COMPREHENSIVE PROJECT REPORT

ON

“An Empirical Study on Universal Banking and its Potential for

Indian Market Consumers”

Submitted towards the partial fulfillment of the course

In
 CERTIFICATE OF COMPLETION

This is to certify that project report on “An Empirical Study on Universal Banking and its
Potential for Indian Market Consumers” prepared by “name ” “Batch has been completed
under my guidance and supervision.

___________________________ _______________

Faculty Guide -

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 ACKNOWLEDGEMENT

This report is a synergetic product of many minds. I am grateful for the inspiration
and wisdom of all those who were with me in this journey. I am sincerely thankful to
ISB&M, Noida for providing me with the opportunity to write a research paper in the
form of a dissertation on the topic“Mutual
Funds”.
To begin with my faculty mentor Prof. Hari Srivastava, ISB&M, Noida who
encouraged me to do my best. Without his support it would have been very difficult
for me to prepare the paper so meaningful. I am also thankful to him for his guidance
that helped me improve a lot.
Besides this I would like to declare that this study would not have been
possible
without the guidance of Mr. Lalu Gadhvi, Asst. Manager and my superiors
at
NJ India Invest, Noida. I thank all the people whose support made it
possible
for me to fulfill this study.
Through this research paper I have learnt a lot about the Mutual Funds as a whole
and hope that this research paper will help all those Investors which are already or
planning to start the process of Financial planning.

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 TABLE OF CONTENTS
S.No. CONTENTS PAGE NO.

1. Abstract 5

2. Introduction 6

3. Literature Review 7

4. Overview 8

4. Concept of Universal Banking 10

5. Example of Universal Banks 11

7. SWOT analysis 14

8. Future Trend of Universal Banking in different countries 21

• International Scenario 21

• Universal Banking in India 32

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9. Is Universal Banking good or bad for the country 38

10. What Universal Banking can result for India 42

11. Methodology 48

12. Results and Discussions 49

13. Findings 65

14. Considerations 66

15. Recommendations 67

16. Conclusion 68

17. Bibliography 69

18. Annexure- Questionnaire

ABSTRACT

Different types of financial products and services penetrate our daily activities. As a major
group of financial institutions, banks have been expanding their service scope, and hence,
universal banks, which provide a variety of financial products and services in one house,
have experienced growing popularity in some industrialized countries. In India, banking
institutions have assumed a key role in the simplistic financial sector. Commercial banks
have made effort to diversify their products and services, but a lengthy process is expected
for their transition into truly universal banks. It is argued that the current structure and
practices of the local market also contribute to this lengthy transformation. Thus, banks,
which assume a leading position in most financial systems, have to be prepared for the
growing need of their customers. Also, government should provide necessary assistance to

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banks for aiding them to get converted into universal banking system for the benefit of Indian
customers.

INTRODUCTION

Banking institutions are dominant operators in modern financial systems and important
business entities in an economy. They are divided into two separate types of institutions,
namely commercial banks and investment banks in some countries, while in other countries
such division is vague or even non-existent. The so-called universal banks engage in all
forms of commercial and investment banking, not only including lending and deposit taking,
but also underwriting securities and securities trading. In particular, some universal banks
may own significant equity interests in companies with voting rights.

Germany is the typical example running the universal banking system. Canada and
Switzerland, among others, are noteworthy examples moving towards universal banking.
Despite the growing popularity of universal banks in a global context, the United States
continues to block commercial banks from engaging in securities transaction and

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underwriting. Hence, it is argued that the practice of universal banking may not be suitable
for all financial systems.

This project is designed to discuss primary practices of universal banks and their relevance to
banking activities in India. The objective is to analyze whether the concept of Universal
Banking, if implemented by Indian banks, have potential for Indian market consumers.

LITERATURE REVIEW

Universal Banking is a multi-purpose and multi-functional financial supermarket (a company

offering a wide range of financial services e.g. stock, insurance and real-estate brokerage)
providing both banking and financial services through a single window.

As per the World Bank, “In Universal Banking, large banks operate extensive network of
branches, provide many different services, hold several claims on firms(including equity and
debt) and participate directly in the Corporate Governance of firms that rely on the banks for
funding or as insurance underwriters”.

In a nutshell, a Universal Banking is a superstore for financial products under one roof.
Corporate can get loans and avail of other handy services, while can deposit and borrow. It
includes not only services related to savings and loans but also investments.

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However in practice the term 'universal banking' refers to those banks that offer a wide range
of financial services, beyond the commercial banking functions like Mutual Funds, Merchant
Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans, Investment
banking, Insurance etc. This is most common in European countries.

For example, in Germany commercial banks accept time deposits, lend money, underwrite
corporate stocks, and act as investment advisors to large corporations. In Germany, there has
never been any separation between commercial banks and investment banks, as there is in the
United States.

OVERVIEW

Universal banking is the opposite of narrow banking. Narrow banking legislation would
require banks to back their liabilities with safe assets, such as government securities. All
other bank lending functions would be transferred to mutual-fund-like institutions that were
not insured by the government. This arrangement would allow the government to base its
costly deposit insurance programs without jeopardizing the safety of the banks. Narrow
banking is the modern and more elaborated version of the “100 percent reserve banking”
principle, invoked by early economists to correct the inadequacy of money reserve against the
stock of banknotes in circulation. The benefits of narrow banking are:

First, by locking bank assets in high-quality instruments, narrow banking regulation would
minimize bank liquidity and credit risk.

Second, since narrow banks would be prohibited from supplying risky loans and would
collateralize deposits with high-quality assets, confidence in the value of their liabilities is
tend to be increased.

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Third, with payment system access restricted to narrow banks, payment would be fully
secure, because payment-system participants would be protected against liquidity, credit, and
settlement risks, and because any shock to non-banks would be isolated, with no systemic
fallout.

In the early nineties, the forces of globalization were unleashed on the hitherto protected
Indian environment. The public sector banks, which had monopoly earlier, then started facing
problems with deteriorating performance. Therefore, the sector was opened up for the private
sector in line with Narsimham Committee’s recommendations. The protected environment
has given rise to several lacunae in the banking system. Most of the public sector banks were
inefficient in areas of liquidity management. In an administered interest regime, discretion of
management was limited and consequently, the risk parameters in these spheres were unclear
and not quantifiable. The share of private sector banks was not substantial while operations of
foreign banks were also restricted. Staff orientation especially at the branch level is a key
ingredient for success and neither the older private banks nor the nationalized banks were
successful in that respect. It would be pertinent to recapitulate that the nationalized sector had
outlived its utility; in fact they became burdened with unwelcome legacies; customer service
had become a casualty. Thus, there arose a need for computerization, including networking
among the vast branch network. Private banking in this context was viewed as an approach to
overcome the structural and operational shortcomings of the public sector.

The ICICI’s decision to turn itself into a universal bank ushered a new era in the banking
scenario. The second Narasimham Committee noted that the global trends in banking
industry towards consolidation and convergence led to the dismantling of boundaries among
suppliers of various financial products. The Khan Working Group also recommended a
progressive move towards universal banking and development of enabling regulatory
framework. It is contended that universal banking will result in greater economic efficiency
in the form of lower cost, higher output, and better products and therefore is believed to be
the panacea for beleaguered development financial institutions (DFIs).

There is a fear that such institutions, by virtue of their sheer size, would gain monopoly in the
market, which can have significant and undesirable consequences for economic efficiency.
Also, combining commercial and investment banking can give rise to conflict of interests.
Conflict of interests was one of the major reasons for introduction of Glass-Steagall Act of
1934 in United States. The Act prohibited commercial banks from collaborating with full-

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service brokerage firms or participating in investment bank activities. The Glass-Steagall Act
was enacted during the Great Depression. It protected bank depositors from the additional
risks associated with security transactions. The Act was dismantled in 1999. Consequently,
the distinction between commercial banks and brokerage firms has blurred; many banks own
brokerage firms and provide investment services. Internationally, the concept was in the
financial segment. However, in India, the issue was more of access to short-term funds and
payment mechanism than access to long-term funds.

However, the enactment of the Gramm-Leach-Bliley Act (GLBA) in November 1999

effectively repealed the long-standing prohibitations on the mixing of banking with securities
or insurance businesses and thus permitting “broad banking”. The repeal of these prohibitions
are due to the increasingly persuasive evidence from academic studies of the pre Glass-
Steagall era, the recent favourable experience in the U.S. following partial deregulation of
banking activities, the experience of banking systems abroad with broader scopes for banking
activities, and rapid technological change in telecommunications and data processing.

THE CONCEPT OF UNIVERSAL BANKING

The entry of banks into the realm of financial services was followed very soon after the
introduction of liberalization in the economy. Since the early 1990s structural changes of
profound magnitude have been witnessed in global banking systems. Large scale mergers,
amalgamations and acquisitions between the banks and financial institutions resulted in the
growth in size and competitive strengths of the merged entities. Thus, emerged new financial
conglomerates, which could maximize economies of scale and scope by building the
production of financial services organization, called Universal Banking.

By the mid-1990s, all the restrictions on project financing were removed and banks were
allowed to undertake several in-house activities. Reforms in the insurance sector in the late
1990s, and opening up of this field to private and foreign players also resulted in permitting
banks to undertake the sale of insurance products. At present, only an ‘arm’s length
relationship between a bank and an insurance entity has been allowed by the regulatory
authority, i.e. IRDA (Insurance Regulatory and Development Authority).

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Universal Banking, means the financial entities – the commercial banks, DFIs, NBFCs, -
undertake multiple financial activities under one roof, thereby creating a financial
supermarket.

The entities focus on leveraging their large branch network and offer wide range of services
under single brand name Universal banking generally takes one of the three forms: -
a. In-house Universal Banking. E.g. Germany

b. Through separately capitalized subsidiaries. E.g. England.

c. Operations carried through a holding company. E.g. USA. (Nair, 1998)

EXAMPLES OF UNIVERSAL BANKS

In line with the growing popularity in merging investment banking, insurance and
commercial banking operations, the number of universal banks have gradually increased.
Universal banks can be broadly categorized in forms of full universal banks, universal-
subsidiary, and holding company

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Germany is one of the most commonly cited countries with a full universal banking system.
German universal banks have prevailed before the Second World War. Cable (1985) has an
impressive analysis of the country’s banking system. German universal banks finance
enterprises mainly in two ways, i.e. current account credit and organization of issues of new
securities. External finance for investment is of great importance to German industrialization
since internal financial resources are obviously inadequate for the development of capital-
intensive industries. As a result, universal banks prove to be a major source of external
finance to enterprises.

Edwards (1996) states that the supply of external finance in the model of universal banking
increases in line with the suppliers’ controlling power over their borrowers’ behaviours. In
the case of Germany, the representatives of universal banks on company boards of directors
increase profitability, as this arrangement makes the provision of external finance more
attractive. Edwards also argues that the universal nature enables German banks to improve
information flows within the economy. In other words, the contribution of universal banks to
the economy should not be only measured in terms of external funds they supply but also of
improved information flows as a result of banks’ improved capability to compare companies
within an industry and across industries within the whole economy.

