030-Heart Maniar-The Indian Banking Industry

8/6/2019 030-Heart Maniar-The Indian Banking Industry

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The Indian Banking IndustryTABLE

Topic Page

EVOLUTION OF BANKING 4

PRE-INDEPENDENCE (1786-1947) 4POST-INDEPENDENCE 5STRUCTURE OF THE BANKING SECTOR 8PUBLIC SECTOR BANKS 9PRIVATE SECTOR BANKS 10FOREIGN BANKS 12CONCENTRATION IN THE BANKING SECTOR 13SECTORAL TRENDS IN CREDIT DEPLOYMENT 15BANKING SECTOR REFORMS 21ASSETS AND LIABILITIES STRUCTURE OF SCBS 22LIABILITIES 27

ASSETS 28STRUCTURAL REFORMS 32IMPACT OF REFORMS ON BANKS 35PROFITS 35CAPITAL ADEQUACY 36DEPOSIT GROWTH 37ASSET QUALITY AND NON-PERFORMING LOANS 37BANKING INDUSTRY PERFORMANCE 39INCOME 40YIELDS 44INTEREST COST 48

SPREADS 50INTERMEDIATION COSTS 52PROFITABILITY 56RETURN ON ASSETS 57CAPITAL ADEQUACY 60ASSET QUALITY 63COMPETITION FROM OTHER INSTITUTIONAL INTERMEDIARIES 70FINANCIAL INSTITUTIONS 70NON-BANKING FINANCE COMPANIES 77MUTUAL FUNDS 80FINANCIAL DISINTERMEDIATION 82

DOMESTIC TRENDS 86MERGERS 86CONSUMER BANKING 88INTERNET BANKING 88ANNEXURE: KEY INDICATORS OF INDIAN SCBS 89CONTENTS


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Introduction

In India, given the relatively underdeveloped capital market and with little internal

resources, firms and economic entities depend, largely, on financial intermediaries to

meet their fund requirements. In terms of supply of credit, financial intermediaries can

broadly be categorised as institutional and non -institutional. The major institutional

suppliers of credit in India are banks and non -bank financial institutions (that is,

development financial institutions or DFIs), other financial institutions (FIs), and non-

banking finance companies (NBFCs). The non-institutional or unorganised sources of

credit include indigenous bankers and money-lenders. Information about the unorganised

sector is limited and not readily available. An important feature of the credit market is its

term structure: (a) short-term credit; (b) medium-term credit; and (c) long-term credit.

While banks and NBFCs predominantly cater for short-term needs1, FIs provide mostly

medium and long-term funds.


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EVOLUTION OF BANKING

Pre-Independence (1786-1947)

The evolution of the modern commercial banking industry in India can be traced to

1786 with the establishment of Bank of Bengal in Calcutta (now Kolkata).

Subsequently, three Presidency Banks were set upat Calcutta in 1806, Bombay

(now Mumbai) in 1840, and Madras (now Chennai) in 1843. In 1860, the concept

of limited liability was introduced in banking, resulting in the establishment of a

number of joint sector banks. The early 1900s led to the establishment of a number

of indigenous joint stock banks, such as the Bank of India, Bank of Baroda, and the

Central Bank of India.

In 1921, the three Presidency Banks were amalgamated to form the Imperial Bank

of India (IBI). This new bank took on the triple role of a commercial bank, a

banker's bank and a banker to the government. The establishment of the Reserve

Bank of India (RBI) as the central bank of the country in 1935 ended the quasi-

central banking role of the IBI. It ceased to be banker to the Government of India

(GoI) and instead became agent of the RBI for the transaction of government

business at centres at which RBI was not established. IBI also acted as a bankers'bank by holding their surplus.


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Post-Independence

India inherited a weak financial system after Independence in 1947. At end-1947,

there were 625 commercial banks in India, with an asset base of Rs. 11.51 billion.

Commercial banks mobilised household savings through demand and term

deposits, and disbursed credit primarily to large corporations. Following

Independence, the development of rural India was given the highest priority. The

commercial banks of the country including the IBI had till then confined their

operations to the urban sector and were not equipped to respond to the emergent

needs of economic regeneration of the rural areas. In order to serve the economy in

general and the rural sector in particular, the All India Rural Credit Survey

Committee recommended the creation of a state-partnered and state-sponsored

bank by taking over the IBI, and integrating with it, the former state-owned or

state-associate banks. Accordingly, an act was passed in Parliament in May 1955,

and the State Bank of India (SBI) was constituted on July1, 1955. More than a

quarter of the resources of the Indian banking system thus passed under the direct

control of the State. Subsequently in 1959, the State Bank of India (Subsidiary

Bank) Act was passed (SBI Act), enabling the SBI to take over 8 former State-

associate banks as its subsidiaries (later named Associates).

The GoI also felt the need to bring about wider diffusion of banking facilities and

to change the uneven distribution of bank lending. The proportion of credit going

to industry and trade increased from a high 83% in 1951 to 90% in 1968. This

increase was at the expense of some crucial segment of the economy like

agriculture and the small-scale industrial sector. Bank failures and mergers resulted

in a decline in number of banks from 648 (including 97 scheduled commercial

banks or SCBs and 551 non -SCBs) in 1947 to 89 in 1969 (compr ising 73 SCBsand 16 non -SCBs). The lop-sided pattern of credit disbursal, and perhaps the spate

of bank failures during the sixties, forced the government to resort to

nationalisation of banks. In July 1969, the GoI nationalised 14 scheduled

commercial banks (SCBs), each having minimum aggregate deposits of Rs. 500

million. State-control was considered as a necessary catalyst for economic growth


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and ensuring an even distribution of banking facilities. Subsequently, in 1980, the

GoI nationalised another 6 banks2, each having deposits of Rs. 2,000 million and

above.

The nationalisation of banks was the culmination of pressures to use the banks as

public instruments of development. The GoI imposed `social control on banks, of

which priority sector lending was a major aspect. It introduced restrictions on

advances by banking companies. These were intended to ensure that bank advances

were confined not only to large-scale industries and big business houses, but were

also directed, in due proportion, to other important sectors like agriculture, small-

scale industries and exports.

Since 1969, there has been a significant spread of the banking habit in the economy

and banks have been able to mobilise a large amount of savings. While the number

of bank offices has increased from 8,262 in June 1969 to 68,561 in March 2003,

average population per office has declined from 64,000 to 16,000. While aggregate

deposits of commercial banks have increased from Rs. 46.46 billion in June 1969

to Rs. 12,809 billion in March 2003 (Rs. 15,019 billion at end-March 2004), credit

has also increased from Rs. 35.99 billion to Rs. 7,292 billion (Rs. 8,354 billion at

end-March 2004). The 1969 nationalisation had raised public sector banks (PSBs)

share of deposit from 31% to 86%, while the nationalisation of 1980 raised the

same to 92%.

However, by the 1980s, it was generally perceived that the operational efficiency

of banks was declining. Banks were characterised by low profitability, high and

growing nonperforming assets (NPAs), and low capital base. Average returns on

assets were only around 0.15% in the second half of the 1980s, and capital

aggregated an estimated 1.5% of assets. Poor internal controls and the lack of

proper disclosure norms led to many problems being kept under cover. The quality

of customer service did not keep pace with the increasing expectations.

In 1991, a fresh era in Indian banking began, with the introduction of banking

sector reforms as part of the overall economic liberalisation in India.


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STRUCTURE OF THE BANKING SECTOR

The banking sector in India functions under the umbrella of the RBIthe

regulatory, central bank. The Reserve Bank of India Act was passed in 1934 andthe RBI was constituted in 1935 as the apex bank. The Banking Regulations Act

was passed in 1949. This Act brought the RBI under government control. Under

the Act, the RBI received wide-ranging powers in

regards to establishment of new banks, mergers and amalgamations of banks,

opening and closing of branches of banks, maintaining certain standards of banking

business, inspection of banks, etc. The Act also vested licensing powers and the

authority to conduct inspections with the RBI.

Banks in India can broadly be classified as regional rural banks or RRBs,

scheduled commercial banks or SCBs, and co-operative banks. The scope of the

present comment includes the SCBs only.

The SCBs for the purpose of this comment can be classified into the following

three categories:

Public sector banks or PSBs (SBI & its associates, and nationalised banks);

Private sector banks (old and new); and

Foreign banks.

ABLE OF CONTENTS

CREDIT MARKET STRUCTURE

In India, given the relatively underdeveloped capital market and with little internal

resources, firms and economic entities depend, largely, on financial intermediaries

to meet their fund requirements. In terms of supply of credit, financial


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intermediaries can broadly be categorised as institutional and non -institutional.

