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    INTRODUCTION

    NON-PERFORMING ASSETS

    The world is going faster in terms of services and physical products. However ithas beenresearched that physical products are available because of the service industries.In the nation

    economy also service industry plays vital role in the boosting up of theeconomy. The nationslike U.S, U.K, and Japan have service industries more than 55%.The banking sector is one of

    appreciated service industries. The banking sector playslarger role in channelising moneyfrom one end to other end. It helps almost every personin utilizing the money at their best.The banking sector accepts the deposits of the peopleand provides fruitful return to people onthe invested money. But for providing the better returns plus principal amounts to the clients;it becomes important for the banks to earn.the main source of income for banks are theinterest that they earn on the loans that have been disbursed to general person, businessman,or any industry for its development.Thus, we may find the input-output system in the bankingsector. Banks first, accepts thedeposits from the people and secondly they lend this money to

    people who are in the needof it. By the way of channelising money from one end to anotherend, Banks earn their profits.However, Indian banking sector has recently faced the serious

    problem of NonPerforming Assets. This problem has been emerged largely in Indian bankingsector sincethree decade. Due to this problem many Public Sector Banks have been

    adverselyaffected to their performance and operations. In simple words Non PerformingAssets problem is one where banks are not able to recollect their landed money from theclientsor clients have been in such a condition that they are not in the position to providethe borrowed money to the banks.The problem of NPAs is danger to the banks because itdestroys the healthyfinancial conditions of the them. The trust of the people would not beanymore if the banks have higher NPAs. So. The problem of NPAs must be tackled out insuch a waythat would not destroy the operational, financial conditions and would not affecttheimage of the banks. recently, RBI has taken number steps to reduce NPAs of theIndian banks. And it is also found that the many banks have shown positive figures inreducing NPAs as compared to the past years.

    MEANING OF NPAS

    An asset is classified as non-performing asset (NPAs) if the borrower does not pay dues inthe form of principal and interest for a period of 180 days. However witheffect from March2004, default status would be given to a borrower if dues were not paid for 90 days. If anyadvance or credit facilities granted by bank to a borrower becomenon-performing, then the

    bank will have to treat all the advances/credit facilities grantedto that borrower as non-performing without having any regard to the fact that there maystill exist certain advances /credit facilities having performing status

    WHAT IS A NPAs (NON PERFORMING ASSETS)

    Action for enforcement of security interest can be initiated only if the securedasset isclassified as Non Performing Asset. Non Performing Asset means an asset or account of

    borrower, which has been classified by a bank or financial institution as sub-standard,doubtful or loss asset, in accordance with the directions or guidelines relating toassetclassification issued by RBI.An amount due under any credit facility is treated as "past due" when ithas not been paidwithin 30 days from the due date. Due to theimprovement in the payment and settlementsystems, recovery climate,upgradation of technology in the banking system, etc., it was

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    decided todispense with 'past due' concept, with effect from March 31, 2001.Accordingly, asfrom that date, a Non performing asset (NPA) shell be anadvance where Interest and /orinstallment of principal remain overdue for a period of more than 180 days in respect of aTerm Loan,

    The account remains 'out of order' for a period of more than 180 days, inrespect of anoverdraft/ cash Credit (OD/CC),

    The bill remains overdue for a period of more than 180 days in the case of bills purchasedand discounted,Interest and/ or installment of principal remains overdue for two harvestseasons but for a

    period not exceeding two half years in the case of anadvance granted for agricultural purpose,andAny amount to be received remains overdue for a period of more than 180days in respect ofother accounts.With a view to moving towards international best practices and to ensuregreater transparency, it has been decided to adopt the '90 days overdue' norm foridentification of NPAs, form the year ending March 31, 2004. Accordingly, with effect formMarch 31,2004, a non-performing asset (NPA) shell be a loan or an advance where;Interest and /or installment of principal remain overdue for a period of more than 90 days inrespect of a Term Loan

    he account remains 'out of order' for a period of more than 90 days, inrespect of an overdraft/cash Credit (OD/CC),The bill remains overdue for a period of more than 90 days in the case of bills purchasedand discounted,Interest and/ or installment of principal remains overdue for two harvestseasons but for a

    period not exceeding two half years in the case of anadvance granted for agricultural purpose,andAny amount to be received remains overdue for a period of more than 90days in respect ofother accounts

    CLASSIFICATION OF LOANS

    In India the bank loans are classified on the following basis.Performing Assets:

    Loans where the interest and/or principal are not overdue beyond 180 days at theend of thefinancial year.Non-Performing Assets:

    Any loan repayment, which is overdue beyond 180 days or two quarters, isconsidered asNPA. According to the securitisation and reconstruction of financial assetsand enforcementof security interest ordinance, 2002 non-performing asset(NPA)means an asset or accountof a borrower, which has been classified by a bank or financial institution as sub-standard,doubtful or loss asset, in accordance with thedirections or guidelines relating to assetclassifications issued by the Reserve BankInternationally, income from non-performingassets is not recognized on accrual basis, but is taken into account as income only when it is

    actually received. It has beendecided to adopt similar practice in our country also. Banks havebeen advised that theyshould not charge and take to income account the interest on all Non-performing assets.An asset becomes non-performing for a bank when it ceases to generateincome

    The basis for treating a credit facility as non-performing is as follows

    INCOME RECOGNITION:

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    sn

    Nature of Credit Fac

    ilityBasis for Treatingas NPA

    1 Term Loans A term loan is to be treated as NPA if interest remains past due for a period of 4quarters for the year ended 31-3-1993,3quartersfor the year ended 31-3-1994 and2 quarters for the year ended

    31-3-1995and onwards.Past due means an amount reamingoutstanding or unpaid for 30 days beyond duedate. For e.g.,interest due on 31-3-1993 becomes past due on 30-4-1993, if itis notreceived by that date

    2 Cash Credit & Overdrafts

    A cash credit or overdraft account should be treated as NPA ifthe account remainsout of order for a period of fourquartersduring the year ended 31-3-1993,threequarters duringthe year ended 31-3-1994and two quarters during the year ended31-3-1995 and onwards. An account may betreated as out oforder if any of thefollowing three conditions is metThe balanceoutstanding in the accountremains continuously in excess of

    thesanctioned limit or drawing power.OR

    The balance outstanding is within thelimit/drawing power, butthere are nocredits in the account continuously for a period ofsix months as on the date of the balance sheet of the bank

    OR

    There are some credits but the creditsare not enough to

    cover the interestdebited to the account during the

    sameperiod

    3 Bill Purchased and Discounted

    An account should be treated as NPA if the bill remains overdueand unpaid for a period of four quarters during the year ended 31stMarch, 1994 and two quartersduring the year ended 31stMarch, 1995 andonwards.It may be added that overdueinterestshould not be charged and taken to incomeaccount inrespect of overdue bills unless itis realized

    4 Other Accounts Any other credit facility should be treatedas NPA if any amountto be received inrespect of that facility remains past due for a

    period of four quarters during the year ended 31

    stMarch 1993. There quartersduring the year ended 31stMarch 1994 andtwo quarters during the year ended 31stMarch 1995 and onwards

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    ASSET CLASSIFITION:

    S.n Category of assets Basis for Deciding the category

    1 Standard Assets An asset, which does not disclose any problem

    and also does not carry more thannormal riskattached to the business, itshould not fall underthis category of NPA.

    2 Sub-Standard Assets An asset, which has been identified as NPAfora period not exceeding two years.In the case ofterm loan, if installments of principal areoverdue for more than one year but notexceeding two years, it is to betreated as sub-standard asset.An asset where the terms of theloanagreement regarding interest and

    principalhave been re-negotiated or re-scheduledshould be classified as sub-standard

    andshould remain in such category for atleasttwo years of satisfactory performanceunder the re-negotiated or rescheduled terms.Inother words, the classification of assetsshouldnot be upgraded merely as a result of re-scheduling unless there issatisfactorycompliance of the above condition.

    3 Doubtful Assets An asset, which remains NPA for more thantwoyears.Here too, rescheduling does not entitlea bank to upgrade the quality of anadvanceautomatically.In the case of a term loan, if installments

    of principal are overdue for more thantwoyears, it is to be treated as doubtful.

    4 Loss Assets An asset where loss has been identified bythe bank or internal/external auditors or byRBIinspection but the amount has not beenwritten-off, wholly or partly. In other words,such anasset is considered unrealizable andof suchlittle value that its continuance as a bankableasset is not warranted althoughthere may besome salvage or recoveryvalue.