Supportive evidences show that the universal banking system in Germany benefits the
country’s industrial development. Stiglitz (1985) points out that default risk generally
decreases in the presence of banks’ control over enterprises but the concern of banks might
overshadow the profitability objective of enterprises. Banks’ prime concern is the repaying
ability of enterprises and not necessarily the maximization of enterprise profitability. As
Stiglitz emphasizes: “Lenders are only concerned with the bottom part of the tail of the
distribution returns. Thus, they may require that the firm undertakes projects with relatively
little (bottom-tail) risk, even though the expected return is much lower.” To conclude, Stiglitz
suggests that the effects of universal banks in boosting industrialization might be overstated.

On the other hand, the story can be rewritten in other way. The prudent governance of
universal banks is not solely for their own good. Shareholders of large enterprises are not
necessarily the managers because shares are usually widely held by an enormous number of

12
individuals or institutions. Most large enterprises will hire managers, who usually are
financial experts, to handle daily business activities. The underlying problem is that these
managers may be less concerned about long-run prospects of the company while short-run
profitability is of their first priority. Their over-aggressiveness in maximizing short-run
profits could increase the risk of bankruptcy. The representation of banks thus acts as a buffer
and promotes the long-term financial health of enterprises.

Universal banks play a dominant role in the German financial system. Yet not all financial
systems are as bank-oriented as the German’s. For example, the United States has a financial
system where markets are of great importance. Boyd et al. (1998) investigate whether the
United States should be transformed into a universal banking system. It is argued that one
concern that could arise is the lack of control over moral hazard problems, which could easily
come up with the close relationship between banks and their borrowers. Furthermore, the
problems led by moral hazard might have negative impacts on the financial sector and also on
other economic sectors. As Boyd et al. (1998) argue, “…regulators have often expressed the
concern that the establishment of universal banking in the U.S. could extend the
‘governmental safety net’ far too broadly, that moral hazard problems could be exacerbated
as a consequence, and that they could, potentially, be transmitted beyond the financial
sector.” After investigating the severity of moral hazard problems in association with the
universal banking system, it is suggested that when banks are allowed to take equity positions
and participate in the decision-making process of the companies, their incentives to control
moral hazard problems could be attenuated seriously. In addition, banks with controlling
rights might sometimes lead enterprises to misallocate their funds for the sole benefits of the
banks.

Contrasts to the situation in the United States, universal banks are becoming more important
in the financial system of Switzerland. Rime and Strioh (2001) examine the production
structure of 290 banks from 1996 to 1999 through the performances of the following areas:
cost efficiency, profit efficiency, economies of scale, and economies of scope. However, their
empirical results indicate that around 40% of costs reflect cost inefficiency and about one-
half of potential profits are foregone because of profit inefficiency in their model, which
includes a “universal” measure of bank output. In addition, there is little evidence of
significant gains from either scale or scope economies for the largest banks in Switzerland.

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The difficulty in monitoring large universal banks is also a major concern. The consequence
of inefficient monitoring could lead to financial instability. Benston (1994) states that
universal banks tend to be larger so that collapse of a single bank of this type could cause
substantial distress in the financial system. When several of those large universal banks are to
collapse, this will greatly increase the risk to the economy’s payments system. At the same
time, it is more difficult to regulate universal banks because of their close and complex ties to
businesses. Hence, financial regulators either have to regulate universal banks very tightly,
thus hindering economic efficiency, or be faced with the possibility of a taxpayer bailout.

THE NEED BEHIND THE ADVENT OF UNIVERSAL BANKING

1. To make pace with the present need of corporate.

Now a day, there is a large market of General Insurance and Project Financing. As only a
bank is not able to fund it properly, due to insufficient asset base and net worth. So, to
overcome this, they form a consortium of lenders, for funding the Greenfield and Brownfield
projects. (In the month June a consortium of 20 lenders led by SBI has committed a 14 year
project finance term loan for a special purpose company promoted BPCL, which is starting a
Greenfield project in Madhya Pradesh) The point of consideration here is the consortium
partner – Bank of Baroda, Bank of Maharashtra, Central Bank of India, LIC, Indian Overseas
Bank. Most of the partners are nationalized banks.

It means there is a need of developing a strong domestic financial system to cater the need of
the corporate sector. It is possible if banks have strong capital/asset base. It fortifies the
importance of Universal Banking. Along with that, the ongoing clamor of Mergers and
Acquisitions in the corporate sector, this needs financial assistance as well as consulting.

14
More financial institutional investors entering in India and several Joint Ventures are being
started between domestic companies and global firms. A number of issues may crop up
between from the signing up of the sale purchase document and the deal actually coming up.
Near about 4% could be getting aborted (e.g.-the failure of Jet Airways and Air Sahara is one
of that. So, the corporate are in need of takers to insure the associated transactions of Mergers
and Acquisitions)

Now International insurers are offering cover in India against the loss arising out of Mergers
and Acquisitions and Breakups. (E.g.-Howden India leading International brokers, which has
introduced transactional insurance of M & A, is now finding takers for their insurance cover)
Indian banking, with the help of Universal Banking has technology edge and better business
models, compared to pre-liberalizations era, today they are able to attract and gain more
volumes simply because they meet their customers' requirements better than anyone else. If
the newer and foreign players can do that, then why can't bigger DFIs try their hands on it?

Liberalization and the banking reforms have given new avenues to Development Finance
Institutions (DFIs) to meet the broader market. They can avail the options to involve in
deposit banking and short term lending as well. DFIs were set up with the objective of taking
care of the investment needs of industries. They have build up expertise in Merchant Banking
and Project Evaluation.

So, saddled with obligations to fund long gestation projects, the DFIs have been burdened
with serious mismatches between their assets and liabilities of the balance sheet. In this
context, the Narsimham Committee II had suggested DFIs should convert into banks or Non-
Banking Finance Companies. Converting of these DFIs into Universal Banks will grant them
ready access to cheap retail deposits and increase the coverage of the advances to include
short term working capital loans to corporate with greater operational flexibility. At that time
DFIs were in the need to acquire a lot of mass in their volume of operations to solve the
problem of total asset base and net worth. So, the emergence of Universal Banking was the
solution for the problem of banking sector.

2. Funds Mobilization and Credit Rationing

The traditional activities of banks are deposit taking and lending. Deposits are liabilities of
banks, while funds extended by banks to borrowers are their assets. The fundamental function

15
of banks is to mobilize available funds from the surplus units to the deficit units. A “must”
technique when banks reallocate funds is credit rationing.

Bank credit is extended to the “good” ones, who are more likely to settle their debt principals
and interests. Default risk is a primary concern of banks when financing the deficit units.
Asymmetric or imperfect information is the factor behind default risk. In reality, financial
markets are not necessarily efficient under prefect information. Information is costly as well
as not available to everyone. Under this circumstance, banks with their advantages in
collecting information could minimize default risk to certain level. To a further extent, some
banks would insist to monitor their borrowers and take certain control over their borrowers’
businesses.

There are three basic mechanisms that banks apply in order to monitor their
borrowers. First, a bank can directly obtain information of the borrower’s cash flow when
the bank itself handles the borrower’s deposit account. The second arrangement is more
formal as restrictive covenants are stipulated in a loan contract. The borrower is required to
maintain a pre-set range of liquidity determined by the bank. Lastly, the bank is granted the
right to monitor the operation of the enterprises that borrow from them. Universal banks often
apply the last mechanism and maintain a close and extensive connection with borrowers.
Such connection will promise certain extent of lender control over those enterprises, and
hence, universal banks are argued to be in advantageous position to overcome the problems
led by the absence of reliable information and facilitate effective funds mobilization

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A SOLUTION OF UNIVERSAL BANKING COUPLED WITH SWOT

The solution of Universal Banking was having many factors to deal with which further
categorized under Strengths, Weaknesses, Opportunities and Threats.

Strengths:

*Economies Of Scale: The main advantage of Universal Banking is that it results in greater
economic efficiency in the form of lower cost, higher output and better products. Various
Reserve Banks Committees and reports in favor of Universal Banking, is that it enables banks
to exploit economies of scale and scope. It means a bank can reduce average costs and
thereby improve spreads if it expands its scale of operations and diversifying activities.

* Profitable Diversions: By diversifying the activities, the bank can use its existing expertise
in one type of financial service in providing other types. So, it entails less cost in performing
all the functions by one entity instead of separate bodies.

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* Resource Utilization: A bank possesses the information on the risk characteristics of the
clients, which it can use to pursue other activities with the same client. A data collection
about the market trends, risk and returns associated with portfolios of Mutual Funds,
diversifiable and non diversifiable risk analysis, etc are useful for other clients and
information seekers. Automatically, a bank will get the benefit of being involved in Research.

* Easy marketing on the foundation a of Brand name: A bank has an existing network of
branches, which can act as shops for selling products like Insurance, Mutual Fund without
much efforts on marketing, as the branch will act here as a parent company or source. In this
way a bank can reach the remotest client without having to take recourse ton an agent.

* One stop shopping: The idea of 'one stop shopping' saves a lot of transaction costs and
increases the speed of economic activities. It is beneficial for the bank as well as customers.

* Investor friendly activities: Another manifestation of Universal Banking is bank holding

stakes in a firm. A bank's equity holding in a borrower firm, acts as a signal for other
investors on to the health of the firm, since the lending bank is in a better position to monitor
the firm's activities.

Weaknesses:

* Grey area of Universal Bank: The path of Universal Banking for DFIs is strewn with
obstacles. The biggest one is overcoming the differences in regulatory requirements for a
bank and DFI. Unlike banks, DFIs are not required to keep a portion of their deposits as cash
reserves.

* No expertise in long term lending: In the case of traditional project finance an area where
DFIs tread carefully, becoming a bank may not make a big difference. Project finance and
Infrastructure Finance are generally long gestation projects and would require DFIs to borrow
long term. Therefore, the transformation into a bank may not be of great assistance in lending
long-term.

* NPA problem remained intact: The most serious problem of DFIs have had to encounter
is bad loans or Non Performing Assets (NPA). For the DFIs and Universal Banking or

18
installation of cutting-edge-technology in operations are unlikely to improve the situation
concerning NPAs.

Most of the NPAs came out of loans to commodity sectors, such as steel, chemicals, textiles,
etc. the improper use of DFI funds by project promoters, a sharp change in operating
environment and poor appraisals by DFIs combined to destroy the viability of some projects.
So, instead of improving the situation Universal Banking may worsen the situation, due to the
expansion in activities banks will fail to make thorough study of the actual need of the party
concerned, the prospect of the business, in which it is engaged, its track record, the quality of
the management, etc.

