Npa in Banking

8/11/2019 Npa in Banking

1/120

A REPORT ON

NON-

PERFORMING

ASSETS-

CHALLENGE TO THE

PUBLIC SECTOR BANKS

1


2/120

INTRODUCTION

After liberalization the Indian banking sector developed very appreciate. The RBI

also nationalized good amount of commercial banks for proving socio economic services

to the people of the nation.

The Public Sector Banks have shown very good performance as far as the

financial operations are concerned. If we look to the glance of the financial operations,

we may find that deposits of public to the Public Sector Banks have increased from

859,461.95crore to 1,079,393.81crore in 2003, the investments of the Public Sector

Banks have increased from 349,107.81crore to 545,509.00crore, and however the

advances have also been increased to 549,351.16crore from 414,989.36crore in 2003.

The total income of the public sector banks have also shown good performance

since the last few years and currently it is 128,464.40crore. The Public Sector Banks have

also shown comparatively good result. The gross profits of the Public Sector Banks

currently 29,715.26crore which has been doubled to the last to last year, and the net profit

of the Public Sector Banks is 12,295,47crore.

However, the only problem of the Public Sector Banks these days are the

increasing level of the non performing assets. The non performing assets of the Public

Sector Banks have been increasing regularly year by year. If we glance on the numbers of

non performing assets we may come to know that in the year 1997 the NPAs were

47,300crore and reached to 80,246crore in 2002.

The only problem that hampers the possible financial performance of the Public

Sector Banks is the increasing results of the non performing assets. The non performing

assets impacts drastically to the working of the banks. The efficiency of a bank is not

always reflected only by the size of its balance sheet but by the level of return on its

assets. NPAs do not generate interest income for the banks, but at the same time banks

are required to make provisions for such NPAs from their current profits.

2


3/120

NPAs have a deleterious effect on the return on assets in several ways -

They erode current profits through provisioning requirements

They result in reduced interest income

They require higher provisioning requirements affecting profits and accretion to

capital funds and capacity to increase good quality risk assets in future, and

They limit recycling of funds, set in asset-liability mismatches, etc.

The RBI has also tried to develop many schemes and tools to reduce the non

performing assets by introducing internal checks and control scheme, relationship

managers as stated by RBI who have complete knowledge of the borrowers, credit rating

system, and early warning system and so on. The RBI has also tried to improve the

securitization Act and SRFAESI Act and other acts related to the pattern of the

borrowings.

Though RBI has taken number of measures to reduce the level of the non performing

assets the results is not up to the expectations. To improve NPAs each bank should be

motivated to introduce their own precautionary steps. Before lending the banks must

evaluate the feasible financial and operational prospective results of the borrowing

companies. They must evaluate the business of borrowing companies by keeping in

considerations the overall impacts of all the factors that influence the business.

3


4/120

RESEARCH OPERATION

1. Significance of the study

The main aim of any person is the utilization money in the best manner since the

India is country were more than half of the population has problem of running the family

in the most efficient manner. However Indian people faced large number of problem till

the development of the full-fledged banking sector. The Indian banking sector came into

the developing nature mostly after the 1991 government policy. The banking sector has

really helped the Indian people to utilise the single money in the best manner as they

want. People now have started investing their money in the banks and banks also provide

good returns on the deposited amount. The people now have at the most understood thatbanks provide them good security to their deposits and so excess amounts are invested in

the banks. Thus, banks have helped the people to achieve their socio economic

objectives.

The banks not only accept the deposits of the people but also provide them credit

facility for their development. Indian banking sector has the nation in developing the

business and service sectors. But recently the banks are facing the problem of credit risk.

It is found that many general people and business people borrow from the banks but due

to some genuine or other reasons are not able to repay back the amount drawn to thebanks. The amount which is not given back to the banks is known as the non performing

assets. Many banks are facing the problem of non performing assets which hampers the

business of the banks. Due to NPAs the income of the banks is reduced and the banks

have to make the large number of the provisions that would curtail the profit of the banks

and due to that the financial performance of the banks would not show good results

The main aim behind making this report is to know how Public Sector Banks are

operating their business and how NPAs play its role to the operations of the Public Sector

Banks. The report NPAs are classified according to the sector, industry, and state wise.The present study also focuses on the existing system in India to solve the problem of

NPAs and comparative analysis to understand which bank is playing what role with

concerned to NPAs.Thus, the study would help the decision makers to understand the

financial performance and growth of Public Sector Banks as compared to the NPAs.

4


5/120

2. Objective of the study

Primary objective:

The primary objective of the making report is:

To know why NPAs are the great challenge to the Public Sector Banks

Secondary objectives:

The secondary objectives of preparing this report are:

To understand what is Non Performing Assets and what are the underlying

reasons for the emergence of the NPAs.

To understand the impacts of NPAs on the operations of the Public Sector

Banks.

To know what steps are being taken by the Indian banking sector to reduce

the NPAs?

To evaluate the comparative ratios of the Public Sector Banks with

concerned to the NPAs.

5


6/120

2. Research methodology

The research methodology means the way in which we would complete ourprospected task. Before undertaking any task it becomes very essential for any one to

determine the problem of study. I have adopted the following procedure in completing

my report study.

1. Formulating the problem

2. Research design

3. Determining the data sources

4. Analysing the data

5. Interpretation

6. Preparing research report

(1) Formulating the problem

I am interested in the banking sector and I want to make my future in the banking

sector so decided to make my research study on the banking sector. I analysed first the

factors that are important for the banking sector and I came to know that providing credit

facility to the borrower is one of the important factors as far as the banking sector is

concerned. On the basis of the analysed factor, I felt that the important issue right now as

far as the credit facilities are provided by bank is non performing assets. I started

knowing about the basics of the NPAs and decided to study on the NPAs. So, I chose the

topic"Non Performing Assts the great challenge before the Public Sector Banks".

(2) Research Design

The research design tells about the mode with which the entire project is prepared.

My research design for this study is basically analytical. Because I have utilised the large

number of data of the Public Sector Banks.

6


7/120

(3) Determining the data source

The data source can be primary or secondary. The primary data are those data

which are used for the first time in the study. However such data take place much time

and are also expensive. Whereas the secondary data are those data which are already

available in the market. These data are easy to search and are not expensive too.for my

study I have utilised totally the secondary data.

(4) Analysing the data

The primary data would not be useful until and unless they are well edited and

tabulated. When the person receives the primary data many unuseful data would also be

there. So, I analysed the data and edited them and turned them in the useful tabulations.

So, that can become useful in my report study.

(5) Interpretation of the data

With use of analysed data I managed to prepare my project report. But the

analyzing of data would not help the study to reach towards its objectives. The

interpretation of the data is required so that the others can understand the crux of the

study in more simple way without any problem so I have added the chepter of analysis

that would explain others to understand my study in simpler way.

(6) Project writing

This is the last step in preparing the project report. The objective of the report

writing was to report the findings of the study to the concerned authorities.

7


8/120

4. Limitations of the study

The limitations that I felt in my study are:

It was critical for me to gather the financial data of the every bank of the Public

Sector Banks so the better evaluations of the performance of the banks are not

possible.

Since my study is based on the secondary data, the practical operations as related

to the NPAs are adopted by the banks are not learned.

Since the Indian banking sector is so wide so it was not possible for me to cover

all the banks of the Indian banking sector.

8


9/120

INDIAN BANKING SECTOR

Banking in India has its origin as early as the Vedic period. It is believed that thetransition from money lending to banking must have occurred even before Manu, the

great Hindu Jurist, who has devoted a section of his work to deposits and advances and

laid down rules relating to rates of interest. During the Mogul period, the indigenous

bankers played a very important role in lending money and financing foreign trade and

commerce. During the days of the East India Company, it was the turn of the agency

houses to carry on the banking business. The General Bank of India was the first Joint

Stock Bank to be established in the year 1786. The others which followed were the Bank

of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued

till 1906 while the other two failed in the meantime. In the first half of the 19th

centurythe East India Company established three banks; the Bank of Bengal in 1809, the Bank of

Bombay in 1840 and the Bank of Madras in 1843. These three banks also known as

Presidency Banks were independent units and functioned well. These three banks were

amalgamated in 1920 and a new bank, the Imperial Bank of India was established on 27th

January 1921. With the passing of the State Bank of India Act in 1955 the undertaking of

the Imperial Bank of India was taken over by the newly constituted State Bank of India.