The major institutional suppliers of credit in India are banks and non -bank

financial institutions (that is, development financial institutions or DFIs), other

financial institutions (FIs), and non-banking finance companies (NBFCs). The non-

institutional or unorganised sources of credit include indigenous bankers and

money-lenders. Information about the unorganised sector is limited and not readily

available. An important feature of the credit market is its term structure: (a) short-

term credit; (b) medium-term credit; and (c) long-term credit. While banks and

NBFCs predominantly cater for short-term needs1, FIs provide mostly medium and

long-term funds.

Structure of Indian Banking Industry at end-March 2003 (end-FY2003)

At end-FY2003, these SCBs had a network of 53,882 offices, and total assets

worth Rs. 16,989 billion, making them the most active and dominant financial

intermediaries in the country.

Public Sector BanksThe banking sector in India has been characterised by the predominance of PSBs.

The PSBs had 47,677 offices (SBI & associates: 13,735; nationalised banks:

33,942) at end-FY2003, and their assets of Rs. 12,852 billion at end-FY2003

accounted for 75.7% of assets of all SCBs in India. An estimated 63.4% of the

offices of PSBs at end-FY2003 were in these areas: rural/semi-urban.

The PSBs large network of branches enables them to fund themselves out of low-


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cost deposits. At end-FY2003, PSBs accounted for 75.7% of assets, 79.6% of

deposits, 74.2% of advances, 74.5% of income, and 88.7% of offices of all SCBs in

India, thus clearly demonstrating their dominance of the Indian banking sector.

However, PSBs have suffered a gradual loss of market share, mainly to new private

sector banks. PSBs accounted for 80% of asset growth of SCBs during FY2003,

compared with 51.9% during FY2002, and 75.3% during FY20014.

Select IndicatorsPSBs

End-FY2003

(Courtesy: Reuters

SBI is the largest PSB, and also the largest SCB in India. At end-FY2003, SBI

accounted for 22.1% of the aggregate assets of all SCBs in India. Further, five out

of the six largest SCBs in India are PSBs (refer Table below). The below

mentioned six SCBs accounted for 47.3% of assets of all SCBs in India at end-FY2003.

Major SCBs in India at end-FY2003

A

ICICI Bank is a new private sector bankCourtesy: Reuters

Private Sector Banks

As of end-FY2003, there were 30 private sector banks operating in India through

5,879 offices. These can further be classified as old (OPBs) and new private sector


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banks (NPBs). At end-FY2003, there were 21 OPSBs operating in the country.

These banks had an estimated 4,737 offices at end-FY2003, are regional in

character and, except for a few, have a comparatively small balance sheet size.

In July 1993, as part of the banking sector reform process and as a measure to

induce competition in the banking sector, the RBI permitted entry by the private

sector into the banking system. This resulted in the introduction of 9 private sector

banks. These banks are collectively known as the `new private sector banks

(NPBs), and operated through an estimated 988 branches at end-FY2002. With the

merger of Times Bank Limited into HDFC Bank Limited in February 2000, and

the entry of Kotak Mahindra Bank Limited (KMBL) during March 2003, there are

nine NPBs in India at present.

Select IndicatorsPrivate Sector Banks

Courtesy: Reuters

At end-FY2003, the total assets of private sector banks aggregated Rs. 2,973

billion and accounted for 17.5% of the total assets of all SCBs. Although the share

of private sector banks in total assets has increased from 12.6% at end-FY2001,

most of the gain has been accounted for by NPBs. The share of NPBs in the share

of assets of all private sector banks increased from 27.5% at end-FY1997 (2.4% of

assets of SCBs) to 64.6% at end-FY2003 (11.3% of assets of SCBs). By contrast,

the share of OPBs banks (in total assets of SCBs) has declined from 6.4% at end-

FY1997 to 6.2% at end-FY2003; their share of assets of private sector banks has

declined from 72.5% at end-FY1997 to 35.4% at end-FY2003. At end- FY2003,

three (ICICI Bank, HDFC Bank, and UTI Bank) of the five largest private sector

banks (by asset size) were NPBs (refer Table below). The five largest private

sector banks controlled 62.5% of assets of all private sector banks at end-FY2003.


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Major Private Sector Banks in India at end-FY2003

(Rs. billion)

Courtesy: Reuters

Foreign Banks

At end-FY2003, 36 foreign banks were operating in India through 208 offices. All

offices of foreign banks were in urban and metropolitan areas. At end-FY2003, the

total assets of foreign banks aggregated Rs. 1,164 billion and accounted for 6.9%

of the total assets of all SCBs (refer Table below). In recent years, because of

closures and increased competition from NPBs, the share of foreign banks in

aggregate assets of SCBs has declined from 8.1% at end- FY1999.

Select IndicatorsForeign BanksEnd-FY2003(

Courtesy: Reuters CBs

The biggest foreign bank in India by asset size is Standard Chartered Bank,

followed by Citibank, and the Hongkong & Shanghai Banking Corporation

(HSBC) (refer Table below). As of end-FY2003, the five largest foreign banks

accounted for 77.9% of assets of all foreign banks in India.

Major Foreign Banks in India at end-FY2003(Rs. billion)


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Assets Deposits Advances Investments IncomeSource: rbi.org/

The primary activity of most foreign banks in India has been in the corporate

segment. However, in recent years, foreign banks have started making consumer

financing a larger part of their portfolios, based on the growth opportunities in this

area in India. These banks also offer products such as automobile finance, home

loans, credit cards and household consumer finance.

CONCENTRAT ION IN THE BANKING SECTOR

The concentration in the Indian banking sector has declined gradually during the

last few years. This is illustrated by table below. While the share of the largest SCB

SBIhas declined only gradually, other PSBs have lost gradual market share to

NPBs. Overall, while the share of the five largest banks in total assets has declined

from 45.2% at end-FY1997 to 42.8% at end-FY2003, the share of the ten largest

banks has declined from 60.3% to 58.2%. As the table below illustrates, PSBs havegradually lost market share to NPBs. However, amongst the PSBs, the share of the

SBI & associate banks has increased at the expense of the nationalised banks

from 36.7% of assets of PSBs at end-FY1997 to 38.4% at end- FY2003.

Nationalised banks have witnessed the most significant decline in share of assets of

all SCBsfrom 52.5% at end-FY1997 to 46.6% at end-FY2003. They have lost

market share mainly to NPBs, whose share of total assets increased from 2.4% at

end-FY1997 to 11.3% at end-FY2003. Foreign banks, with limited branch

presence, have also witnessed a decline in share of assets. NPBs have expanded the

most in the deposit market as well, with their share of total deposits increasing

from 2.4% at end-FY1997 to 8.5% at end-FY2003. By comparison, the share of

nationalised banks declined from 56.2% to 50.8%.


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Share of total assets of SCBs in India(Percent of assets of all SCBs)

As 2

Source: goidirectory.nic.in

An analysis of the state-wise share of deposits and credit indicates that at end-

FY2003, PSBs continue to be dominant (with more than 85% of deposits of SCBs)in many major statesUttar Pradesh, Punjab, Madhya Pradesh, Rajasthan, Bihar,

Haryana, and Orissa.

Share of bank deposits in major states

Foreign banks, despite the apparently superior quality of services they offer, have

not been a major competitive threat in Delhi, West Bengal, Maharashtra,


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Karnataka, and Tamil Nadu, where their presence is greatest. These five states

accounted for an estimated 94.4% of deposits of foreign banks at end-FY2003. In

fact, foreign banks have lost market share in these statesfrom 12.5% of deposits

at end-FY1999 to 8.5% of deposits at end-FY2003. Private sector banks have

gained more than 25% of deposits in many major states Maharashtra, Tamil

Nadu, Kerala, and Jammu & Kashmirbut the impact on PSBs is smaller than on

foreign banks. The trends so far indicate that, even after a decade of reforms, PSBs

continue to dominate in most of the states.

SECTORAL TRENDS IN CREDIT DEPLOYMENTAn analysis of gross bank credit (GBC)6 of SCBs reveals that while the share of

industry has declined from 50.1% at end-FY1998 to 42.4% at end-FY2002, the

share of personal loans has increased from 10.4% to 12.3%. Similarly, the share ofagriculture in total credit has also declined from 9.5% at end-FY1998 to 8.7% at

end-FY2002.

Distribution of outstanding credit of SCBsend FY1998 to end-FY2002(in percent)

As at end March

An analysis of GBC of select SCBs accounting for 8590% of bank credit of all


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SCBs indicates that GBC to agriculture increased 17.9% during FY2003, as

compared with growth of 17% during FY2002, and 17% during FY2001. The

agricultural sector was impacted by a severe drought in 2002, with the monsoon

season rainfall (June-September 2002) being 81% of normal. This adversely

impacted on the farm sector in several States, producing a contraction in real GDP

originating from `agriculture and allied activities. The production of food grains

was adversely affected with a 14.6% decline to 182.6 million tonnes during

FY2003. As a result, GDP from agriculture declined 3.2% during FY2003.