ICICI suffered the least in this section, but the IDBI has got worst hit of NPAs, considering
the negative developments at Dabhol Power Company (DPC)

Threats:

* Big Empires: Universal Banking is an outcome of the mergers and acquisitions in the
banking sector. The Finance Ministry is also empathetic towards it. But there will be big
empires which may put the economy in a problem. Universal Banks will be the largest banks,
by their asset base, income level and profitability there is a danger of 'Price Distortion'. It
might take place by manipulating interests of the bank for the self interest motive instead of
social interest. There is a threat to the overall quality of the products of the bank, because of
the possibility of turning all the strengths of the Universal Banking into weaknesses. (e.g. -
the strength of economies of scale may turn into the degradation of qualities of bank
products, due to over expansion.

If the banks are not prudent enough, deposit rates could shoot up and thus affect profits. To
increase profits quickly banks may go in for riskier business, which could lead to a full in
asset quality. Disintermediation and securitization could further affect the business of banks.

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Opportunities:

* To increase efficiency and productivity: Liberalization offers opportunities to banks.

Now, the focus will be on profits rather than on the size of balance sheet. Fee based incomes
will be more attractive than mobilizing deposits, which lead to lower cost funds. To face the
increased competition, banks will need to improve their efficiency and productivity, which
will lead to new products and better services.

* To get more exposure in the global market: In terms of total asset base and net worth the
Indian banks have a very long road to travel when compared to top 10 banks in the world.
(SBI is the only Indian bank to appear in the top 100 banks list of 'Fortune 500' based on
sales, profits, assets and market value. It also ranks II in the list of Forbes 2000 among all
Indian companies) as the asset base sans capital of most of the top 10 banks in the world are
much more than the asset base and capital of the entire Indian banking sector. In order to
enter at least the top 100 segment in the world, the Indian banks need to acquire a lot of mass
in their volume of operations.

Pure routine banking operations alone cannot take the Indian banks into the league of the Top
100 banks in the world. Here is the real need of universal banking, as the wide range of
financial services in addition to the Commercial banking functions like Mutual Funds,
Merchant banking, Factoring, Insurance, credit cards, retail, personal loans, etc. will help in
enhancing overall profitability.

* To eradicate the 'Financial Apartheid: A recent study on the informal sector conducted
by Scientific Research Association for Economics (SRA), a Chennai based association, has
found out that, 'Though having a large number of branch network in rural areas and urban
areas, the lowest strata of the society is still out of the purview of banking services. Because
the small businesses in the city, 34% of that goes to money lenders for funds. Another 6.5%
goes to pawn brokers, etc.

The respondents were businesses engaged in activities such as fruits and vegetables vendors,
laundry services, provision stores, petty shops and tea stalls. 97% of them do not depend the
banking system for funds. Not because they do not want credit from banking sources, but
because banks do not want to lend these entrepreneurs. It is a situation of Financial Apartheid
in the informal sector. It means with the help of retail and personal banking services
Universal Banking can reach this stratum easily.

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THE FUTURE TREND OF UNIVERSAL BANKING IN DIFFERENT
COUNTRIES

International Scenario

Universal banks have long played a leading role in Germany, Switzerland, and other
Continental European countries. The principal financial institutions in these countries
typically are universal banks offering the entire array of banking services. Continental
European banks are engaged in deposit taking, real estate and other forms of lending, foreign
exchange trading, as well as underwriting, securities trading, and portfolio management. In
the Anglo-Saxon countries and in Japan, by contrast, commercial and investment banking
tend to be separated. In recent years, though, most of these countries have lowered the
barriers between commercial and investment banking, but they have refrained from adopting
the Continental European system of universal banking. In the United States, in particular, the
resistance to softening the separation of banking activities, as enshrined in the Glass-Stegall
Act, continues to be stiff.

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The purpose of this project is to analyze the German and Swiss experience with regard to
universal banking. I attempt to show to what extent that experience supports or refutes the
arguments against universal banking frequently voiced in the Anglo-Saxon world.

Salient Characteristics of the German and Swiss Banking Systems

Popular discussions of universal banking are often flawed by misconceptions about the
characteristics of Continental European financial systems. The German system, in particular,
is frequently portrayed as being dominated by large oligopolistic universal banks with
branches all over the country. German banks are said to intermediate the bulk of financial
flows, while domestic capital markets remain underdeveloped. Furthermore, emphasis is
placed on the fact that German banks tend to hold equity stakes in industrial companies and,
therefore, yield considerable influence on their management.

This characteristic of the German banking system is overly simplistic and fails to do justice to
the realities of universal banking. It is certainly true that in countries like Germany and
Switzerland large universal banks with nationwide networks of branches play an important, if
not dominant, role. However, this simplistic description omits crucial features of universal
banking that tend to get lost in the public debate. Three such features are worthy of note:

• Even if legislation allows for universal banks, not all financial institution chooses to
offer the entire gamut of banking services. Only the largest institutions tend to be
truly universal banks, which coexist with smaller, specialized institutions. Moreover,
universal banking may take on a variety of institutional forms.
• The importance of universal banks has tended to increase since the end of World War
II. But the techniques employed for promoting universal banking have varied. In
particular, there are substantial differences between Switzerland and Germany in this
regard.
• Universal banking need not prevent capital markets from playing an important
supplementary role in financial intermediation. The German and Swiss experiences
also differ significantly in this respect.

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Universal Banking and Specialization
Table 1 provides information on the structure of the German and Swiss banking systems. In
both countries, financial institutions may be classified into broadly similar groups: big banks,
government-owned savings banks, regional banks, cooperative banks, branches of foreign
banks, and private banks. In addition, both countries feature one of two remaining groups of
diverse and highly specialized institutions.

The group of big banks comprises institutions with nationwide branch networks, as well as an
important international business. They are truly universal institutions involved in all aspects
of banking. They play a leading role in financing foreign trade and industry. They are also
heavily engaged in investment and trust banking. Most of the big German and Swiss banks
occupy an important position in domestic and international securities markets. They act as
leading underwriters of domestic and international securities issues. The big Swiss banks, in
particular, are also well known for their role as international portfolio managers.

The regional banks, as their name indicates, normally confine their activities to specific
regions. In Germany that group includes the subsidiaries of foreign banks. Regional banks
tend to be more specialized than the big institutions. The largest German regional banks,
however, have turned into truly universal institutions. They have spread to other parts of the
country and have also penetrated foreign markets. They now operate nationwide branch
networks, but remain "regional" in the sense that they continue to focus their business on
their home region. Many of the large German regional banks are also authorized to engage in
mortgage lending. In Switzerland most of the regional banks, in fact, are small savings banks
heavily engaged in mortgage lending. These banks do not play a significant role in
investment banking and they are not active abroad.

In both German and Switzerland, government-owned banks account for a substantial share of
total assets (Table 1). The majority of these banks were founded in the 19th century by
municipalities or districts in Germany and by cantons in Switzerland. The purpose of these
banks was, and is, to encourage saving by the local population. However, in contrast to
private-sector savings institutions, government-owned banks must accept certain public-
service functions, such as promoting the development of the local economy or assisting
disadvantaged groups. In Germany, these banks are chartered by the Lander (states) and can
only operate within their home-Land (state). Although the individual German government-
owned savings banks can hardly be regarded as universal establishments, they operate central

23
institutions (Landesbanken) placed at the level of the Lander and at the federal level. These
central institutions initially were set up to provide payments services to their members, but
later evolved into full-fledged universal institutions. Through these central institutions, the
individual savings banks are able to offer universal banking services to their customers.
Among the Swiss cantonal banks cooperation is less common. Only the largest cantonal
banks come close to resembling universal institutions. They do play a limited role in
underwriting domestic securities and in portfolio management, but are legally constrained to
engage in foreign business.

Cooperative banks, like government-owned savings banks, are institutions focusing on the
savings business. Although initially conceived as self-help organizations, which mainly
accepted deposits from and lent funds to members of the cooperative, they gradually evolved
into universal banks when they set up central institutions, as was done in Germany. In
Switzerland, by contrast, cooperative banks remained less important, as indicated by their
respective shares in total assets of the banking system (Table 1). Due to their small market
share, Swiss cooperative banks have not expanded into universal banking to any great extent.

The remaining banking groups in Table 1 largely consist of specialized institutions involved
in the most diverse lines of activity. In both Germany and Switzerland, private banks, whose
importance has shrunk considerably, are active in portfolio management. Branches of foreign
banks, though often part of a universal institution, typically also specialize. In Switzerland,
they tend to concentrate on underwriting and portfolio management. Finally, in Germany, the
category "other financial institutions" includes building societies, mortgage establishments,
and other specialized institutions. In Switzerland, the groups of "other banks" and "finance
companies," which include the subsidiaries of foreign banks, cover institutions involved in
various activities, such as commercial banking, underwriting, securities trading, and portfolio
management.

An analysis of bank earnings reveals further differences between the German and Swiss
banking systems. Table 1 shows the share of commission income in net revenue, broken
down by banking groups. Commission income covers fees obtained on such banking services
as payments services, guarantees, foreign exchange and securities trading, underwriting,
portfolio management, and financial derivatives. Aside from commission income, net
revenue includes interest income on the banks' assets net of interest paid on the banks'
liabilities. Therefore, institutions involved mainly in traditional commercial banking activities

24
display a low ratio of commission income to net revenue. Investment and trust banks, by
contrast, display a high ration, while truly universal banks occupy the middle range.

Table 1 point to two striking differences in the structure of German and Swiss banks'
earnings. First, German institutions, as a whole, resemble more closely traditional
commercial banks than their Swiss counterparts. In Germany, the average ratio of
commission income to net revenue is much lower than in Switzerland. The relatively high
Swiss ratio reflects the important role played by Swiss banks in underwriting, securities
trading, and portfolio management. Second, in Germany, that ratio displays a much smaller
variability across the various banking groups than in Switzerland. In Germany it fluctuates
between 12 to 30 percent as compared to a range of 9 to 80 percent in Switzerland. Thus,
while German banks, on average, are less universal than their Swiss counterparts, universal
banking in Germany is more evenly spread across the various groups of financial institutions
than in Switzerland.

A high ratio need not imply that the group concerned specializes in investment banking.
Unfortunately, the available data on Switzerland do not provide a detailed breakdown of
commission income by sources. There is little doubt that Swiss banks derive their
commission income mainly from four sources: foreign exchange trading, underwriting,
securities trading in the secondary market, and portfolio management. Separate data are
available on commission income gained from foreign exchange trading. They indicate that
big banks and branches of foreign banks are more heavily engaged in foreign exchange
trading than the other groups. However, the patterns revealed by Table 1 are not altered much
if the foreign-exchange component is eliminated, although the ratio of commission income to
net revenue, for the Swiss banking system as a whole, drops from 44 to 33 percent.

While some specialized Swiss institutions act as pure investment banks, they typically
combine investment and trust banking under one roof. Many of the specialized Swiss banks
operate as portfolio managers. They are members of the domestic stock exchanges and, thus,
provide both brokerage and portfolio management services to their clients. In most cases,
they do not participate to any great extent in underwriting, which is dominated by big banks.
Consequently, the strategy of specialization pursued by many of the smaller Swiss banks does
not fit the Glass-Steagall mould. Rather, it has resulted in a separation of traditional bank
borrowing and lending from investment and trust banking.