The Reserve Bank which is the Central Bank was created in 1935 by passing Reserve

Bank of India Act 1934. In the wake of the Swadeshi Movement, a number of banks with

Indian management were established in the country namely, Punjab National Bank Ltd,Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank of Baroda Ltd, the

Central Bank of India Ltd. On July 19, 1969, 14 major banks of the country were

nationalised and in 15thApril 1980 six more commercial private sector banks were also

taken over by the government.

9


10/120

Indian Banking: A Paradigm shift-A regulatory point of view

The decade gone by witnessed a wide range of financial sector reforms, with

many of them still in the process of implementation. Some of the recently initiated

measures by the RBI for risk management systems, anti money laundering safeguards and

corporate governance in banks, and regulatory framework for non bank financial

companies, urban cooperative banks, government debt market and forex clearing and

payment systems are aimed at streamlining the functioning of these instrumentalities

besides cleansing the aberrations in these areas. Further, one or two all India development

financial institutions have already commenced the process of migration towards universal

banking set up. The banking sector has to respond to these changes, consolidate and

realign their business strategies and reach out for technology support to survive emerging

competition. Perhaps taking note of these changes in domestic as well as international

arena

All of we will agree that regulatory framework for banks was one area which has

seen a sea-change after the financial sector reforms and economic liberalisation and

globalisation measures were introduced in 1992-93. These reforms followed broadly the

approaches suggested by the two Expert Committees both set up under the chairmanship

of Shri M. Narasimham in 1991 and 1998, the recommendations of which are by now

well known. The underlying theme of both the Committees was to enhance the

competitive efficiency and operational flexibility of our banks which would enable them

to meet the global competition as well as respond in a better way to the regulatory and

supervisory demand arising out of such liberalisation of the financial sector. Most of the

recommendations made by the two Expert Committees which continued to be subject

matter of close monitoring by the Government of India as well as RBI have been

implemented. Government of India and RBI have taken several steps to :- (a) Strengthen

the banking sector,

(b) Provide more operational flexibility to banks,

(c) Enhance the competitive efficiency of banks, and

(d) Strengthen the legal framework governing operations of banks.

10


11/120

Regulatory measures taken to strengthen the Indian Banking sectors

The important measures taken to strengthen the banking sector are briefly, the

following:

Introduction of capital adequacy standards on the lines of the Basel norms,

prudential norms on asset classification, income recognition and provisioning,

Introduction of valuation norms and capital for market risk for investments

Enhancing transparency and disclosure requirements for published accounts ,

Aligning exposure norms - single borrower and group-borrower ceiling - with

inter-national best practices

Introduction of off-site monitoring system and strengthening of the supervisory

framework for banks.

(A) Some of the important measures introduced to provide moreoperational flexibil ityto

banks are:

Besides deregulation of interest rate, the boards of banks have been given the

authority to fix their prime lending rates. Banks also have the freedom to offer

variable rates of interest on deposits, keeping in view their overall cost of funds.

Statutory reserve requirements have significantly been brought down.

The quantitative firm-specific and industry-specific credit controls were abolishedand banks were given the freedom to deploy credit, based on their commercial

judgment, as per the policy approved by their Boards.

The banks were given the freedom to recruit specialist staff as per their

requirements,

The degree of autonomy to the Board of Directors of banks was substantially

enhanced.

Banks were given autonomy in the areas of business strategy such as, opening of

branches / administrative offices, introduction of new products and certain other

operational areas.

(b) Some of the important measures taken to increase thecompeti tive effi ciencyof banks

are the following:

Opening up the banking sector for the private sector participation.

11


12/120

Scaling down the shareholding of the Government of India in nationalised banks

and of the Reserve Bank of India in State Bank of India.

(c) Measures taken by the Government of India to provide a more conducivelegal

environmentfor recovery of dues of banks and financial institutions are:

Setting up of Debt Recovery Tribunals providing a mechanism for expeditious

loan recoveries.

Constitution of a High Power Committee under former Justice Shri Eradi to

suggest appropriate foreclosure laws.

An appropriate legal framework for securitisation of assets is engaging the

attention of the Government,

Due to this paradigm shift in ther egulatory f rameworkfor banks had achieved the

desired results. The banking sector has shown considerable degree of resilience.

(a) The level of capital adequacy of the Indian banks has improved: the CRAR of

public sector banks increased from an average of 9.46% as on March 31, 1995 to

11.18% as on March 31, 2001.

(b) The public sector banks have also made significant progress in enhancing their

asset quality, enhancing their provisioning levels and improving their profits.

The gross and net NPAs of public sector banks declined sharply from 23.2% and

14.5% in 1992-93 to 12.40% and 6.7% respectively, in 2000-01.

Similarly, in regard to profitability, while 8 banks in the public sector recorded

operating and net losses in 1992-93, all the 27 banks in the public sector showed

operating profits and only two banks posted net losses for the year ended March

31, 2001.

The operating profit of the public sector banks increased from Rs.5628 crore as on

March 31, 1995 to Rs.13,793 crore as on March 31, 2001.

The net profit of public sector banks increased from Rs.1116 crore to Rs.4317

crore during the same period, despite tightening of prudential norms on

provisioning against loan losses and investment valuation.

The accounting treatment for impaired assets is now closer to the international best

practices and the final accounts of banks are transparent and more amenable to

meaningful interpretation of their performance.

12


13/120

WAY FORWARD

RBI president recently recommended Indian banks to go for larger provisioning

when the profits are good without frittering them away by way of dividends, however

tempting it may be. As a method of compulsion, RBI has recently advised banks to createan Investment Fluctuation Reserve upto 5 per cent of the investment portfolio to protect

the banks from varying interest rate regime.

He further added that one of the means for improving financial soundness of a bank is by

enhancing the provisioning standards of the bank. The cumulative provisions against loan

losses of public sector banks amounted to a mere 41.67% of their gross NPAs for the year

ended March 31, 2001. The amount of provisions held by public sector banks is not only

low by international standards but there has been wide variation in maintaining the

provision among banks. Some of the banks in the public sector had as low provisioningagainst loan losses as 30% of their gross NPAs and only 5 banks had provisions in excess

of 50% of their gross NPAs. This is inadequate considering that some of the countries

maintain provisioning against impaired assets at as high as 140%. Indian Banks should

improve the provisioning levels to at least 50% of their gross NPAs. There should

therefore be an attitudinal change in banks' policy as regards appropriation of profits and

full provisioning towards already impaired assets should become a priority corporate goal.

He also suggested that banks should also develop a concept of buildingdesirable

capitalover and above the minimum CRAR which is insisted upon in developedregulatory regimes like UK. This can be at, say around 12 percent as practised even today

by some of the Indian banks, so as to provide well needed cushion for growth in risk

weighted assets as well as provide for unexpected erosion in asset values.

As banks would have observed, the changes in the regulatory framework are now

brought in by RBI only through an extensive consultative process with banks as well as

public wherever warranted. While this serves the purpose of impact assessment on the

proposed measures it also puts the banks on notice to initiate appropriate internal

readjustment to meet the emerging regulatory prescriptions. Though adequate transitionalroute has been provided for switchover to new regulatory measures such as scaling down

the exposure to capital market, tightening the prudential requirements like switch over to

90 day NPA norm, reduction in exposure norms, etc., I observe from the various quarters

13


14/120

from which RBI gets its inputs that the banks are yet to take serious steps towards

implementation of these measures.

The Boards of banks have been accorded considerable autonomy in regard to their

corporate strategy as also several other operational matters. This does not; however, seemto have translated to any substantial improvement in customer service. It needs to be

recognised that meeting the requirements of the customer - whether big or small -

efficiently and in a cost effective manner, alone will enable the banks to withstand the

global competition as also the competition from non-bank institutions.

The profitability of the public sector banks is coming under strain. Despite the

resilience shown by our banks in the recent times, the income from recapitalisation bonds

accounted for a significant portion of the net profits for some of the nationalised banks.

The Return on Assets (RoA) of public sector banks has, on an average, declined from0.54 for the year ended March 31, 1999 to 0.43 for the year ended March 31, 2001.

Therefore, the Boards' attention needs to be focused on improving the

profitability of the bank. The interest income of public sector banks as a percentage of

total assets has shown a declining trend since 1996-97: it declined from 9.69 in 1996-97

to 8.84 in 2000-01. Similarly, the spread (net interest income) as a percentage of total

assets also declined from 3.16 in 1996-97 to 2.84 in 2000-01.

