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Banking Regulations Project Draft

Aiming to achieve a High Performing Banking Sector:

Strategy of the Indian Banking Sectors

Submitted to Submitted By

Professor Kumud Malviya Anirudhya Dutta

B.A. LLB. 7th

Semester

Roll: 1183007

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Contents

1. Research Methodology and Questions…………………………….3

2. Global Banking Standards………………………………………...4

3. Indian Banks to Achieve Banking Standards……………………...8

4. Strategies for Global Standards – Indian Aspect………………...10

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Research Methodology

The Methodology adopted for the representation and making of this project has been empirical.

This paper is a reconstruction from the previously discussed literature and brings out an

analytical perspective of the topic in question. The references drawn are from previously

published report of various Government and Financial Institutions, prevailing laws and the case

studies which portray the Banking strategy landscape.

The issues or widespread problems that are faced by the Indian banking sector due to the

prevailing strategies are of plentitude. Offshore banking activities take a toll, and this prevents

inflow of foreign funds. The other issue is setting up an international standard banking system so

as to meet the world standards. This is vehemently needed as the economic markets are

stabilizing after the turmoil, and the Indian banks can pull in large foreign money-flows.

Research Question

1. What is the global standard for banking sector?

2. What is the present law affecting the banking sector in India?

3. What is to be done, so as to meet global banking standards?

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Global Banking Standards

The banking standards of the world have evolved in partisans, where Americas, Asia-Pacific and

European banking business regulations have faced stark changes in regulations. This in turn is

showing the new International Standards.

EVOLUTION IN BANKING REGULATIONS

1. ASIA PACIFIC

Regulatory reform was intended to make financial institutions and markets more transparent,

less complex and less leveraged. But progress has been limited because many of the reforms

are still in the early stages of implementation, other reforms remain on the drawing BOARD

and crisis intervention measures are still in place in many countries. As the IMF remarked in

its Global Financial Stability Report of October 20121,“although there has been some

progress over the past five years, financial systems have not come much closer to those

desirable features.”

The regulators want banks to be prudent. Customers want lower banking costs. Banks’

creditors want to make sure they get their money back. Shareholders want them to be

profitable. There inevitably have to be trade-offs here, and striking the right balance is

proving difficult for both the banks and their regulators. Second, banks face a wide range of

regulatory reforms – both individually and collectively. There is then the even more

important challenge of deciding what these regulatory reforms – together with all the other

drivers of the business – mean for each bank’s strategy and business model; and

implementing effectively the necessary changes.

Senior management has to focus simultaneously on two very different aspects of their

businesses. One is the internal re-engineering of corporate and risk governance, and making

crucial changes to the roles of Risk and Compliance functions. The other is a response to

external pressures, from the market and regulators, to restructure, alter the mix of business

activities and innovate in order to reduce costs and raise revenue during a period of economic

stagnation in Europe and slow growth in the rest of the world.

1 Global Financial Stability Report, IMF, October 2012.

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Five to seven years on, we are likely to see four common themes in the banking world.

•Restructuring in favour of robustly capitalized, locally funded, client driven businesses

centered on regional hubs.

• A real client focus at the heart of the organization will make firms more agile.

• The right culture and people will engender trust and enable banks to successfully execute

business.

• Good relationships with regulators, built on trust from regulators, investors and the public,

will provide sufficient freedom for banks to operate.

2. AMERICAS

There are two issues in relation to implementation in the region that are being

increasingly voiced. First, should Asian jurisdictions have more discretion to tailor the

global requirements to local circumstances? Are the new requirements too focused on the

particular issues faced by banks in Europe and the US, rather than in Asia?

Second, even if banks in the region can meet the new requirements at this particular point

in time, might it be more of a challenge in a few years’ time, when bank balance sheets

have grown significantly, on the back of strong economic growth? Could the new capital

and liquidity requirements impair banks’ ability to provide the necessary finance to

support the growth of the economy?

Certainly, the possible negative effect of regulatory reform on banks’ ability to lend is an

increasing concern to regulators and politicians globally, as evidenced by the moves to

phase implementation of the new requirements not just on capital but also now on

liquidity over an extended period. In Asia, however, the story is different: banks can

largely meet the new requirements now – but will they be able to do so twoor three years

down the line?

Looking ahead, difficulties in meeting the new requirements could be exacerbated if the

Basel Committee’s review of the trading book results in higher capital requirements.

Similarly, there is a suggestion that regulators may implement floors on banks’ IRB

capital calculations relative to the standardized approach, which again could raise capital

requirements.