25
In summary, the German and Swiss experiences indicate that many banks choose to
specialize even if legislation does not place any constraints on universal banking. Specialized
banks tend to be small institutions coexisting and competing with big universal banks.
Although both the German and Swiss systems allow for specialization, there is little doubt
that since the end of World War II, market forces have served to enhance the importance of
universal banks and have permitted them to expand their sphere of influence.

Are the Objections to Universal Banking Justified?

There are four major objections to universal banking. In his study of the Glass-Steagall Act,
George Benston (1990) reviews critically these objections. In his view, the case for
separation of commercial and investment banking rests on weak foundations

1. Riskiness and Lender-of-Last Resort Problems

Are universal banks prone to incur excessive risks and, thus, to jeopardize the stability of the
financial system? Benston (1990) examines various studies that attempt to answer this
question by drawing on U.S. evidence. Most of these studies, he concludes, reject the view
that university enhances the riskiness of banking operations.

The available Swiss evidence leads to similar conclusions. As a result of the recent collapse
of the real estate market, many Swiss banks are compelled to make provisions against bad
mortgage loans. Regional and continual banks are particularly afflicted by these problems.
For this reason, the number of regional banks is shrinking substantially, mainly as a result of
mergers within that group or takeover by bigger institutions. The big banks, by contrast, are

26
weathering their real-estate problems without much difficulty, due to their ability to diversify
risk among a wide range of activities.

Since universal banks are better equipped to diversify their risk than the specialized
institutions, universality as such not complicates the lender-for-last-resort role of central
banks. However, problems may arise from the fact that universal banks are typically large. If
large institutions run into solvency problems, central banks may be confronted with the
dilemma of "too big to fail." In principle, these institutions should be closed, but such
closures might send shockwaves through the entire financial system and impair its stability.
Clearly, the "too big to fail" dilemma is not related to the universality of banks but not their
size.

2. Conflicts of Interest
Universal banking may give rise to conflicts of interest that need to be taken seriously. It
would not be difficult to find examples of conflicts of interest in the history of Swiss banking.
Nevertheless, two reasons lead us to believe that in Switzerland conflicts of interest today
create far less serious problems than in the past.

First, Swiss regulations of securities markets are being strengthened considerably. Insider
trading is now a criminal offense in Switzerland. Furthermore, the government is proposing
legislation that would guarantee transparency of stock exchange trading, as well as adequate
financial reporting by listed companies. A second reason is even more important than the first
one. Market forces themselves support the legislative efforts for diffusing conflicts of interest
and preventing other abuses in securities markets. For example, if universal bank attempts to
hide blunders in underwriting by shifting unsaleable securities to its trust department, its
customers are likely to be confronted with relatively low returns on their portfolio
investments. Competitors, including specialized banks, have an incentive to bid away
customers from the low-performing universal institution. Thus, market forces tend to induce
universal banks to eradicate conflict-of-interest problems.

3. Concentration of Power
Students of the German banking system frequently express concern about the concentration
of power in the hands of the big domestic universal institutions. In Switzerland, these
concerns are less pronounced even though the big Swiss institutions account for almost 50

27
percent of the domestic bank's aggregate assets. The intensification of competition and the
regulatory changes mentioned earlier have curbed the power of the big Swiss banks.

The Future of Universal Banking

We have argued that in Germany and Switzerland the importance of universal banking has
growth since the end of World War II. Will this trend continue so that universal banks could
completely overwhelm the specialized institutions in the future? Are the specialized banks
doomed to disappear? This question cannot be answered with a simple "yes" or 'no". The
German and Swiss experiences suggest that three factors will determine future growth of
universal banking.

First, universal banks no doubt will continue to play an important role. They posses a
number of advantages over specialized institutions. In particular, they are able to exploit
economies of scale and scope in banking. These economies are especially important for banks
operating on a global scale and catering to customers with a need for highly sophisticated
financial services. As we saw in the preceding section, universal banks may also suffer from
various shortcomings. However, in an increasingly competitive environment, these defects
will likely carry far less weight than in the past.

28
Second, although universal banks have expanded their sphere of influence, the smaller
specialized institutions have not disappeared. In both Germany and Switzerland, they are
successful coexisting and competing with the big banks. In Switzerland, for example, the
specialized institutions are firmly entrenched in such areas as real estate lending, securities
trading, and portfolio management. The continued strong performance of many specialized
institutions suggests that universal banks do not enjoy a comparative advantage in all areas of
banking. As a matter of fact, a substantial body of research indicates that most big banks have
already grown beyond the point at which further expansion in their market shares results in
significant returns to scale or scope. On the contrary, a continued expansion is often
detrimental to the banks' profitability as decision making within the institution becomes
bureaucratic and inflexible. Thus, even if legislation allows for universal banks, many
financial institutions will elect to specialize. However, the pattern of specialization generated
by market forces need not resemble the Glass-Steagall type of separation o commercial and
investment banking. German and Swiss experiences strongly suggest that banking activities
will be separated along different lines.

Third, universality of banking may be achieved in various ways. No single type of universal
banking system exists. We have shown that the German and Swiss universal banking systems
differ substantially in this regard. In Germany, universality has been strengthened without
significantly increasing their market shares of the big banks. Instead, the smaller institutions
have acquired universality through cooperation. They have set up central institutions
conducting those banking activities that are subject to significant returns to scale and scope.
In Switzerland, the cooperative approach has not worked as well as in Germany. The smaller
Swiss institutions find it difficult simultaneously to compete with one another in some areas
of banking and to cooperate in others. For this reason, in Switzerland the growth in
universality has been associated with a substantial increase in the market shares of the big
banks. It remains to be seen whether the cooperative approach will survive in an environment
of highly competitive and globalize banking.

TABLE 1
Banking Structure in Germany and Switzerland, 1991

Number of Banks Percentage Share of Banking

(End of Year) Group in Total Assets

29
 (End of Year)
Germany
Big Banks 4 9
4
9
Regional Banks 198 14
198 14
Government-owned Savings 757 34
Banks
Saving Banks 746 20
Central Savings Banks 11 14
11 14
Cooperative Banks 3158 15
Credit Cooperatives 3154 11
Central Cooperative Banks 4 4
Private Banks 84 1
Branches of Foreign Banks 60 1
Other Financial Institutions 102 25
Total 4363 100

Switzerland
Big Banks 4 49
Regional & Savings Banks 189 8
Cantonal Banks 28 20
Cooperative Banks 2 3
Private Banks 19 1
Branches of Foreign Banks 16 1
Other Banks 222 16
Finance Companies 112 2
Total 592 100

Commissions as Percentage of Net Revenue

Germany
Big Banks 26
Regional Banks 21
Government-owned Savings Banks 14
Saving Banks 14
Central Savings Banks 12
Cooperative Banks 1 16
Credit Cooperatives 14
Central Cooperative Banks 30
Private Banks 29
Branches of Foreign Banks 29
Other Financial Institutions n.a.

30
Total 18

Switzerland
Big Banks 47
Regional & Savings Banks 19
Cantonal Banks 21
Cooperative Banks 9
Private Banks 80
Branches of Foreign Banks 34
Other Banks 54
Finance Companies 32
Total 44

Sources: Deutsche Bundesbank (1992a: Tables 13, 22a; 1992b:42-47), and Swiss National
Bank (1992: Tables III, 1, 1; 40.0-40-8).

31
UNIVERSAL BANKING IN INDIA

For determining the applicability of Universal Banking in India, first we must understand
what the present economic scenario in India is:

Indian Scenario

1. Commercial banks

In early 90's the financial sector in India was crying out for reforms. Ever since the process of
liberalization hit the Indian shores, the banking sector saw the emergence of new-generation
private sector banks. Public sector banks which played a useful role earlier on are now facing
deterioration in their performance. For very long, the banks in India were not allowed to have
access to stock markets. So their dealing in other securities were minimal. But the financial
sector reforms changed it all, Indian banks started to deal on the stock market but their bitter
experience with scams, they became averse to deal in equities and debentures. Off late,
commercial banks in India have been permitted to undertake a range of in-house financial
services. Some banks have even setup their own subsidiaries for their investment activities.
Subsidiaries include in the area of merchant banking, factoring, credit cards, housing finance
etc.

2. Financial Institutions

DFIs were traditionally engaged in long term financing, as their main objective was to take
care of the investment needs of industries and to contribute to a better industrial climate.
They had, over the time, built up expertise in merchant banking, project evaluation and also
started giving working capital finance. Recently, they were allowed to accept medium-term
deposits within the specified limits. Lots of changes have taken place in DFIs in the recent
past. Most of DFIs have floated banks, institutions and mutual fund subsidiaries. Ownership

32
changes took place, several institutions went public, organization structure itself got
transformed.

Indian Perspective on Universal Banking

Some argue that the approach is very slow, while some call for steady approach. The debate
of universal banking is very much on. Should India have universal banking and if so when?
Much has been written about it domestically; however the following are the issues which are
key in Indian context.

i. Regulatory burden

ii. Regulatory requirements

iii. Distinction between maturity and duration

iv. Optimum Transition path

i. Regulatory burden:

One of the major problems associated with universal banking is the issue of regulation. DFIs
in India are governed by separate Acts and banks are regulated by RBI and Banking
Regulation Act. DFIs in India have commercial banks as their subsidiaries, but due to the
separation of regulation, the DFIs cannot have direct access to the resource base of its
subsidiary bank. Without any doubt, the net regulatory burden for all participants in the entire
financial system should be equalized in order to ensure that no participant might end up
having a disadvantage relative to any other. The importance of this point can be highlighted
by citing the example of USA, Japan, West Germany and Britain where there was a
tremendous decline in the share of banks in composition of household financial assets and its
movement to mutual funds and insurance. The study revealed that the decline has been due to
very high net regulatory burden being imposed upon the entire banking system relative to that
on the mutual funds and insurance companies. In India there is an urgent need to reduce the

33
regulatory burden, particularly for banks vis-à-vis mutual funds and insurance companies, if
the banks are expected to compete in free market place.

ii. Regulatory requirements

Salient operational and regulatory issues of RBI to be addressed by the FI’s for conversion
into a universal bank

a) Reserve requirements. Compliance with the cash reserve ratio and statutory liquidity
ratio requirements (under Section 42 of RBI Act, 1934, and Section 24 of the Banking
Regulation Act, 1949, respectively) would be mandatory for an FI after its conversion into a
universal bank.

b) Permissible activities. Any activity of an FI currently undertaken but not permissible

for a bank under Section 6(1) of the B. R. Act, 1949, may have to be stopped or divested after
its conversion into a universal bank..

c) Disposal of non-banking assets. Any immovable property, howsoever acquired by an

FI, would, after its conversion into a universal bank, be required to be disposed of within the
maximum period of 7 years from the date of acquisition, in terms of Section 9 of the B. R.
Act.

d) Composition of the Board. Changing the composition of the Board of Directors might
become necessary for some of the FIs after their conversion into a universal bank, to ensure
compliance with the provisions of Section 10(A) of the B. R. Act, which requires at least
51% of the total number of directors to have special knowledge and experience.

e) Prohibition on floating charge of assets. The floating charge, if created by an FI, over
its assets, would require, after its conversion into a universal bank, ratification by the Reserve
Bank of India under Section 14(A) of the B. R. Act, since a banking company is not allowed
to create a floating charge on the undertaking or any property of the company unless duly
certified by RBI as required under the Section.