A disheartening feature is that a large number of public sector banks haverecorded far below the median RoA of 0.4% for 2000-01 in their peer group. Incidentally

the RoA recorded by new private banks and foreign banks ranged from 0.8% to 1% for

the same period. An often quoted reason for the decline in profitability of public sector

banks is the stock of NPAs which has become a drag on the bank's profitability. As you

are aware, the stock of NPAs does not add to the income of the bank while at the same

time, additional cost is incurred for keeping them on the books. To help the public sector

banks in clearing the old stock of chronic NPAs, RBI had announced 'one-time non

discretionary and non discriminatory compromise settlement schemes' in 2000 and 2001.

Though many banks tried to settle the old NPAs through this transparent route, theresponse was not to the extent anticipated as the banks had been bogged down by the

usual fear psychosis of being averse to settling dues where security was available. The

moot point is if the underlying security was not realised over decades in many cases due

to extensive delay in litigation process, should not the banks have taken advantage of the

one time opportunity provided under RBI scheme to cleanse their books of chronic

14


15/120

NPAs? This would have helped in realizing the carrying costs on such non-income

earning NPAs and released the funds for recycling. If better steps are taken placed in this

connection then the performance of the Public Sector Banks can show very good and

healthy results in the shorter period.

To make the better future of the Public Sector Banks, the Boards need to be alive

to the declining profitability of the banks. One of the reasons for the low level of

profitability of public sector banks is the high operating cost. The cost income ratio

(which is also known as efficiency ratio of public sector banks) increased from 65.3

percent for the year ended March 31, 2000 to 68.7 per cent for the year ending March 31,

2001. The staff expenses as a proportion to total income formed as high as 20.7% for

public sector banks as against 3.3% for new banks and 8.2% for foreign banks for the

year ended March 31, 2001. There is thus an imperative need for the banks to go for cost

cutting exercise and rationalise the expenses to achieve better efficiency levels in

operation to withstand declining interest rate regime.

Boards of banks have much more freedom now than they had a decade ago, and

obviously they have to play the role of change agents. They should have the expertise to

identify, measure and monitor the risks facing the bank and be capable to direct and

supervise the bank's operations and in particular, its exposures to various sectors of the

economy, and monitoring / review thereof, pricing strategies, mitigation of risks, etc. The

Board of the banks should also ensure compliance with the regulatory framework, and

ensure adoption of the best practices in regard to risk management and corporategovernance standards. The emphasis in the second generation of reforms ought to be in

the areas of risk management and enhancing of the corporate governance standards in

banks.

15


16/120

THE INDIAN BANKING INDUSTRY

The origin of the Indian banking industry may be traced to the establishment of

the Bank of Bengal in Calcutta (now Kolkata) in 1786. Since then, the industry has

witnessed substantial growth and radical changes. As of March 2002, the Indian banking

industry consisted of 97 Commercial Banks, 196 Regional Rural Banks, 52 Scheduled

Urban Co-operative Banks, and 16 Scheduled State Co-operative Banks.

The growth of the banking industry in India may be studied in terms of two broad

phases: Pre Independence (1786-1947), and Post Independence (1947 till date). The post

independence phase may be further divided into three sub-phases:

Pre-Nationalisation Period (1947-1969)

Post-Nationalisation Period (1969-1991)

Post-Liberalisation Period (1991- till date)

The two watershed events in the postindependence phase are the nationalisation

of banks (1969) and the initiation of the economic reforms (1991). This section focuses

on the evolution of the banking industry in India post-liberalisation.

1. Banking Sector Reforms - Post-Liberalisation

In 1991, the Government of India (Gol) set up a committee under the

chairmanship of Mr. Narasimaham to make an assessment of the banking sector. The

report of this committee contained recommendations that formed the basis of the reforms

initiated in 1991.

The banking sector reforms had the following objectives:

1. Improving the macroeconomic policy framework within which banks operate;

2. Introducing prudential norms;

3. Improving the financial health and competitive position of banks;

4. Building the financial infrastructure relating to supervision, audit technology and legal

framework; and

5. Improving the level of managerial competence and quality of human resources.

1.1 Impact of Reforms on Indian Banking Industry

16


17/120

With the initiation of the reforms in the financial sector during the 1990s, the

operating environment of banks and term-lending institutions has radically transformed.

One of the fall-outs of the liberalisation was the emergence of nine new private sector

banks in the mid1990s that spurred the incumbent foreign, private and public sector

banks to compete more fiercely than had been the case historically. Another developmentof the economic liberalisation process was the opening up of a vibrant capital market in

India, with both equity and debt segments providing new avenues for companies to raise

funds. Among others, these two factors have had the greatest influence on banks

operating in India to broaden the range of products and services on offer. The reforms

have touched all aspects of the banking business. With increasing integration of the

Indian financial markets with their global counterparts and greater emphasis on risk

management practices by the regulator, there have been structural changes within the

banking sector. The impact of structural reforms on banks' balance sheets (both on the

asset and liability sides) and the environment they operate in is discussed in the followingsections.

1.2 Reforms on the Liabilities Side

Reforms of Deposit Interest Rate

Beginning 1992, a progressive approach was adopted towards deregulating the

interest rate structure on deposits. Since then, the rates have been freed gradually.

Currently, the interest rates on deposits stand completely deregulated (with the exceptionof the savings bank deposit rate). The deregulation of interest rates has helped Indian

banks to gain more control on the cost of their deposits, the main source of funding for

Indian banks. Besides, it has given more, flexibility to banks in managing their Asset-

Liability positions.

17


18/120

Increase in Capital Adequacy Requirement

During the 1990s, the Reserve Bank of India (RBI) adopted a strategy aimed at all

banks attaining a Capital Adequacy Ratio (CAR) of 8% in a phased manner. On therecommendations of the Committee on Banking Sector Reforms, the minimum CAR was

further raised to 9%, effective March 31, 2000.While the stipulation of a higher Capita!

Adequacy' Ratio has increased the capital requirement of banks; it has provided more

stability to the Indian banking system.

1.3 Reforms on the Asset Side

Reforms on the Lending Interest Rate

During 1975-76 to 1980-81, the RBI prescribed both the minimum lending rateand the ceiling rate. During 1981-82 to 1987-88. The RBI prescribed only the ceiling

rate. During 198889 to 1994-95, the RBI switched from prescribing a ceiling rate to

fixing a minimum lending rate. From 1991 onwards, interest rates have been increasingly

freed. At present, banks can offer loans at rates below the Prime Lending Rate (PLR) to

exporters or other creditworthy borrowers (including public enterprises), and have only to

announce the FLR and the maximum spread charged over it. The deregulation of lending

rates has given banks the flexibility to price loan products on the basis of their own

business strategies and the risk profile of the borrower. It has also lent a competitive

advantage to banks with lower cost of funds.

Lower Cash Reserve and Statutory Liquidity Requirements

During the early 1980s, statutory pre-emption in the form of Cash Reserve Ratio

(CRR) and Statutory Liquidity Ratio (SLR) accounted for 42% of the deposits. In the

1990s, the figure rose to 53.5%, which during the post-liberalisation period has been

gradually reduced. At present, banks are required to maintain a CRR of 4% of the Net

Demand and Time Liabilities (NDTL) (excluding liabilities subject to zero CRR

prescriptions). The RBI has indicated that the CRR would eventually be brought down to

the statutory minimum level of 3% over a period of time.

The SLR, which was at a peak of 38.5% during September 1990 to December

1992, now stands lower at the statutory minimum of 25%.A decrease in the CRR and

SLR requirements implies an increase in the share of deposits available to banks for loans

and advances. It also means that bank's now have more discretion in the allocation of

18


19/120

funds, which if deployed efficiently, can have a positive impact on their profitability. By

increasing the amount of invisible funds available to banks, the reduction in the CRR and

SLR requirements has also enhanced the need for efficient risk management systems in

banks.

Asset Classification and Provisioning Norms

Prudential norms relating to asset classification have been changed post-

liberalisation. The earlier practice of classifying assets of different quality into eight

`health codes" has now been replaced by the system of classification into four categories

(in accordance with the international norms): standard, sub-standard, doubtful, and loss

assets. On 1st April 2000, provisioning requirements of a minimum of 0.25% were

introduced for standard assets. For the sub-standard, doubtful and loss asset categories,

the provisioning requirements remained at 10%, 20-50% (depending on the duration for

which the asset has remained doubtful), and 100%, respectively, the recognition normsfor NPAs have also been tightened gradually. Since March 1995, loans with interest

and/or installment of principal overdue for more than 180 days are classified as non-

performing. This period will be shortened to 90 days from the year ending 31st' March

2004.

