which
substantially reduces risks for savers which would prevail while lending
directly in the absence of financial intermediation).
The
process of financial intermediation supports increasing capital accumulation
through the institutionalization of savings and investment and, thereby,
fosters economic growth. The gains to the real sector of the economy,
therefore, depend on how efficiently the financial sector performs this basic
function of financial intermediation.
Structural
reforms in areas such as industrial and trade policy can succeed only, if
resources are redeployed towards more efficient producers, which are encouraged
to expand under the new policies. This
reallocation is possible only if the financial system plays a crucial
supportive role. The reforms in the banking sector and in the capital markets
are aimed precisely at achieving this primary objective.
The
ongoing financial sector reform programme aims at promoting a diversified,
efficient and competitive financial sector with the ultimate objective of
improving the allocative efficiency of available resources, increasing the
return on investments and promoting an accelerated growth of the real sector of
the economy.
More specifically, the financial sector reform programme seeks to achieve the following :
Suitable
modifications in the policy framework within which various components of the
financial system operate, such as freeing of interest rates, reduction in the
levels of resource pre-emptions and improving the effectiveness of directed
credit programmes;
Improvement
in the financial health and competitive capabilities by means of prescription
of prudential norms, recapitalisation of banks; restructuring of weaker banks,
allowing entry of new banks and generally improving the incentive system under
which banks function;
Building
an appropriate infrastructure relating to supervision, audit, technology and
the legal framework; and
Upgradation
of the level of managerial competence and the quality of human resource of
banks by reviewing the policies relating to recruitment, training and
placement.
The first
stage of the banking sector reform has come to an end and we are now in the
next stage of the reform and development.
In the years to come, the Indian financial system will grow not only in
size but also in complexity as the forces of competition gain further momentum
and as the financial markets acquire greater width and depth. While the policy environment will have to
remain supportive of healthy growth and development with an accent on greater
operational flexibility as well as greater prudential regulation and
supervision, the thrust of the second phase of reform would have to be on
improvement in the organizational effectiveness of banks and other financial
entities.
The
financial sector of India, as a whole, exhibits vibrancy and resilience. Our banking sector reforms have been
unique. It has been able to bring about
fundamental changes in the banking system in a non-disruptive manner. Judged by the creation of capital adequacy,
provisioning and profitability in the Indian banking system is in a strong
position. The capital position of the
Indian banks has improved significantly over the past decade. Since 1995-96, the banking sector, on the
whole, has been maintaining CRAR consistently well above the minimum stipulated
norm. Overall CRAR for all scheduled commercial
banks has increased from 8.7 per cent at the end-March 1996 to 12.3 percent at
the end-March 2006. The performance of
the banks in reducing their non-performing assets has also been equally
encouraging. The gross NPAs of all
scheduled commercial banks declined from 15.7 per cent of gross advances at the
end-March 1997 to 3.3 percent at the end-March 2006. The net NPA to net advances ratio also declined from 8.1 per cent
to 2.1 per cent during the same period.
The financial performance of the scheduled commercial banks has also
improved in recent years. The operating
profit to asset ratio of the scheduled commercial banks, which was 1.69 per
cent in 1995-96, touched a peak of 2.66 per cent in 2003-04. Thereafter, the ratio declined to 2.03 per
cent in 2005-06. Hardening of interest
rates in the past two years have affected the performing profit and net profit
of the scheduled commercial banks. The
banking sector has thus become robust over the years.
In
meeting the challenges of tomorrow, the financial sector, and more
particularly, the banking system, must respond to the changes in the real
sector. In this context, one can point
to four important facets of the changes occurring in the Indian economy –
The
service sector is rapidly expanding.
Today, it accounts for nearly half of the GDP;
The
external sector is also growing, constituting as much as 30 per cent of the GDP
today;
The
economy has moved on to a higher growth trajectory, and to be sustained, this
would require increasing investments in infrastructure; and,
Despite
the faster rate of growth of manufacturing and service sectors, bulk of the
population still depends on agriculture and allied activities for its
livelihood.
Going by
the experiences of commercial banks in other countries, the following trends
may tend to dominate the future course of banking development in India:
greater
specialization by banks in different niches of the market such as retail,
agriculture, export and the small-scale and corporate sector;
greater
reliance on non-fund business such as advisory and consultancy services,
guarantee and custody services;
greater
overlap in product coverage between commercial banks and non-bank financial
intermediaries; and
greater
financial disintermediation with large companies accessing securitised debt
domestically and from financial markets abroad.
Banks
have to prepare themselves to grapple with these challenges and convert them
into opportunities which calls for critical introspection and intelligent
anticipation. In this regard, several imperatives merit attention:
Banks
would have to move away from excessive concentration on asset management and
adopt a more general approach of asset-liability management aimed at modifying
their liability structure in consonance with the desired assets structure. This entails a continuous process of
planning, organizing and controlling assets-liability volumes, maturities,
rates and yields. It is essential for banks to understand the growing
interdependence of various market segments, and to develop the necessary
expertise for forecasting the relevant variables taking into account this
interdependence.