34
 f) Nature of subsidiaries. If any of the existing subsidiaries of an FI is engaged in an
activity not permitted under Section 6(1) of the B R Act , then on conversion of the FI into a
universal bank, delinking of such subsidiary / activity from the operations of the universal
bank would become necessary since Section 19 of the Act permits a bank to have
subsidiaries only for one or more of the activities permitted under Section 6(1) of B. R. Act.

g) Restriction on investments. An FI with equity investment in companies in excess of 30

per cent of the paid up share capital of that company or 30 per cent of its own paid-up share
capital and reserves, whichever is less, on its conversion into a universal bank, would need to
divest such excess holdings to secure compliance with the provisions of Section 19(2) of the
B. R. Act, which prohibits a bank from holding shares in a company in excess of these limits.

h) Connected lending. Section 20 of the B. R. Act prohibits grant of loans and advances
by a bank on security of its own shares or grant of loans or advances on behalf of any of its
directors or to any firm in which its director/manager or employee or guarantor is interested.
The compliance with these provisions would be mandatory after conversion of an FI to a
universal bank.

i) Licensing. An FI converting into a universal bank would be required to obtain a

banking licence from RBI under Section 22 of the B. R. Act, for carrying on banking
business in India, after complying with the applicable conditions.

j) Branch network An FI, after its conversion into a bank, would also be required to
comply with extant branch licensing policy of RBI under which the new banks are required
to allot at least 25 per cent of their total number of branches in semi-urban and rural areas.

k) Assets in India. An FI after its conversion into a universal bank, will be required to
ensure that at the close of business on the last Friday of every quarter, its total assets held in
India are not less than 75 per cent of its total demand and time liabilities in India, as required
of a bank under Section 25 of the B R Act.

l) Format of annual reports. After converting into a universal bank, an FI will be required
to publish its annual balance sheet and profit and loss account in the forms set out in the
Third Schedule to the B R Act, as prescribed for a banking company under Section 29 and
Section 30 of the B. R. Act.

35
 m) Managerial remuneration of the Chief Executive Officers. On conversion into a
universal bank, the appointment and remuneration of the existing Chief Executive Officers
may have to be reviewed with the approval of RBI in terms of the provisions of Section 35 B
of the B. R. Act. The Section stipulates fixation of remuneration of the Chairman and
Managing Director of a bank by Reserve Bank of India taking into account the profitability,
net NPAs and other financial parameters. Under the Section, prior approval of RBI would
also be required for appointment of Chairman and Managing Director.

n) Deposit insurance. An FI, on conversion into a universal bank, would also be required
to comply with the requirement of compulsory deposit insurance from DICGC up to a
maximum of Rs.1 lakh per account, as applicable to the banks.

o) Authorized Dealer's License. Some of the FIs at present hold restricted AD licence
from RBI, Exchange Control Department to enable them to undertake transactions necessary
for or incidental to their prescribed functions. On conversion into a universal bank, the new
bank would normally be eligible for full-fledged authorised dealer licence and would also
attract the full rigour of the Exchange Control Regulations applicable to the banks at present,
including prohibition on raising resources through external commercial borrowings.

p) Priority sector lending. On conversion of an FI to a universal bank, the obligation for

lending to "priority sector" up to a prescribed percentage of their 'net bank credit' would also
become applicable to it .

q) Prudential norms. After conversion of an FI in to a bank, the extant prudential norms

of RBI for the all-India financial institutions would no longer be applicable but the
norms as applicable to banks would be attracted and will need to be fully complied
with.

iii. Distinction between Maturity and Duration

This is the issue of debate between long term and short term. Somehow DFIs are the
suppliers of term finance, where the maturity is clearly specified which could be between 3
years to 7 years, where as banks are providers of short-term finance where in reality bank
finance in a way amounts to financing in perpetuity since there are in general no definite
maturity dates. Usually the deposit base of the banks have are short duration but with a

36
variably high interest rates but its not the case with DFIs. Their funds have a longer duration
with less interest rate.

The interim report of S H Khan committee has argued that the distinction between
commercial and investment banking have become increasingly blurred with banks providing
both working capital and term loans to corporates but DFIs can provide only term loans as
they cannot accept short term deposits. The committee further argued that DFIs should be
given banking licenses eventually and until then they should be allowed to establish 100
percent banking subsidiaries while they continue to play their present role.

iv. Optimal Transition path

Viable transition path is one of the major areas of concern for institutions which are desirous
of moving in the direction of universal banking. The transition path contains several
operational and regulatory issues for information and guidance of DFIs. The S H Khan
working group and the discussion paper on the subject prepared by RBI eventually felt that
DFIs should transform themselves into commercial banks but in a phased manner. The
committee also recommended that DFIs can have 100 percent owned banking subsidiaries
which would be extremely beneficial to them. If this happens, then it would allow DFIs to
gain expertise in the area of commercial banking which would in turn help the DFIs if they
are seriously looking at the prospect of converting into a commercial bank. Also the 100
percent subsidarisation allows banks to have a full access to capital base of DFIs and gain
substantial knowledge in the area of project financing.

The RBI has asked FIs, which are interested to convert itself into a universal bank, to submit
their plans for transition to a universal bank for consideration and further discussions. FIs
need to formulate a road map for the transition path and strategy for smooth conversion into a
universal bank over a specified time frame. The plan should specifically provide for full
compliance with prudential norms as applicable to banks over the proposed period.

In India Development financial institutions (DFIs) and refinancing institutions (RFIs) were
meeting specific sect oral needs and also providing long-term resources at concessional
terms, while the commercial banks in general, by and large, confined themselves to the core
banking functions of accepting deposits and providing working capital finance to industry,

37
trade and agriculture. Consequent to the liberalisation and deregulation of financial sector,
there has been blurring of distinction between the commercial banking and investment
banking.

The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to
RBI to discuss the time frame and possible options for transforming itself into an universal
bank. Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance,
its proposed policy for universal banking, including a case-by-case approach towards
allowing domestic financial institutions to become universal banks.

Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit
their plans for transition to a universal bank for consideration and further discussions. FIs
need to formulate a road map for the transition path and strategy for smooth conversion into a
universal bank over a specified time frame. The plan should specifically provide for full
compliance with prudential norms as applicable to banks over the proposed period.

IS UNIVERSAL BANKING GOOD OR BAD FOR THE COUNTRY?

Universal banking is being peddled as a panacea to most of the ills that plague the financial
system in India. The issue of whether it is good for our country, in the current stage of
development, is being sidelined.

Universal banking brings about convergence of financial services under one roof. The initial
impetus to the concept worldwide was the need to bring down the intermediation costs. But
this is surely not a driver for developments in India. It is being used as an instrument to move
into commercial banking as a source to raise low-cost funds and crowd out smaller players. In
the process, profit considerations over-ride the mandate with which institutions were
founded.

The real issue here is who will fill the void that these institutions are so eager to leave. Have
we built alternative systems that will take over the functions of industrial financing? Some
may argue that our industries have passed the stage where no more handholding is required.
But look at the continuous decline in manufacturing output and the virtual dearth of any new
investment, and you will know how misplaced this view is.

38
Indian industry now needs to compete with global capacities. An economic size of 15,000 mt
for which licences were issued during the licence-permit raj and were considered
economically viable capacities for financing by FIs, now have to compete with producers
with capacities of millions of tonnes. The stage is set for a concerted effort to make these
units survive. Some will say ‘let them vanish from the scene if they can’t compete’. Let us
import everything. Yes, we can, but how do we pay for the imports? Unless we have areas
where we build up, at least, certain segments in the industry where we can match the price
and quality, we will have no export earnings to pay for imports. Universal banking, which
may result in changed priorities of FIs, will seriously hinder our efforts to build a
manufacturing sector that can compete with the best on its own terms.

What FIs are today is on account of large amount of transfer of funds that came at the cost of
exchequer — through directed investments, tax shields and suppressed yields from
investments. Now that these sources are drying up, they are on to poach on the constituencies
nurtured by commercial banks, the retail and household sectors. Pundits of the financial
world may call it mergers.

39
UNIVERSAL BANKING: THE MEANS AND THE ENDS ARE
CONTROVERSIAL

The move towards universal banking has not been by choice and — whatever one might say
— has been dictated by the failure of the DFI model.

In India the growing literature on the subject, nearly all of it pro-universal banking, has been
overtaken by certain practical developments. Universal banking is about to become a reality.
On April 1, ICICI’s reverse merger with ICICI Bank was expected to be completed. Both in a
de jure and in a de facto sense universal banking would have arrived in India. However there
have been obstacles, mainly in the form of a legal challenge to the terms of the merger
between ICICI and ICICI Bank. The predicament of the ICICI's top management shows that
even the means to achieve the universal banking status can be controversial. Also, it should
not be forgotten that it is the inadequacy and irrelevance of the DFI model (which ICICI and
IDBI represent) that has pushed the universal bank model on to the centre stage. There has
been no evolution, as the RBI had hoped, but a sudden jump into a new territory.

For that reason at least the controversy over universal banking will not end. Among other key
issues waiting to be addressed is the role and efficacy of the regulator in the new set up. Even
more basically the consumers for whom the universal banking model is touted to be a big
virtue need to understand its rationale. In India, as in the U.S. and the U.K., commercial
banks have had a clear cut role earmarked for them by law and practice. As a financial
intermediary, banks accepted deposits which they lent and the difference between the interest
earned (from the borrowers) and that paid (on deposits) called the spread has traditionally
formed the major part of their income. All other income which came from say issuing a draft
or confirming a letter of credit have been called miscellaneous income, probably because
such business was originally considered to be incidental to the main banking activity of
deposit taking and lending. DFIs, on the other hand, have primarily been into project
financing for which they developed substantial expertise. They have been in the long end of

40
the banking business, granting term loans (project loans) while banks have been primarily
short-term lenders.

The difference between the two — banks and DFIs — is even more marked if one looks at
the liabilities side of their balance sheets. To fund their long-term lending activities, DFIs
looked to the government for cheap funds and tax breaks. Part of the SLR securities which
banks have been compelled to buy were instruments issued by one of the DFIs. Banks meet
their funding requirements by accepting deposits of less than three year duration.