    After liberalization the Indian banking sector developed very appreciate. The RBI alsonationalized good amount of commercial banks for proving socio economic services to the

    people of the nation. The Public Sector Banks have shown very good performance as far asthe financial operations are concerned. If we look to the glance of the financial operations, wemay find that deposits of public to the Public Sector Banks have increasedfrom859,461.95crore to 1,079,393.81crore in 2010, the investments of the PublicSector Banks have increased from 349,107.81crore to 545,509.00crore, and however theadvances have also been increased to 549,351.16crore from 414,989.36crore in 2010.Thetotal income of the public sector banks have also shown good performance since the last few

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    years and currently it is 128,464.40crore. The Public Sector Banks have also showncomparatively good result. The gross profits of the Public Sector Banks currently29,715.26crore which has been doubled to the last to last year, and the net profit of the PublicSector Banks is 12,295,47crore.However, the only problem of the Public Sector Banks these

    days are the increasing level of the non performing assets. The non performing assets of thePublic Sector Banks have been increasing regularly year by year. If we glance on the

    numbers of non performing assets we may come to know that in the year 1997 the NPAswere47,300crore and reached to 80,246crore in 2002.The only problem that hampers the

    possible financial performance of the Public Sector Banks is the increasing results of the nonperforming assets. The non performing assets impacts drastically to the working of the banks.

    The efficiency of a bank is not always reflected only by the size of its balance sheet but bythe level of return on its assets. NPAs do not generate interest income for the banks, but at thesame time banks are required to make provisions for such NPAs from their current profits.

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

    They erode current profits through provisioning requirementsThey result in reduced interest incomeThey require higher provisioning requirements affecting profits and accretion to capitalfunds and capacity to increase good quality risk assets in future, andThey limit recycling of funds, set in asset-liability mismatches, etc. The RBI has also tried todevelop many schemes and tools to reduce the non performing assets by introducing internalchecks and control scheme, relationship managers as stated by RBI who have completeknowledge of the borrowers, credit rating system, and early warning system and so on. TheRBI has also tried to improve the securitization Act and SRFAESI Act and other acts relatedto the pattern of the borrowings .Though RBI has taken number of measures to reduce thelevel of the non performing assets the results is not up to the expectations. To improve NPAs

    each bank should be motivated to introduce their own precautionary steps. Before lending the

    banks must evaluate the feasible financial and operational prospective results of theborrowing companies. They must evaluate the business of borrowing companies by keepingin considerations the overall impacts of all the factors that influence the business.

    2. Objective of the study

    To know why NPAs are the great challenge to the Public Sector BanksTo understand what is Non Performing Assets and what are the underlying reasons for theemergence of the NPAs.To understand the impacts of NPAs on the operations of the Public Sector Banks.To know what steps are being taken by the Indian banking sector to reduce the NPAs?To evaluate the comparative ratios of the Public Sector Banks with concerned to the NPAs.

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    4. Limitations of the study

    The limitations that I felt in my study are:It was critical for me to gather the financial data of the every bank of the Public Sector

    Banks so the better evaluations of the performance of the banks are not possible.Since my study is based on the secondary data, the practical operations as related to the

    NPAs are adopted by the banks are not learned.Since the Indian banking sector is so wide so it was not possible for me to cover all the

    banks of the Indian banking sector.

    INDIAN BANKING SECTOR

    Banking in India has its origin as early as the Vedic period. It is believed that the transitionfrom money lending to banking must have occurred even before Manu, the great HinduJurist, who has devoted a section of his work to deposits and advances and laid down rulesrelating to rates of interest. During the Mogul period, the indigenous bankers played a veryimportant role in 0lending money and financing foreign trade and commerce. During the daysof the East India Company, it was the turn of the agency houses to carry on the banking

    business. The General Bank of India was the first Joint Stock Bank to be established in theyear 1786. The others which followed were the Bank of Hindustan and the Bengal Bank. TheBank of Hindustan is reported to have continued till 1906 while the other two failed in themeantime. In the first half of the 19

    thcentury the East India Company established three

    banks; the Bank of Bengal in 1809, the Bank of Bombay in 1840 and the Bank of Madras in1843. These three banks also known as Presidency Banks were independent units andfunctioned well. These three banks were amalgamated in 1920 and a new bank, the Imperial

    Bank of India was established on 27th January 1921. With the passing of the State Bank ofIndia Act in 1955 the undertaking of the Imperial Bank of India was taken over by the newlyconstituted State Bank of India. The Reserve Bank which is the Central Bank was created in1935 by passing Reserve Bank of India Act 1934. In the wake of the Swadeshi Movement, anumber of banks with Indian management were established in the country namely, Punjab

    National Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank ofBaroda Ltd, the Central Bank of India Ltd. On July 19, 1969, 14 major banks of the countrywere nationalised and in 15thApril 1980 six more commercial private sector banks were alsotaken over by the government.

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

    The decade gone by witnessed a wide range of financial sector reforms, with many of themstill in the process of implementation. Some of the recently initiated measures by the RBI forrisk management systems, anti money laundering safeguards and corporate governance in

    banks, and regulatory framework for non bank financial companies, urban cooperative banks,government debt market and forex clearing and payment systems are aimed at streamliningthe functioning of these instrumentalities besides cleansing the aberrations in these areas.Further, one or two all India development financial institutions have already commenced the

    process of migration towards universal banking set up. The banking sector has to respond to

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    these changes, consolidate and realign their business strategies and reach out for technologysupport to survive emerging competition. Perhaps taking note of these changes in domestic aswell as international arena All of we will agree that regulatory framework for banks was onearea which has seen a sea-change after the financial sector reforms and economic

    liberalisation and globalisation measures were introduced in 1992-93. These reformsfollowed broadly the approaches suggested by the two Expert Committees both set up under

    the chairmanship of Shri M. Narasimham in 1991 and 1998, the recommendations of whichare by now well known. The underlying theme of both the Committees was to enhance thecompetitive efficiency and operational flexibility of our banks which would enable themtomeet the global competition as well as respond in a better way to the regulatory andsupervisory demand arising out of such liberalisation of the financial sector. Most of therecommendations made by the two Expert Committees which continued to be subject matter ofclose monitoring by the Government of India as well as RBI have been implemented.Government of India and RBI have taken several steps to :- (a) Strengthen the bankingsector,(b) Provide more operational flexibility to banks,(c) Enhance the competitiveefficiency of banks, and(d) Strengthen the legal framework governing operations of banks.

    Regulatory measures taken to strengthen the Indian Banking sectors

    The important measures taken to strengthen the banking sector are briefly, the following:Introduction of capital adequacy standards on the lines of the Basel norms, prudential norms on asset classification, income recognition and provisioning,Introduction of valuation norms and capital for market risk for investmentsEnhancing transparency and disclosure requirements for published accounts ,Aligning exposure norms single borrower and group-borrower ceiling withinter-national

    best practicesIntroduction of off-site monitoring system and strengthening of the supervisoryframeworkfor banks.(A) Some of the important measures introduced to provide moreoperational flexibilityto banks are:

    Besides deregulation of interest rate, the boards of banks have been given theauthority to fixtheir prime lending rates. Banks also have the freedom to offer variable rates of interest ondeposits, keeping in view their overall cost of funds.Statutory reserve requirements have significantly been brought down.The quantitative firm-specific and industry-specific credit controls were abolishedand bankswere given the freedom to deploy credit, based on their commercial judgment, as per the

    policy approved by their Boards.The banks were given the freedom to recruit specialist staff as per their requirements,

    The degree of autonomy to the Board of Directors of banks was substantiallyenhanced.Banks were given autonomy in the areas of business strategy such as, opening of branches /

    administrative offices, introduction of new products and certain other operational areas.(b)Some of the important measures taken to increase the competitive efficiency of banksare the

    following:

    y Opening up the banking sector for the private sector participation.y Scaling down the shareholding of the Government of India in nationalised banksand

    of the Reserve Bank of India in State Bank of India.(c) Measures taken by theGovernment of India to provide a more conducive

    y legal environmenty for recovery of dues of banks and financial institutions are:

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    y Setting up of Debt Recovery Tribunals providing a mechanism for expeditiousloanrecoveries.

    y Constitution of a High Power Committee under former Justice Shri Eradi tosuggestappropriate foreclosure laws.

    y An appropriate legal framework for securitisation of assets is engaging theattentionof the Government,Due to this paradigm shift in the regulatory framework for banks

    had achieved thedesired results. The banking sector has shown considerable degreeof resilience.(a) The level of capital adequacy of the Indian banks has improved: theCRAR of public sector banks increased from an average of 9.46% as on March 31,1995 to11.18% as on March 31, 2001.(b) The public sector banks have also madesignificant progress in enhancing their asset quality, enhancing their provisioninglevels and improving their profits.

    y The gross and net NPAs of public sector banks declined sharply from 23.2%and14.5% in 1992-93 to 12.40% and 6.7% respectively, in 2000-01.

    y Similarly, in regard to profitability, while 8 banks in the public sectorrecordedoperating and net losses in 1992-93, all the 27 banks in the public sectorshowedoperating profits and only two banks posted net losses for the year ended

    March31, 2001.y The operating profit of the public sector banks increased from Rs.5628 crore as

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

    y The net profit of public sector banks increased from Rs.1116 crore to Rs.4317croreduring the same period, despite tightening of prudential norms on provisioningagainst loan losses and investment valuation.The accounting treatment for impairedassets is now closer to the international best

    The accounting treatment for impaired assets is now closer to the international best practicesand the final accounts of banks are transparent and more amenable tomeaningfulinterpretation of their performance.

