Indian Banking: Key Developments

1969 Government acquires ownership in major banks

Almost all banking operations in manual mode

Some banks had Unit record Machines of IBM for IBR & Pay roll

1970- 1980 Unprecedented expansion in geographical coverage, staff,

business & transaction volumes and directed lending to

agriculture, SSI & SB sector

Manual systems struggle to handle exponential rise in

transaction volumes --

Outsourcing of data processing to service bureau begins

Back office systems only in Multinational (MNC) banks' offices

1981- 1990 Regulator (read RBI) led IT introduction in Banks

Product level automation on standalone PCs at branches

(ALPMs)

In-house EDP infrastructure with UNIX boxes, batch processing in

COBOL for MIS.

Mainframes in corporate office

1991-1995 Expansion slows down

Banking sector reforms resulting in progressive de-regulation of

banking, introduction of prudential banking norms entry of new

private sector banks

Total Branch Automation (TBA) in Govt. owned and old private

banks begins

New private banks are set up with CBS/TBA from the start

1996-2000 New delivery channels like ATM, Phone banking and Internet

banking and convenience of any branch banking and auto sweep

products introduced by new private and MNC banks

Retail banking in focus, proliferation of credit cards

Communication infrastructure improves and becomes cheap.

IDRBT sets up VSAT network for Banks

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Govt. owned banks feel the heat and attempt to respond using

intermediary technology, TBA implementation surges ahead

under fiat from Central Vigilance

Commission (CVC), Y2K threat consumes last two years

2000-2003 Alternate delivery channels find wide consumer acceptance

IT Bill passed lending legal validity to electronic transactions

Govt. owned banks and old private banks start implementing

CBSs, but initial attempts face problems

Banks enter insurance business launch debit cards

Current Scenario of Indian Banking Industry:

The banking industry in India is in a midst of transformation, thanks to the economic

liberalization of the country, which has changed business environment in the country.

During the pre-liberalization period, the industry was merely focusing on deposit

mobilization and branch expansion. But with liberalization, it found many of its advances

under the non-performing assets (NPA) list. More importantly, the sector has become very

competitive with the entry of many foreign and private sector banks. The face of banking is

changing rapidly. There is no doubt that banking sector reforms have improved the

profitability, productivity and efficiency of banks, but in the days ahead banks will have to

prepare themselves to face new challenges.

For the first quarter ended June 2004, the banking sector recorded a bottom line

growth of 18% to Rs 4852.50 crore. Higher net interest income and lower provisioning

were the main reasons for the profit growth during the quarter. However, the above

results were achieved despite higher operating expenses and a lower rise in non-

interest income.

Among banks, public sector banks outperformed private sector banks by registering a

20% rise in the net profit compared to an 11% growth reported by private sector

banks. This was mainly due to a higher rise in other income (OI) and a lower increase in

operating expenses by public sector banks compared to a fall in OI and higher

operating expenses by private sector banks. However, at the net interest level, private

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sector banks outperformed public sector banks by registering a growth of 36%

compared to a 14% rise reported by public sector banks. .

The net interest income of the overall banking sector during the quarter rose 17% to Rs

11962.53 crore, mainly due to low cost of funds. The interest earned rose 4% to Rs

29747.88 crore, contributed mainly by interest income from core operations (i.e.,

lending). The interest expenses decreased by 4% to Rs 17785.35 crore. The interest

spread of most banks witnessed an increase over the corresponding previous quarter,

as the decline of yield on lending was lower than the cost of funds. In the falling

interest rate scenario, the rate on deposits for most banks fell faster than advances.

Thus, interest expenses came down faster to protect profit.

The sound economic growth, soft interest rate regime, upward migration of incomes

and wider distribution to cover a larger proportion of the population are expected to

increase the demand for retail loans in a significant manner. The retail credit as a

percentage of GDP in India is only around 5% as compared to levels of 30 - 50% in

other Asian economies and, therefore, offers significant growth opportunities. Also,

favorable demographic profile like 69% of the population estimated to be under 35

years and an increase in upper middle/high income households are to be the main

drivers for retail credit. In the medium term, stronger demand for credit from the

corporate sector is also expected consequent to the resurgence of this sector. Earlier,

banks were seeing lower credit off take from corporate because of weak business

sentiments and lower credit requirement due to improved operational efficiency.