Universal banking, involving manifold activities, can be successful only if there is no

mismatch between their resources and their lending/investments. And for managing their
risks better universal banks claim to undertake a wide variety of activities. To succeed
uniformly across a spectrum of financial products, these banks should also nurture and
develop a strong brand. Branding of financial products has become the new mantra. Any
institution whether fully integrated as ICICI would be (post merger) or operating through a
number of associates can be a "virtual" universal banking, offering a garland of financial
products under one brand.

Hence, according to one view, universal banking is already in vogue and that it has arrived
without the pains of a restructuring of a type attempted by ICICI. Interestingly, IDBI has also
contemplated a similar move to acquire the universal banking status.

In the recent budget, there are two concrete moves to convert it into a universal bank
eventually: legislative changes to "corporotise" it and conversion of certain long term loans to
"appropriate" long term instruments. Critics, however, point out that it is not much the
attractiveness of the idea as much as the sheer necessity of abdicating the DFI model that
motivates the drive towards universal banking. It has been admitted that DFIs have to move
on and into retail. But no thought has been given to the likely problems the banking regulator
will face. At a larger level there is always the need for setting up a level playing field for all-
former DFIs which have converted to universal banks as well the more established banks.

41
WHAT UNIVERSAL BANKING CAN RESULT FOR INDIA

Banking will never be the same again. With official committees recommending a move
towards universal banking, DFIs, led by ICICI, are getting set to storm the banking arena.

THE DOMESTIC banking sector is going through some interesting times -- not just
economically, but on the policy front as well. And the major policy shift was heralded by the
Narasimham committee's recommendation that development finance institutions (DFIs)
ultimately convert into either commercial banks or non-banking finance companies. This, in a
way, spelt the beginning of the end of specialized services from DFIs, and the introduction of
universal banks.

With universal banking, banks will offer a wide range of financial services, beyond solely
commercial banking or investment banking. The main advantage of universal banking is that
it results in greater economic efficiency and enables asset diversification, not only in the
nature of ventures financed but also in the age profile of assets. Additionally, it offers
reasonable protection from economic cycles. For FIs, moving towards universal banking will
mean the ability to raise short-term, low-cost funds.

In India, banks have traditionally been prime lenders for working capital loans and DFIs
financed term loans. Now, with DFIs told to move towards universal banking, banks have
been allowed to diversify into investments and long-term financing, and DFIs will lend for
working capital.

Starting trouble. In spite of the Narasimham committee's recommendations -- later endorsed

by the Khan working group -- the road to universal banking is proving far from smooth. One
major impediment for FIs is the fact that they have past liabilities on which reserve
requirements -- SLR, CRR and priority sector advances -- have not been met. Meeting this
requirement in its current form and level would require FIs to raise huge resources from the

42
capital market, which could give rise to liquidity concerns. Now, depending on the fiscal and
monetary situation, RBI is slated to reduce the CRR requirement to a minimum of 3 per cent.

It has been suggested that reserve requirements apply only to the incremental liabilities, but
this may not be a prudent move when the huge backlog of liabilities is not covered. The most
plausible solution would be to adhere to the reserve requirements over a period of time to be
specified by the FI. In fact, RBI has mentioned that DFIs would need to prepare a transition
path in order to fully comply with the regulatory requirement of a bank and such requests will
be considered on ‘case by case’ basis.

Services on offer ICICI IDBI SBI HDFC LIC

Insurance Yes No Yes Yes Yes
MF Yes Yes Yes Yes Yes
Banking Yes Yes Yes Yes Yes
Merchant banking Yes Yes Yes No No
Broking Yes Yes Yes Yes No
Retail finance
Housing Yes No Yes Yes Yes
Credit/debit cards Yes No Yes Yes No

Moving to universal banking may also create some pressure on the asset and liability side of
balance sheets. On the liability side -- sources of funds (at least for banks) -- there will be
increasing competition from investment alternatives such as MFs where schemes with similar
liquidity but a better return are available. On the asset side -- deployment of funds -- the
growth of capital markets, new players and efficient investment banking have enabled
corporates to raise funds directly from the market.

The new bankers. The shift from specialized to universal banks is not restricted to FIs -- SBI
and LIC can be considered universal banks. SBI deals with MFs and investment banking, and
its insurance initiative with Cardiff SA brings it closer to the universal bank objective. And
LIC's move to acquire a stake in Corporation Bank makes it a serious candidate.

ICICI, which will have to raise something like Rs 20,000 crore for reserve compliance, has
decided to join the few universal banks. It has begun reducing the number of its subsidiaries,
and is planning to merge with ICICI Bank, in a bid to turn into a universal bank in 12-18
months.

43
ICICI will benefit
ICICI ICICI Bank
CAR (%) 14.6 11.57
Net NPAs (%) 5.2 2.19
Cost of funds (%) 11.71 7.77
ROA (%) 0.79 0.82
Spread (%) 1.83 2.00

While this may be good news for customers, shareholders have reason to be wary. ICICI is
seen to benefit more from the deal (see table above) as ICICI Bank is the better placed
company on most counts. The better financials from ICICI Bank will aid in reducing the cost
of funds. And the bank's lower NPA, in view of the higher NPA provisioning by ICICI,
augurs well for the merged entity. The possibility of the swap ratio being skewed in favour of
ICICI in view of its 47 per cent holding in ICICI Bank cannot be ruled out. Investors should,
therefore, wait for clarity on the merger proposal before taking any decision to buy or sell.

44
THE ROAD AHEAD TO INDIA

Economic historians have long emphasized the importance of financial institutions in

industrialization. More recently, economists have begun more intensive investigation of the
links between financial system structure and real economic outcomes. In theory, the
organization of financial institutions partly determines the extent of competition among
financial intermediaries, the quantity of financial capital drawn into the financial system, and
the distribution of that capital to ultimate uses. The choice between universal and specialized
banking may affect interest rates, underwriting costs, and the efficiency of secondary markets
in securities. Furthermore, the presence or absence of formal bank relationships may affect
the quality of investments undertaken, strategic decision-making, and even the
competitiveness of industry.

Particularly since World War II, many economists and historians have argued that German-
style universal banks offer advantages for industrial development and economic growth.
Universal banking efficiency combined with close relationships between banks and industrial
firms, they hypothesize, spurred Germany’s rapid development at the end of the nineteenth
century and again in the post-World War II reconstruction. A corollary to this view holds that
countries that failed to adopt the universal-relationship system suffered as a consequence.
Adherents suggest that British industry has declined over the past hundred years or more, and
that the American economy has failed to reach its full potential, due to short-comings of the
financial system that lead to relatively high costs of capital.

In Indian context, the phenomenon of universal banking, as different from narrow banking,
has been in the news in the recently. With the last Narasimham Committee and the Khan
Committee reports recommending consolidation of the banking industry through mergers and
integration of financial activities, the stage seems to be set for a debate on the entire issue.
A universal bank is a one-stop supplier for all financial products and activities, like deposits,
short-term and long-term loans, insurance, investment banking etc. Global experience with
universal banking has been varied. Universal banking has been prevalent in different forms in
many European countries, such as Germany, Switzerland, France, Italy etc. For example, in
these countries, commercial banks have been selling insurance products, which have been

45
referred to as Banc assurance or Allfinanz. After the stock market crash of 1929 and banking
crisis of the 1930s, the US banned all forms of universal banking through what is known as
the Glass-Steagall Act of 1933. This prohibited commercial banks from investment banking
activities, taking equity positions in borrowing firms, selling insurance products etc. The idea
was to mitigate risky behaviour by restricting commercial banks to their traditional activity of
accepting deposits and lending. Research on the effects of universal banking has been
inconclusive as there is no clear-cut evidence in favour of or against it anywhere.

Nevertheless, the United States has once again started moving cautiously towards universal
banking through the Gramm-Leach-Bliley Act of 1999 which rolled back many of the earlier
restrictions. Some recent phenomenon, like the merger between Citicorp (banking group) and
Travelers (insurance group) confirmed the fact that universal banking is here to stay. Hence it
becomes all the more imperative to know whether we need universal banks in India and
whether it is a more efficient concept than the traditional narrow banking. The standard
argument given everywhere in favour of universal banking is that it enables banks to exploit
economies of scale and scope. What it means is that a bank can reduce average costs and
thereby improve spreads if it expands its scale of operations and diversifies its activities. By
diversifying, the bank can use its existing expertise in one type of financial service in
providing the other types. So, it entails less cost in performing all the functions by one entity
instead of separate specialized bodies. A bank possesses information on the risk
characteristics of its clients, which it can use to pursue other activities with the same clients.
This again saves cost compared to the case of different entities catering to the different needs
of the same clients. A bank has an existing network of branches, which can act as shops for
selling products like insurance. This way a big bank can reach the remotest client without
having to take recourse to an agent. Many financial services are inter-linked activities, e.g.
insurance and lending. A bank can use its instruments in one activity to exploit the other, e.g.,
in the case of project lending to the same firm which has purchased insurance from the bank.

Now, let us turn to the benefits accruing to the customers. The idea of one-stop-shopping
saves a lot of transaction costs and increases the speed of economic activity. Another
manifestation of universal banking is a bank holding stakes in a firm. A bank’s equity holding
in a borrower firm acts as a signal for other investors on the health of the firm, since the
lending bank is in a better position to monitor the firm’s activities. This is useful from the
investors point of view. Of course, all these benefits have to be weighed out against the

46
problems. The obvious drawback is that universal banking leads to a loss in economies of
specialization. Then there is the problem of the bank indulging in too many risky activities.

To account for this, appropriate regulation can be devised, which will ultimately benefit all
the participants in the market, including the banks themselves. In spite of the associated
problems, there seems to be a lot of interest expressed by banks and financial institutions in
universal banking. In India, too, a lot of opportunities are there to be exploited. Banks,
especially the financial institutions, are aware of it. And most of the groups have plans to
diversify in a big way. Even though there might not be profits forthcoming in the short run
due to the switching costs incurred in moving to a new business. The long-run prospects,
however, are very encouraging. At present, only an arms-length relationship between a bank
and an insurance entity has been allowed by the regulatory authority, i.e. the Insurance
Regulatory and Development Authority (IRDA). This means that commercial banks can enter
insurance business either by acting as agents or by setting up joint ventures with insurance
companies. And the RBI allows banks to only marginally invest in equity (5 per cent of their
outstanding credit). Development financial institutions (DFIs) can turn themselves into banks,
but have to adhere to the statutory liquidity ratio and cash reserve requirements meant for
banks. Even then, some groups like the HDFC (commercial banking and insurance joint
venture with Standard Assurance), ICICI (commercial banking), SBI investment banking)
etc., have already started diversifying from their traditional activities through setting up
subsidiaries and joint ventures. In a recent move, the Life Insurance Corporation increased its
stakes in Corporation Bank and is planning to sell insurance to the customers of the Bank.
Corporation Bank itself has been planning to set up an insurance subsidiary since a long time.
Even a specialized DFI, like IIBI, is now talking of turning into a universal bank. All these
can be seen as steps towards an ultimate culmination of financial intermediation in India into
universal banking.