During FY2003, industrial sector recovered as evident in a sharp rise in the

production and imports of capital goods. Industrial performance is dominated by

the behaviour of manufacturing, and during FY2003, the manufacturing sector

contributed 86% of the growth of overall industrial production. The industrial

recovery enabled a healthy growth in exports, and resulted in upswing in non -food

credit from the banking system. The industrial sector GDP increased 5.7% during

FY2003 because of improvements in infrastructure, lag effect of increased

agricultural output during FY2002, and improvement in exports. Industrial activity

was broadly insulated from the impact of the drought, except in the durable

consumer goods segment.

Sectoral Real Growth rates in GDP at factor cost1993-94 prices

Ninth Plan(FY1998-

Reflecting the recovery in industrial activity from March 2002, GBC to industry

(medium and large) increased 16.3% during FY2003, as compared with increases

of 5.8% during FY2002, and 10.5% during FY2001. The recovery permeated all

segments during FY2003, with manufacturing contributing more than 80% of the

overall growth of industrial production. Indian industry was largely insulated from

the impact of the drought, except in the durable consumer goods segment where


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production was adversely impacted. In recent years, there has been increased share

of GBC to housing and other non-priority sector personal loans. GBC to housing

increased 55.1% during FY2003, as compared with growth of 38.4% during

FY2002, and 14.5% during FY2001. Accordingly, the share of housing loans in

GBC increased from 3.4% at end-FY2001 to 5.6% at end-FY2003. Housing loans

accounted for 15.4% of incremental GBC during FY2003, as compared with 9.2%

during FY2002, and only 3% during FY2001. During FY2003, growth of credit to

housing continued to remain high, because of tax incentives as well as the decline

in interest rates. In May 2002, RBI liberalised the prudential requirements for

housing finance by banks and investment by banks in securitised debt instruments

of housing finance companies (HFCs). Residential housing properties now attract a

risk weight of 50% as compared with the previous 100%. Because of liberalised

prudential requirements and general decline in interest rates, there has been a

significant decline in the interest rates charged by banks on housing loans. Many

banks have set their lending rates lower on housing loans, and at times below PLR,

due to lower risk weight. Many banks have con sistently exceeded the targets

prescribed for providing housing loans during FY2002 and FY2003. While

minimum prescribed allocations for housing finance by SCBs increased from Rs.

50.46 billion during FY2002 to Rs. 85.74 billion during FY2003, disbursements

increased from Rs. 147.46 billion to Rs. 338.41 billion.


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Sectoral Deployment of Gross Bank Credit

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As compared with PSBs, foreign banks have placed increased thrust on consumer

financing, which has enabled them to enjoy consistently higher yields and margins.

Personal loans accounted for 23.6% of outstanding credit of foreign banks at end-

FY2002, as compared with 18.9% at end-FY2001. By contrast, with the slowdown

in the economy, PSBs have only recently placed increased focus on consumer

financing. Personal loans accounted for 12.5% of their credit at end-FY2002, as

compared with 11.7% at end-FY2001, and 9.9% at end- FY1998.

Bank Group-wise distribution of outstanding creditend-FY2000 to end-FY2002


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As the following table indicates, industry wise, the largest credit growth over thepast five years has been observed in power, roads and ports, computer software,

telecom, gems & jewellery, petrochemicals, cement, electricity, and food

processing. By contrast, GBC has declined or stagnated in traditional commodity

sectors such as jute textiles, tobacco & tobacco products, leather & leather

products, rubber & rubber products, tea, and vegetable oils. During FY2003, while

GBC to industrysmall, medium and largeincreased 13.6% to Rs. 2,608.21

billion, some major industries showed a decline in GBC. The important amongst

these were coal, sugar, tobacco & tobacco products, and other engineering. By

comparison, some important industries that have showed an increase in GBC

during FY2003 include computer software (growth of 52%), roads & ports

(49.3%), power (45.8%), cement (22.6%), electricity (20.9%), cotton textiles

(18%), and gems & jewellery (16.8%).


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Industry wise deployment of gross bank credit

(Percent)

As on last

As on last reporting Friday of March 2003 2002 2001 2000 1999


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BANKING SECTOR REFORMS

In general, the post-nationalisation period during the 1970s and 1980s was marked

by a high degree of regulation and control. The two dominant financialintermediariescommercial banks and long-term lending institutionshad

mutually exclusive roles and objectives and operated in a largely stable

environment, with little or no competition. Long-term lending institutions were

focused on the achievement of the GoIs various socio-economic objectives,

including balanced industrial growth and employment creation, especially in areas

requiring development. They were extended access to long-term funds at

subsidized rates through loans and equity from the GoI and from funds guaranteed

by the GoI, originating from commercial banks in India and foreign currency

resources, originating from multilateral and bilateral agencies. The banks

functioned in a heavily regulated and controlled environment, with an administered

interest rate structure, quantitative restrictions on credit flows, high reserve

requirements, and pre-emption of a significant proportion of lend able resources

towards the `priority and government sectors. The banks formed a captive pool of

resources for the government's borrowings. Since the government was the largest

borrower in the economy, it could assume the role of price maker. The imposition

of high statutory liquidity reserve (SLR) requirements and cash reserve ratio (CRR)

requirements and priority sector norms led to a significant reduction in the bank

operational flexibility in asset deployment, and to credit rationing for the private

sector. Interest rate controls led to sub-optimal use of credit, and low levels of

investment and growth. The administered interest rate system worked on cost-plus

pricing. The RBI worked out the lending and deposit rate structure to ensure that

banks got a decent spread for their operations. The resultant heavy regulation led toa decline in productivity and efficiency. Although the business volumes improved,

asset quality suffered because of the higher incidence of concessional and directed

lending. To evaluate the systemic banking problems, the GoI set up a nine-member

Committee on Financial Systems, under the chairmanship of Mr. N. Narasimham,

in 1991. The Narasimham Committee Report, published towards the end of 1991,


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contained far-reaching recommendations for the banking sector and formed the

basis of the sectors reform process.

These reforms were undertaken together with, and formed an important element of,

the overall economic reforms of the 1990s. The salient features of these reforms

were:

introduction of stricter income recognition and asset classification norms;

introduction of higher capital adequacy requirements;

introduction of higher disclosure standards in financial reporting;

introduction of phased deregulation of interest rates;

and lowering of SLR and CRR requirements.

Assets and Liabilities Structure of SCBs

The reforms in the banking sector were targeted at both the asset and the liability

sides of the balance sheet. Before the banking sector reforms are discussed in

detail, it would perhaps be instructive to look at how Indian banks raise funds and

how these funds are deployed. The liability profile of the Indian banking sector is

presented in the following Table.

Liability Profile


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As the Table shows, the major sources of funds for the Indian banking sector are

deposits, which accounted for 79.8% of SCBs liabilities at end-FY2003, as

compared with 81.1% at end-FY1999. Deposits are of three kinds:

Demand deposits, accounting for 12.1% of deposits of SCBs at end-FY2003,

carry zero interest and are, typically, used by corporates for storing funds for short

periods. Demand deposits offer unlimited liquidity in that they can be withdrawn at

any time.

Savings deposits offer only a slightly lower degree of liquidity but carry a low

interest rate (presently 3.5% per annum). Savings deposits accounted for 22.3% of

the deposits of SCBs at end-FY2003. However, the operating costs of servicing

these deposits are high as they consist of a large number of small value accounts

that are geographically widespread (61% of savings deposit accounts of SCBs are

in rural and semi-urban areas). SCBs try to enhance the share of savings deposits

from retail customers as these offer lower costs as well as higher stability.

Term deposits are the most illiquid of the three and carry the highest interest cost.

Term deposits can have a minimum maturity of 15 days7. Term deposits accounted

for 65.6% of deposits of SCBs at end-FY2003. In terms of maturity, only 34.8% of

term deposits at end-FY2002 had a maturity of less than 1 year. Nearly 55.4% of

term deposits were for maturity periods of 1 to 5 years. An estimated 9.8% of term

deposits were for maturity periods exceeding 5 years.

An analysis of bank deposits by type indicates that the `household sector

accounted for 66.7% of outstanding deposits of SCBs at end-FY2002, followed by

Government (10.6%), foreign (10.2%), financial sector (6.9%), and private

corporatenon financial (5.7%). At end-FY2002, households accounted for 87.3%

of savings deposits of SCBs, 62.8% of term deposits, and 46.3% of current

deposits. Despite the significant increase in branch network, urban andmetropolitan branches of SCBs accounted for 66.4% of deposits of all SCBs at

end-FY2002.

There is a flow of resources from the rural/semi-urban branches as indicated by the

fact that the credit extended by rural/semi urban branches of SCBs is less than the

deposits of these branches.