1.4 Structural Reforms

Increased Competition

With the initiation of banking-sector reforms, a more competitive environmenthas been ushered in. Now banks are not only competing within themselves, but also with

non-banks, such as financial services companies and mutual funds. While existing banks

have been allowed greater flexibility in expanding their operations, new private sector

banks have also been allowed entry. Over the last decade nine new private sector banks

have established operations in the country. Competition amongst Public Sector Banks

(PSBs) has also intensified. PSBs are now allowed to access the capital market to raise

funds. This has diluted Government's shareholding, although it remains the major

shareholder in PSBs, holding a minimum 51% of their total equity. Although competition

in the banking sector has reduced the share of assets and deposits of the PSBs, their

dominant positions, especially of the large ones, continues.

Although the PSBs will remain major players in the banking industry, they are likely

to face tough competition, from both private sector banks and foreign banks. Moreover,

the banking industry is likely to face stiff competition from other players like non-bank

19


20/120

finance companies, insurance companies, pension funds and mutual funds. The

increasing efficiency of both the equity and debt markets has also accelerated the process

of financial disintermediation, putting additional pressure on banks to retain their

customers. Increasing competition among banks and financial intermediaries is likely to

reduce the Net Interest Spread of banks.

Banks entry into New Business Lines

Banks are increasingly venturing into new areas, such as, Insurance and Mutual

Funds, and offering a wider bouquet of products and services to satisfy the diverse needs

of their customers. With the enactment of the Insurance Regulatory and Development

Authority (IRBA) Act, 1999, banks and NBFCs have been allowed to enter the insurance

business. The RBI has also issued guidelines for-banks' entry into insurance, according to

which, banks need to obtain prior approval of the RBI to enter the insurance business. So

far, the RBI has accorded its approval to three of the 39 commercial banks that hadsought entry into insurance.

Insurance presents a new business opportunity for banks. The opening up of the insurance

business to banks is likely to help them emerge as financial supermarkets like their

counterparts in developed countries.

Increased thrust on Banking Supervision and Risk Management

To strengthen banking supervision, an independent Board for Financial

Supervision (BFS) under the RBI was constituted in November 1994. The Board is

empowered to exercise integrated supervision over all credit institutions in the financialsystem, including select Development Financial Institutions (DFIs) and Non Banking

Financial Companies (NBFCs), relating to credit management, prudential norms and

treasury operations. A comprehensive rating system, based on the CAMELS

methodology, has also been instituted for domestic banks; for foreign banks, the rating

system is based on CACS. This rating system has been supplemented by a technology-

enabled quarterly off- site surveillance system.

To strengthen the Risk Management Process in banks, in line with proposed Basel

11 accord, the RBI has issued guidelines for managing the various types of risks that

banks are exposed to. To make risk management an integral part of the Indian banking

system, the RBI has also issued guidelines for Risk based Supervision (RBS) and Risk

based Internal Audit (RBIA).

20


21/120

These reform initiatives are expected to encourage banks to allocate funds across

various lines of business on the basis of their Risk adjusted Return on Capital (RAROC).

The measures would also help banks be in line with the global best practices of risk

management and enhance their competitiveness.

The Indian banking industry has come a long way since the nationalisation of

banks in 1969. The industry has witnessed great progress, especially over the past 12

years, and is today a dynamic sector. Reforms in the banking sector have enabled banks

explore new business opportunities rather than remaining confined to generating revenues

from conventional streams. A wider portfolio, besides the growing emphasis on

consumer satisfaction, has led to the Indian banking sector reporting robust growth

during past few years.

It is clear that the deregulation of the economy and of the Banking sector over thelast decade has ushered in competition and enabled Indian banks to better take on the

challenges of globalisation.

1.5 Operational and Efficiency Benchmarking

Benchmarking of Return on Equity

Return on Equity (ROE) is an indicator of the profitability of a bank from the

shareholder's perspective. It is a measure of Accounting Profits per unit of Book Equity

Capital. The ROE of Indian banks for the year ended 31st March 2003, was in the rangeof 14 - 40%; the median ROE. Being 23.72% for the same period. On the other hand, the

global benchmark banks had a median ROE of 12.72% for the year ended 31st December

2002.

In recent years, Indian banks have reported unusually high trading incomes,

driven mainly by the scope to booking profits that arise from a sharply declining interest

rate environment. However, such high trading income may not be sustainable in future.

The adjusted median ROE for Indian banks (adjusted for trading income) stands at 5.42%

for Indian banks for FY2003 as compared with 11.77% for the global benchmark

banks.After adjusting for trading income, the median ROE of Indian hanks stands lower

than the same for the global benchmark banks, thus implying that the contribution of

trading income to the RoE of Indian banks is significant.

21


22/120

Further, the ROE benchmarking method favors banks that operate with low levels

of equity or high leverage. To assess the impact of the leverage factor on the ROE of

banks, "Equity Multiplier" is presented in the next section.

Benchmarking of Equity Multiplier

Equity Multiplier (EM) is defined as "Total Assets divided by Net Worth". This is

the reciprocal of the Capital-to-Asset ratio, which indicates the leverage of a bank

(amount of Assets of a bank pyramided on its equity capital). Banks with a higher

leverage will be able to post a higher ROE with a similar level of Return on Asset (ROA),

because of the multiplier effect. However, the banking industry is safer with a lower

leverage or a higher proportion of equity capital in the total liability. Capital is important

for banks for two main reasons:

Firstly, capital is viewed as the ultimate line of protection against any potentiallosscredit, market, or operating risks. While loan and investment provisions are

associated with expected losses, capital is a cushion against unexpected losses.

Secondly, capital allows banks to pursue their growth objectives; a bank has to

maintain a minimum capital adequacy ratio in accordance with regulatory requirements.

A bank with insufficient capital may not be able to take advantage of growth

opportunities offered by the external operating environment the same way as another

bank with a higher capital base could.

Benchmarking of Return on Assets

ROA is defined as Net Income divided by Average Total Assets. The ratio

measures a bank's Profits per currency unit of Assets. The median ROA for Indian banks

was 1.15% for FY2003. For the global benchmark banks, the ROA ranged from 0.05% to

1.44% for the year ended December 2002, with the median at 0.79%.

For the year ended December 2002, Bank of America reported the highest ROA

(1.44%) among the global benchmark banks, followed by Citi group Inc. (1.42%). The

median value for Indian banks at 1.15% was higher than that of ABN AMRO Bank,

Deutsche Bank, Rabo Bank and Standard Chartered Bank. Two banks, namely Bank of

America and Citigroup Inc., posted higher ROAs as compared with the European and

other banks for both FY2003 and FY2002 primarily on the strength of higher Net Interest

Margins. The reasons for the Net Interest Margins being higher are discussed in the

sections that follow.

22


23/120

As with the ROE analysis, here too adjustments for non-recurring

income/expenses must be made while comparing figures on banks' ROA. Adjusting for

trading income, for both Indian banks and the global benchmark banks, the median works

out to be lower for Indian banks vis-a-vis the global benchmark banks for FY 2003.

I have further analysed the effect of adjustment for trading income on the ROAs

of both Indian Banks and the Global Benchmark Banks. Here, it must be noted that the

global benchmark banks have a more diversified income portfolio as compared with

Indian banks, and a decline in interest rate could have increased profitability of global

benchmark banks indirectly in more ways than one. However, from the disclosures

available in the annual reports of the global banks, it is not possible to quantify the

impact of declining interest rates on their profitability (`thus, the same has not been

adjusted for in this analysis). Nevertheless, to further analyse the profitability (per unit ofassets) of Indian banks vis-a-vis the global benchmark banks, ICRA has conducted a

ROA decomposition analysis.

1.6 Decomposition of Return on Assets

Net Interest Margin

Net Interest Margin (NIM) measures the excess income of a bank's earnings

assets (primarily loans, fixed-income investments, and interbank exposures) over its

funding costs. To the past, for banks NIM was the main source of earnings, which weretherefore directly correlated with the margin levels. But with NIM declining significantly

in many countries, banks are now trying to compensate the "lost" margins with non-fund

based fee incomes and trading income. Despite these changes, net interest income

continues to account for a significant share of the earnings of most banks. The median

NIM for Indian banks was 3.16% for FY2003 and 3.92% for FY2002. The figures

compare favorably with those of the global benchmark banks.

Before drawing inferences on the NIM benchmarking results, three aspects must be

considered, namely: (a) The external operating environment, (b) The quality and type of

assets, and (c) Accounting policies followed by banks.