47
METHODOLOGY

Data were colleted using questionnaires through personal interviews. Indian citizens
constituted the population. Convenience sampling method was used to select the respondents.
70 respondents from various regions in Delhi, Faridabad & Noida having sound banking
knowledge were interviewed. The questionnaire includes various dimensions related to
attractiveness of universal banking, its influence on customer’s product choice behaviour,
advantages of universal banking, the most suitable model and service provider in India which
can readily be converted into Universal Bank.

48
RESULTS AND DISCUSSION:

As the countries of Western Europe and other areas of the world move increasingly toward
universal banking, it is a useful time for India to examine how these institutions might affect
financial stability, economic development, and other financial institutions, concentration of
political and economic power, consumer choice, and conflicts of interest. Thus, through the
following research, I try to examine some of these parameters.

As per the responses of the respondents, the following results could be interpreted.

• Are you aware about the concept of UNIVERSAL BANKING

Yes No

80

70
Total no. of respondents

60

50

40 Series1
70
30

20

10

0 0
yes no

Since, I only approached those respondents who are aware about the concept of Universal
Banking. Therefore, the following stats show that everyone whom I approached replied in
affirmative.

49
Dimension 1: Attractiveness of Universal Banking to potential customers

Ques 1. Concept of Universal Banking attracts me

60

50
Total no. of respondents

40

30 57 Series1

20

10
8 5
0 0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Thus, the above chart shows majority of respondents agree to the point that they are attracted
towards the concept of Universal Banking. And none of the respondents disagree with the
point that universal banking tends to be an attractive concept for them.

Ques 2. The concept can become very popular in India.

35

30
Total no. of respondents

25

20
Series1
15 32

10 19

5 12
5
0 2
Strongly Agree Agree Uncertain Disagree Strongly
Disagree
Thus, the above result shows that the majority of people agree that concept, if implemented in
India, can become very popular in India. Only few disagree with the following result.

50
Ques 3. Availability of all products information under one roof can make me pay more
attention to product details

40

35
Total no. of respondents

30

25

20 Series1
36
15

10 20

5
7 7
0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Hence, above result can be examined in the respect that concept of ‘all products under one
roof’ can help people examine and analyse the product details with greater attention.

51
Dimension 2: Influence of Universal Banking on customer’s product choice behaviour

Ques1. Idea of ‘one stop shopping’ may help me to make my investing and financing
decisions more wisely.

45
40
Total no. of respondents

35
30
25
Series1
20 40
15
10
16
5 8 6
0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Thus, the above result shows that majority of the respondents agree to the point that the idea
of ‘one stop shopping’ can help them make their investing and financing decisions more
wisely by availing more information about product attributes.

Ques 2. Availability of all products under one roof can help me remember the products with
their details

40
35
30
25
20 Series1
36
15
10
16
5 10
6
0 2
Strongly Agree Agree Uncertain Disagree Strongly
Disagree
Total no. of respondents

52
Majority of the respondents feel that availability of all products under one roof can help them
remember much about the product and its details and thus can prove to be beneficial in
planning their financing activities. Very few are uncertain about the benefits they can avail
through the above concept.

Ques 3. Universal Banking may increase acceptance of endorsed products.

40

35
Total no. of respondents

30

25

20 Series1
37
15

10
12 13
5 8
0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree
Thus, the above result shows that the large number of respondents believe that the availability
of greater degree of information with much ease can increase their acceptance of products
being endorsed.

Ques 4. Universal Banking can enhance my awareness of available products

53
 40

35
Total no. of respondents

30

25

20 Series1
36
15

10 19
13
5

0 2 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Thus the above stats shows, that the concept of all products under one roof can enhance the
awareness of the customers regarding products, its attributes and various other products being
offered by the service provider.

Dimension: 3 Advantages of universal Banking

1. Economies of Scale to bank

54
 60

50
Total no. of respondents

40

30 Series1
48
20

10 16
6
0 0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Majority of respondents agree that Universal Banking results in greater economic

efficiency in the form of lower cost, higher output and better products.

2. Profitable Diversions

50
45
Total no. of respondents

40
35
30
25 Series1
44
20
15
10
14
5 10
0 2 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

The above result shows that 54 out of 70 respondents agree or strongly agree to the point that
by diversifying its activities bank can utilise its existing expertise in one type of financial
products for providing financial services in other type.

3. Resource Utilization

55
 35

30
Total no. of respondents

25

20
Series1
15 30 32

10

5 8
0 0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Approximately, all of the respondents being approached agree that Universal Banking can
help the bank in effective utilisation of their resource. A bank, possessing the information on
the risk characteristics of the clients, can utilize it to pursue other activities with the same
clients.

4. Easy Marketing on the Foundation of a Brand Name

45
40
Total no. of respondents

35
30
25
42 Series1
20
15
23
10
5
5
0 0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

A large number of respondents agree or strongly agree that Universal Banking concept can
help bank in easy marketing of their products as bank’s existing branch can act as a shop for
selling financial products, acting as a parent company or source, without requiring to spend

56
much effort on marketing. None of the respondents being approached disagree with the above
mentioned advantage.

5. One-stop shopping

45
40
Total no. of respondents

35
30
25
Series1
20 41

15
23
10
5
6
0 0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Respondents agree to the point that the concept of ‘one-stop shopping’ can act as an
advantage both to the banks as well as customers as it can save lot of transaction cost and
speed up the economic activities.

6. Investor Friendly Activities

57
 35

30
Total no. of respondents

25

20
Series1
15 31

10 19
16
5
4
0 0
Strongly Agree Agree Uncertain Disagree Strongly
Disagree

Majority of respondent agree that availability of greater details about the product can help
them in making their investing decisions more wisely. Only few disagree with the above
stated advantage.

Dimension 4: Applicability of Model

Acceptance of models

18%

German
England
US
55%
27%

The above results shows that the acceptance of German banking system over others by Indian
customers. Thus the Indian service provider who wants to bring in Universal Banking, are
recommended to implement the system in line with German Universal Banking system for
achieving greater acceptability.

58
Dimension 5: Service provide which can readily be converted into Universal Bank

Service providers

10%
6%
40% ICICI
IDBI
SBI
HDFC
LIC
32%

12%

Thus, the above results shows that the ICICI bank has been voted by the respondents as the
most favoured service provider for Universal Banking services, closely followed by largest
public sector bank, SBI.

59
In addition to above results, to determine the applicability of Universal Banking model
in India, answers to following questions was also found out:

1.Do Universal Banks Increase the Risk of Financial Instability?

Universal banks tend to be large, so large that failure of even one such bank could bring the
entire system down or at least cause substantial distress. In addition, universal banks are said
to be particularly vulnerable, because of their close ties to business, particularly their role in
underwriting and distributing securities.

In this scenario, universal banking might result in a variety of negative consequences for the
economy. If one or several universal banks were to collapse, it might lead to a systematic
financial crisis, possibly including a risk to the economy's payments system. There is concern
that universal banks would be more difficult to regulate, because their ties to business would
be more complex. Furthermore, these banks' officers would realize that their banks were too
big to be allowed to fail. Hence, they might succumb to the temptation of taking excessive
risks. Government regulators, recognizing this threat, would either have to regulate universal
banks very tightly, thus hindering economic efficiency, or be faced with the possibility of a
taxpayer bailout.
However, the claim that universal banks are more risky than specialized banks, while
plausible in some ways, is not borne out by experience. Most recently, specialized U.S.
savings and loans failed in large numbers because their assets, liabilities, and operations were
not well diversified. This $150 billion-plus disaster is due largely to the fact that these
institutions specialized in fixed-interest long-term mortgages funded with short-term savings,

60
blend that took them into deep trouble when interest rates rose rapidly over the period of
1979-81. These risks are exacerbated by the U.S. prohibition against nationwide branching,
which has made depository institutions vulnerable to unexpected declines in natural resource
and farm-product prices, along with changes in regional real estate values.

Indeed, all except ten of the over 9,000 banks that failed during the Great Depression were
unit (single office) banks, most of which were located in small towns. In addition, specialized
depository institutions have been affected adversely by shifts in consumer preferences and
advances in technology. In contrast to the fragility of many specialized banks, failures among
the much better diversified universal banks are almost unknown. Even if, in a worst-case
scenario, several very large universal financial firms failed, it need not cause a failure of the
financial system. If the Federal Reserve maintains the money supply, there is no reason for
the financial system to collapse, even though some banks or other financial firms fail. In fact,
if the government wants to conduct economic policy through control of bank loans, such
control is likely to be more effective if relatively fewer firms made the loans. For this
purpose, specialized banking presents the government with a greater problem than universal
banking.
Neither theory nor evidence support the assumption that limitations on banking—like the
separation of commercial and investment banking—either were or are likely to be effective in
reducing risk-taking. Most of the activities in which universal banks engage are no more
risky than ordinary commercial bank activities. Empirical evidence on the combined risks of
various activities can be obtained from past experience and simulations. As noted above,
commercial banks that engaged in investment banking before passage of the Glass-Steagall
Act experienced relatively few failures. The expected effect of combining commercial and
investment banking on risks has been much studied. Most of commercial banks can take
interest rate risk with options and futures, by holding duration-unbalanced portfolios, and by
making loans that bear both high risk and promised fees and interest. Although, compared to
commercial banking alone, returns from combined commercial and investment banking (and
other activities, such as mortgage banking, insurance, and real estate investment) would be
significantly higher, and risk would be slightly higher.

In short, both theory and evidence support the expectation that risks are more likely to be
reduced than increased should banks be permitted to engage in securities, insurance, and
other products and services. Any remaining concerns about the failure of large depository

61
institutions should be dealt with not by restricting the size or scope of banks (whether
universal or specialized), but by allowing greater diversification, higher required levels of
capital, and explicit rules forcing banks to replace lost capital or be resolved (liquidated, sold
or merged) by the authorities before their economic (rather than book) capital falls below
zero.
2. Do Universal or Specialized Banks Enhance Economic Development More?
Some legislators and government officials believe that they can enhance economic
development by directing resources towards specific goals. Although subsidies could be
granted directly, governments often establish specialized institutions for this purpose. For
example, savings and loan associations are encouraged to make home mortgages to help the
home building. Some specialized lenders are created to avoid laws that legislators do not
want to repeal (for example, consumer finance companies were established as legal
exceptions to usury laws). Specialized institutions also allow the government to conceal
subsidies by allocating funds and other resources at less-than-market rates for distribution to
favored borrowers. But, the government never can be sure that borrowers will use loans as the
government wants. For example, home-buyers who receive mortgages at subsidized rates can
make smaller down-payments and use the funds saved to buy other assets, such as securities
or automobiles. Hence, a policy of directing resources towards specific ends is not likely to
be successful.