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Apart from deposits, the other major source of funds is a banks net worth. Banks

are required to fund a certain proportion of their assets (weighted by their risk) by

their net worth. This proportion is known as the capital adequacy ratio (CAR). For

all SCBs, the minimum CAR was increased from 8% to 9% from the year ended

March 31, 2000, as per Basel norms, covering both on and off-balance sheet items.

Liability Profile of SCBs

The asset profile of SCBs in India is presented below:

Asset Profile of SCBsend-FY2003

Source: goidirectory.nic.in


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The funds raised by banks are deployed under two major headsloans &

advances, and investments. As of end-FY2003, loans & advances constituted

43.6% of the total assets of SCBs, while investments accounted for 40.8%. The

assets financed by the banks are linked to the liabilities through statutory

regulation, principal among which are the SLR and the CRR that mandate banks to

maintain a certain minimum proportion of their deposits in certain designated

liquid assets. The CAR also determines the nature (i.e., riskiness) and the quantum

of assets a bank can finance.

Advances by Indian banks, generally, take three formscash credit (CC), bills

purchased and discounted, and term loans. CC (49.8% of outstanding advances of

SCBs at end-FY2003) is the most popular mode of borrowing by business concerns

in India. The advantage of this mode is that the borrower does not need to borrow

the entire limit sanctioned at once. The borrower can withdraw only the amount

needed and return any surplus funds. When the customer requires temporary

accommodation, he may be allowed to overdraw his current account, usually

against collateral securities. While the overdraft is theoretically temporary, in

practice, bankers set regular limits for overdrafts also, in addition to the CC limit.

CC is generally given for a period of up to 12 months, with subsequent reviews.

Bill purchase and discounting (8.3% of outstanding advances at end-FY2003)

involves the financing of shortterm trade receivables through negotiable

instruments. These negotiable instruments can then be discounted with other banks

if required, providing the bank with liquidity. Term loans (41.9% of outstanding

advances at end-FY2003) are longer duration loans given typically for financing

projects, core working capital (WC) requirements, and normal capital expenditures.

The investments of banks are, primarily, in government securities in India (76.8%

of investments at end-FY2003). Banks in India, and especially PSBs, generally

hold government securities far in excess of their SLR requirements. Investments in

government securities benefit banks in the following ways. While the return is low,

the investments are virtually risk-free and there is no danger of generation of


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NPAs. Thus, government securities provide banks with a steady source of risk-free

income. Banks would naturally prefer to lend to the government at market-

determined rates than make `risky' loans to the private/corporate sector. Even

strong SCBs voluntarily invest in excess of SLR requirements in a bid to minimise

credit risk while increasing profitability. Such investments also do not entail

priority sector commitments, whereby a PSB has to set aside 40 paise for the

priority sector (priority sector requirements are detailed below) for every rupee that

it lends. Further, in an environment of declining interest rates, a fall in interest rates

results in an increase in prices of government securities. During the last three years,

SCBs have significantly improved their profitability by investing largely in

government securities, reaping trading gains with the declining yields and rising

prices. The system of fixed managerial compensation also discourages PSB

managers from taking risks. There is little incentive for officials of stateowned

banks to take additional risk. A failure or loss can lead to career damage, whereas

success may bring little reward. Thus, it is far easier to maintain a high proportion

of Government bonds with zero risk of default. Incentive and career structures in

PSBs do not encourage or reward dealing success. PSBs avoid any possible

investigation of their lending and any risk of default by investing in government

debt, both important considerations for their management in the current

environment.

Asset Profile of SCBs

Source: rbi.org/

The major elements of the reforms relate to the assets and liabilities side of the

balance sheet and are discussed in the following sections below.


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Liabilities

Liberalisation of Interest Rate on Deposits

Beginning 1992, a progressive approach was adopted towards deregulation of the

interest rate structure on deposits. The rates have been gradually freed, and at

present, the interest rate on term deposits have been completely deregulated. The

only administered interest rate is that on savings bank deposits, with a prescribed

interest rate of 3.5% per annum. The continued regulation of interest rates on

savings deposit (aggregating Rs. 3,023 billion or 22.3% of deposits at end-

FY2003) provides a degree of comfort to the PSBs since their margins are already

falling and deregulation is likely to spur added competition on the funding side.While the PSBs have an advantage in funding costs on account of their vast branch

network, new private and foreign banks tend to incur lower operational costs.

Capital Adequacy

The RBI also adopted a strategy to introduce the attainment of CAR of 8% in a

phased manner was adopted. Based on the recommendations of the Committee on

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

March 31, 2000.

Phased Increase of CAR

(Percentage)


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Assets

Interest Rate on Loans and Advances

During 1975-76 to 1980-81, the RBI prescribed both the minimum lending rate

(13.5%) and the ceiling rate (19.5%). During 1981-82 to 1987-88, the RBI

prescribed only the ceiling rate, which was also progressively reduced to 16.5% in

1987-88. During 1988-89 to 1994-95, the RBI switched from a ceiling rate to a

minimum lending rate. The minimum lending rate, which was initially fixed at

16%, was increased to 19% in 1991-92, but, subsequently, lowered to 14% in

1993-94. After 1992, rates on priority lending were also allowed to be set more

freely. In October 1994, lending rates on loans exceeding Rs. 0.2 million were

freed. In April 1998, rates on loans under Rs. 0.2 million were also freed provided

they did not exceed the Prime Lending Rate (PLR) that the banks were allowed to

set. Banks are also allowed to offer loans at below-PLR rates to exporters or other

creditworthy borrowers, including public enterprises. Banks are now required to

announce the PLR and the maximum spread charged over the PLR. Currently,

interest rates are prescribed for only three categories of loans: first, for loans below

Rs. 0.2 million, interest rates cannot exceed the PLR: second, lending rates for

exports are prescribed: and third, ceilings are prescribed on certain advances inforeign currency.

Reduced Cash Reserve and Statutory Liquidity Requirements

A major reform measure has been the gradual reduction in statutory pre-emptions

in the form of CRR and SLR requirements. CRR and SLR together aggregated

42% of deposits in the early 1980s, rising to 53.5% of deposits in 1990. This pre-

emption meant a decline in the share of deposits available for loans, even to the

priority sectors. The CRR has been progressively reduced from 15% in 1989 to

4.5%8 at present. Currently, SCBs are required to maintain with the RBI a CRR of

4.5% of the Net Demand and Time Liabilities (NDTL), excluding liabilities subject

to zero CRR prescriptions). The RBI has indicated that the CRR would ultimately

be reduced to the statutory minimum of 3%. However, with effect from the


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fortnight beginning November 3, 2001, all exemptions on the liabilities have been

withdrawn except inter -bank liabilities for computation of NDTL for the purpose

of maintenance of CRR. The SLR, which was at a peak of 38.5% during September

1990 to December 1992, has been reduced to the present statutory minimum of

25%.

These measures were designed to give greater discretion in the allocation of funds

to the SCBs and enable them to raise their profitability. The share of low interest

bearing cash and bank balances in total assets has declined from 16.6% at end-

FY1998 to 9.5% at end-FY2003. By increasing the quantum of investible funds in

the hands of banks, these measures also enhanced the need for efficient risk

management systems. While the reduction in CRR has resulted in an increase in

investible funds, the impact has been limited as the SCBs hold government

securities far in excess of the statutory minimum. SCBs' holding of government

and other approved securities aggregated 41.4% of their NDTL at end-December

2003. This has to be viewed in the context of the high level of fiscal deficit and

market borrowings by the government, which has the risk of crowding out bank

financing to the commercial sector. As the figure below shows, a large fraction of

bank deposits are being deployed for holding government securities. This ratio, as

is evident, has been increasing steadily over the last few years, and has persisted

even recently despite a strong economic recovery and, presumably, a consequent

increase in demand for credit.

Select Ratios of SCBs in India

Source: goidirectory.nic.in/


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In deciding on a trade-off of lendable resources between increasing credit flows

and investing in government securities, the economic, regulatory and fiscal

environment favours the latter. Restricted commercial lending (arising from

structural changes in corporate resource raising patterns and multiple oversight

processes for PSBs), coupled with distortions in borrowing and lending structures

(including interest rate restrictions, the former artificially raising the cost of funds

for intermediaries and the latter relating to various PLR related guidelines for

SMEs and priority lending), have made treasury operations an important activity in

improving banks profitability. On the other hand, declining interest rates have

made holding government securities more profitable. There is also significant

potential of portfolio appreciation because of the trend of declining interest rates in

the economy. The system of fixed managerial compensation also discourages PSB

managers from taking risks.

