Experience Next Generation Banking

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A monthly publication from South Indian Bank

22nd Year of Publication

 SIB STUDENTS ECONOMIC FORUM

Experience Next Generation Banking

NOVEMBER 2013
The South Indian Bank Ltd., H.O. : 'S.I.B. House', Thrissur, Kerala

THEME NO. 264 : BANKING STRUCTURE IN INDIA - THE WAY FORWARD

A well informed customer will make the policy makers as well as organisations which
produce goods and services more responsive to the customer needs. This will also result
in healthy competition among organisations and improve the quality of goods and services
produced.
The SIB Students Economic Forum is designed to kindle interest in economic affairs
in the minds of our younger generation. We highlight one theme in every monthly meeting
of the Forum. RBI has proposed a comprehensive overhaul of the countrys banking
structure, to increase competition and growth, and for further financial inclusion. In a
discussion paper issued recently, titled Banking Structure in India the way forward,
the regulator has provided a road map for the reorientation. It proposes a four-tier
structure. The first tier may consist of three or four large Indian banks with domestic and
international presence along with branches of foreign banks in India. The second tier is
likely to comprise several mid-sized banking institutions including niche banks with
economy-wide presence. These are capable of offering a broad range of banking products
and services to the domestic economy such as investment banking, wholesale banking and
funding large infrastructure projects. The third tier may encompass old private sector
banks, Regional Rural Banks, and Multi State Urban Cooperative Banks. The fourth tier
may embrace many small privately owned local banks and cooperative banks, which may
specifically cater to the credit requirements of small borrowers in the unorganised sector
in unbanked and under banked areas.
What do you know of the present banking structure in India?
At present, only a universal banking structure is allowed; there is no separate licensing for
niche activities as in developed nations. The central bank still thinks the universal model
is the preferred model, particularly in the aftermath of the global financial crisis. However,
it acknowledges the need for differentiated banking licenses - for infrastructure financing,
retail banking, wholesale banking and investment banking. There is a need to address the
concerns and consider the issues arising out of any proposal for a new structure.
What are the major challenges in the way of structural reforms?
Small banks vs. large banks: Small local banks with geographical limitations play an
important role in the supply of credit to small enterprises and agriculture and have the
potential for financial inclusion. If small banks are to be preferred, the issues relating to
their size, numbers, capital requirements, exposure norms, regulatory prescriptions and
corporate governance need to be suitably addressed.
Universal Banking: In India, the universal banking model is followed with banks
themselves as holding companies. Under the universal banking model, the Financial
Holding Company (FHC) structure has distinct advantages and may be a preferred model.
Continuous authorisation : Entry of new banks would increase the level of competition,
bring new ideas and variety in the system , but the entry norms should be stringent.
Authorities should seek to facilitate and encourage entry by only well-qualified entities
in order to improve the quality of the banking system and promote competition.
Conversion of UCBs into commercial banks: In the context of extending banking
services, there is a case for exploring the possibilities of converting some urban co-
operative banks into commercial banks / local area banks or small banks.
Consolidation: The issue of consolidation in the banking sector has assumed significance,
considering the need for a few Indian banks to cater to global needs of the economy by
becoming global players. Consolidation in the banking sector may pave the way for
stronger financial institutions with the capacity to meet corporate and infrastructure
funding needs.
Presence of Foreign Banks in India: In view of the inherent potential for sustained
growth in the domestic economy and also growing integration into the global economy
there needs to be commensurate expansion in the presence of foreign banks in India. The
Central bank is now in the process of unveiling new norms for the entry of foreign banks
either as a subsidiary with greater freedom or purely as a branch and the final rules are
expected to be announced soon.
Indian banks presence overseas: Indian banks abroad are facing challenges due to a
highly competitive environment, enhanced regulation, more intensive supervision and
growing emphasis on ring fencing of operations in host jurisdictions in the wake of the
crisis.
Government Ownership: On one hand, the predominance of Government owned banks
in India has contributed to financial stability, while on the other, meeting their growing
capital needs casts a very heavy burden on the Government. What is, therefore, needed
is an optimal ownership mix to promote a balance between efficiency, equity and financial
stability.
Deposit Insurance and resolution: The crisis has brought into sharp focus the need for
effective deposit insurance and resolution regimes to deal with the failing / failed banks
with least cost. In India, failures of commercial banks have been rare, and the beneficiaries
of the deposit insurance system have mainly been the urban co-operative banks.
Which are the major issues discussed in the paper?
The major points discussed are
Consolidation of large-sized banks with a view to having a few global banks;
Desirability and practicality of having small and localised banks as preferred vehicles
for financial inclusion;
The need for having investment banks and other specialised banks through
differentiated licensing regime for domestic and foreign banks instead of granting
of universal banking license;
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 Policy regarding presence of foreign banks in India;
Feasibility of conversion of urban cooperative banks into commercial banks; and
Periodicity of licensing the new banks - ad hoc issue or continuous licensing
What are the recent approaches towards reforming existing banking structure?
The Committee on Financial Sector Reforms 1991 & Banking Sector Reforms 1998 ,
chaired by Shri M. Narasimham; the Committee on Fuller Capital Account Convertibility
2006, chaired by Shri S.S. Tarapore ; and the Report of the Committee on Financial Sector
Reforms 2009, chaired by Shri Raghuram G. Rajan have dealt extensively about the need
for structural reforms in the Indian banking system. The recommendations of some of
these Expert Committees were
consolidation in the Indian banking structure to create well-capitalised, automated