3. Will Universal Banks Deploy Capital as Efficiently as the Stock Market?

A key function of financial markets is to deploy capital as efficiently as possible. Economists
have long praised stock markets for fulfilling this role. Critics of universal banking worry that
such institutions will injure stock markets, because when universal banks trade and hold
equity securities, they are sometimes said to discourage the development of an active stock
exchange and independent stock brokers and dealers. One essential issue, then, is the role of
the stock market versus universal banks in facilitating the efficient deployment of corporate
resources.
However, the evidence that universal banks reduce stock market activity is actually quite
weak. In addition, without disparaging the importance of the stock market in monitoring
firms, there is good reason to believe that universal banks also have some strength in this
regard. Universal banks also have certain advantages in restructuring firms. The transactions
cost of takeovers and mergers are high in a stock market system. and might well be lower
with a universal bank If, instead [of being restricted to loans], a bank were to own the full

62
range of classes of both the firm's debt and equity, the bank could gain the control necessary
to effect reorganization much more economically. The covenants of the loans and other
liabilities can be designed to give the bank progressively greater authority to intercede in the
management of the firm as dividend and interest payment performance deteriorates.
Moreover, because the debt holder is also the equity holder, there are no conflicts between
holders of debt and equity securities to impede a needed reorganization. The result would be
fewer agency problems, lower costs in "work-outs" of financial problems, and a resultant
increase in organizational efficiency.

4. Will Universal Banks Crowd Out Other Financial Institutions?

Opponents of universal banks expect them to be large, bureaucratic and inflexible; hence,
they fear that such banks would tend to work primarily with large, established customers and
ignore or discourage smaller and newly formed businesses. Moreover, the indictment
continues, universal banks could use such tactics as limit pricing or predatory pricing (Limit
pricing refers to the strategy whereby prices are lowered to the point where entrants cannot
expect to offset the costs of entry with sufficient revenue. With predatory pricing, prices are
reduced to below competitors' marginal costs, until the competitors are driven out of
business, at which point the existing institution can exploit its monopoly position if it can
restrain reentry) to prevent smaller specialized banks from serving that market. These
problems will be especially salient if universal banks are more efficient, perhaps because of
economies of scale or scope, or for other reasons.

Economies of scale and scope and efficiency indicate some advantage for universal banks
over specialized banks. However, considering that specialized banks are able to survive in
direct competition with universal banks (and vice versa), it does not appear that the efficiency
advantages of either form of banking are overwhelming. Data on the performance and growth
of banking in countries that have universal or specialized banking are so difficult to interpret
that not much can be concluded about the "revealed" efficiency of either banking
organization.

5. Will Universal Banks Reduce Consumer Choice?

Some critics fear that if universal banks were to dominate financial markets, there would he
fewer independent organizations and less choice for a more extensive discussion. Supporters

63
of universal banking argue against this scenario on two grounds. First, as noted above, the
German experience indicates that universal banking does not result in a few firms dominating
the market or the exclusion of other financial services firms. This situation is consistent with
the premise that universal banks have neither significant economies of scale or scope nor
great political power. Second, even if universal banks were to dominate financial markets,
consumers could still patronize one bank for loans, another for underwriting, and a third for
securities trading. Consequently, consumers' choices would not necessarily decline.

6. Can Universal Banks Give Impartial Investment Advice?

Having discussed the risk of tie-in sales, and the risk that universal banks might dominate the
financial or nonfinancial sector, one additional form of possible abuse remains: the fear that
universal banks will not advise their clients objectively on securities. The generic answer to
such problems is that if a banker is inclined to such conflicts of interest (and doesn't care
about the bank's reputation) and customers are blind to the possibilities, then such conflicts
can occur as easily under specialized as well as universal banking. Furthermore, many of the
possible conflicts specified either do not disadvantage consumers or would occur only if the
bank were operated contrary to the interests of its shareholders.

64
FINDINGS

After considering issues of financial stability, economic development, competition among

financial institutions, concentration of economic and political power, consumer choice, and
conflicts of interest, I find that universal banking can provide considerable benefits and
would pose few problems for the economy. It does not follow, though, that specialized
providers of financial services should not or would not also exist. Experience and logic
indicate that these companies can do many things better than can universal banks. In
particular, specialized firms are more likely to handle many important aspects of investment
banking. Takeovers, leveraged buyouts, mergers, spin-offs, and other capital restructurings
often must be completed quickly and imaginatively. Commercial banks, which tend to be
bureaucratically organized, often are not well-suited to this kind of activity. Furthermore,
companies not designated as "banks" and individuals provide a wide range and considerable
volume of financial services in countries characterized by universal or by specialized
banking. Thus, the adoption of universal banking is unlikely to result in these banks
dominating financial services.

There is room for disagreement over what form of universal banking makes the most sense
for India. The above research results in Germany making a most suitable model for India.
However, either approach would generate significant advantages over our present system of
specialized banking. We agree that the Glass-Steagall Act's separation of commercial and
investment banking and the Bank Holding Company Act's and other legislative restrictions
against banks offering a full range of financial services should be repealed. Restricting banks'

65
securities activities was either a misguided reaction to the financial crisis of the 1930s or a
means of enhancing the position of investment bankers (or punishing banks) at the expense of
the general public (Benston, 1990). The fact that the restrictions have not been repealed is
evidence of the power of well-focused suppliers to maintain their legal advantage over poorly
organized competitors and consumers.

Considerations

Though, the above research results in Universal Banking being beneficial for India customers
offering various advantages, still, caution must be applied in implementing Universal banking
because of the following considerations:

1. Dis-intermediation (i.e. replacement of traditional bank intermediation between savers and

borrowers by a capital market process) is only a decade old in India and has badly slowed
down due to loss of investors' confidence.

2. There is an ample room for financial deepening (by banks & DFIs) since loan market will
continue to grow.

3. DFIs as a folder of equity in most of the projects promoted in the past have never used the
tool advantageously.

4. DFIs are now only moving into working capital finance, an area in which they need to gain
lot of expertise and this involves creation of network of services (including branches) in all
fields like remittances, collections etc.

5. Reforms in the Indian capital market are still in the half way stage. The priority will be to
ensure branch expansions, financial deepening of credit markets, and creation of an efficient
credit delivery mechanism that can compete with the capital market.

66
Recommendations

The following are the steps suggested for successful implementation of Universal Banking in
India:

a. Equalise the net regulatory burden across the financial system (including banks, DFIs,
mutual funds, NBFCs and Insurance companies).

b. Lower the regulatory burden on the over regulated entities.

c. Promote and encourage strong competition.

d. Do not allow the merger of a weak bank with a viably strong DFI or vice-versa.

e. DFIs should be permitted to set up a 100 percent owned banking subsidiaries.

f. Need is felt to re-examine the minimum level of SLR requirement in order to meet the best
of international standards.

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CONCLUSION:

Finance has very close ties with most people. Numerous financial products and services have
penetrated our lives. The globe is ever-changing and financial products and services have to
keep up with the pace of people’s demand. Banks, which assume a leading position in most
financial systems, have to be prepared for the growing need of their customers. In some
countries, universal banks, which offer a wide range of financial services, have proved
responsive to customer demand and helpful in facilitating economic developments.

India’s financial sector is relatively bank-oriented, and banks are the primary supplier of
financial services. With the regulatory allowance for universal banking, Indian banks
continue to expand its coverage of financial services in response to customer demand and
profitability concerns. In countries with universal banking system, banks usually serve as an
important source of external finance for enterprises.

India’s banking sector follows closely the global trend of financial developments. It is
believed that the concept of financial supermarkets could play a significant role in future
given that an increasing number of transnational companies have been set up in the region
and also by the opening of Indian Banking sector to foreign players.

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 BIBLIOGRAPHY

 www.banknetindia.com/banking/ubfeature.htm Universal Banking: introduction, RBI

rules and regulations, Universal Banking in India
 www.answers.com/topic/universal-banking: Universal Banking: definition
 ‘The Universal Banking’: introduction, concept, pros and cons. Journal of
Professional Banker, October 2006 pg 24-27
 "Universal Banking by DFIs: Handy But no solution to NPAs" "Sanjiv
Sbankaran" “Business Line"

 "Approach to Universal Banking" www.banknetindia.com

 "Banking in the New Millennium" "M. Guruprasad" (Asst. Prof in Economics)

 "Universal Banking: the Road Ahead" Kamal Sehgal (IIFT) www.

Indiainfoline.com

 "Universal Banking – The Indian Perspective" Chaitnya Krishna V.

 "Consolidation of Indian Banks – challenges" BNV Parthasarathi "Professional

Banker" (The ICFAI University Press)

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ANNEXURE

QUESTIONNAIRE
Objective:
To study the potential of universal Banking for Indian market consumers
CONCEPT: Universal Banking is a superstore for financial products under one roof. It is a
multi-purpose and multi-functional financial supermarket (a company offering a wide range
of financial services e.g. stock, insurance and real-estate brokerage) providing both banking
and financial services through a single window.

Instructions:

Questionnaire consists of three dimensions. Please tick the appropriate level of

agreement/disagreement in front of each question.

This research is for academic purpose. All information provides will remain strictly
confidential, will not be disclosed in any form to any organization and will be used only
for fulfilling research objective.

• Are you aware about the concept of UNIVERSAL BANKING

Yes No

If yes, answer the questions under following dimensions:

Dimension 1: Attractiveness of Universal Banking to potential customers

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Statements Strongly Strongly
Agree Uncertain Disagree
Agree Disagree

Concept of Universal Banking attracts

me

The concept can become very popular

in India

Availability of all products

information under one roof can make
me pay more attention to product
details

Dimension 2: Influence of Universal Banking on customer’s product choice behaviour

Statement Strongly Strongly

Agree Uncertain Disagree
Agree Disagree

Idea of ‘one stop shopping’ may

help me to make my investing and
financing decisions more wisely.

Availability of all products under

one roof can help me remember
the products with their details

Universal Banking may increase

acceptance of endorsed products.

Universal Banking can enhance

my awareness of available
products.

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Dimension 3: Advantages of universal Banking

Strongly Strongly
No. Parameters Agree Uncertain Disagree
Agree Disagree

1. Economies of Scale to bank

2. Profitable Diversions

3. Resource Utilization

Easy Marketing on the Foundation of a

4.
Brand Name

5. One-stop shopping

6. Investor Friendly Activities

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Dimension 4: Applicability of Model
Amongst the three, two different model should not be voted on the same level of
applicability.
Highly
No. Model more suitable for India Applicable Inapplicable
Applicable

Germans Model, where commercial

banks accept time deposits, lends
1. money, underwrite corporate stocks,
and act as investment advisors to
large corporations.

England Model, where securities and

2. other such activities are conducted in

separately capitalized subsidiaries of
banks.
United States model, where there is
3. separation between commercial banks
and investment banks

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Dimension 5: Service provide which can readily be converted into Universal Bank
Amongst the five listed, two different service providers should not be voted at the same level
of agreement/disagreement.

Strongly Strongly
No. Name of service providers Agree Uncertain Disagree
Agree Disagree

1 ICICI

2 IDBI

3 SBI

4 HDFC

5 LIC

Name:
Age:
Occupation:
Contact Number:

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