    WAY FORWARD

    RBI president recently recommended Indian banks to go for larger provisioningwhen theprofits are good without frittering them away by way of dividends, however tempting it may be. As a method of compulsion, RBI has recently advised banks to createan InvestmentFluctuation Reserve upto 5 per cent of the investment portfolio to protectthe banks fromvarying interest rate regime.He further added that one of the means for improving financialsoundness of a bank is byenhancing the provisioning standards of the bank. The cumulative

    provisions against loanlosses of public sector banks amounted to a mere 41.67% of theirgross NPAs for the year ended March 31, 2001. The amount of provisions held by public

    sector banks is not onlylow by international standards but there has been wide variation inmaintaining the provision among banks. Some of the banks in the public sector had as low

    provisioningagainst loan losses as 30% of their gross NPAs and only 5 banks had provisionsin excessof 50% of their gross NPAs. This is inadequate considering that some of the

    countriesmaintain provisioning against impaired assets at as high as 140%. Indian Banksshouldimprove the provisioning levels to at least 50% of their gross NPAs. There should

    therefore be an attitudinal change in banks policy as regards appropriation of profits and fullprovisioning towards already impaired assets should become a priority corporategoal.He also

    suggested that banks should also develop a concept of building Desirable capitalover and above the minimum CRAR which is insisted upon in developedregulatory regimeslike UK. This can be at, say around 12 percent as practised even today by some of the Indian

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    banks, so as to provide well needed cushion for growth in risk weighted assets as well asprovide for unexpected erosion in asset values.As banks would have observed, the changes inthe regulatory framework are now brought in by RBI only through an extensive consultative

    process with banks as well as public wherever warranted. While this serves the purpose of

    impact assessment on the proposed measures it also puts the banks on notice to initiateappropriate internalreadjustment to meet the emerging regulatory prescriptions. Though

    adequate transitionalroute has been provided for switchover to new regulatory measures suchas scaling down the exposure to capital market, tightening the prudential requirements likeswitch over to90 day NPA norm, reduction in exposure norms, etc., I observe from thevarious quarters from which RBI gets its inputs that the banks are yet to take serious stepstowardsimplementation of these measures.The Boards of banks have been accordedconsiderable autonomy in regard to their corporate strategy as also several other operationalmatters. This does not; however, seemto have translated to any substantial improvement incustomer service. It needs to berecognised that meeting the requirements of the customer whether big or small efficiently and in a cost effective manner, alone will enable the banksto withstand theglobal competition as also the competition from non-bank institutions.The

    profitability of the public sector banks is coming under strain. Despite theresilience shown byour banks in the recent times, the income from recapitalisation bondsaccounted for a

    significant portion of the net profits for some of the nationalised banks.The Return on Assets(RoA) of public sector banks has, on an average, declined from0.54 for the year ended March31, 1999 to 0.43 for the year ended March 31, 2001.Therefore, the Boards attention needs to

    be focused on improving the profitability of the bank. The interest income of public sector banks as a percentage of total assets has shown a declining trend since 1996-97: it declinedfrom 9.69 in 1996-97to 8.84 in 2000-01. Similarly, the spread (net interest income) as a

    percentage of totalassets also declined from 3.16 in 1996-97 to 2.84 in 2000-01.Adisheartening feature is that a large number of public sector banks haverecorded far below themedian RoA of 0.4% for 2000-01 in their peer group. Incidentallythe RoA recorded by new

    private banks and foreign banks ranged from 0.8% to 1% for the same period. An oftenquoted reason for the decline in profitability of public sector banks is the stock of NPAswhich has become a drag on the banks profitability. As youare aware, the stock of NPAsdoes not add to the income of the bank while at the sametime, additional cost is incurred forkeeping them on the books. To help the public sector banks in clearing the old stock ofchronic NPAs, RBI had announced one-time nondiscretionary and non discriminatorycompromise settlement schemes in 2000 and 2001.Though many banks tried to settle the old

    NPAs through this transparent route, theresponse was not to the extent anticipated as thebanks had been bogged down by the usual fear psychosis of being averse to settling dueswhere security was available. Themoot point is if the underlying security was not realisedover decades in many cases dueto extensive delay in litigation process, should not the bankshave taken advantage of theone time opportunity provided under RBI scheme to cleanse their

    books of chronic NPAs? This would have helped in realizing the carrying costs on such non-incomeearning NPAs and released the funds for recycling. If better steps are taken placed in

    thisconnection then the performance of the Public Sector Banks can show very goodandhealthy results in the shorter period.To make the better future of the Public Sector Banks,the Boards need to be aliveto the declining profitability of the banks. One of the reasons forthe low level of profitability of public sector banks is the high operating cost. The costincome ratio(which is also known as efficiency ratio of public sector banks) increased from65.3 percent for the year ended March 31, 2000 to 68.7 per cent for the year ending March31,2001. The staff expenses as a proportion to total income formed as high as 20.7%for public sector banks as against 3.3% for new banks and 8.2% for foreign banks for theyearended March 31, 2001. There is thus an imperative need for the banks to go for costcutting

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    exercise and rationalise the expenses to achieve better efficiency levels inoperation towithstand declining interest rate regime.Boards of banks have much more freedom now thanthey had a decade ago, andobviously they have to play the role of change agents. They shouldhave the expertise toidentify, measure and monitor the risks facing the bank and be capable to

    direct andsupervise the banks operations and in particular, its exposures to various sectors oftheeconomy, and monitoring / review thereof, pricing strategies, mitigation of risks, etc.

    TheBoard of the banks should also ensure compliance with the regulatory framework,andensure adoption of the best practices in regard to risk management andcorporategovernance standards. The emphasis in the second generation of reforms ought to

    be inthe areas of risk management and enhancing of the corporate governance standardsin banks.

    THE INDIAN BANKING INDUSTRY

    The origin of the Indian banking industry may be traced to the establishment of the Bank ofBengal in Calcutta (now Kolkata) in 1786. Since then, the industry haswitnessed substantialgrowth and radical changes. As of March 2002, the Indian bankingindustry consisted of 97

    Commercial Banks, 196 Regional Rural Banks, 52 ScheduledUrban Co-operative Banks, and16 Scheduled State Co-operative Banks.The growth of the banking industry in India may bestudied in terms of two broad phases: Pre Independence (1786-1947), and Post Independence(1947 till date). The postindependence phase may be further divided into three sub-phases:Pre-Nationalisation Period (1947-1969)Post-Nationalisation Period (1969-1991)Post-Liberalisation Period (1991- till date)The two watershed events in the postindependence phase are the nationalisationof banks(1969) and the initiation of the economic reforms (1991). This section focuseson theevolution of the banking industry in India post-liberalisation.

    1. Banking Sector Reforms - Post-Liberalisation

    In 1991, the Government of India (Gol) set up a committee under thechairmanship of Mr. Narasimaham to make an assessment of the banking sector. Thereport of this committeecontained recommendations that formed the basis of the reformsinitiated in 1991.The bankingsector reforms had the following objectives:1. Improving the macroeconomic policyframework within which banks operate;2. Introducing prudential norms;3. Improving thefinancial health and competitive position of banks;4. Building the financial infrastructure

    relating to supervision, audit technology and legalframework; and5. Improving the level ofmanagerial competence and quality of human resources.

    1.1Impact of Reforms on Indian Banking IndustryWith the initiation of the reforms in the financial sector during the 1990s, theoperatingenvironment of banks and term-lending institutions has radically transformed.One of thefall-outs of the liberalisation was the emergence of nine new private sector banks in themid1990s that spurred the incumbent foreign, private and public sector banks tocompete more fiercely than had been the case historically. Another developmentof theeconomic liberalisation process was the opening up of a vibrant capital market inIndia,

    with both equity and debt segments providing new avenues for companies to raisefunds.Among others, these two factors have had the greatest influence on banksoperating in

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    India to broaden the range of products and services on offer. The reformshave touchedall aspects of the banking business. With increasing integration of theIndian financialmarkets with their global counterparts and greater emphasis on risk management

    practices by the regulator, there have been structural changes within the banking sector.

    The impact of structural reforms on banks' balance sheets (both on theasset and liabilitysides) and the environment they operate in is discussed in the followingsections.

    1.2 Reforms on the Liabilities Side

    Reforms of Deposit Interest RateBeginning 1992, a progressive approach was adopted towards deregulating theinterest

    rate structure on deposits. Since then, the rates have been freed gradually.Currently, theinterest rates on deposits stand completely deregulated (with the exceptionof the savings

    bank deposit rate). The deregulation of interest rates has helped Indian banks to gainmore control on the cost of their deposits, the main source of funding for Indian banks.Besides, it has given more, flexibility to banks in managing their Asset-Liability

    positions.

    Increase in Capital Adequacy Requirement

    During the 1990s, the Reserve Bank of India (RBI) adopted a strategy aimed at all banksattaining a Capital Adequacy Ratio (CAR) of 8% in a phased manner. Ontherecommendations of the Committee on Banking Sector Reforms, the minimum CARwasfurther raised to 9%, effective March 31, 2000.While the stipulation of a higherCapita!Adequacy' Ratio has increased the capital requirement of banks; it has providedmorestability to the Indian banking system.