Priority Sector Lending Requirement

Priority lending was a major aspect of `social banking, and part of the mechanism

to set up cross subsidy from `free lending. The nationalisation of the banks

enabled the government to exert significantly greater pressure to lend to the

priority sectors. Post nationalisation, there were initially no specific targets fixed in

respect of priority sector lending. However, in November 1974, banks were

advised to raise the share of these sectors in their aggregate advances to 331/3% by

March 1979. In March 1980, the target was revised to 40% by March 1985. By the

1980s, about 55% of the funds available, after the CRR and SLR requirements,

were met (i.e., about 25% of deposits) went into priority and quasi-priority lending.

Beginning in the 1990s, the 40% (of net bank credit or NBC) priority sector

lending requirement (for PSBs and private sector banks) remained but its burdenwas eased by freeing the rates on loans above Rs. 0.2 million 10, raising the rates

on small loans and making additional types of credit available11. The requirement

was increased to 32% for foreign banks in 1993. Thus, the priority sector has been

liberalised only to the extent that the interest rates have been liberalised and

additional types of credit have been made eligible. In fact, the share of priority


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sector advances in the gross bank credit of SCBs increased from 14% in June 1969

to 33% in March 2003. As of end-FY2003, all the bank groups had achieved their

priority sector lending targets.

Priority Sector Lending of SCBs

(Rs. billion)

High priority sector lending targets have been one of the major factors behind the

high NPAs of SCBs. While the share of priority sector lending in NBC is around

42.5% of PSBs, their share of NPAs was around 47.2% at end-FY2003.

Segment wise Distribution of NPAs at end-FY2003

(Rs. billion)

Asset Classification and Provisioning Norms

The prudential norms relating to asset classification have been tightened. The

earlier system of eight `health codes has been replaced by the classification of

assets into four categories:

Standard, Sub-standard, Doubtful, and Loss assets, in accordance with international

norms. The provisioning requirements of a minimum of 0.25% were introduced for

standard assets from the year ended March 31, 2000. The provisioning

requirements have also been prescribed for sub-standard, doubtful and loss assetcategories. The RBI has imposed a provision of 0.25% on standard assets; 10% on

sub-standard assets, 20-50% on doubtful assets (depending on the duration for

which the asset has remained doubtful), and 100% on loss assets.

The recognition of NPAs has also been gradually tightened, so that since March

2001, loans with interest and/or installment of principal remaining overdue for a


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period of more than 180 days are classified as non-performing. The period has

been shortened to 90 days from the year ending March 31, 2004, but provisions are

required to be made from March 31, 2002. Banks have also been required to

progressively `mark-to-market their holdings of government securities.

Structural ReformsCompetition:

Since the initiation of banking sector reforms, a more competitive environment has

been created wherein banks are not only competing within the industry but also

with players outside the industry. While existing banks have been allowed greater

flexibility to expand their operations, new private sector banks have been allowed

entry. After the guidelines were issued in January 1993, nine new private sector

banks are in operation. Competition amongst PSBs has also intensified. PSBs are

now allowed to access the capital market to raise funds. This has diluted the

Governments shareholding in them, although it remains the major shareholder in

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

banking sector has been increasing in recent years, the dominance of the PSBs, and

especially of a few large banks, continues.

The PSBs are, thus, able to influence decisions about liquidity and rate variables in

the system. Although a significant decline in such concentration ratios is unlikely

in the near future, the PSBs are likely to face tougher competition, given the

gradual upgrade of skills and technologies in competing banks and the

restructuring and re-engineering processes being attempted by both private sector

and foreign banks. Moreover, banks are also facing stiff competition from other

players like non-bank finance companies, and mutual funds (MFs).

Government Ownership and Management of PSBs

Though the government has allowed equity dilution of its stake in nationalised

banks, it has not ceded management control. Equity dilution has largely been a

capital raising exercise, without greater non -governmental shareholder

supervision. Individual voting rights, the key instrument of shareholder

participation, are still limited by rules to a maximum of 10% of the total voting


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rights of all the shareholders of the banking company13. Nationalized banks are

accountable to the Indian Parliament. Key appointments and policies have to be

vetted by government. As long as shareholders are denied full voting rights, and

are placed at par with government, there seems little or no scope for effective

transition to market discipline. Little effort has also been made to encourage sound

bank management practices through a system of incentives, nor are there

significant disincentives. Top management salaries in the nationalized banks

continue to be pegged to salaries at comparable levels in government. The system

of employee wage negotiations cutting across the banking industry without

reference to either the health or the paying ability of individual banks means that

employees or management have little stake in the health of the bank. Even if the

government stake falls to 33%, as long as banks are covered under the definition of

State under the Indian Constitution, there seems to be little to no flexibility on the

human resource issue. To examine the relationship between Government

ownership and performance, the RBI recently compared the performance of banks

based on select parameters at two levels: (a) comparison of a representative sample

of five PSBs which divested their Government holding early in the reform process

with a representative sample of five wholly government-owned PSBs, and (b)

comparison of the aforesaid two categories with old private sector banks as a

group.

The findings for the period FY1996 to FY2002 indicate:

PSBs wholly owned by the GoI had the highest ratio of operating expenses

to total assets.

Interest spread (net interest income to total assets) of wholly government-

owned PSBs was lower than divested PSBs during each of the seven years,

but generally higher than old private sector banks.

Profitability (ratio of net profit to total assets), on an average, was the

lowest for wholly government owned PSBs. However, the gap narrowed

down significantly from FY1999 onwards.

Asset impairment (ratio of gross NPAs to gross advances) during each of


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the years under reference in respect of wholly-government owned PSBs

was the highest.

The CAR of wholly-government owned PSBs was the lowest. However,

their CAR has improved over the years.

Banks Entry into Insurance With the enactment of the Insurance

Regulatory and Development Authority (IRDA) Act, 1999, banks and

NBFCs have been permitted to enter the insurance business. The RBI has

issued the final guidelines for banks entry into insurance business. For

banks, prior approval of the RBI is required to enter into the insurance

business. The RBI would give permission to banks on a case-by-case basis,

keeping in view all relevant factors. Banks having a minimum net worth of

Rs. 5 billion and, satisfying other criteria in respect of capital adequacy,

profitability, NPA level and track record of existing subsidiaries, can

undertake insurance business through joint ventures, subject to certain

safeguards. The maximum equity contribution such a bank can hold in the

joint venture company will normally be 50% of the paid-up capital of the

insurance company. On a selective basis, the RBI may permit a higher

equity contribution by a promoter bank initially, pending divestment of

equity within the prescribed period. Banks which are not eligible as jointventure participants, as above, can make investments up to 10% of the net

worth of the bank or Rs. 0.5 billion, whichever is lower, in the insurance

company for providing infrastructure and services support. Such

participation shall be treated as an investment and should be without any

contingent liability for the bank. Banks are also now allowed to undertake

referral arrangements with insurance companies, through their network of

branches, subject to certain conditions to protect the interests of their

customers. Under the referral arrangement, banks provide physical

infrastructure within their select branch premises to insurance companies

for selling their insurance products to the banks' customers with adequate

disclosure and transparency and, in turn, earn referral fees on the basis of

premia collected.


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At present, amongst the PSBs, the SBI has floated a life-insurance subsidiary.

During FY2003, seventeen PSBs, 9 private sector banks, one foreign bank, and

a subsidiary of a private sector bank were given 'in principle' approval by the

RBI for acting as corporate agents of insurance companies to undertake

distribution of insurance products on non-risk participation basis.

IMPACT OF REFORMS ON BANKS

To gauge the effects of reforms on the banking industry, it is imperative to view

the reforms over a period of time. When the reform process was launched in 1991,

the banking sector received a jolt. Implementation of uniform and transparent

accounting practices exposed the fragility in the system in terms of the bad loan

problem and lack of profitability.

Profits

Till the adoption of the prudential norms, 26 out of 27 PSBs were reporting profits.

In the first post-reform year, i.e., FY1993, the combined profitability of the PSBs

turned negative with a net loss of Rs. 32.93 billion during FY1993, with as many

as 12 nationalised banks reporting net losses. However, subsequently, there hasbeen a significant improvement. The PSBs reported a net profit of Rs. 11.16 billion

during FY1995, compared with a net loss of Rs. 43.49 billion in FY1994. In recent

years, the net profits of PSBs increased 48% during FY2003 to Rs. 122.94 billion

during FY2003, as compared with a growth of 92.5% during FY2002. However,

net profits of PSBs declined 15.7% during FY2001, mainly because of voluntary

retirement scheme (VRS) expenses12. All the twenty-seven PSBs reported net

profits during FY2003 and FY2002, as compared with 25 during FY2001, and 19

during FY1996. The net profits of all SCBs have also increased from Rs. 19.60

billion in FY1996 to Rs. 170.68 billion during FY2003 (refer Table below). Net

profits, as per cent of average assets, have increased significantly from 0.53% in

FY1999 to 1.06% in FY2003.