Also, most banks are aggressively augmenting their fee incomes and have embarked

upon cross selling of products. They are also focusing on fuller utilization of their IT

investments such as ATMs by entering into sharing arrangement with other banks to

earn extra OI. Many banks are hopeful of effecting significant NPA recoveries due to

the Securitization Act.

CURRENT RATES

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S.No Rates/Reserve Ratios %1 Bank Rate 9.00%2 Repo Rate 8.00%3 Reverse Repo Rate 7.00%4 Cash Reserve Ratio(CRR) 4.00%5 Statutory Liquidity Ratio(SLR) 22.00%

MARKET SHARE OF VARIOUS BANKS

SegmentMarket Share of Financial Assets

(Percentage)

Banks 63

Insurance Companies 19

Non-banking Financial Institutions 8

Mutual Funds 6

Provident and Pension Funds 4

Total 100

Institution

Market Share of Total Banking Assets

(2013)

(Percentage)

Public Sector Banks 67.2

Private Sector Banks 18.7

Foreign Banks 6.5

Regional Rural Banks 2.7

Rural and Urban Co-operative Banks 3.4

Local Area Banks 1.5

Total 100.0

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RECENT TRENDS

I. Universal Banking

Universal banking refers to Financial Institution offering all types of financial services under

one roof. Thus, for example, besides borrowing and lending for the long term, the

Development Financial Institutions will be able to borrow/lend for the short-term as well.

Impact on FDI:

Two key aspects of the business are affected. The institution can have access to cheap

retail deposits and the breadth of its advances increase to include short-term working

capital loans to corporate. The Institution has greater operational flexibility. Also they can

now effectively compete with the commercial banks.

Indian Scenario:

In India the five FDIs that are frontrunners in the race to convert to Universal Bank are:

1. Industrial Credit and Investment Corporation of India (ICICI)

2. Industrial Development Bank of India (IDBI)

3. Export Import Bank (EXIM Bank)

4. Industrial Finance Corporation of India (IFCI)

5. Industrial Investment Bank of India (IIBI)

ICICI is already a virtual bank with subsidiaries like ICICI Bank engaged in banking business.

Thus with clearing of legal hurdles it just has to work out the modalities to formally call

itself a universal bank.

Similarly other FDIs are charting out aggressive plans to stay ahead in this race.

Also recently Bank of Baroda, a commercial bank has indicated its intention to convert to a

Universal Bank.

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II. RBI Norms:

The norms stipulated by RBI treat FDIs at par with the existing commercial banks. Thus all

Universal banks have to maintain the CRR and the SLR requirement on the same lines as

the commercial banks. Also they have to fulfill the priority sector lending norms applicable

to the commercial banks. These are the major hurdles as perceived by the institutions, as it

is very difficult to fulfill such norms without hurting the bottom-line

Effect on the Banking Sector:

However, with large Term lenders converting into Commercial banks, the existing players

in the industry are likely to face stiff competition; lower bottom line ultimately leading to a

shakeout in the industry with only the operationally efficient banks will stay into the

business, irrespective to the size.

III. Mergers & Acquisition

The Indian Banking Sector is more overcrowded than ever. There are 96 commercial banks

reporting to the RBI. Ever since the RBI opened up the sector to private players, there have

been nine new entrants. All of them are growing at a scorching pace and redefining the

rules of the business. However they are dwarfed by many large public and old private

sector banks with a large network of branches spread over a diverse geographical area.

Thus they are unable to make a significant dent in the market share of the old players. Also

it is impossible to exponentially increase the number of branches. The only route available

for these banks is to grow inorganically via the M & A route. Hence the new banks are

under a tremendous pressure to acquire older banks and thus increase their business.

Currently most of the institutionally promoted banks have already gobbled smaller banks.

ICICI Bank has acquired ITC Classic, Anagram Finance and Bank of Madura within a period

of two years. HDFC Bank has merged Times Bank with itself. UTI bank had almost

completed its merger with Global Trust Bank before it ran into rough weather. Also

Nationalized Banks like Bank of Punjab, Vyasa Bank are wooing IDBI Bank for a merger.

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Among foreign banks, Standard & Chartered Bank has acquired ANZ Grind lays Bank’s

Asian and Middle East operations

The above happenings clearly indicate that the M & A scenario in the Indian banking sector

are far from over. Strong banks will continue to takeover weak and inefficient banks to

increase their size.

IV. Multiple Delivery Channels

Today the technology driven banks are finding various means to reduce costs and reach

out to as many customers as possible spread over a diverse area. This has led to using

multiple channels of delivery of their products.