    1.2Reforms on the Asset Side1.3

    Reforms on the Lending Interest RateDuring 1975-76 to 1980-81, the RBI prescribed both the minimum lending rateand the ceilingrate. During 1981-82 to 1987-88. The RBI prescribed only the ceilingrate. During 198889 to1994-95, the RBI switched from prescribing a ceiling rate tofixing a minimum lending rate.From 1991 onwards, interest rates have been increasinglyfreed. At present, banks can offerloans at rates below the Prime Lending Rate (PLR) toexporters or other creditworthy

    borrowers (including public enterprises), and have only toannounce the FLR and themaximum spread charged over it. The deregulation of lendingrates has given banks theflexibility to price loan products on the basis of their own business strategies and the risk

    profile of the borrower. It has also lent a competitiveadvantage to banks with lower cost offunds.

    Lower Cash Reserve and Statutory Liquidity RequirementsDuring the early 1980s, statutory pre-emption in the form of Cash Reserve Ratio(CRR) andStatutory Liquidity Ratio (SLR) accounted for 42% of the deposits. In the1990s, the figurerose to 53.5%, which during the post-liberalisation period has beengradually reduced. At

    present, banks are required to maintain a CRR of 4% of the NetDemand and Time Liabilities(NDTL) (excluding liabilities subject to zero CRR prescriptions). The RBI has indicated thatthe CRR would eventually be brought down tothe statutory minimum level of 3% over a

    period of time.

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    The SLR, which was at a peak of 38.5% during September 1990 to December 1992, nowstands lower at the statutory minimum of 25%.A decrease in the CRR andSLR requirementsimplies an increase in the share of deposits available to banks for loansand advances. It alsomeans that bank's now have more discretion in the allocation of funds, which if deployed

    efficiently, can have a positive impact on their profitability. Byincreasing the amount ofinvisible funds available to banks, the reduction in the CRR andSLR requirements has also

    enhanced the need for efficient risk management systems in banks.

    Asset Classification and Provisioning NormsPrudential norms relating to asset classification have been changed post-liberalisation. The

    earlier practice of classifying assets of different quality into eight`health codes" has now beenreplaced by the system of classification into four categories(in accordance with theinternational norms): standard, sub-standard, doubtful, and lossassets. On 1st April 2000,

    provisioning requirements of a minimum of 0.25% wereintroduced for standard assets. Forthe sub-standard, doubtful and loss asset categories,the provisioning requirements remainedat 10%, 20-50% (depending on the duration for which the asset has remained doubtful), and100%, respectively, the recognition normsfor NPAs have also been tightened gradually. SinceMarch 1995, loans with interestand/or installment of principal overdue for more than 180

    days are classified as non- performing. This period will be shortened to 90 days from the yearending 31st' March2004.1.4 Structural Reforms

    Increased CompetitionWith the initiation of banking-sector reforms, a more competitive environmenthas been

    ushered in. Now banks are not only competing within themselves, but also withnon-banks,such as financial services companies and mutual funds. While existing bankshave beenallowed greater flexibility in expanding their operations, new private sector banks have also

    been allowed entry. Over the last decade nine new private sector bankshave establishedoperations in the country. Competition amongst Public Sector Banks(PSBs) has alsointensified. PSBs are now allowed to access the capital market to raisefunds. This has diluted

    Government's shareholding, although it remains the major shareholder in PSBs, holding aminimum 51% of their total equity. Although competitionin the banking sector has reducedthe share of assets and deposits of the PSBs, their dominant positions, especially of the largeones, continues.

    Although the PSBs will remain major players in the banking industry, they are likelyto facetough competition, from both private sector banks and foreign banks. Moreover,the banking

    industry is likely to face stiff competition from other players like non-bank financecompanies, insurance companies, pension funds and mutual funds. Theincreasing efficiencyof both the equity and debt markets has also accelerated the processof financialdisintermediation, putting additional pressure on banks to retain their customers. Increasingcompetition among banks and financial intermediaries is likely toreduce the Net Interest

    Spread of banks.

    Banks entry into New Business LinesBanks are increasingly venturing into new areas, such as, Insurance and MutualFunds, andoffering a wider bouquet of products and services to satisfy the diverse needsof theircustomers. With the enactment of the Insurance Regulatory and DevelopmentAuthority(IRBA) Act, 1999, banks and NBFCs have been allowed to enter the insurance business. TheRBI has also issued guidelines for-banks' entry into insurance, according towhich, banks needto obtain prior approval of the RBI to enter the insurance business. Sofar, the RBI has

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    accorded its approval to three of the 39 commercial banks that hadsought entry intoinsurance.Insurance presents a new business opportunity for banks. The opening up of theinsurance business to banks is likely to help them emerge as financial supermarkets liketheir counterparts in developed countries.

    Increased thrust on Banking Supervision and Risk Management

    To strengthen banking supervision, an independent Board for FinancialSupervision (BFS)under the RBI was constituted in November 1994. The Board isempowered to exerciseintegrated supervision over all credit institutions in the financialsystem, including selectDevelopment Financial Institutions (DFIs) and Non BankingFinancial Companies (NBFCs),relating to credit management, prudential norms andtreasury operations. A comprehensiverating system, based on the CAMELSmethodology, has also been instituted for domestic

    banks; for foreign banks, the ratingsystem is based on CACS. This rating system has beensupplemented by a technology-enabled quarterly off- site surveillance system.To strengthenthe Risk Management Process in banks, in line with proposed Basel11 accord, the RBI hasissued guidelines for managing the various types of risks that banks are exposed to. To make

    risk management an integral part of the Indian banking system, the RBI has also issuedguidelines for Risk based Supervision (RBS) and Risk based Internal Audit (RBIA).

    These reform initiatives are expected to encourage banks to allocate funds acrossvarious linesof business on the basis of their Risk adjusted Return on Capital (RAROC).The measureswould also help banks be in line with the global best practices of risk management andenhance their competitiveness.The Indian banking industry has come a long way since thenationalisation of banks in 1969. The industry has witnessed great progress, especially overthe past 12years, and is today a dynamic sector. Reforms in the banking sector have enabled

    banksexplore new business opportunities rather than remaining confined to generatingrevenuesfrom conventional streams. A wider portfolio, besides the growing emphasis

    onconsumer satisfaction, has led to the Indian banking sector reporting robust growthduring

    past few years.It is clear that the deregulation of the economy and of the Banking sector overthelast decade has ushered in competition and enabled Indian banks to better take onthechallenges of globalisation.

    1.5 Operational and Efficiency Benchmarking

    Benchmarking of Return on Equity

    Return on Equity (ROE) is an indicator of the profitability of a bank from theshareholder'sperspective. It is a measure of Accounting Profits per unit of Book EquityCapital. The ROEof Indian banks for the year ended 31st March 2010, was in the rangeof 14 - 40%; the medianROE. Being 23.72% for the same period. On the other hand, theglobal benchmark banks hada median ROE of 12.72% for the year ended 31st December 2002.In recent years, Indian

    banks have reported unusually high trading incomes,driven mainly by the scope to booking profits that arise from a sharply declining interestrate environment. However, such hightrading income may not be sustainable in future.The adjusted median ROE for Indian banks(adjusted for trading income) stands at 5.42%for Indian banks for FY2010 as compared with11.77% for the global benchmark banks.After adjusting for trading income, the median ROEof Indian hanks stands lower than the same for the global benchmark banks, thus implyingthat the contribution of trading income to the RoE of Indian banks is significant.

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    Further, the ROE benchmarking method favors banks that operate with low levelsof equity orhigh leverage. To assess the impact of the leverage factor on the ROE of banks, "EquityMultiplier is presented in the next section.

    Benchmarking of Equity Multiplier

    Equity Multiplier (EM) is defined as "Total Assets divided by Net Worth". This isthereciprocal of the Capital-to-Asset ratio, which indicates the leverage of a bank (amount ofAssets of a bank pyramided on its equity capital). Banks with a higher leverage will be ableto post a higher ROE with a similar level of Return on Asset (ROA), because of the multipliereffect. However, the banking industry is safer with a lower leverage or a higher proportion ofequity capital in the total liability. Capital is importantfor banks for two main reasons:Firstly,capital is viewed as the ultimate line of protection against any potentiallosscredit, market, oroperating risks. While loan and investment provisions areassociated with expected losses,capital is a cushion against unexpected losses.Secondly, capital allows banks to pursue theirgrowth objectives; a bank has tomaintain a minimum capital adequacy ratio in accordancewith regulatory requirements.A bank with insufficient capital may not be able to takeadvantage of growthopportunities offered by the external operating environment the same

    way as another bank with a higher capital base could.

    Benchmarking of Return on Assets

    ROA is defined as Net Income divided by Average Total Assets. The ratiomeasures a bank'sProfits per currency unit of Assets. The median ROA for Indian bankswas 1.15% forFY2010. For the global benchmark banks, the ROA ranged from 0.05% to1.44% for the yearended December 2002, with the median at 0.79%.For the year ended December 2002, Bankof America reported the highest ROA(1.44%) among the global benchmark banks, followed

    by Citi group Inc. (1.42%). Themedian value for Indian banks at 1.15% was higher than thatof ABN AMRO Bank Deutsche Bank, Rabo Bank and Standard Chartered Bank. Two banks,namely Bank of America and Citigroup Inc., posted higher ROAs as compared with theEuropean and other banks for both FY2010 and FY2002 primarily on the strength of higher

    Net Interest Margins. The reasons for the Net Interest Margins being higher are discussed inthe sections that follow.