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Net Profits of SCBs in India

(Rs. billion)

Capital AdequacyAs of end-FY1993, only one PSB had a CAR of above 8%. The equity capital of

the PSBs has been rising steadily after the reformsfrom Rs. 30.34 billion at end-

FY1991 to Rs. 141.75 billion at end-FY2003. By end-FY1996, the outer time limit

for attaining capital adequacy of 8%, eight PSBs were still below the prescribed

level. Since then, the CAR has improved for all major categories of banks. Overall

CAR of the banking sector has improved significantly from 10.4% at end-FY1997

to 12% at end-FY2002, and to 12.6% at end-FY2003. At-end FY2003, the CAR of

91 out of 93 SCBs exceeded the stipulated minimum of 9%; only 2 NPBs had CAR

below the stipulated minimum of 9%.

Distribution of SCBs by CAR

A key factor in the quick improvement in the CAR of PSBs is that the GoI owns a

majority stake. Thus, the GoI did not need to resort to complicated procedures

observed in the rehabilitation process of banks in Korea and Japan, to inject funds

into major banks. Till FY2003, the government had injected Rs. 230 billion

towards recapitalisation of 19 nationalised banks.

Deposit Growth

The deposits of the banks have also increased over the years. After the securities

scam of 1992, bank deposit mobilisation increased, as a greater part of the


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household sector savings started to move from the stock markets to the banking

sector. Over the last decade, the deposits of all SCBs increased 4.6 timesfrom

Rs. 2,619 billion at end-FY1992 to 13,559 billion at end-FY2003. Deposits

increased at a compounded annual growth rate (CAGR) of 16.1% between FY1999

and FY2003, as compared with 5.4% between FY1993 and FY1997. As indicated

in figure below, overall efficiency of the banking sector (as measured by deposits

as a percentage of GDP) has also increased.

SCBs deposits as a percentage of GDP

Source: rbi.org/

Asset Quality and Non-Performing Loans

The position on the asset quality front has also improved over the last few years.Net NPAs, as percentage of net advances of all SCBs, has declined from 8.1% at

end-FY1997 to 4.3% at end-FY2003. During FY2003, there was also an absolute

decline in the NPAs of SCBs. Gross NPAs declined Rs. 21.47 billion during

FY2003, as compared with an increase of Rs. 71.20 billion during FY2002.

Amongst the bank categories, three of the eight SBI & associate banks had net

NPA to net advances exceeding 10% at end-FY1997. Their number declined to just

one at end-FY2000, and nil thereafter. The number of nationalised banks having

NPAs exceeding 10% also declined from seven at end-FY1997 to three at end-

FY2002, and two at end-FY2003. In the case of old private sector banks, this

number declined from three to two over the same period. None of the new Indian

private sector banks had net NPAs exceeding 10% during FY1997 to FY2002;

however there was one new Indian private sector banks with net NPAs exceeding


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10% at end-FY2003. In the case of foreign banks operating in India, the number of

banks with NPAs/net advances exceeding 10% increased from three at end-

FY1997 to 14 at end-FY2002, before declining to 8 at end-FY2003.

Frequency distribution of Net NPAs to Net AdvancesSCBs

While as a percentage of advances, the net NPAs have come down, in absolute

terms, net NPAs had increased from Rs. 277.74 billion at end-FY1997 to Rs.355.54 billion at end- FY2002. Similarly, while gross NPAs/gross advances have

declined from 15.7% at end- FY1997 to 8.8% at end-FY2002, the gross NPAs of

the SCBs increased from Rs. 473 billion at end-FY1997 to Rs. 687.14 billion at

end-FY2003. However, during FY2003, recoveries of NPAs outpaced additions

resulting in a decline in both gross and net NPAs.

Since 1993, the growth of NPAs has been held below asset growth, even while

interest rates have been liberalised. At the same time, provisioning has increased,

so that the gross NPAs, as per cent of assets, have declined from 7% at end-

FY1997 to 4% at end-FY2003; net NPAs, as per cent of assets, have also declined

from 3.3% at end-FY1997 to 1.9% at end-FY2003. In terms of credit allocations,

banks investments in government securities, which earlier formed a major part of

credit allocations, have been nearly unaffected by the liberalisation. Including the

reduced CRR requirements, SCBs cash balances with the RBI; and investments in

India in government & approved securities aggregated 37.6% of assets at end-

FY2003. During FY1998-2003, the growth in SCBs investment in government

securities exceeded the growth in assets. During FY2004, while aggregate deposits

of SCBs in India increased 17.3%, investments in government and approved

securities increased 24.1%; bank credit increased 14.6%. As discussed, government

debt is an attractive instrument with its higher market-based rates and minimal


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limited capital requirement (zero until the increase in risk weighting to 2.5% in

1998). PSBs also avoid any possible investigation of their lending and any risk of

default by investing in government debt, both important considerations for their

management in the current environment.

A decade after financial sector liberalisation, although there has been a significant

improvement in the banking industry performance, there has been little concerted

effort at restructuring the PSBs. As a consequence, profitability and viability of the

PSBs are still below global standards and even the average values within the Indian

banking industry. Intermediation costs are high, resulting in high nominal lending

interest rates. The fact that there have been no instances of systemic crises,

contagion, bank closures, bank runs, bank nationalisation post-liberalization,

should not divert attention from the problems of high and unresolved NPAs,

inadequate management skills, and relatively volatile operating performance.

BANKING INDUSTRY PERFORMANCEWhile carrying out a time-scale performance analysis of the Indian banking sector,

it is important to keep in mind the perceptible impact that the phased

nationalization has had on the structure and performance of the Indian banking

sector. The nationalization of the banking sector was an endeavor by the Central

Government to achieve geographical expansion and increase directed lending to

the priority sectors, including agriculture and small-scale industries. The

nationalisation was successful, to a large extent, in meeting the social objectives of

the government. The total branch network of commercial banks increased more

than eight-fold from 8,262 branches in 1969 to 68,561 in March 2003. During the

same period, the growth in advances to the priority sector, including agriculture

and small-scale industries outstripped the growth in aggregate credit. As a result,

the ratio of priority sector credit to total credit by SCBs increased from 14% in

June 1969 to 33% by end-March 2003.

The following discussion will analyse the financial performance of the Indian

banking industry against the following parameters:


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Income;

Yields;

Interest Costs;

Spreads;

Intermediation Costs;

Profitability;

Return On Assets;

Capital Adequacy; And

Asset Quality.

Income

The total income of all SCBs in India increased 14% during FY2003 to Rs. 1,724

billion, compared with a growth of 14.5% during FY2002, and 14.5% during

FY2001. While interest income increased 10.7% during FY2003 (10.4% during

FY2002) to Rs. 1,407 billion, other income increased 31.2% during FY2003

(42.1% during FY2002) to Rs. 317 billion. Interest income has declined from

87.1% of income during FY2001 to 84% of income during FY2002, and to 81.6%

of income during FY2003.

During FY2003, the income of PSBs increased 9.6% to Rs. 1,285 billion,compared with a growth of 13.3% in FY2002. Their dominance in the banking

sector is attested by their consistent share of 78% to 79% of income of all SCBs

during FY1998-FY2002. However, because of the ICICI merger, the PSBs share of

total income declined to 74.5% during FY2003. Because of the merger, the NPBs

recorded the highest increase in income of 104.7% during FY2003, followed by

OPBs (3%). The foreign banks recorded an income decline of 7.1% during

FY2003, caused by declining interest rates, and a reduction in the number of

foreign banks operational.

Income Trends and Growth Rate(Rs. billion)


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(10.7)

Interest income, which constituted 81.6% of income during FY2003, increased

10.7% during FY2003, compared with 10.4% during FY2002. The growth in

interest income was led by a healthy growth in advances and investments, rather

than yields (which declined). Domestic advances and investments of SCBs

increased 16.6% during FY2003 to Rs. 13,810 billion (refer Table below),

compared with a growth of 21.5% during FY2002, and 18.5% during FY2001.

Overall advances and investments increased 16.2% during FY2003 to Rs. 14,343

billion, as compared with a growth of 21.2% during FY2002, and 18.5% during

FY2001. A recent study by the RBI on finances of selected 997 non-Government,

non -financial large public limited companies has indicated that while incremental

borrowings from banks increased from Rs. 55.85 billion in FY2002 to Rs. 63.99

billion in FY2003, the share of incremental bank borrowings in external funds

decreased from 65.1% to 53.6%. However, the share of external sources of funds

such as issues of equity and trade creditors increased during FY2003.

SCBsAdvances/Investments and Growth

Non-interest (or other) income of SCBs increased 31.2% during FY2003 to Rs.