and technology-oriented banks through mergers and acquisitions;
fostering competition in the banking structure by permitting entry for more private
sector banks;
setting up of small banks with local character to cater to the requirements of rural and
unorganised sectors;
more active foreign banks participation;
strengthening of the existing structure through enhancing appropriate risk management
capabilities;
Putting in place prudential measures to enable the banking structure to discharge its
core functions in an efficient and inclusive manner.
What are the pros and cons in encouraging small banks structure?
Small banks have low capital base, with small borrowers, with limited area of operation,
with limited infrastructure, staff and lower operational expenses. Small banks would help
improve penetration of banking sector to unbanked areas and mobilize resources.
Generally their operations are confined to a district or few contiguous districts and hence
they would be in a better position to understand the needs and priorities in their area of
operation. They would be able to explore business potential more tailored to the socio
economic background in the area of operation and extend banking services to the people
in that area. Small banks may develop core competence through relationship banking in
financing agriculture, SMEs, industries in a particular geographical area, and, thereby,
able to serve their credit needs better. Small banks are potentially vulnerable to sector and
geographical concentration risk. Small banks are vulnerable to shocks from the local
economy and hence require higher level of CRAR. Small banks cannot finance big-ticket
investments, including infrastructure. They lack economies of scale and scope. Small
banks are prone to be captured by local influence. Small banks generally rely on
relationship banking as against lending practices adopted by big banks. A large number
of small banks adds to the pressure on the supervisory resources of the central bank.
What are the major advantages of Financial Holding Company over others in a
Universal Banking Model?
Universal Banking model still remains the dominant model and has functioned well in
India. Broadly there are three different regulatory models such as complete integration,
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parent bank with non-bank operating subsidiaries and a holding company (FHC) parent
with bank and non-bank affiliates. FHC model is better in removing capital constraints
and facilitating expansion in other financial services. Since under the FHC, the subsidiaries
will not be directly held by the bank, the responsibility to infuse capital in the subsidiaries
would rest with the holding company. Management of individual entities in a disaggregated
structure is also expected to be easier and more effective. The FHC model may enable a
better regulatory oversight of financial groups from a systemic perspective. It would also
be in consonance with the emerging post-crisis consensus of having an identified systemic
regulator responsible inter alia for oversight of systemically important financial institutions
(SIFI).The FHC model would provide requisite differentiation in regulatory approach for
the holding company vis-a-vis the individual entities. The FHC model is likely to allow
for neater resolution of different entities as compared with BHC model where liquidation
of the parent bank may make the liquidation of subsidiaries inevitable. The FHC model
broadly on the lines of recommendations of the Report of the Working Group on
Introduction of Financial Holding Company Structure in India would be suitable both
for private and public sector banks on account of several advantages it offers over the
currently existing bank holding company (BHC) model. With the broadening and
deepening of financial sector, some banks may choose to operate in niche areas. This has
certain obvious advantages in terms of managing business and risk management. With the
broadening and deepening of financial sector, a need is felt that banks move from the
situation where all banks provide all the services to a situation where banks find their
specific realm and mainly provide services in their chosen areas.
What are the advantages of a differentiated licensing regime?
On balance it would appear that differentiated licensing would be a desirable step
particularly for infrastructure financing, whole sale banking and retail banking (focused
on SME financing). The small banks could also be under differentiated licensing regime
with restrictions on their area of operation, size and range of activities. These banks will
have to be under differentiated prudential regimes depending on their risk profile.
What are the advantages of a continuous authorization approach?
Shri Raghuram G. Rajan in his report on Financial Sector Reforms suggested that there
is a strong need for making the entry into banking more liberal. Bank licenses available
on tap would put competitive pressure on the existing banks and improve performance and
efficiency. Also it would bring new technology and new ideas into banking on a
continuous basis. The gradual increase in the number of banks spread over a long period
of time would be efficient and would not strain the existing banking system. It would ease
undue pressure on the regulatory resources during a short period of time and enable
allocation of regulatory resources evenly. The objectives of financial inclusion and
broadening the geographical reach of banking can be achieved only when the entry
process is not a restricted one. However, it is important that the entry norms should be
stringent. Authorities should seek to facilitate and encourage entry by well-qualified
entities in order to improve the quality of the banking system and promote competition.
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 DIFFERENTIATED LICENSING REGIME

Very large ticket, long term infrastructure lending

requires risk management expertise that goes beyond
traditional credit appraisals at banks.

Very low ticket unsecured credit requires risk

management methodology and cost control that is
not easy in business model of conventional banks.

Issues of conflict of interest when a bank performs

multiple functions would not arise, where
differentiated licenses are issued.

Risk management systems and structure for

regulatory compliance could be customised
according to the banking type.

Customised application of supervisory resources

according to the banking type could result in greater
optimisation of such scarce resources.

Core competency could be better harnessed leading

to enhanced productivity in terms of reduced
intermediation cost, better price discovery and
improved allocative efficiency.

Your comments and feedback on this publication may be sent to Staff Training College,
The South Indian Bank Ltd., Thrissur 680 001 or by E.mail: [email protected]