    As with the ROE analysis, here too adjustments for non-recurringincome/expenses must bemade while comparing figures on banks' ROA. Adjusting for trading income, for both Indian

    banks and the global benchmark banks, the median worksout to be lower for Indian banksvis-a-vis the global benchmark banks for FY 2010.I have further analysed the effect of

    adjustment for trading income on the ROAsof both Indian Banks and the Global BenchmarkBanks. Here, it must be noted that theglobal benchmark banks have a more diversified

    income portfolio as compared withIndian banks, and a decline in interest rate could haveincreased profitability of global benchmark banks indirectly in more ways than one.

    However, from the disclosuresavailable in the annual reports of the global banks, it is notpossible to quantify theimpact of declining interest rates on their profitability (`thus, the same

    has not beenadjusted for in this analysis). Nevertheless, to further analyse the profitability(per unit of assets) of Indian banks vis-a-vis the global benchmark banks, ICRA has

    conducted aROA decomposition analysis.

    1.6 Decomposition of Return on Assets

    Net Interest Margin

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    Net Interest Margin (NIM) measures the excess income of a bank's earningsassets (primarilyloans, fixed-income investments, and interbank exposures) over itsfunding costs. To the past,for banks NIM was the main source of earnings, which weretherefore directly correlated withthe margin levels. But with NIM declining significantlyin many countries, banks are now

    trying to compensate the "lost" margins with non-fund based fee incomes and trading income.Despite these changes, net interest incomecontinues to account for a significant share of the

    earnings of most banks. The median NIM for Indian banks was 3.16% for FY2010 and 3.92%for FY2002. The figurescompare favorably with those of the global benchmark banks.Beforedrawing inferences on the NIM benchmarking results, three aspects must beconsidered,namely: (a) The external operating environment, (b) The quality and type of assets, and (c)Accounting policies followed by banks.The three aspects are explored in detail in thesubsequent paragraphs.

    (a)External Operating Environment(b)Intermediation cost is a significant factor explaining the differences in NIMsacross

    countries. Interest margins tend to be higher in countries where the intermediationcosts are high. Generally, the absence of a vibrant capital market results in theintermediation costs being higher. In India, the debt market is relatively lessdeveloped(as compared with the markets in USA and Europe), and therefore, most

    corporate entities are dependent mainly on banks for meeting their financing needs.As a result,Indian banks are able to command higher NIMs as compared with theglobal benchmarks banks. To make a like-to-like comparison and understand theimpact of intermediationcost, ICRA has compared the NIMs of the Indianoperations of the global benchmark banks with those of Indian banks. Of the sixglobal benchmark banks, the local operationsof four banks earned higher NIMs vis-a-vis the median of Indian banks in FY2002 andFY2010. Of these four banks, threeearned NIMs above 4%. This analysis strengthensICRA's hypothesis that theexternal operating environment is an important factor while benchmarking NIMs.

    (c) (b) Type & Quality of Assets(d)The higher NIMs of US-based banks are attributable to their sharper focus onconsumerloans and credit cards as compared with European banks. Also, the high NIMsof US banksare the cause for their comparatively high ROAs. To overcome the potentialfor higher

    provisions arising from its strategy of lending to riskier assets, a bank maycharge a higherrate of interest to its borrowers (with a consequently higher NIM) thananother bank. So whilecomparing the NIMs of two banks, the effect of asset quality must be normalised. One way ofdoing this is to use Total Risk Weighted Adjusts (RWA)instead of Total Assets as thedenominator. However, many Indian banks do not disclosetheir RWA values in their annualreports, and therefore, ICRA has not been able to usethis method in this study. The alternativemethod is to adjust the NIM for provisions &contingencies. If the asset quality of a bank isrelatively weak, it is likely to generatehigher Non-Performing Assets (NPAs). As a result, its

    provisions & contingencies arealso likely to be higher. Therefore, if the effect of asset quality

    is normalised by removing provisions & contingencies from the NIM, a better understandingof the efficiency of thefund based business of banks may be obtained. ICRA defined adjusted

    NIM as NetInterest Spread (Net Interest Income less Provisions & Contingencies)/AverageTotalAssets]. The Net Interest Spread's for the global benchmark banks ranged from 0.14to2.10% for the financial year ended December 2002, with the median at 1.54%.Thecorresponding median figure for Indian banks was 1.68%. The difference betweenthe NIMs of the global benchmark banks and Indian bank; reduces substantiallyafter adjusting for provisions. This strengthens ICRA's hypothesis that the type and qualityof assets substantially affect NIM.

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    (3)Accounting PoliciesThe Net Interest Spreads adjusted for Provisions can vary substantially,depending on theincome recognition and provisioning norms. According to InternationalAccounting Standard,(IAS) provisioning for NPAs is based on management discretion,Whereas in India, the RBI

    defines the provisioning requirement for impaired assets asa function of time and security. Anillustration of difference in accounting for NPA is thatfor Indian banks, an asset is reckoned

    as NPA when principal or interest are past due for 180 days as compared with 90 days for theglobal benchmark banks (the norms willconverge with effect from financial year 2004).Keeping in view the levels of NIM for Indian and global benchmark banks, and the threefactors analysed above, ICRA believesthat the NIM for Indian banks is comparable with thatof the global benchmark banks.Non-Interest Income RatioIncreased competition in the Indian Banking industry has driven the interestyields andconsequently, the NIMs, southwards. Hence, banks are increasinglyconcentrating on non-interest income to shore up profits. In FY2010, the range of non-interest income for Indian

    banks (as percentage of average Total Assets) was between1.01 and 3.00%. The median forIndian banks showed a moderate increase from 1.63% in2002 to 1.77% in 2010. The non-interest income (as percentage of Average Total assets)of the global benchmark banks varied

    from 0.72 to 3.13% (with a median value of 1.62%), or the year ended December 31, 2002.The decline in interest rates in India over the last few years has helped Indian banks booksubstantial profits from the sale of investments, thus boosting their Non-Interest Income. Asthe high profits accruing fromthe sale of investments are not lively to be sustainable, ICRAhas benchmarked the purefee based income (i.e. looking at Non-interest income without

    profits from sale of investments) as a percentage of average total income. 16 of the 21 Indianbanks in thestudy had a fee based income ratio of between 0.4 and 0.8%.A comparison aftersimilar adjustment for the global benchmark banks reveals that the fee-based income ratioof Indian banks is lower.

    Operating Expense Ratio

    The Operating Expense Ratio (operating expenses as a ratio of the average totalassets)reveals how expensive it is for a bank to maintain its fixed assets and humancapital that areused to generate that income streams, The median Operating Expenseratio for Indian banks

    was 2.26% in 2010, which is comparable with that for the global benchmark banks (2.09%).1.7 Asset Quality Benchmarking

    Gross NPAsThe median Gross NIA ratio (Gross NPA as a proportion of total advances) for Indian banks

    was 9.40% for FY2010 and 10.66% for FY2002. The values of the Gross NPA ratio for FY2010 range between 2.26 and 14.68%.Many global banks do notdisclose their Gross NPA

    percentages in their annual reports.Net NPAsThe median Net NPA ratio ("Net NPA as a proportion of Net advances) of Indian banks was

    4.33% for FY2010 and 5.39% for FY2002. The values of Net NPA ratio for FY 2010 for theglobal benchmark banks ranged between 0.37 and 7.08%. Most of theglobal benchmark

    banks do not disclose their Net NPA ratios in their annual reports.From the study it can beinferred that the median Net NPA percentage for Indian banks ismarginally higher than thatfor the global benchmark banks.Efficiency BenchmarkingICRA studied the following parameters to assess the efficiency of Indian banksvis--vis their

    foreign counterparts: Profitability per employee Profitability per branch Business peremployee Business per branch Expenses per employee Expenses per branchThe business

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    model of the global benchmark banks involves outsourcing of non-core activities. In the caseof Indian banks, particularly those in the public sector, bothnon-core and core businessfunctions are carried out in-house. The global benchmark banks display higher efficiency

    parameters, mainly because of the outsourcing model.