1. ATM (Automatic Teller Machine):

An ATM is basically a machine that can deliver cash to the customers on demand after

authentication. However, nowadays we have ATMs that are used to vend different FMCG

products also. An ATM does the basic function of a bank’s branch, i.e., delivering money on

demand. Hence setting of newer branches is not required thereby significantly lowering

infrastructure costs.

Cost reduction is however possible only when these machines are used. In India, the

average cash withdrawal per ATM per day has fallen from 100 last year to 70 this year.

Though the number of ATMs has increased since last year, it is not in sync with the number

of cards issued. Also, there are many dormant cardholders who do not use the ATMs and

prefer the teller counters. Inspire of these odds, Indian banks are increasing the number of

ATMs at a feverish pace. These machines also hold the keys to future operational

efficiency.

2. Net Banking:

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Net banking means carrying out banking transactions via the Internet. Thus the need for a

branch is completely eliminated by technology. Also this helps in serving the customer

better and tailoring products better suited for the customer

A customer can view his account details, transaction history, order drafts, electronically

make payments, transfer funds, check his account position and electronically communicate

with the bank through the Internet for which he may have wanted to visit the bank branch.

Net banking helps a bank spread its reach to the entire world at a fraction of the cost.

3. Phone Banking:

This means carrying out of banking transaction through the telephone. A customer can call

up the banks helpline or phone banking number to conduct transactions like transfer of

funds, making payments, checking of account balance, ordering cheques, etc,. This also

eliminates the customer of the need to visit the bank’s branch.

4. Mobile Banking:

Banks can now help a customer conduct certain transactions through the Mobile Phone

with the help of technologies like WAP, SMS, etc,. This helps a bank to combine the

Internet and telephone and leverage it to cut costs and at the same time provide its

customer the convenience.

Thus it can be seen that tech savvy banks are tapping all the above alternative channels to

cut costs improve customer satisfaction.

V. VRS (Voluntary Retirement Scheme):

VRS or the ‘Golden Handshake’ is picking up very fast in the recent times due to the

serious attention of the government towards overstaffing in the banks, especially among

the public sector banks. The government had also cleared a uniform VRS framework for

the sector giving the banks a seven months time frame to cut flab. The scheme was open

till 31st march, 2001.

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Though many banks had announced different VRS schemes it involved an outflow of huge

sums of money. This could have had an adverse impact on the Capital Adequacy Ratio

(CAR). Hence the RBI allowed the banks to write off the VRS expenses over a period of 5

years.

SERVICES: DOMESTIC TREASURY SBI VISHWA YATRA FOREIGN TRAVEL CARD BROKING SERVICES REVISED SERVICE CHARGES ATM SERVICES INTERNET BANKING E-PAY E-RAIL RBIEFT SAFE DEPOSIT LOCKER GIFT CHEQUES MICR CODESFOREIGN INWARD REMITTANCES

ATM SERVICES

STATE BANK NETWORKED ATM SERVICESState Bank offers you the convenience of over 8000 ATMs in India, the largest network in the country and continuing to expand fast! This means that you can transact free of cost at the ATMs of State Bank Group (This includes the ATMs of State Bank of India as well as the Associate Banks – namely, State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of Indore, State Bank of Mysore, State Bank of Patiala, State Bank of Saurashtra, and State Bank of Travancore) and wholly owned subsidiary viz. SBI Commercial and International Bank Ltd., using the State Bank ATM-cum-Debit (Cash Plus) card.

KINDS OF CARDS ACCEPTED AT STATE BANK ATMsBesides State Bank ATM-Cum-Debit Card and State Bank International ATM-Cum-Debit Cards following cards are also accepted at State Bank ATMs: -1) State Bank Credit Card2) ATM Cards issued by Banks under bilateral sharing viz. Andhra Bank, Axis Bank, Bank of India, The Bank of Rajasthan Ltd., Canara Bank, Corporation Bank, Dena Bank, HDFC Bank, Indian Bank, Induslnd Bank, Punjab National Bank, UCO Bank and Union Bank of India.3) Cards issued by banks (other than banks under bilateral sharing) displaying Maestro, Master Card, Cirrus, VISA and VISA Electron logos4) All Debit/ Credit Cards issued by any bank outside India displaying Maestro, Master Card, Cirrus, VISA and VISA Electron logos