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On the issue of adapting the Basel standards to Asian characteristics, regulators in the

region clearly have less discretion than in the past, as many are now members of the

Basel Committee and subject to the peer review process.

In practice this means that they cannot go below the Basel standards – but of course they

can still go above them.And in a number of cases we have seen regulators in the region –

in China and Singapore, for example – setting requirements above the Basel minimums in

areas such as capital adequacy and leverage, in order to reflect the characteristics of the

local market.

It seems likely that we will see similar actions from some regulators in respect of

liquidity. While the Liquidity Coverage Ratio (LCR) will certainly be adopted, regulators

will be looking at whether it needs to be supplemented with alternative measures to

reflect the liquidity characteristics of Asian markets, including catering for additional

types of scenarios and employing alternative run-off rates.

They will also be considering whether the LCR need be adopted by all institutions, or

perhaps only by the larger ones. We are also likely to see variety in the way that Asian

regulators apply requirements on Recovery and Resolution Plans (RRPs), and in the

designation of domestic Systemically Important Financial Institutions (SIFIs).So

although we may be moving towards something more like a level playing field in terms

of the minimum standards on capital, liquidity, leverage, RRPs and so on, it is clear that

there will remain considerable differences in requirements (such as the timing of

implementation and the scope of application) from jurisdiction to jurisdiction. This will

pose a major challenge for banks operating in the region, be they foreign or domestic, big

or small, in terms of understanding local requirements and timelines, appreciating the

differences compared to the Basel ‘central approach’, and identifying the actions

necessary for both regulatory and business purposes.

Clearly, it is not going to be straightforward for those doing business in the region to

meet all these new requirements, particularly when one considers that many of the

economies and of course financial markets in the region are still developing.

Moreover, there remain major unresolved questions, such as the ability of banks in the

region to supplement their equity capital with the new-style subordinated debt under

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Basel 3, the subject of a separate section of this report. The issue of instruments such as

‘CoCos’ is untested in Asia at present.

Another section of this report looks at the challenges facing foreign banks in Asia, which

look particularly daunting as they juggle home and host country requirements and face

issues on funding and suggestions of pressure to subsidiaries. Future publications in this

series will provide further insight into how the regulatory regime in Asia is developing

and the issues as they affect foreign and domestic institutions operating in the region.

3. BASEL III

"Basel III" is a comprehensive set of reform measures, developed by the Basel Committee

on Banking Supervision, to strengthen the regulation, supervision and risk management

of the banking sector. These measures aim to:

improve the banking sector's ability to absorb shocks arising from financial and economic

stress, whatever the source

improve risk management and governance

Strengthen banks' transparency and disclosures.

The reforms target:

Bank-level, or micro prudential, regulation, which will help raise the resilience of

individual banking institutions to periods of stress.

Macro prudential, system wide risks that can build up across the banking sector as well as

the pro-cyclical amplification of these risks over time.

These two approaches to supervision are complementary as greater resilience at the

individual bank level reduces the risk of system wide shocks.

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Indian Banks to achieve Global Standards

Indian banks have been increasingly growing their international presence in the recent past. In

part to cater to the growing Indian diaspora in foreign countries (estimated at ~ 20 million

persons) and in part to meet the growing demands from cross border trade and economic activity.

The Public sector banks (PSBs) are much ahead of the Private sector banks in their overseas

presence, constituting over 90 percent of 171 overseas branches as of March 31st, 2013.2

Many of the private banks do not have branches, but are present through representative offices.

Nonresident Indians (NRIs) deposits aggregated USD 14.2 billion in the financial year ended

March 2013, a y-o-y increase of 19 percent. The Indian Diaspora worldwide is estimated to be

~20 mn persons3 and is on a constant rise.

Supply Chain Financing (SCF) is rapidly gaining attention in international markets and is

growing at a pace of 30 – 40 percent at major international banks according to a research6. Key

elements of SCF include factoring, invoice discounting/reverse factoring, purchase order/invoice

data management, and bank assisted open account, open account payment, export/seller finance

and buyer side finance. All the products aiming at providing better liquidity to the corporates and

their entire value chain at lower financing rates. Currently, the growth in this domain comes from

US and western European countries, but the future growth is expected to come from emerging

economies like India and China.

With various government policies supporting exporters in India, the export credit is growing at a

rapid rate (Three year CAGR at 14 percent and five year CAGR at 22 percent). A part of this is

also supplier financing, which has been gaining popularity.

Banks are increasingly focusing on increasing their business from SCF. This can be witnessed in

growing number of branches in Industrial units. The banks are holding awareness campaigns and

seminars to educate the corporate world of the benefits of SCF. Certain players are focusing on

developing expertise in particular sectors.