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

    the business plans of specific banks and also by economy-specific considerations.ICRA haspresented the analysis of the performance of Indian and international banksin the followingsections. We would like to highlight that several factors influence theresults here, and cautionneeds to be exercised in arriving at inferences. E.g. comparingexpenses per branch (oremployee) for banks across different economies involvesconversion of amounts to a commoncurrency. The results depend on the conversion ratesof foreign exchange used (e.g. USD perrupee or Euro per rupee). In this report, ICRAhas used nominal rates of foreign currenciesrather than rates based on PPP (PurchasingPower Parity). On another dimension, Indian

    banks and international banks operate under different business models and levels oftechnology. Increasingly, sophisticated banks(particularly in advanced countries) use severalchannels to transact business withcustomers, such as, the Internet, telephone, debit cards, andATMs. Therefore, resultsfrom benchmarking using parameters such as business per branch or

    expenses per branch(which are appropriate parameters to compare across banks that operatepredominantlythrough branches) need to be appropriately interpreted in an exercise when wecompareheterogeneous banks across different economies.Profitability per EmployeeThe profit per employee figure for 17 out of the 21 Indian banks was in the rangeof Rs. 0.02crore for the financial year ended March 2010. Most Indian banks postedhigher profits peremployee in FY2010 as compared with FY2002. This overall trend of increasing employee

    profitability may be attributed to the reduction in the number of employees following thelaunch of Voluntary Retirement Schemes (VRS) by some banksas well as higher profits bythe banks. On an average, new private sector banks enjoy ahigher increase in profitability peremployee, as compared with their public sector counterparts. This may be attributed largelyto the better technology that the new privatesector banks employ, besides the advantage of

    carrying no historical baggage. As for theglobal benchmark banks, the profitability peremployee for HSBC was robust at USD0.12 million (Rs. 0.552 crore) for FY 2002. For ABNAMRO Bank, the figure was EUR 0.02 million (Rs.l crore). On an intertemporal basis, the

    profitability per employee for theglobal benchmark bank also showed growth.

    Profitability per Branch

    For most Indian banks, the profit, per branch was in the range of Rs. 0-0.2 crore.However, thenew private sector banks displayed the highest profits per branch, at Rs. 1.73 and 1.22 crorefor the years 2010 and 2002, respectively. On an inter-temporal basis, profit per branch has

    been increasing gradually in the Indian banking sector. The growthin profit per branch forIndian banks is attributable to the overall increase in profitabilityin the banking industry. In

    the case of the foreign peer group, profitability per branchshows a small increase over theperiod covered by this study. As for the global benchmark banks, profitability per branch forBank of America is at a robust USD 1.62million (Rs. 7.44 crore), while the figure for ABNAMRO Bank is EUR 0.87 million (Rs.4.36 crore) for the FY 2002. Hence, profitability per

    branch for the global benchmark banks is higher than that of Indian banks.

    Business per EmployeeSince different employees in a bank contribute in different ways to the revenuesand profits ofa bank, it is difficult to come up with one universal metric that captures the business per

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    employee accurately. For' this analysis, ICRA has used the amount of deposits mobilised peremployee as a measure of the business per employee. The Indian banking industry on anaverage mobilised Rs. 1-2 crore of deposits per employee for theyear ended March 2010. Inthis respect, private sector banks lead the group of Indian banks. The top bank in this

    category showed a deposit per employee of Rs. 7.14 crore for the year ended March 2010. Asfor the global benchmark banks, business per employeefor HSBC was robust at USD9.71

    million (Rs. 44.66 crore), while that for ABN AMROBank was EUR 4 million (Rs. 20 crore)for the year ending December 2002.Thus, deposit mobilisation per employee for the global

    benchmark banks is higher than that of Indian banks.Business per BranchOn an average, the banks showed a deposit of around Rs. 10-30 crore per branchfor the yearended March 2010. In recent times, the deposit mobilisation for Indian Bankson a branch

    basis has witnessed a steady increase. The new private sector banks in Indiahave led the wayin this regard, because of the better use of technology. The highestdeposit per branch stood atRs. 103.24 crore in 2010 for a new private sector bank, ascompared with Rs, 68.71 crore in2002. The global benchmark banks mobilised more business per branch as compared withtheir Indian counterparts. Bank of Americamobilised USD 88.9 million (Rs. 408.94 crores)for the financial year ended 2002, whileABN AMRO Bank mobilised EUR 140 million (Rs.

    700 crores). The higher per-bank deposit mobilisation for the global benchmark banks maybe attributed to their superior technology orientation and the higher gross domestic products(GDP) of their respectivecountries. 3.5.5 Expenses per EmployeeFor this analysis, ICRA hasused the employee expenses per employee as ameasure of the expenses per employee. Indian

    banks, on an average, expensed Rs. 0.025crore per employee in FY2002. For the new privatesector banks, this figure was higher.The highest expense per employee incurred by an Indian

    bank for the year 2002 was Rs.0.041 crore per employee.

    In the case of the global benchmark banks, the expenses per employee for Citi GroupInc. wasat USD 0.08 million (Rs. 0.36 crore), while for ABN AMRO Bank it was EUR 0.07 millionRs. 0.36 crore).Expenses per Branch

    For this analysis, ICRA has used operating expenses per branch as a measure of the expenses per branch. The expense per branch for most Indian banks was Rs. 0.56crore for FY2002.Over the years, Indian banks have reported a gradual increase in suchexpenses, withcompetition-prompted upgrade being the primary reason for the same. Inthe case of theglobal benchmark banks, expense per branch for Bank of America wasUSD 4.93 million(amount in Rs. 22.68 crore), while for ABN AMRO Bank it was EUR 4.6 million (Rs. 22.99crore).

    1.8 Structural Benchmarking

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

    supervisors. These notes have sought to improve the integrity of the global bankingsystemand propagate best practices in banking across the world. For issues related toaccounting, BIS

    has relied on the International Accounting Standards (IAS) issued by theInternationalAccounting Standards Committee (IASC). Banks are supposed to followthese accountingstandards as part of best practices. For the structural benchmarkingstudy of the Indian

    banking sector, ICRA has used primarily the guidance notes issued byBIS and the relevant

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    IAS as the benchmarks of best practices. ICRA has also referred tostandards as mentionedunder, US and UK. GAAP (Generally Accepted AccountingPractices) where they provide agood understanding of international best practices.

    Capital Adequacy Norms for Banks

    BIS introduced capital adequacy norms for banks for the first time in 1988. Toimprove on theexisting norms, BIS issued a Consultative Document in January 2001, proposing changes tothe existing framework. The objective of this document is todevelop a consensus on the BaselII Accord (as it is popularly known), which is expectedto be implemented in 2007. Based onfeedback received from various quarters, BISissued a new Consultative Document in April2010. In this document, BIS has proposedthe following key changes over the existing norms:

    Introduction (of finer grades of risk weighting in corporate credit

    According to the original 1988 Accord, all credit risks have a 100% per centweighting. Underthe new method, grades of weightings in the 20-150% range will beassigned.Introduction of charges for operational risks:Under the proposed Basel II Accord, banks have to allocate capital for operationalrisks. BIS

    has suggested three methods for estimating operational risk capitals:1. Basic Approach,2.Standardised Approach, and3. Advanced Measurement Approach.Capital requirement for mortgages reduced:The risk weights on residential mortgages will be reduced to 35% from 50%.During the1990s, the RBI adopted the strategy of attaining a Capital Adequacy Ratio(CAR) of 8% in a

    phased manner. Subsequently, in line with the recommendations of theCommittee onBanking Sector Reforms, the minimum CAR was further raised to 9%,effective 31st March2000.As a step towards implementing the Basel II guidelines, the RBI in its circular of 14thMay, 2010 has proposed new methods for estimating regulatory risk capital. Toestimate theimpact of the proposed changes on the capital adequacy position of Indian banks, the RBI has

    asked select banks to estimate their riskweighted assets on the basis of the new method. As per this, the RBI has asked for the estimation of capital requirementon the basis of theexternal credit rating of borrowers. For nonrated borrowers, the RBIhas asked the select

    banks to use the existing 100% risk weights.The RBI has also asked the banks to calculateoperational risk capital separatelyfollowing the Basel approach. Based on the result of theexercise, the RBI will issue newguidelines on estimating economic capital.Additionally, theRBI has asked banks to introduce internal risk scoring models. It isexpected that once theBasel II Accord is signed, the RBI will allow banks to move to theIRB approach.The CapitalAdequacy norms in India are in line with the best practices as suggested by BIS. Once theBasel II Accord is implemented, the method of estimation of risk capital will undergo asignificant change. RBI has already taken appropriate steps to prepare the Indian bankingindustry for such changes.

    Recognition of Financial Assets & LiabilitiesIAS 39 requires that all financial assets and all financial liabilities be recognisedon the

    balance sheet. This includes all derivatives. Historically, in many parts of theworld,derivatives have not been recognised as liabilities or assets on balance sheets. Theargumentfor this practice has been that at the time the derivative contract was enteredinto, no cash orother asset was paid. The zero cost justified non-recognition,notwithstanding the fact that astime pauses and the value of the underlying variable (rate, price, or index) changes, thederivative has a positive (asset) or negative (liability) value.In India, derivatives are still off-

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    balance sheet items and considered part of contingent liabilities. So in Indian treatment ofderivatives is different from InternationalAccounting Standards.Valuation of Financial AssetsIAS 39 has classified financial assets under four categories. The following tablesummarises

    the classification and measurement scheme for financial assets under IAS 39,Under USGAAP, marketable equity securities and debt securities are classified as under: trading,

    Available for sale, or held to maturity.Recognition of Non-Performing Assets (NPAs)/Impaired AssetsUnder IAS 39, impairment recognition is left to management discretion (its perception of thelikelihood of recovery). Impairment calculation compares the carryingamount of the financialasset with the present value of the currently estimated amountsand timings of payments. Ifthe present value is lower than. The carrying amount, theloan is classified as NPL.Under USGAAP, loans assume non-accrual statuses if any of the following conditionsare fulfilled:Fullrepayment of principal or interest is in doubt (in management's judgment), or if scheduled

    principal or interest payment is past due 90 days or more, and if thecollateral is insufficient tocover the principal and interest.