Management
of credit risks would have to be accorded a very high priority. This is an area
which has received considerable attention in recent years. The new Basle Accord
rests on the assumption that an internal assessment of risks by a financial
institution will be a better measure than an externally imposed formula. The
economic structure is undergoing a change. The service sector has emerged as a
major sector. Assessing credit risks in lending to service sectors needs a
methodology different from risk assessment in lending to manufacturing. There
are other emerging areas of lending such as Housing and Consumer Credit, which
will need new approaches.
Equally
important will be the area of management of exchange risk. Besides enabling
customers to adopt appropriate exchange cover, banks themselves will have to
ensure that their exposure is within acceptable risk.
Banks
would have to equip themselves to operate in a deregulated interest rate
environment. As banks would be increasingly subject to interest rate risk with
fluctuation in the interest rate, special attention would have to be given to
developing the necessary treasury management expertise while managing their
investment portfolios.
A
significant improvement in customer service by banks can no longer be
ignored. In a competitive environment,
banks, which provide poor customer service, will find themselves losing their
clients. In this regard, there is a paramount need for banks to put in place
appropriate corporate strategies, depending upon the nature of their clientele.
Finally,
the housekeeping issues within would have to be addressed in a proactive and
innovative manner. Computerisation and
overall upgradation of technology, rationalization of branch structure and
staffing, reduction of costs, inculcating greater degree of professionalism and
improvement in productivity must receive their due attention regularly in the
functioning of banks.
The last
two decades have been rocked by periodic financial crises. These bouts of
financial instability within individual countries and across countries have
compelled policy makers to pay attention to the problem of predicting,
preventing and managing financial crises. As part of the crisis prevention
initiatives, the Financial Stability Forum was set up in 1999, which has since
become a nodal agency for setting up standards and
codes. Detailed standards and codes for
12 core areas have been developed and are being continuously supplemented by
the respective standard-setting bodies.
India has
been actively involved in implementing these standards. As Indian banks get
active in the global scene, it is important that our standards converge towards
internationally accepted standards. Then only our banks can gain credibility
and acceptability.
In
conclusion, I would like to stress on 3 or 4 issues.
First is
improvement in customer service. Banks
exist to provide service to customers.
With the introduction of technology, there has been a significant change
in the way banks operate. This is a far
cry from the situation that existed even 15 years ago. The induction of technology has enabled
several transactions to be processed in a shorter period of time. Transmission of funds to customers takes
less time now. ATMs provide easy access
to cash. Nevertheless, it is not very
clear whether the customers are fully satisfied with the services provided when
they come to a bank. This is an area,
which must receive continuous attention.
The interface with the customers needs to improve.
Provision
of credit is a basic function of banks.
The effective discharge of this function is part of the intermediation
process. The sectoral deployment of
credit must keep pace with the changes in the structure of the economy. The banking industry in India must equip
itself to be able to assess and meet the credit needs of the emerging segments
of the economy. In this context, two
aspects require special attention.
First, as
the Indian economy gets increasingly integrated with the rest of the world, the
demands of the corporate sector for banking services will change not only in
size but also in composition and quality. The growing foreign trade in goods
and services will have to be financed. Apart from production credit, financing
capital requirements from the cheapest sources will become necessary. Provision
of credit in foreign currency will require in turn a management of foreign
exchange risk. Thus, the provision of a whole gamut of services related to
integration with the rest of the world will be a challenge. Foreign banks
operating in India will be the competitors to Indian banks in this regard. The
foreign banks have access to much larger resources and have presence in many
parts of the world. Therefore, Indian banks will have to evolve appropriate
strategies in enabling Indian firms to accessing funds at competitive rates.
Another aspect of global financial strategy relates to the presence of Indian
banks in foreign countries. Indian banks will have to be selective in this
regard. Here again the focus may be on how to help Indian firms acquire funds
at internationally competitive rates and how to promote trade and investment
between India and other countries. We must recognize that in foreign sectors,
Indian banks will be relatively smaller players.
Second, despite the faster rate of growth of manufacturing and service sectors, bulk of the population still depends on agriculture and allied activities for its livelihood. In this background, one cannot over-emphasize the need for expanding credit to agricultural and allied activities. While banks have achieved a higher growth in provision of credit to agriculture and allied activities last year, this momentum has to be carried further. In this context, it has to be noted that credit for agriculture is not a single market. Provision of credit for high-tech agriculture is no different from providing credit to industry. Provision of credit to farmers with a surplus is also of similar nature. Commercial banks in particular must have no hesitation in providing credit to these segments where the normal calculation of risk and return applies. It is only with respect to provision of credit to small and marginal farmers, special attention is required. They constitute a bulk of the farmers, which account for a significant proportion of the total output.
The
National Sample Survey Organization has recently released a Report entitled,
“Indebtedness of Farmer Households”.