2 RBI Country-wise branches of Indian Banks at Overseas Centers as on March 31, 2013 3 Including Non Resident Indians and Person of Indian origin.

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Factoring and reverse factoring has not gained much momentum in India and still offers an

untapped market. Factor products offer greater flexibility compared to other instruments used for

working capital finance. Although receivables enjoy property rights and are transferable, a

statutory framework for factoring was introduced only in 2011 by way of the Factoring

Regulation Bill.

The Factoring bill essentially protects micro and small businesses from delayed payments for

goods and services by larger entities. Traditional banks used to provide loans based on the

borrower’s (i.e. the MSME player’s) ability to service the loan. Factoring will however evaluate

the lending decision based on the ultimate debtor (i.e. the ultimate customer of the MSME). This

will greatly improve the liquidity and working capital problems of MSME players.

With favorable legislations, factoring is gradually taking off in India. The Indian market

constitutes a mere one percent of the world’s factoring market and 0.5 percent of the working

capital requirement of Indian companies and is constantly growing.

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Strategies for Global Standards – Indian Aspect

The main objective of the Indian Banking sector reforms of the 1990s was to promote a

diversified, efficient and competitive financial system with the ultimate goal of improving the

allocative efficiency of resources through operational flexibility, improved financial viability and

institutional strengthening, to bring it at par with global benchmarks. However, with increased

deregulation of financial markets and subsequent integration of the global economy, the period

also noticed turbulence for global financial markets; 63 countries suffered from systemic banking

crisis in that decade, much higher than 45 in the 1980s. It is particularly noteworthy here that

India could pursue its process of financial deregulation and opening of the economy without

suffering financial crisis during this turbulent period in world financial markets. Even today, the

fact that current annual growth of around 8 percent can be achieved in India at about 30 percent

rate of gross domestic investment suggests that the economy is functioning quite efficiently. As

the Indian economy continues on such a growth path and attempts to accelerate it, new demands

are being placed on the Banking sector. Higher sustained growth is contributing to the movement

of large number of households into higher income categories, and hence, higher consumption

categories, along with enhanced demand for financial savings opportunities. On the production

side, industrial expansion has accelerated; merchandise trade growth is high; and there are vast

demands for infrastructure investment, from the public sector, private sector and through public

private partnerships.

Efficiency

If we look at the data published by the International Monetary Fund, for the year 2005, it shows

that the median Return on Assets (ROA) is highest in Central Europe (1.4%), followed by Latin

America (1.3%) and Asia (1.0%). Asia showed sizeable recovery since 1997, when its ROA was

-0.8% that fell further in the next year to -1.4%, but has been gradually recovery since then to

reach close to 1.0 % by the year 2005. The differences in the ROA of banks in Asian economies,

as measured by the standard deviation, which was at 8% in 1998 gradually declined to 0.5% by

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2005. India has been maintaining a ROA of about 0.8 to 1.1% throughout the six year where as

Indonesia showed rapid improvement in the last two years.4

Quality of Assets & Capital Adequacy standards

Median levels of Non-Performing Assets of Asian Banks in 2005 remained more or less similar

what it was six years ago. It does not mean that bad debts stopped growing in these banks, but

only that they have managed to bring down from about a median level of 20 percent they have

reached in 1998. The latest data puts bad debts of Asian banks at 10.3 percent of the assets,

similar to Latin America but 2 percentage points than Eastern Europe. One encouraging feature

is that banking systems across all the regions in emerging economies possess capital adequacy

levels that are considered safe and sound. The median levels of capital adequacy levels in banks

in Asia, Latin and Central Europe are around 10 percent and these have been consistently

showing improvement. Korea in the Asian region tops the regulatory capital as a percent to risk

weighted assets, a trend which is evident in most of the countries, in particular Philippines,

Malaysia etc. Capital adequacy levels in Asian countries are much higher even compared to the

banking systems in the mature performing assets in India, Indonesia, Philippines, Thailand,

Pakistan remain at higher levels, the problem of which could be further compounded by any

setbacks in the economy either owing to developments in the domestic sector or international

economy. In India in the last six years this capital adequacy ratio hovered around 10 to 11

percent and given the subdued growth of assets, it remains pretty significant. Despite overall

improvement in various aspects of operational efficiency, the financial strength of banking

systems remains a matter of great concern.

4 Prof. Prakash Singh, Global Competitiveness of Indian Banks: A study of select banking indicators, issues of

concern and opportunities, IIM Lucknow.