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316.56 billion, compared with a growth of 42.1% during FY2002 and 6.6% during

FY2001. The other income mainly consisted of profit on sale of investments

(45.1% of non -interest income), commission, exchange & brokerage (33.4%), and

profit on exchange transactions (8.9%). Other income has increased substantially

during the last two years because of the substantial profits on the sale of

investmentsnet profit from sale/revaluation of investments increased from Rs.

30.26 billion in FY2001 to Rs. 93.41 billion in FY2002, and to Rs. 142.62 billion

in FY2003. Banks have been able to report significant capital gains on account of

the downward movement of interest rates. With their substantial holding of

Government securities, SCBs have profited from a significant decline in yields on

government securities. Net profit from sale/revaluation of investments as a percent

of aggregate net profits has increased from 18.7% in FY1999 to 80.8% during

FY2002, and 83.6% during FY2003. Yields have declined because of the excess

liquid funds of commercial banks flowing into the Government securities market.

During FY2003, yield on 10-year Government securities declined by 115 basis

points to 6.21% at end-March 2003. During FY2004, due to the reduction of the

repo rate by 50 basis points from 5% to 4.5% from August 25, 2003, there was a

sharp decline in the yields and the 10-year yield touched a historic low of 5.23%.

The 10-year yield reached a further low of 4.95% on October 16, 2003. However,

the markets stabilised in view of the RBI's low inflation outlook and reiteration of

the soft interest rate stance. The benchmark 10-year yield declined to 5.14% at end-

March 2004. Even after significant sale of higher-interest Government securities,

SCBs continue to hold a high proportion of higher -interest government securities.

As the table below shows, nearly 70% of the SCBs outstanding investments in

central and state government securities at end- FY2003 carried an annual interest

rate exceeding 10%. Further, an estimated 23% of these securities at end-FY2003

(29.3% at end-FY2002) carried an annual interest rate exceeding 12%.

Interest Rate Distribution of SCBs investments in central and state

government securities

(Percentage of total)Less than 6% 6-8% 8-10% Over 10%


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Income from commission, exchange and brokerage is another major source of non-

interest income, accounting for 6.1% of income of SCBs during FY2003. Such

income is mainly earned from off-balance sheet activities such as forward

exchange contracts, guarantees, acceptances, and endorsements. Income from

commission, exchange and brokerage increased 14.7% during FY2003 to Rs.

105.70 billion, mainly because of a 31.4% increase in contingent liabilities to Rs.

11,642 billion. Foreign banks are very active in derivatives, with the exposure offoreign banks in forward currency contracts increasing from Rs. 3,609 billion at

end-FY2002 (57.3% of forex exposures of all SCBs) to Rs. 4,172 billion at end-

FY2003 (54.7% of forex exposures of all SCBs). Contingent liabilities represented

68.5% of liabilities of SCBs at end-FY2003, as compared with 57.7% at end-

FY2002.

Contingent liabilities and income from commission, brokerage and exchange of

SCBs

Contingent

As discussed below, the growth in income lagged the growth in average assets,

which increased 14.3% during FY2003, compared with a growth of 17.7% during

FY2002, and 16.7% during FY2001. As a result, yields have declined over the past

few years. Interest earned, as per cent of average assets, declined from 10% during

FY1999 to 8.70% during FY2003. However, non-interest incom e, as per cent of

average assets, increased from 1.46% during FY1999 to 1.96% during FY2003.


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The increase in non -interest income (because of trading profits from interest rates

declines) has partially offset the decline in income from advances and investments

(because of interest rate declines). Total income, as percent of average assets, has

declined by 80 basis pointsfrom 11.46% during FY1999 to 10.66% during

FY2003.Because of the merger of ICICI and ICICI Bank, the figures for FY2002

are underestimates. However, the decline in yields has been accompanied by a

decline in cost of deposits.

Interest and Non-Interest Income of SCBs

As can be seen from the above table, foreign banks report a substantially higher

non-interest income (as percent of average assets). Foreign banks are the most

active in off-balance sheet activities. Their contingent liabilities aggregated 482.8%

of liabilities at end-FY2003, and income from commission, exchange and

brokerage accounted for 11.5% of income of foreign banks during FY2003.

YieldsFor all SCBs, income from advances, which constituted 39.8% of income of SCBs

during FY2003, increased 15.3% during FY2003 to Rs. 686.36 billion, compared

with a growth of 7.5% during FY2002, and 16.6% during FY2001. By comparison,

advances increased 14.5% during FY2003 to Rs. 7,405 billion, compared with a

growth of 22.9% during FY2002, and 18.1% during FY2001. The growth in

income from advances outpaced the growth in average advances, mainly because

of the full inclusion of income for FY2003 of merged ICICI Bank as compared

with 2 days inclusion for FY2002). However, yields on average advances have

been declining because of the decline in interest rates in the Indian economy. The


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yield on average advances for all SCBs has declined from 12.34% in FY1999 to

9.90% in FY2003. The PLR of PSBs declined from 10-13% in March 2001 to

9.75-12.25% in December 2003. On balance, PLRs were lower as at end-FY2003

than the corresponding levels as at end-FY2002 for the three groups of SCBs. The

following Table sets forth the decline in PLR for the last few years.

Trends in PLR of SCBs

(Percent per annum)

Source: RBI, Source: rbi.org/

Interest/dividend income from investments, which constituted 36.2% of SCBs

income during FY2003, increased 8.9% during FY2003 to Rs. 623.59 billion,

compared with a growth of 13.8% during FY2002, and 14.4% during FY2001. By

comparison, investments increased 18.1% during FY2003 to Rs. 6,938 billion,

compared with a growth of 19.5% during FY2002, and 18.9% during FY2001.

However, as with advances, the growth in investment income lagged the growth in

average investments, which increased 18.7% during FY2003, compared with

19.2% in FY2002, and 20.2% in FY2001. The yield on average investments for all

SCBs increased from 11.89% in FY1999 to 9.73% in FY2003. The decline in yield

was because of revised provisioning norms, high investment in India in

government and approved securities, and a decline in yield on government

securities. The monetary and credit policy for the second half of FY2001,

announced in October 2001, had resulted in introduction of a significant change in

banks valuation of investments. Investments are now to be classified into three

categoriesheld to maturity (HTM), available for sale (AFS), and held for trading

(HFT). At end-FY2003, SCBs investments AFS accounted for 75.4% ofinvestments, followed by HTM (20.2%), and HFT (4.2%). The HTM category

securities need not be marked to market and cannot exceed 25% of the portfolio.

Earlier, the RBI had stipulated that banks must mark to market at least 70% of the

portfolio. Many banks had, however, marked 100% of the portfolio to the market

to take advantage of the declining interest rates. The decline in yield on


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investments has also been because of increased investment in domestic government

securities. Incremental investments in domestic government and approved

securities accounted for 96.2% of incremental investments of SCBs during

FY2003, compared with 79.1% during FY2002. Higher investments in government

securities was also accompanied by a decline in yields on government securities

over the past few years.

Average Yield levels on Govt. securities

(Per cent per annum)

A positive impact of the declining interest rates was an appreciation in prices of

securities resulting in a 52.7% increase in net profit from sale/revaluation of

investments during FY2003. Including such profits, yield on average investments

declined from 12.34% during FY2002 (11.79% during FY2001) to 11.96% during

FY2003. Interest income on balances with RBI and interbank funds, which

constituted 3.9% of SCBs income during FY2003, declined 14.4% during FY2003

to Rs. 67.99 billion, compared with a growth of 23.2% during FY2002, and 18.1%

during FY2001. Such income declined because of a 21.7% decline in cash and

bank balances to Rs. 1,607 billion at end-FY2003, caused by lower CRR.

However, income on such balances has been boosted because of an increase in the

interest rate payable on eligible cash balances maintained with RBI. The annual

interest rate was increased from 4% to 6% (from the fortnight beginning April 21,

2001). With effect from the fortnight beginning November 3, 2001, the interestpaid on eligible cash balances was at the Bank Rate. However, average call money

rates declined from 6.58% in April 2002 to 5.86% in March 2003, and to 4.40% in

December 2003. Overall, the yield on cash and bank balances increased from

4.01% during FY2002 to 3.72% during FY2003.


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CRR MovementsFY1999 to FY2004Per cent (effective date)

Overall, the decline in yields on advances and investments has resulted in a

decline in yield on average interest bearing assets of SCBs, which declined from

10.87% in FY1999 to 9.27% in FY2003 (refer Table below).

Yield Indicators of SCBs

(Per cent per annum)

.40% 9.73%Source: banknetindia.com/

Another reason for the falling yields is the focus of banks on highly rated clients.