The three aspects are explored in detail in the subsequent paragraphs.

(a) External Operating Environment

23


24/120

Intermediation cost is a significant factor explaining the differences in NIMs

across countries. Interest margins tend to be higher in countries where the intermediation

costs are high. Generally, the absence of a vibrant capital market results in the

intermediation costs being higher. In India, the debt market is relatively less developed

(as compared with the markets in USA and Europe), and therefore, most corporateentities are dependent mainly on banks for meeting their financing needs. As a result,

Indian banks are able to command higher NIMs as compared with the global benchmarks

banks. To make a like-to-like comparison and understand the impact of intermediation

cost, ICRA has compared the NIMs of the Indian operations of the global benchmark

banks with those of Indian banks. Of the six global benchmark banks, the local operations

of four banks earned higher NIMs vis-a-vis the median of Indian banks in FY2002 and

FY2003. Of these four banks, three earned NIMs above 4%. This analysis strengthens

ICRA's hypothesis that the external operating environment is an important factor while

benchmarking NIMs.

(b) Type & Quality of Assets

The higher NIMs of US-based banks are attributable to their sharper focus on

consumer loans and credit cards as compared with European banks. Also, the high NIMs

of US banks are the cause for their comparatively high ROAs. To overcome the potential

for higher provisions arising from its strategy of lending to riskier assets, a bank may

charge a higher rate of interest to its borrowers (with a consequently higher NIM) than

another bank. So while comparing the NIMs of two banks, the effect of asset quality mustbe normalised. One way of doing this is to use Total Risk Weighted Adjusts (RWA)

instead of Total Assets as the denominator. However, many Indian banks do not disclose

their RWA values in their annual reports, and therefore, ICRA has not been able to use

this method in this study. The alternative method is to adjust the NIM for provisions &

contingencies. If the asset quality of a bank is relatively weak, it is likely to generate

higher Non-Performing Assets (NPAs). As a result, its provisions & contingencies are

also likely to be higher. Therefore, if the effect of asset quality is normalised by removing

provisions & contingencies from the NIM, a better understanding of the efficiency of the

fund based business of banks may be obtained. ICRA defined adjusted NIM as NetInterest Spread (Net Interest Income less Provisions & Contingencies)/Average Total

Assets]. The Net Interest Spread's for the global benchmark banks ranged from 0.14 to

2.10% for the financial year ended December 2002, with the median at 1.54%. The

corresponding median figure for Indian banks was 1.68%. The difference between the

NIMs of the global benchmark banks and Indian bank; reduces substantially after

24


25/120

adjusting for provisions. This strengthens ICRA's hypothesis that the type and quality of

assets substantially affect NIM.

(3)Accounting Policies

The Net Interest Spreads adjusted for Provisions can vary substantially,

depending on the income recognition and provisioning norms. According to International

Accounting Standard, (IAS) provisioning for NPAs is based on management discretion,

Whereas in India, the RBI defines the provisioning requirement for impaired assets as a

function of time and security. An illustration of difference in accounting for NPA is that for

Indian banks, an asset is reckoned as NPA when principal or interest are past due for 180

days as compared with 90 days for the global benchmark banks (the norms will converge

with effect from financial year 2004). Keeping in view the levels of NIM for Indian andglobal benchmark banks, and the three factors analysed above, ICRA believes that the

NIM for Indian banks is comparable with that of the global benchmark banks.

Non-Interest Income Ratio

Increased competition in the Indian Banking industry has driven the interest

yields and consequently, the NIMs, southwards. Hence, banks are increasingly

concentrating on non-interest income to shore up profits. In FY2003, the range of non-

interest income for Indian banks (as percentage of average Total Assets) was between1.01 and 3.00%. The median for Indian banks showed a moderate increase from 1.63% in

2002 to 1.77% in 2003. The non-interest income (as percentage of Average Total assets)

of the global benchmark banks varied from 0.72 to 3.13% (with a median value of

1.62%), or the year ended December 31, 2002. The decline in interest rates in India over

the last few years has helped Indian banks book substantial profits from the sale of

investments, thus boosting their Non-Interest Income. As the high profits accruing from

the sale of investments are not lively to be sustainable, ICRA has benchmarked the pure

fee based income (i.e. looking at Non-interest income without profits from sale of

investments) as a percentage of average total income. 16 of the 21 Indian banks in the

study had a fee based income ratio of between 0.4 and 0.8%.A comparison after similar

adjustment for the global benchmark banks reveals that the fee-based income ratio of

Indian banks is lower.

Operating Expense Ratio

25


26/120

The Operating Expense Ratio (operating expenses as a ratio of the average total

assets) reveals how expensive it is for a bank to maintain its fixed assets and human

capital that are used to generate that income streams, The median Operating Expense

ratio for Indian banks was 2.26% in 2003, which is comparable with that for the globalbenchmark banks (2.09%).

1.7 Asset Quality Benchmarking

Gross NPAs

The median Gross NIA ratio (Gross NPA as a proportion of total advances) for

Indian banks was 9.40% for FY2003 and 10.66% for FY2002. The values of the Gross

NPA ratio for FY 2003 range between 2.26 and 14.68%.Many global banks do not

disclose their Gross NPA percentages in their annual reports.

Net NPAs

The median Net NPA ratio ("Net NPA as a proportion of Net advances) of Indian

banks was 4.33% for FY2003 and 5.39% for FY2002. The values of Net NPA ratio for

FY 2003 for the global benchmark banks ranged between 0.37 and 7.08%. Most of the

global benchmark banks do not disclose their Net NPA ratios in their annual reports.

From the study it can be inferred that the median Net NPA percentage for Indian banks is

marginally higher than that for the global benchmark banks.

Efficiency Benchmarking

ICRA studied the following parameters to assess the efficiency of Indian banks

vis--vis their foreign counterparts:

Profitability per employee

Profitability per branch

Business per employee

Business per branch

Expenses per employee

Expenses per branch

The business model of the global benchmark banks involves outsourcing of non-

core activities. In the case of Indian banks, particularly those in the public sector, both

non-core and core business functions are carried out in-house. The global benchmark

banks display higher efficiency parameters, mainly because of the outsourcing model.

26


27/120

Thus, the efficiency parameters are not strictly comparable, as they are affected by the

business plans of specific banks and also by economy-specific considerations.

ICRA has presented the analysis of the performance of Indian and international banks

in the following sections. We would like to highlight that several factors influence theresults here, and caution needs to be exercised in arriving at inferences. E.g. comparing

expenses per branch (or employee) for banks across different economies involves

conversion of amounts to a common currency. The results depend on the conversion rates

of foreign exchange used (e.g. USD per rupee or Euro per rupee). In this report, ICRA

has used nominal rates of foreign currencies rather than rates based on PPP (Purchasing

Power Parity). On another dimension, Indian banks and international banks operate under

different business models and levels of technology. Increasingly, sophisticated banks

(particularly in advanced countries) use several channels to transact business with

customers, such as, the Internet, telephone, debit cards, and ATMs. Therefore, resultsfrom benchmarking using parameters such as business per branch or expenses per branch

(which are appropriate parameters to compare across banks that operate predominantly

through branches) need to be appropriately interpreted in an exercise when we compare

heterogeneous banks across different economies.

Profitability per Employee

The profit per employee figure for 17 out of the 21 Indian banks was in the range

of Rs. 0.02 crore for the financial year ended March 2003. Most Indian banks posted

higher profits per employee in FY2003 as compared with FY2002. This overall trend ofincreasing employee profitability may be attributed to the reduction in the number of

employees following the launch of Voluntary Retirement Schemes (VRS) by some banks

as well as higher profits by the banks. On an average, new private sector banks enjoy a

higher increase in profitability per employee, as compared with their public sector

counterparts. This may be attributed largely to the better technology that the new private

sector banks employ, besides the advantage of carrying no historical baggage. As for the

global benchmark banks, the profitability per employee for HSBC was robust at USD

0.12 million (Rs. 0.552 crore) for FY 2002. For ABN AMRO Bank, the figure was EUR

0.02 million (Rs.l crore). On an intertemporal basis, the profitability per employee for the

global benchmark bank also showed growth.

Profitability per Branch

For most Indian banks, the profit, per branch was in the range of Rs. 0-0.2 crore.

However, the new private sector banks displayed the highest profits per branch, at Rs.