    In India, NPAs are classified under three categories-Sub-standard, Doubtful andLoss on the

    basis of the number of months the amount is overdue for. India proposed to move from 180days to a 90-day past due classification rule for NPA recognitioneffective March 2004.Thefinancial instrument's original effective interest rate is the rate to be used for discounting.Any impairment loss is charged to profit and loss account for the period.Impairment or"uncollectability" must be evaluated individually for material financialassets. A portfolioapproach may be used for items that are individually small [IAS39.109]. Therefore, underIAS, provisioning is based on management discretion.Provision in excess of expected loanlosses may be booked directly to shareholders'equity. As with IAS, under the UK, And USGAAP also, provisioning is based onmanagement discretion. Under US GAAP, when the NetPresent Value of a loan is lessthan the carrying value, the difference is booked as provision.InIndia; provisioning norms are more explicit than they are under the IAS. RBIhas specifiednorms for various classes of NPL as follows:Standard Assets: 10%Doubtful Assets: 100% of

    unsecured portion,20-50% on secured portionLoss Assets: 100%Interest Accrual on M on- performing Loans / impaired AssetsUnder both IAS and US GAAP, there is no specific prescription for interestaccrual on NPAs. Under UK. GAAP, interest is suspended uponclassification as NPL.However, suspension may be deferred up to 12 months if sufficientcollateral exists.According to Sound Practices for Loan Accounting and Disclosure (1999)number 11, the BIS Committee on Banking Supervision recommends that when a loanisidentified as impaired, a bank should cease accruing interest in accordance with the termsofthe contract. Interest on impaired loans should not contribute to net income if doubtsexist

    over the collectability of loan interest or principal.

    In India, accrual of interest is suspended upon classification of a loan as non performing.General Provisioning on Performing Loans

    Under IAS, UK and US GAAP, there is no specific prescription for general provisioningtowards performing loans. However, Indian banks have a provisioningrequire; f tent of 0.25% on all standard assets.ConclusionThe RBI norms for classification of assets, and provisioning against, bad/doubtfuldebts aremore detailed and precise vis-a-vis international rules. While the internationalnorms oftenleave bad debt provision levels to "management discretion", Indian standardsare precise and

    clearly state exactly when and by how much reported earnings must becharged off for bad

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    debts.In India, detailed accounting standards for derivatives are yet to be introduced. Asof now, derivatives continue to be considered as off-balance sheet liabilities.1.9 Likely Future Trends and their Implications for Indian Banks

    Financial Disintermediation and Bank ProfitabilityThe degree of banking disintermediation and financial sophistication areimportant factors in

    the development of a country's economy. Disintermediation affectsthe allocation process for both savings and credits in the economy. With the introductionof sophisticated deposit products by mutual funds, pension funds and insurancecompanies, individual and corporatedepositors now have more options for savings. Asimilar trend is also visible in creditofferings. More and more corporate entities are nowapproaching the capital market to raisefunds either in the form of debt or equity.At the end of the 1990s, the US banking industrywas facing a high level of disintermediation, as most outstanding savings were in mutualfunds, pension funds, andlife insurance plans, but not in bank deposits or other liability

    products. However, incontinental Europe, most banking systems (as in Germany, Spain, Italy,Austria, France,etc.) are still highly bank-intermediated, although the trend is clearly towardsfaster disintermediation for both savings and credits. In India, financial disintermediationislikely to catch up with banks sooner than later. With the opening up of the financialsector,

    Indian banks are facing competition from the mutual fund and insurance sectorsfor savings.On the credit side, good quality borrowers have started raising debt directlyfrom the marketat competitive rates.

    Changing Capital Adequacy Norms

    Capital adequacy norms for banks are likely to undergo a change after the Basel IIAccord isimplemented. In the current system, Indian banks need to allocate 9% capital, irrespective ofthe credit quality of a borrower. In the new system, a bank offering creditto a better qualitycorporate entity is likely to require less regulatory capital. Theallocation of regulatory capitalon the basis of credit quality would encourage banks toestimate their Risk adjusted Return onCapital (RAROC) rather than compute simplemargins. Similarly, banks now need todistinguish between the credit qualities of sovereign borrowings and inter-bank borrowing, as

    they would need to allocate capital tosovereign credit and inter-bank credit on the basis ofexternal ratings, or using the IRBapproach.To emerge successful in the Basel II regulatoryenvironment, banks would need tointroduce the practice of risk-based pricing of loans, whichin turn would require a bank to implement advance Risk Management Systems. Toimplement such systems, bankswould need to implement the following key steps:

    Develop Credit Risk Scoring Models

    Generate Probability of Default (PD) associated with each risk gradeEstimate Loss Given Default (LGD) for each collateral type.Calculate expected and unexpected loss in a portfolio based on correlationamongst loans.Compute the capital that would be required to be held against economic loss potential of the

    portfolio.Similarly, banks would have to introduce robust systems for measuring

    andcontrolling Market Risk and Operations Risk. .3 Management of Non-PerformingAssetsThe size of the NPA portfolio in the Indian banking industry is close to Rs.1,00,000 crore,which is around 6% of India's GDP. NPAs affect banks profitability ontwo counts:Theintroduction of scientific credit risk management systems would lower slippage of assetsfrom the performing to the nonperforming category. Further, bankswith better NPA recovery

    processes would be able to reduce their provisioningrequirements, thereby increasing theirprofitability. To enable a fair borrower-lender relationship in credit, the Government of India

    has recently enacted the Securitisation and Reconstruction of Financial Assets andEnforcement of Security interest Act 2002 (SRESAct). Due to several cases still to be

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    resolved in courts of law, it is. Not clear as yet, howfar this Act is set to alter the NPArecovery scenario in India.Following the announcement of the RBI's Asset Classification norms, the processof AssetQuality Management involves segregating the total portfolio into three segmentsand having

    detailed strategies for each. The three segments are:

    Standard/Performing AssetsSpecial Mention Accounts/Sub-Standard AssetsChronic Non-Performing AssetsBanks need to vigilantly monitor Standard Assets to arrestany account slippageinto the non-performing grade. Besides, banks need to churn their credit

    portfolio so as tomaximise returns while keeping the risks pegged at acceptable levels.SpecialMention Accounts are assets with potential weaknesses which deserveclose attention andtimely remedial action. The typical warning signs exhibited by a borrower ranges fromfrequent excesses in the account to non-submission of periodicalstatements. Accountrestructuring and rehabilitation tools are best implemented duringthis stage. However, thechallenges faced while restructuring include, (a) selecting thegenre of assets to be

    restructured, (b) quantifying the benefits to be extended, (c)determining repayment schedules,and (d) coordinating and balancing the needs of several lenders.Chronic Non-PerformingAssets can now be better managed following theenactment of the SIZES Act. The Act

    provides the requisite regulatory framework for theforeclosure of assets by lenders,incorporation of Asset Reconstruction Companies(ARCS), and formation of a CentralRegistry. In the wake of this new legislation,amicable solutions may be realised for Chronic

    NPAs. The strategies includeEnforcement of Security Interest, Securitisalion, One-TimeSettlement (OTS), and Write-off. However, a scientific approach to deciding which of thesealternative routes must betaken hinges on: (a) assessment in terms of quality of theunderlying assets and their realisable value, (b) alternative use of the assets, and (c)willingness of the borrower tosettle outstanding dues.

    conclusionThe profitability of Indian banks in recent years compares well with that of theglobal

    benchmark banks primarily because of the higher share of profit on the sale of investments,higher leverage and higher net interest margins of Indian banks. However,many of thesedrivers of higher profits of Indian banks may not be sustainable. To ensure long-term

    profitability, Indian banks need to focus on the following parameters and buildsystemiccapability in management of the same:

    Ensure that loans are diversified across several customer segmentsIntroduce robust risk scoring techniques to ensure better quality of loans,as well as to enable

    better risk-adjusted returns at the portfolio levelImprove the quality of credit monitoring systems so that slippage in assetquality is

    minimisedRaise the share of non-fund income by increasing product offeringswherever necessary by

    better use of technologyReduce operating expenses by upgrading banking technology, andImprove the management of market risksReduce the impact of operational risks by putting in place appropriateframeworks tomeasure risks, mitigate them or insuring them.The RBI as the regulator of the Indian banking

    industry has shown the way instrengthening the system, and the individual banks haveresponded in good measure inorienting them selves towards global best practices.