Faced with high NPA levels, banks are concentrating on safer clients who cannot

be charged high riskpremiums. Further, a higher proportion of assistance now takes

the form of CP, bonds and debentures. In the present situation of easy liquidity,

banks prefer investing in CPs, as they can deploy funds at interest rates higher than

call rates, and also avoid the higher transaction costs associated with bank loans. In

return for the higher liquidity they offer, these instruments are issued at lower

interest rates. 2.85 The discount rates on CP declined from a range of 6-7.75%

during end-March 2003 to 4.7-6.5% by end-March 2004. CP has now emerged asan important source of funding WC needs; however, it is restricted to a few large

companies with healthy credit ratings and does not enjoy wider market

acceptability. Further, SCBs investments in CP have declined in recent years

because of a decline in primary issuances by manufacturing companies having

access to sub-PLR lending.


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SCBs investments in CP, Shares, Bonds, Debentures, etc

(Rs. billion)

Interest CostAlthough all categories of SCBs have experienced a decline in yields on average

interest bearing assets, the decline has been accompanied by a decline in cost of

funds. Interest expended, which accounted for 54.3% of SCBs income during

FY200314, increased 6.9% during FY2003 to Rs. 936.07 billion, compared with a

growth of 12.1% during FY2002, and 12.7% during FY2001. The cost of deposits

constituted 88.3% of interest expended during FY2003, and increased 2.5% during

FY2003, compared with a growth of 12.3% during FY2002, and 11.8% during

FY2001. By comparison, deposits increased 12.7% during FY2003 to Rs. 13,559

billion, compared with a growth of 14% during FY2002, and 17.2% during

FY2001. Deposit mobilisation was higher during FY2001 because of Rs. 257

billion raised through India Millenium Deposits (IMD).

Over the last few years, the cost of deposits, and the cost of average interest

bearing funds has declined because of softening of interest rates in the economy.

The decline in interest rates is in consonance with the monetary policy stance of a

soft and a flexible interest rate regime. Bank rates have been reduced significantly

over the years (refer Table below). The reduction in bank rates acts as a signalling

device for a lower interest rate regime. However, the average lending rates of

banks continue to be substantially higher than the Bank Rate.

Thus, the relation between lending rates and Bank rate is now relatively weak.

Bank Rate Movements during FY1999 to FY2004

Per cent per annum (effective date)

The spreads of lending rates of commercial banks over their average costs of


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deposits reveal a marginal narrowing down FY1997. The RBI has noted that the

stickiness in the interest rate structure of commercial banks is because of a number

of reasons:

Average cost of deposits for major banks continues to be relatively high,

because of the high returns on alternative savings instruments. Despite

reductions in the administered interest rates on small savings and provident

funds in recent years, they yield higher returns than bank deposits. This

constrains the ability of banks to reduce deposit rates.

Longer-duration term deposits at fixed interest rates constitute a substantial

portion of bank deposits, thereby limiting the flexibility to reduce lending

rates in the short-term.

High NPAs increase the average cost of funds for banks.

High non -interest operating expenses of banks reduce the flexibility to

reduce interest rates.

In view of legal constraints and procedural bottlenecks in recovery of dues

by banks, the risk premium tends to be higher resulting in a wider spread

between deposit rates and lending rates.

The large borrowing programme of the Government, over and above SLR

requirements, gives an upward bias to the interest rate structure.

The deposit rates have been gradually freed from regulation, and, at present, the

only administered interest rate is that on savings bank deposits. The prescribed rate

of interest on savings deposits is 3.5% per annum. The average term deposit rates

have also declined.

Trends in Domestic Deposit Rates of SCBs(Per cent per annum)

In tune with the trend of declining interest rates over the past few years, the

average cost of deposits for SCBs declined from 8.05% in FY1999 to 6.46% in

FY2003. The cost of average deposits also declined significantly during FY2003


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because of lower growth in term deposits (because of lower accrual of interest in

view of declining interest rates, and a shift to current accounts in consonance with

higher industrial activity), and a shift in maturity structure of deposits towards

lower -cost lower-duration deposits.

Maturity Pattern of Deposits of SCBs(% of deposits)

goidirectory.nic.in/

The cost of average interest bearing funds has also declined from 8.23% in FY1999

to 6.80% in FY2003. Various policy measures over the years have, thereby,

resulted in lower average cost of interest bearing funds for SCBs (refer Table

below).

Cost of Deposits and Interest Bearing Funds of SCBs

SpreadsOver the past few years, although the yield on average earning assets has declined

for SCBs, the decline has been partially offset through a decline in cost of average

interest bearing funds. However, the gross interest spread (yield on average earningassets minus the cost of average interest bearing funds) declined from 2.64% in

FY1999 to 2.47% in FY2003. Another indicator of spreadsnet interest income as

a percentage of average assetsalso declined from 3.02% to 2.91% over the same

period.


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Spread Indicators of SCBs

(Per cent of average assets)

However, a distinguishing feature of SCBs performance during FY2003 was the

increase in gross spreads. The increase in spreads in FY2003 was caused by the

larger fall in cost of funds compared with the yields. One reason is the lower

deployment of cash balances because of CRR cuts. Another reason for the increase

in spreads during FY2003 is the assetliability maturity profile of banks. As of end-

FY2003, SCBs term deposits constituted 65.6% of deposits, and 52.3% of liabilities.

Term deposits carry a higher interest rate than savings deposits, and the interest rate

on term deposits is, usually, directly related to duration. Nearly all major SCBs

reported a shift in maturity structure of deposits, with an increased proportion of

shorter duration deposits during FY2003. In terms of maturity pattern, deposits of

SCBs with a maturity upto 1-year increased from 34.3% of deposits at end-FY2002to 37.8% at end-FY2003. Such deposits increased 24.3% during FY2003. By

comparison, the share of deposits with maturity exceeding 1 year declined from

65.7% to 62.2%. Such deposits increased only 6.7% during FY2003, with most of

the increase accounted for by deposits with a maturity exceeding 5 years. The shift

in maturity structure of deposits has benefited banks and provided them more

flexibility in responding to interest rate declines.

The increase in spreads has been accompanied with a significant improvement in

oninterest income. As a result, net operating income, as percent of average assets,

increased from 4.50% in FY2002 to 4.87% in FY2003. Further, the figure was

higher than 4.48% in FY1999. Foreign banks enjoy the highest spreads in India,

primarily because of high gross spreads, and significant off-balance sheet activities.

Over the last few years, while SCBs have reduced their PLRs and are now also


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extending sub-PLR loans, effective lending rates remain high. It is estimated that the

average lending rate of scheduled commercial banks has declined from a peak of

17.1% during FY1996 to 13.9% during FY2002. However, real interest rates have

not declined in the same magnitude. As a result, the effective real lending rate

continues to remain high.

Real Interest Rates(Percent per annum)

Intermediation CostsThe intermediation cost (operating expenses to average total assets) of SCBs showed

a significant decline from 2.84% in FY2001 to 2.38% in FY2002, and to 2.35% in

FY2003. This followed a significant increase during FY2001from 2.68% in

FY2000. Intermediation costs increased 12.9% during FY2003 to Rs. 380.88 billion,

compared with a decline of 1.3% during FY2002, and increase of 23.8% during

FY2001. Employee expenses constitute the largest proportion of intermediation

costs. However, their share of intermediation costs declined from 68% during

FY2001 to 62.1% during FY2003, mainly because of a significant decline in

employee strength for PSBs. Over the period FY2001-03, the decline in employee

expenses for PSBs has been the primary factor behind the significant decline in

intermediation costs (as percent of average assets). Employee expenses, as percent of

average assets, declined from 1.93% during FY2001 to 1.54% during FY2002, and

to 1.46% during FY2003. Employee expenses represented 13.7% of income duringFY2003, compared with 14.4% during FY2002, and 17.6% during FY2001. The

combined employee strength of all SCBs declined an estimated 0.7% during

FY2003, as compared with declines of 3.4% during FY2002, 8.1% during FY2001,

and 1.1% during FY2000. The combined employee strength of SCBs aggregated

0.839 million at end-FY2003.


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Staff Strength at SCBs

(Thousands)

The SCBs had manpower strength of 0.951 million at end-FY2000, of which PSBs

accounted for nearly 92%. PSBs accounted for almost all the decline in

intermediation costs during FY2002 and FY2003, and nearly all the increase in

intermediation costs during FY2001. During FY2001, 26 out of 27 PSBs (with the

exception of Corporation Bank) implemented a voluntary retirement scheme (VRS)

for their employees. As a result, their employee strength declined 8.7% during

FY2001 to 0.80 million. Employee strength of PSBs declined an additional 5.1%

during FY2002, and 0.2% during FY2003 to 0.755 million at end-FY2003. By end-

FY2003, PSBs had implemented employee reductions of approximately 13.5% of

their end-FY2000 levels. The cost of VRS was estimated at Rs. 123 billion. In

accordance w

030-Heart Maniar-The Indian Banking Industry

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