27


28/120

1.73 and 1.22 crore for the years 2003 and 2002, respectively. On an inter-temporal basis,

profit per branch has been increasing gradually in the Indian banking sector. The growth

in profit per branch for Indian banks is attributable to the overall increase in profitability

in the banking industry. In the case of the foreign peer group, profitability per branch

shows a small increase over the period covered by this study. As for the globalbenchmark banks, profitability per branch for Bank of America is at a robust USD 1.62

million (Rs. 7.44 crore), while the figure for ABN AMRO Bank is EUR 0.87 million (Rs.

4.36 crore) for the FY 2002. Hence, profitability per branch for the global benchmark

banks is higher than that of Indian banks.

28


29/120

Business per Employee

Since different employees in a bank contribute in different ways to the revenues

and profits of a bank, it is difficult to come up with one universal metric that captures the

business per employee accurately. For' this analysis, ICRA has used the amount ofdeposits mobilised per employee as a measure of the business per employee. The Indian

banking industry on an average mobilised Rs. 1-2 crore of deposits per employee for the

year ended March 2003. In this respect, private sector banks lead the group of Indian

banks. The top bank in this category showed a deposit per employee of Rs. 7.14 crore for

the year ended March 2003. As for the global benchmark banks, business per employee

for HSBC was robust at USD9.71 million (Rs. 44.66 crore), while that for ABN AMRO

Bank was EUR 4 million (Rs. 20 crore) for the year ending December 2002.

Thus, deposit mobilisation per employee for the global benchmark banks is higher

than that of Indian banks.

Business per Branch

On an average, the banks showed a deposit of around Rs. 10-30 crore per branch

for the year ended March 2003. In recent times, the deposit mobilisation for Indian Banks

on a branch basis has witnessed a steady increase. The new private sector banks in India

have led the way in this regard, because of the better use of technology. The highest

deposit per branch stood at Rs. 103.24 crore in 2003 for a new private sector bank, as

compared with Rs, 68.71 crore in 2002. The global benchmark banks mobilised more

business per branch as compared with their Indian counterparts. Bank of Americamobilised USD 88.9 million (Rs. 408.94 crores) for the financial year ended 2002, while

ABN AMRO Bank mobilised EUR 140 million (Rs. 700 crores). The higher per-bank

deposit mobilisation for the global benchmark banks may be attributed to their superior

technology orientation and the higher gross domestic products (GDP) of their respective

countries. 3.5.5 Expenses per Employee

For this analysis, ICRA has used the employee expenses per employee as a

measure of the expenses per employee. Indian banks, on an average, expensed Rs. 0.025

crore per employee in FY2002. For the new private sector banks, this figure was higher.

The highest expense per employee incurred by an Indian bank for the year 2002 was Rs.

0.041 crore per employee.

29


30/120

In the case of the global benchmark banks, the expenses per employee for Citi Group

Inc. was at USD 0.08 million (Rs. 0.36 crore), while for ABN AMRO Bank it was EUR

0.07 million Rs. 0.36 crore).

Expenses per Branch

For this analysis, ICRA has used operating expenses per branch as a measure of

the expenses per branch. The expense per branch for most Indian banks was Rs. 0.56

crore for FY2002. Over the years, Indian banks have reported a gradual increase in such

expenses, with competition-prompted upgrade being the primary reason for the same. In

the case of the global benchmark banks, expense per branch for Bank of America was

USD 4.93 million (amount in Rs. 22.68 crore), while for ABN AMRO Bank it was EUR

4.6 million (Rs. 22.99 crore).

1.8 Structural Benchmarking

Since its inception in 1980s) BIS has issued several guidance notes for banks and

bank supervisors. These notes have sought to improve the integrity of the global banking

system and propagate best practices in banking across the world. For issues related to

accounting, BIS has relied on the International Accounting Standards (IAS) issued by the

International Accounting Standards Committee (IASC). Banks are supposed to follow

these accounting standards as part of best practices. For the structural benchmarking

study of the Indian banking sector, ICRA has used primarily the guidance notes issued by

BIS and the relevant IAS as the benchmarks of best practices. ICRA has also referred tostandards as mentioned under, US and UK. GAAP (Generally Accepted Accounting

Practices) where they provide a good understanding of international best practices.

Capital Adequacy Norms for Banks

BIS introduced capital adequacy norms for banks for the first time in 1988. To

improve on the existing norms, BIS issued a Consultative Document in January 2001,

proposing changes to the existing framework. The objective of this document is to

develop a consensus on the Basel II Accord (as it is popularly known), which is expected

to be implemented in 2007. Based on feedback received from various quarters, BIS

issued a new Consultative Document in April 2003. In this document, BIS has proposed

the following key changes over the existing norms:

Introduction (of finer grades of risk weighting in corporate credit:

30


31/120

According to the original 1988 Accord, all credit risks have a 100% per cent

weighting. Under the new method, grades of weightings in the 20-150% range will be

assigned.

Introduction of charges for operational risks:

Under the proposed Basel II Accord, banks have to allocate capital for operational

risks. BIS has suggested three methods for estimating operational risk capitals:

1. Basic Approach,

2. Standardised Approach, and

3. Advanced Measurement Approach.

Capital requirement for mortgages reduced:

The risk weights on residential mortgages will be reduced to 35% from 50%.

During the 1990s, the RBI adopted the strategy of attaining a Capital Adequacy Ratio(CAR) of 8% in a phased manner. Subsequently, in line with the recommendations of the

Committee on Banking Sector Reforms, the minimum CAR was further raised to 9%,

effective 31st March 2000.

As a step towards implementing the Basel II guidelines, the RBI in its circular of

14th May, 2003 has proposed new methods for estimating regulatory risk capital. To

estimate the impact of the proposed changes on the capital adequacy position of Indian

banks, the RBI has asked select banks to estimate their riskweighted assets on the basis of

the new method. As per this, the RBI has asked for the estimation of capital requirementon the basis of the external credit rating of borrowers. For nonrated borrowers, the RBI

has asked the select banks to use the existing 100% risk weights.

The RBI has also asked the banks to calculate operational risk capital separately

following the Basel approach. Based on the result of the exercise, the RBI will issue new

guidelines on estimating economic capital.

Additionally, the RBI has asked banks to introduce internal risk scoring models. It is

expected that once the Basel II Accord is signed, the RBI will allow banks to move to the

IRB approach.

The Capital Adequacy norms in India are in line with the best practices as suggested

by BIS. Once the Basel II Accord is implemented, the method of estimation of risk

capital will undergo a significant change. RBI has already taken appropriate steps to

prepare the Indian banking industry for such changes.

31


32/120

Recognition of Financial Assets & Liabilities

IAS 39 requires that all financial assets and all financial liabilities be recognised

on the balance sheet. This includes all derivatives. Historically, in many parts of the

world, derivatives have not been recognised as liabilities or assets on balance sheets. The

argument for this practice has been that at the time the derivative contract was enteredinto, no cash or other asset was paid. The zero cost justified non-recognition,

notwithstanding the fact that as time pauses and the value of the underlying variable (rate,

price, or index) changes, the derivative has a positive (asset) or negative (liability) value.

In India, derivatives are still off-balance sheet items and considered part of

contingent liabilities. So in Indian treatment of derivatives is different from International

Accounting Standards.

Valuation of Financial Assets

IAS 39 has classified financial assets under four categories. The following table

summarises the classification and measurement scheme for financial assets under IAS 39,

Under US GAAP, marketable equity securities and debt securities are classified as under:

trading,

Available for sale, or held

to maturity.

Recognition of Non-Performing Assets (NPAs)/Impaired Assets

Under IAS 39, impairment recognition is left to management discretion (itsperception of the likelihood of recovery). Impairment calculation compares the carrying

amount of the financial asset with the present value of the currently estimated amounts

and timings of payments. If the present value is lower than. The carrying amount, the loan

is classified as NPL.

Under US GAAP, loans assume non-accrual statuses if any of the following conditions

are fulfilled:

Full repayment of principal or interest is in doubt (in management's judgment), or

if scheduled principal or interest payment is past due 90 days or more, and if the

collateral is insufficient to cover the principal and interest.

In India, NPAs are classified under three categories-Sub-standard, Doubtful and

Loss on the basis of the number of months the amount is overdue for. India proposed to

32


33/120

move from 180 days to a 90-day past due classification rule for NPA recognition

effective March 2004.

The financial instrument's original effective interest rate is the rate to be used for

discounting. Any impairment loss is charged to profit and loss account for the period.Impairment or "uncollectability" must be evaluated individually for material financial

assets. A portfolio approach may be used for items that are individually small [IAS

39.109]. Therefore, under IAS, provisioning is based on management discretion.