This Report contains a wealth of data relating to the extent and nature
of indebtedness. One stunning fact that
emerges is that there is a substantial difference between marginal and
sub-marginal farmers on the one hand and the rest of the farmer households on
the other regarding the purpose for which loans are obtained and the sources of
credit. For all farmer households taken
together, at the all-India level, institutional sources were responsible for
providing 57.5 per cent of the total credit.
But as far as farmer households owning one hectare and less, this proportion
is only 39.6 per cent. For all farmer
households, the proportion of loan going for production purposes is 65.1 per
cent as against 40.2 per cent for marginal and sub-marginal farmer households. Thus, for sub-marginal and marginal farmers,
the proportion of production loan is lower than for all farmers. Similarly, the proportion of institutional
credit is lower for sub-marginal and marginal farmers than for all
farmers. This, in fact, is true of
every state of the country. Thus, a
critical issue is how to meet the credit requirements of marginal and
sub-marginal farmers. What changes do
we need to introduce so that credit can flow to this class of farmer
households? Can the banking system
through its present mode of distribution of credit meet this challenge? Should we think in terms of banks supporting
other institutions who are in a better position to lend to marginal and
sub-marginal farmers? In any case, a
re-look at the organizational structure of our rural branches is called
for. Banks need to think deeply on how
to meet this challenge of meeting the credit needs of marginal farmers. The financial inclusion is no longer an
option; it is a compulsion.
In recent
years, size has become an important issue. It is being argued that on account
of increased competitive pressures and the requirement of heavy investment in
IT, small banks may not be able to survive. It is argued that smaller
institutions simply would not have resources to introduce either new products
or new delivery channels. Corporates may also prefer for one-stop shopping
given their diverse requirements. This
would mean that only bigger banks may survive in a competitive
environment. In fact, there has been an
increasing trend towards consolidation in recent years the world over.
The
Committee on Banking Sector Reforms (CBSR) chaired by Shri M. Narasimham, which
submitted its report in 1998, looked into the issues relating to the structure
of the banking industry in India in the context of the current national and
international environment. The Committee observed that the global trend in
banking is marked by the twin phenomena of consolidation and convergence. The
increase in competition requires banks to attain meaningful balance sheet sizes
and market shares as also to adopt new and sophisticated risk management tools.
It is essential for banks to increase their size for investing in certain new
areas emerging in the wake of progress in information technology and modern
communication. In the changing economic scenario, the banks need to diversify
their services and products as also cover the customers across globe. Thus,
from all the perspectives, size is
regarded as a major source of strength.
This does
not, however, suggest that the smaller banks will have no future. The actual
experience also suggests that small banks even in advanced countries have been
able to survive and remain profitable.
For instance, there has been massive consolidation in the US during last
25 years or so (there are about 7600 commercial banks in America today as
compared with about 13,000 operating in 1980), However, in the US, community
banks, that is, banks with assets of US $ 1 billion or less, continue to
experience financial success and attract capital from the market. In European countries also there are a large
number of relatively small, and often locally or regionally based banks. These
banks have survived along with very large financial conglomerates. This would
suggest that the size as such is not the main issue. The key issue is whether the bank is operating efficiently.
There is some evidence to suggest that banks of different sizes
having different portfolio and cost structures behave differently. These
differences suggest that small banks may be the more natural lenders to small businesses.
Large
banks may not like to deal with small borrowers, who may be driven to small
banks. Also, some
customers value personalised services, which small banks may be in a better
position to provide. Small banks also have much lower deposit volatility, and
hence, less need for liquidity. A major challenge for small banks, however,
is to manage a large number of transactions of low value. They need to have clear understanding of
customer needs and provide them an ease of transacting a business at low cost
and in a flexible manner. They also need to provide convenient access to their
clients. Thus, although in the coming years there may be an increasing
trend towards consolidation, it is felt that efficient small banks could
survive alongside large and diversified financial institutions.
The
process of consolidation has also been taking place in India. Since 1990, 19
mergers have taken place in the commercial banking sector. Moreover, with a
view to improving the operational viability of RRBs, merger/amalgamation of
RRBs has been implemented at the initiative of the Government of India since
September 2005. Consequently, 137 RRBs were amalgamated to form 43 new RRBs,
sponsored by 18 banks in 15 States, bringing down the total number of RRBs all
over India to 102, from 196 in March 2005. Bank
mergers have taken place in India mostly with the objective to synergise the
strength of the merging institutions.
Notwithstanding the increased
process of consolidation of banks in India, a large number of small and medium
sized banks continue to operate successfully. The performance of many smaller
sized banks in terms of profitability and non-performing assets has been
comparable with large banks.
Success is not the synonyms with bigness. Small banks can be successful and can create a niche for themselves, as Karnataka Bank has shown. By meeting the local needs more effectively, Karnataka Bank can continue to grow stronger. The vision of the Founders must continue to inspire the Bank.
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