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    MAJOR DEVELOPMENTS IN BANKING ANDFINANCE

    Banking Developments

    The RBI allowed resident Indians to maintain foreign currency accounts. Theaccounts to beknown as resident foreign currency (domestic) accounts, can be used to park forex received

    while visiting any place abroad by way of payment for services, or money received from any person not resident in India, or who is on a visit to India, insettlement of any lawfulobligations. These accounts will be maintained in the form of current accounts with a chequefacility and no interest is paid on these accounts. With aview to liberalise gold trading, theReserve Bank has decided to permit authorised banksto enter into forward contracts withtheir constituents like exporters of gold products, jewellery manufacturers and trading houses,in respect of the sale, purchase and loantransactions in gold with them. The tenor of suchcontracts should not exceed 6 months.The Reserve Bank of India has told foreign banks notto shut down branches withoutinforming the central bank well in advance. Foreign bankshave been further advised bythe Reserve Bank of India to furnish a detailed plan of closure toensure that their customers interests and conveniences are addressed properly.The RBI has

    prohibited urban co-operative banks from acting as agents or sub-agents of money transfer

    service schemes. The RBI has allowed banks to investundeployed foreign currency non-resident (FCNR-B) funds in the overseas markets in thelong-term fixed income securitieswith ratings a notch lower than highest safety. Earlier, banks were allowed to invest only inlong-term securities with highest safety ratings byinternational agencies.The RBI has definedthe term willful defaulter paving the way for banks toacquire assets of defaultingcompanies through the Securitisation Ordinance and reducetheir NPAs faster. According tothe RBI a wilful defaulter is one who has not used bank funds for the purpose for which itwas taken and who has not repaid loans despite havingadequate liquidity. International creditrating agency Standard & Poor has estimated thatthe level of gross problematic assets in Indiacan move into the 35-70 per cent range inthe event of a recession. It has also estimated thatthe level of non-performing assets (NPAs) in the system to be at 25 per cent, of which only30 per cent can be recovered.

    The Reserve Bank of India has decided to extend operation of the guidelines for the one timesettlement scheme for loans upto Rs.50,000 to small and marginal farmers by public sector

    banks for another 3 months, i.e, upto March 31, 2010.The Reserve Bank of India, as part ofits policy of deregulating interest rates onrupee export credit, has freed interest rates on thesecond slab - 181 to 270 days for pre-shipment credit and 91 to 180 days for post-shipmentcredit with effect from May 1,2010.The Cabinet cleared a financial package for IDBI andagreed to take over thecontingent liabilities to the tune of Rs.2500 crore over five years. The

    IDBI Act will berepealed during the winter session of the Parliament, paving the way forIDBIsconversion into a banking company.The IDBI would be given access to retail deposits,

    toenable it to bring down the cost of funds, but will be spared from priority sector lendingandSLR requirements for existing liabilities.The RBI has issued guidelines for setting up of

    offshore banking units (OBUs)within special economic zones (SEZs) in various parts of thecountry. Minimuminvestment of $10 million is required for setting up an OBU. All

    commercial banks areallowed to set up one OBU each. OBUs have to undertake wholesale banking operationsand should deal only in foreign currency. Deposits of the OBUs will not

    be covered bydeposit insurance. The loans and advances of OBUs would not be reckoned asnet bank credit for computing priority sector lending obligations. The OBUs will be regulatedandsupervised by the exchange control department of the RBI.With a view to develop thederivatives market in India and making availablehedged currency exposures to residents an

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    RBI Committee headed by Smt. Grace Koshie,recommended phased introduction of foreigncurrency-rupee (FC/NR) options. _TheReserve Bank of India has notified the draft schemefor merging Nedungadi Bank withPunjab National Bank. This is the first formal step towards

    bringing about a merger between the two Banks.The Reserve Bank of India has agreed to

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

    institutional investors (FIIs) to enter into a forward contract with the rupee as one of thecurrencies, with an authorised dealer (AD) in India to hedge their entire exposure in equitiesat a particular point of time without any reference to the cut-off date. Further, the RBI hasalsoincreased Authorised Dealers overseas market investment limit to 50 per cent oftheir unimpaired tier-I capital or $ 25 million, whichever is higher.The Reserve Bank of Indiadoubled the foreign exchange available under the basic travel quota (BTQ) to residentindividuals from US $5000 to US $10000, or itsequivalent.The Government has decided todispose of UTI Bank as part of restructuringUnit Trust of India.Though the details in thisregard is yet to be worked out, it has beendecided that the bank will be disposed of during thecourse of the restructuring.The RBI has allowed tour operators to sell tickets issued byoverseas traveloperators such as Eurorail and other rail/road and water transport operators inIndia, inrupees, without deducting the paymentfrom the travellers basic travel quota.The

    Reserve Bank of India (RBI) has banned banks from offering swapsinvolving leveragedstructures, which can cause huge losses if the market moves the other way.The RBIconstituted committee on payment system has recommended that thecentral bank, as theregulator of payment and settlement systems, should be empoweredto regulate non-bankingsystems.

    Market Developments and New ProductsThe Hong Kong and Shanghai Banking Corporation will be bringing $150million additionalcapital to India in the current fiscal.The Reserve Bank of India has ordered a moratorium onthe Nedungadi Bank.The moratorium effective from the close of business will be in forceupto February 1,2010. During this period, the central bank is likely to finalise the plans formerging Nedungadi Bank with Punjab National Bank.ABN Amro Bank launched its Business

    Process outsourcing (BPO) operations,ABN Amro Central Enterprise Services (ACES) inMumbai. It has been set up with an initial investment of 4 million euros (Rs.19 crore) and has

    been capacitised at 650 seats ina single shift.

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

    before its Initial Public Offer.China has granted licence to Bank of India to open arepresentative office in thesouth Chinese city of Shenzhen.Shri A.K. Purwar is appointed as

    the Chairman of State Bank of India.The State Bank of India has launched SBI Cash Plus,its Maestro debit card for which it has tied up with Master Card International. SBI Cash Pluswill allow customersto access their deposit accounts from ATMs and merchantestablishments.The Siam Commercial Bank, having Thailand government as the majorshareholder, is planning to close down its banking operations in India from November 30,

    2002, as part of its global restructuring strategy.The Punjab National Bank (PNB) has gotlicense from the Reserve Bank of Indiafor doing internet banking. The bank is likely to do theformal launch of its internet banking solution within a few weeks time.The ICICI Bank is

    planning to set up kiosks to offer financial services in the ruralareas. This outfit would alsoextend agricultural loans.

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    CLASSIFICATION OF SCHEDULED BANKING STRUCTURE IN INDIA

    The scheduled banks are divided into scheduled commercial banks and scheduledco operative banks. Further scheduled commercial banks divided into the Public Sector Banks, privatesector banks, foreign banks, and regional rural banks. Whereas scheduledco-operative banksare classified into scheduled urban co operative and scheduled stateco- operative.RBI hasfurther classified public sector banks into nationalized banks, state bank of India and its

    subsidiaries. And private banks have been classified into old andnew private sector banks. Asfar as the number is concerned, total public sector banksare 27, private sector banks are 30,foreign banks are 36, and regional rural banks are196. Thus in scheduled commercial bans,the regional rural banks are on the top number.In the scheduled co-operative banks, there are57 scheduled cooperatives and 16scheduled co-operative banks. Today the overallcommercial banking system in Indiamay be distinguished into:

    1. Public Sector Banks2. private Sector Banks3. Co-operative Sector Banks4. DevelopmentBanks

    PUBLIC SECTOR BANKSa. State Bank of India and its associate banks called the State Bank group b. 20 nationalised

    banksc. Regional Rural Banks mainly sponsored by Public Sector Banks

    PRIVATE SECTOR BANKSa. Old generation private banks b. New generation private banksc. Foreign banks in Indiad.

    Scheduled Co-operative Bankse. Non-scheduled Banks

    CO-OPERATIVE SECTOR

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    The co-operative banking sector has been developed in the country to the supplimentthevillage money lender. The co-operatiev banking sector in India is divided into 4components1.State Co-operative Banks2. Central Co-operative Banks3. Primary Agriculture CreditSocieties4. Land Development Banks5. Urban Co-operative Banks 6. Primary Agricultural

    Development Banks7. Primary Land Development Banks8. State Land Development Banks

    DEVELOPMENT BANKS1. Industrial Finance Corporation of India (IFCI)2. Industrial Development Bank of India

    (IDBI)3. Industrial Credit and Investment Corporation of India (ICICI)4. IndustrialInvestment Bank of India (IIBI)5. Small Industries Development Bank of India(SIDBI)6. SCICI Ltd.7. National Bank for Agriculture and Rural Development(NABARD)8. Export Import Bank of India9. National Housing Bank

    PUBLIC SECTOR BANKS

    Before the independence, the banking system in India was primarily associatedwith urbansector. After independence, the banks had to spread out into rural and un- banked areas andmake credit available to the people of those areas.In 1969 the government nationalized 14

    major commercial banks. Still the widedisparities continued. To reduce the disparities thegovernment nationalized 6 morecommercial banks in 1980 government came to own 28 banks including SBI and its 7subsidiaries. Today, we are having a fairly well developedbanking system with differentclasses of banks-public sector banks, foreign banks, and privatesector banks-both old andnew generation.In July 1993, New Bank of India was merged withPunjab National Bank. Now, there are 27 banks in the public sector viz. State Bank of Indiaand its 7 associates,19 commercial banks exclusive of Regional Rural.In terms of sheergeographical spread, the public sector system is the largest. Thestatis