Provision in excess of expected loan losses may be booked directly to shareholders'

equity. As with IAS, under the UK, And US GAAP also, provisioning is based on

management discretion. Under US GAAP, when the Net Present Value of a loan is less

than the carrying value, the difference is booked as provision.

In India; provisioning norms are more explicit than they are under the IAS. RBIhas specified norms for various classes of NPL as follows:

Standard Assets: 10%

Doubtful Assets: 100% of unsecured portion,

20-50% on secured portion

Loss Assets: 100%

Interest Accrual on M on-performing Loans / impaired Assets

Under both IAS and US GAAP, there is no specific prescription for interestaccrual on NPAs. Under UK. GAAP, interest is suspended upon classification as NPL.

However, suspension may be deferred up to 12 months if sufficient collateral exists.

According to Sound Practices for Loan Accounting and Disclosure (1999) number

11, the BIS Committee on Banking Supervision recommends that when a loan is

identified as impaired, a bank should cease accruing interest in accordance with the terms

of the contract. Interest on impaired loans should not contribute to net income if doubts

exist over the collectability of loan interest or principal.

In India, accrual of interest is suspended upon classification of a loan as non

performing.

General Provisioning on Performing Loans

33


34/120

Under IAS, UK and US GAAP, there is no specific prescription for general

provisioning towards performing loans. However, Indian banks have a provisioning

require; f tent of 0.2 5% on all standard assets.

Conclusion

The RBI norms for classification of assets, and provisioning against, bad/doubtful

debts are more detailed and precise vis-a-vis international rules. While the international

norms often leave bad debt provision levels to "management discretion", Indian standards

are precise and clearly state exactly when and by how much reported earnings must be

charged off for bad debts.

In India, detailed accounting standards for derivatives are yet to be introduced. As of

now, derivatives continue to be considered as off-balance sheet liabilities.

1.9 Likely Future Trends and their Implications for Indian Banks

Financial Disintermediation and Bank Profitability

The degree of banking disintermediation and financial sophistication are

important factors in the development of a country's economy. Disintermediation affects

the allocation process for both savings and credits in the economy. With the introduction

of sophisticated deposit products by mutual funds, pension funds and insurance

companies, individual and corporate depositors now have more options for savings. A

similar trend is also visible in credit offerings. More and more corporate entities are now

approaching the capital market to raise funds either in the form of debt or equity.At the end of the 1990s, the US banking industry was facing a high level of

disintermediation, as most outstanding savings were in mutual funds, pension funds, and

life insurance plans, but not in bank deposits or other liability products. However, in

continental Europe, most banking systems (as in Germany, Spain, Italy, Austria, France,

etc.) are still highly bank-intermediated, although the trend is clearly towards faster

disintermediation for both savings and credits. In India, financial disintermediation is

likely to catch up with banks sooner than later. With the opening up of the financial

sector, Indian banks are facing competition from the mutual fund and insurance sectors

for savings. On the credit side, good quality borrowers have started raising debt directly

from the market at competitive rates.

Changing Capital Adequacy Norms

Capital adequacy norms for banks are likely to undergo a change after the Basel II

Accord is implemented. In the current system, Indian banks need to allocate 9% capital,

34


35/120

irrespective of the credit quality of a borrower. In the new system, a bank offering credit

to a better quality corporate entity is likely to require less regulatory capital. The

allocation of regulatory capital on the basis of credit quality would encourage banks to

estimate their Risk adjusted Return on Capital (RAROC) rather than compute simple

margins. Similarly, banks now need to distinguish between the credit qualities ofsovereign borrowings and inter-bank borrowing, as they would need to allocate capital to

sovereign credit and inter-bank credit on the basis of external ratings, or using the IRB

approach.

To emerge successful in the Basel II regulatory environment, banks would need to

introduce the practice of risk-based pricing of loans, which in turn would require a bank

to implement advance Risk Management Systems. To implement such systems, banks

would need to implement the following key steps:

Develop Credit Risk Scoring Models Generate Probability of Default (PD) associated with each risk grade

Estimate Loss Given Default (LGD) for each collateral type.

Calculate expected and unexpected loss in a portfolio based on correlation

amongst loans.

Compute the capital that would be required to be held against economic loss

potential of the portfolio.

Similarly, banks would have to introduce robust systems for measuring and

controlling Market Risk and Operations Risk. .3 Management of Non-Performing

Assets The size of the NPA portfolio in the Indian banking industry is close to Rs.

1,00,000 crore, which is around 6% of India's GDP. NPAs affect banks profitability on

two counts:

The introduction of scientific credit risk management systems would lower

slippage of assets from the performing to the nonperforming category. Further, banks

with better NPA recovery processes would be able to reduce their provisioning

requirements, thereby increasing their profitability. To enable a fair borrower-lender

relationship in credit, the Government of India has recently enacted the Securitisation and

Reconstruction of Financial Assets and Enforcement of Security interest Act 2002 (SRES

Act). Due to several cases still to be resolved in courts of law, it is. Not clear as yet, how

far this Act is set to alter the NPA recovery scenario in India.

35


36/120

Following the announcement of the RBI's Asset Classification norms, the process

of Asset Quality Management involves segregating the total portfolio into three segments

and having detailed strategies for each. The three segments are:

Standard/Performing Assets

Special Mention Accounts/Sub-Standard Assets Chronic Non-Performing Assets

Banks need to vigilantly monitor Standard Assets to arrest any account slippage

into the non-performing grade. Besides, banks need to churn their credit portfolio so as to

maximise returns while keeping the risks pegged at acceptable levels.

Special Mention Accounts are assets with potential weaknesses which deserve

close attention and timely remedial action. The typical warning signs exhibited by a

borrower ranges from frequent excesses in the account to non-submission of periodicalstatements. Account restructuring and rehabilitation tools are best implemented during

this stage. However, the challenges faced while restructuring include, (a) selecting the

genre of assets to be restructured, (b) quantifying the benefits to be extended, (c)

determining repayment schedules, and (d) coordinating and balancing the needs of

several lenders.

Chronic Non-Performing Assets can now be better managed following the

enactment of the SIZES Act. The Act provides the requisite regulatory framework for the

foreclosure of assets by lenders, incorporation of Asset Reconstruction Companies

(ARCS), and formation of a Central Registry. In the wake of this new legislation,

amicable solutions may be realised for Chronic NPAs. The strategies include

Enforcement of Security Interest, Securitisalion, One-Time Settlement (OTS), and Write-

off. However, a scientific approach to deciding which of these alternative routes must be

taken hinges on: (a) assessment in terms of quality of the underlying assets and their

realisable value, (b) alternative use of the assets, and (c) willingness of the borrower to

settle outstanding dues.

conclusion

The profitability of Indian banks in recent years compares well with that of the

global benchmark banks primarily because of the higher share of profit on the sale of

investments, higher leverage and higher net interest margins of Indian banks. However,

many of these drivers of higher profits of Indian banks may not be sustainable. To ensure

36


37/120

long-term profitability, Indian banks need to focus on the following parameters and build

systemic capability in management of the same:

Ensure that loans are diversified across several customer segments

Introduce robust risk scoring techniques to ensure better quality of loans,

as well as to enable better risk-adjusted returns at the portfolio level Improve the quality of credit monitoring systems so that slippage in asset

quality is minimised

Raise the share of non-fund income by increasing product offerings

wherever necessary by better use of technology

Reduce operating expenses by upgrading banking technology, and

Improve the management of market risks

Reduce the impact of operational risks by putting in place appropriate

frameworks to measure risks, mitigate them or insuring them.

The RBI as the regulator of the Indian banking industry has shown the way in

strengthening the system, and the individual banks have responded in good measure in

orienting them selves towards global best practices.

