Statement of Problem

What strategies can be adopted by Indian financial sector to become and remain globally competitive?
While there is no single mantra to become globally competitive, let me raise a few issues on this count. In the context of the Banking Sector, there is the issue of consolidation, which is the current buzzword in the banking industry worldwide. The largest bank in China with an asset base of over US $400 billion. In contrast, the total asset of the largest two banks in India, one in public sector and another a private entity, are US $105 billion and US $38 billion. These figures are extremely illuminating and the onus is on Indian banks to take cognisance of this fact. The Government has raised the cap on FDI in private banks. The Reserve Bank has, on its part, suggested certain changes in the Banking Regulation (Amendment) Bill, 2003 that seek to address some of the legal impediments arising in the consolidation process. The second issue of import is that of management of costs. Cost containment is a key to sustainability of bank profits as well as their long-term viability. In 2003, operating costs of banks, expressed as per cent of total average asset, was lower than 2 per cent in major European economies like Sweden, Austria, Germany and France. In contrast, in 2004, operating costs of commercial banks in India were 2.2 per cent of total assets. The downward stickiness continued in 2005 as operating costs have remained well above 2 per cent, as percentage of total assets. Another related challenge is in reducing the cost of funds of the banking sector.1 In tandem with the soft interest regime over the last few years, cost of funds of the banking sector has been declining. The cost of funds of public sector banks, which was 6.9 per cent in 1995-96 has since declined to 4.3 per cent in 2004-05. Other bank groups have also experienced concomitant declines. With the rise in oil prices and its cascading effects on inflation along with the raising of policy rates by several central banks, sooner or later, this reversal of the existing comfortable liquidity conditions is likely to have
1 Cost
of funds=[(Interest paid on deposits plus interest paid on borrowing)/(Deposit plus borrowing)]
21 ramifications on domestic financial markets, and with that, on the cost of funds of banks as well. Diversification into fee-based activities coupled with prudent asset liability management hold the key to future profitability. The issue of credit delivery systems has come into focus of late. The persistence of divergence between the informal and formal sector interest rates in effect has meant that, with deregulation, the formal credit mechanisms have not been able to pierce the informal system. The differences in apparent cost and total real cost might be an important factor behind this divergence.2 Reducing the total real cost in the formal sector is likely to be an important consideration to bring about a degree of convergence between the price of credit between the formal and informal sectors. In recognition of this fact, the last several Annual policies have placed explicit emphasis on streamlining credit delivery through a gamut of measures, including, among others, widening the scope of infrastructure lending, revamping the rural credit delivery system by envisaged restructuring of the rural banking segment, widening the scope of priority sector lending, and the like. I am sure that Indian banks would be up to the task to address the issue of credit delivery. The fourth issue is the management of sticky assets. This is a key to the stability and continued viability of the banking sector. Although the ratio
of nonperforming loans to total assets are higher in comparison to international standards, the Indian banks have done a marvellous job in containment of nonperforming loans (NPL) in recent times. Non-performing loans to total loans of banks were 1.2 per cent in the US, 1.4 per cent in Canada and in the range of 25 per cent in major European economies. In contrast, the same for Indian banks was 7.2 per cent in 2004-05. Gross NPL ratio for Indian scheduled commercial banks declined to 5.4 per cent in 2005 bearing testimony to the serious efforts by our banking system to converge towards global benchmarks. The fifth issue concerns the management of risks. Banking in modern economies is all about risk management. The successful negotiation and
2 Apparent
cost is what is shown in the loan document, whereas total real cost includes cost incurred on formalities, including documentation (number of photocopies required, the paper work, transportation cost, etc.)
22 implementation of Basel II is likely to lead to an even closer focus on risk measurement and risk management at the institutional level. Thankfully, Basel II has, through their various publications, provided useful guidelines on managing the various facets of risk. I believe institution of sound risk management practices would be an important plank for staying ahead of the growing competition. Over the past few years, the Reserve Bank of India has initiated several steps to promote adequate risk management systems across market participants. Among the measures that were instituted to insulate the financial institutions from the vagaries of the market were gradual increase in the cushion of capital, frequent revaluation of the portfolio based on market fluctuations, increasing transparency and a framework for asset liability management (ALM) to combat the risks facing the Indian financial Sector. The RBI has taken a lead in providing guidance to banks by bringing out guidance notes on how to identify, monitor, measure and control the various facets of risks. However, in the ultimate analysis, the onus is on the banks themselves to adopt an integrated risk management approach, based on coherent risk models suited to their risk appetite, business philosophy and expansion strategies. Such improved risk management systems are not only crucial stepping stones towards Basel II but also are expected to enable banks to shed their risk averse attitude and contributing more finance to hitherto unbaked segments of agriculture, industry and services. It is important that banks look at the expansion of the credit portfolio in a healthy way, particularly in the background of higher industrial growth, new plans of corporate expansion and higher levels of infrastructure financing. Improved risk management practices by financial intuitions is the key to success in a competitive environment where new instruments such as derivatives are introduced in a gradual and progressive manner. Financial innovation provides opportunities and rewards to those with enterprise and vision. But at the same time, it exposes them to increased risks. Unless market participants institute sound risk management systems, holding trading positions tantamount expose them to severe risks. Indeed, risk taking and risk 23 management must go hand in hand. The financial market needs players who are not afraid to take contrarian positions, who search for unoccupied habitats to provide diversity, provided they have adequate risk management systems in place. For market participants, there is little room for complacency and there
appears to be no choice but to be pro-active in instituting appropriate risk management models. My view is that early adoption in this regard makes sound business sense and may prove immensely beneficial in a competitive financial sector.

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What strategies can be adopted by Indian financial sector to become and remain globally competitive?

of funds=[(Interest paid on deposits plus interest paid on borrowing)/(Deposit plus borrowing)]

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