37


38/120

DISTRIBUTION OF THE INDIAN BANKS AS TO STATES

AND POPULATION

How Indian banks are distributed as to states and population is explained from the

following table:

Table- Distribution of Banking Centers According to State and Population Group (As at The End of March)

POPULATION GROUP RURAL SEMI-URBAN URBAN METROPOLITAN ALL CENTRES

REGION/STATE/ 2001 2002 2001 2002 2001 2002 2001 2002 2001 2002

UNION TERRITORY 1 2 3 4 5 6 7 8 9 10

NORTHERN REGION 4578 4576 458 458 36 36 3 3 5075 5073Haryana 644 644 94 94 11 11 749 749

Himachal Pradesh 605 605 14 14 619 619 Jammu & Kashmir 477 477 2222 2 2 501 501 Punjab 1022 1023 102 102 991 11134

1135 Rajasthan 1765 1762 212 212 13 13 111991 1988Chandigarh 9922 11 12 12 Delhi 55 56 12 12 1169

69

NORTH-EASTERN REGION 1166 1152 123 123 8 8 1297 1283Arunachal Pradesh 53 53 6 6 59 59Assam 749 736 73 73 44 826 813 Manipur

40 39 11 11 11 52 51 Meghalaya122 122 77 11 130 130 Mizoram 6060 55 11 66 66 Nagaland 34 34 88

42 42 Tripura 108 108 13 13

11

122 122

EASTERN REGION 6979 6972 773 773 67 68 1 1 7820 7814Bihar 2346 2346 313 313 12 12 2671 2671Jharkhand 906 904 88 88 44 998 996 Orissa 1533

1532 93 93 66 1632 1631 Sikkim 32

32 11 33 33

38


39/120

West Bengal 2147 2143 276 276 45 45 1 1 2469 2465Andaman & Nicobar Islands 15 15 2 2 17 17

CENTRAL REGION 7368 7331 805 805 60 60 4 4 8237 8200Chhattisgarh 639 629 61 61 6 6 706 696Madhya Pradesh 1698 1680 225 225 15 15 22 1940 1922 Uttar

Pradesh 4539 4530 480 480 36 36 22 5057 5048 Uttaranchal492 492 39 39 33 534 534

WESTERN REGION 3777 3767 674 674 42 42 7 7 4500 4490Goa 140 140 12 12 152 152Gujarat 1445 1438 260 260 14 14 33 1722 1715Maharashtra 2186 2183 399 399 28 28 44 2617 2614 Dadra &Nagar Haveli 5 5 1 1 6 6Daman & Diu 11 2 2 3 3

SOUTHERN REGION 6400 6359 2218 2213 83 83 3 3 8704 8658Andhra Pradesh 2283 2279 466 466 35 35 1 1 2785 2781Karnataka 2064 2057 278 278 15 15 1 1 2358 2351

Kerala 303 304 1039 1037 7 7 1349 1348Tamil Nadu 1719 1691 430 427 25 25 11 2175 2144Lakshadweep 9 9 9 9Pondicherry 22 19 5 51 1 28 25

ALL-INDIA 30268 30157 5051 5046 296 296 18 18 35633 35517

39


40/120

MAJOR DEVELOPMENTS IN BANKING AND

FINANCE

Banking Developments

The RBI allowed resident Indians to maintain foreign currency accounts. The

accounts to be known as resident foreign currency (domestic) accounts, can be used to

park forex received while visiting any place abroad by way of payment for services, or

money received from any person not resident in India, or who is on a visit to India, in

settlement of any lawful obligations. These accounts will be maintained in the form of

current accounts with a cheque facility and no interest is paid on these accounts. With a

view to liberalise gold trading, the Reserve Bank has decided to permit authorised banksto enter into forward contracts with their constituents like exporters of gold products,

jewellery manufacturers and trading houses, in respect of the sale, purchase and loan

transactions in gold with them. The tenor of such contracts should not exceed 6 months.

The Reserve Bank of India has told foreign banks not to shut down branches without

informing the central bank well in advance. Foreign banks have been further advised by

the Reserve Bank of India to furnish a detailed plan of closure to ensure that their

customers' interests and conveniences are addressed properly.

The RBI has prohibited urban co-operative banks from acting as agents or sub-agents of money transfer service schemes. The RBI has allowed banks to invest

undeployed foreign currency non-resident (FCNR-B) funds in the overseas markets in the

long-term fixed income securities with ratings a notch lower than highest safety. Earlier,

banks were allowed to invest only in long-term securities with highest safety ratings by

international agencies.

The RBI has defined the term "willful defaulter" paving the way for banks to

acquire assets of defaulting companies through the Securitisation Ordinance and reduce

their NPAs faster. According to the RBI a wilful defaulter is one who has not used bank

funds for the purpose for which it was taken and who has not repaid loans despite having

adequate liquidity. International credit rating agency Standard & Poor has estimated that

the level of gross problematic assets in India can move into the 35-70 per cent range in

the event of a recession. It has also estimated that the level of non-performing assets

(NPAs) in the system to be at 25 per cent, of which only 30 per cent can be recovered.

40


41/120

The Reserve Bank of India has decided to extend operation of the guidelines for

the one time settlement scheme for loans upto Rs.50,000 to small and marginal farmers

by public sector banks for another 3 months, i.e, upto March 31, 2003.

The Reserve Bank of India, as part of its policy of deregulating interest rates on

rupee export credit, has freed interest rates on the second slab - 181 to 270 days for pre-

shipment credit and 91 to 180 days for post-shipment credit with effect from May 1, 2003.

The Cabinet cleared a financial package for IDBI and agreed to take over the

contingent liabilities to the tune of Rs.2500 crore over five years. The IDBI Act will be

repealed during the winter session of the Parliament, paving the way for IDBI's

conversion into a banking company.The IDBI would be given access to retail deposits, to

enable it to bring down the cost of funds, but will be spared from priority sector lendingand SLR requirements for existing liabilities.

The RBI has issued guidelines for setting up of offshore banking units (OBUs)

within special economic zones (SEZs) in various parts of the country. Minimum

investment of $10 million is required for setting up an OBU. All commercial banks are

allowed to set up one OBU each. OBUs have to undertake wholesale banking operations

and should deal only in foreign currency. Deposits of the OBUs will not be covered by

deposit insurance. The loans and advances of OBUs would not be reckoned as net bank

credit for computing priority sector lending obligations. The OBUs will be regulated andsupervised by the exchange control department of the RBI.

With a view to develop the derivatives market in India and making available

hedged currency exposures to residents an RBI Committee headed by Smt. Grace Koshie,

recommended phased introduction of foreign currency-rupee (FC/NR) options._The

Reserve Bank of India has notified the draft scheme for merging Nedungadi Bank with

Punjab National Bank. This is the first formal step towards bringing about a merger

between the two Banks.

The Reserve Bank of India has agreed to allow capital hedging for foreign banksin India. The guidelines pertaining to capital hedging will be issued by RBI soon.

The Reserve Bank of India has decided to allow foreign institutional investors

(FIIs) to enter into a forward contract with the rupee as one of the currencies, with an

41


42/120

authorised dealer (AD) in India to hedge their entire exposure in equities at a particular

point of time without any reference to the cut -off date. Further, the RBI has also

increased Authorised Dealer's overseas market investment limit to 50 per cent of their

unimpaired tier-I capital or $ 25 million, whichever is higher.

The Reserve Bank of India doubled the foreign exchange available under the

basic travel quota (BTQ) to resident individuals from US $5000 to US $10000, or its

equivalent.The Government has decided to dispose of UTI Bank as part of restructuring

Unit Trust of India.Though the details in this regard is yet to be worked out, it has been

decided that the bank will be disposed of during the course of the restructuring.

The RBI has allowed tour operators to sell tickets issued by overseas travel

operators such as Eurorail and other rail/road and water transport operators in India, in

rupees, without deducting the paymentfrom the travellers' basic travel quota.

The Reserve Bank of India (RBI) has banned banks from offering swaps

involving leveraged structures, which can cause huge losses if the market moves the other

way.

The RBI constituted committee on payment system has recommended that the

central bank, as the regulator of payment and settlement systems, should be empowered

to regulate non-banking systems.

Market Developments and New Products

The Hong Kong and Shanghai Banking Corporation will be bringing $150

million additional capital to India in the current fiscal.

The Reserve Bank of India has ordered a moratorium on the Nedungadi Bank.

The moratorium effective from the close of business will be in force upto February 1,

2003. During this period, the central bank is likely to finalise the plans for merging

Nedungadi Bank with Punjab National Bank.

ABN Amro Bank launched its Business Process outsourcing (BPO) operations,

ABN Amro Central Enterprise Services (ACES) in Mumbai. It has been set up with an

initial investment of 4 million euros (Rs.19 crore) and has been capacitised at 650 seats in a

single shift.

42


43/120

The Canara Bank has returned 48 per cent (Rs. 277.87 crore) of its capital to the

Government before its Initial Public Offer.

China has granted licence to Bank of India to open a representative office in thesouth Chinese city of Shenzhen.

Shri A.K. Purwar is app

Documents

Npa in Banking