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Note: If you are a cardholder of bank other than State Bank Group, kindly contact your Bank for the charges recoverable for usage of State Bank ATMs.STATE BANK INTERNATIONAL ATM-CUM-DEBIT CARD

Eligibility:All Saving Bank and Current Account holders having accounts with networked branches and are: 18 years of age & above Account type: Sole or Joint with “Either or Survivor” / “Anyone or Survivor” NRE account holders are also eligible but NRO account holders are not.Benefits: Convenience to the customers traveling overseas can be used as Domestic ATM-cum-Debit Card §Available at a nominal joining fee of Rs. 200/- Daily limit of US $ 1000 or equivalent at the ATM and US $ 1000 or equivalentAt Point of Sale (POS) terminal for debit transaction Purchase Protection*up to Rs. 5000/- and Personal Accident cover*up to Rs.2, 00,000/- Charges for usage abroad: Rs. 150+ Service Tax per cash withdrawal Rs. 15 +Service Tax per enquiry.

State Bank ATM-cum-Debit (State Bank Cash plus) Card:India’s largest bank is proud to offer you unparalleled convenience viz. State BankATM-cum-Debit (Cash Plus) card. With this card, there is no need to carry cash in your wallet. You can now withdraw cash and make purchases anytime you wish to with your ATM-cum-Debit Card. Get an ATM-cum-Debit card with which you can transact for FREE at any of over 8000 ATMs of State Bank Group within our country.SBI GOLD INTERNATIONAL DEBIT CARDS

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E-PAYBill Payment at Online SBI (e-Pay) will let you to pay your Telephone, Mobile, Electricity, Insurance and Credit Card bills electronically over our Online SBI website

E-RAILBook your Railways Ticket Online.The facility has been launched wef Ist September 2003 in association with IRCTC.The scheme facilitates Booking of Railways Ticket Online.

The salient features of the scheme are as under: All Internet banking customers can use the facility. on giving payment option as SBI, the user will be redirected to onlinesbi.com.After logging on to the site you will be displayed payment amount, TID No. andRailway reference no. . The ticket can be delivered or collected by the customer. the user can collect the ticket personally at New Delhi reservation counter. The Payment amount will include ticket fare including reservation charges,Courier charges and Bank Service fee of Rs 10/. The Bank service fee has beenWaived unto 31st July 2006.

SAFE DEPOSIT LOCKER

For the safety of your valuables we offer our customers safe deposit vault or lockerFacilities at a large number of our branches. There is a nominal annual charge, which depends on the size of the locker and the centre in which the branch is located.

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Risk Management Systems in Banks

Introduction

Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify, measure, monitor and control the overall level of risks undertaken.

The broad parameters of risk management function should encompass:i) organisational structure; ii) comprehensive risk measurement approach; iii) risk management policies approved by the Board which should be consistent with the

broader business strategies, capital strength, management expertise and overall willingness to assume risk;

iv) guidelines and other parameters used to govern risk taking including detailed structure of prudential limits;

v) strong MIS for reporting, monitoring and controlling risks; vi) well laid out procedures, effective control and comprehensive risk reporting framework; vii) separate risk management framework independent of operational Departments and with

clear delineation of levels of responsibility for management of risk; and viii) periodical review and evaluation.

2. Risk Management Structure2.1 A major issue in establishing an appropriate risk management organisation structure is choosing between a centralised and decentralised structure. The global trend is towards centralising risk management with integrated treasury management function to benefit from information on aggregate exposure, natural netting of exposures, economies of scale and easier reporting to top management. The primary responsibility of understanding the risks run by the bank and ensuring that the risks are appropriately managed should clearly be vested with the Board of Directors. The Board should set risk limits by assessing the bank’s risk and risk-bearing capacity. At organisational level, overall risk management should be assigned to an independent Risk Management Committee or Executive Committee of the top Executives that reports directly to the Board of Directors. The purpose of this top level committee is to empower one group with full responsibility of evaluating overall risks faced by the bank and determining the level of risks which will be in the best interest of the bank. At the same time, the Committee should hold the line management more accountable for the risks under their control, and the performance of the bank in that area. The functions of Risk Management Committee should essentially be to identify, monitor and measure the risk profile of the bank. The Committee should also develop policies and procedures, verify the models that are used for pricing complex products, review the risk models as development takes place in the markets and also identify new risks. The risk policies should clearly spell out the quantitative prudential limits on various segments of banks’ operations. Internationally, the trend is towards

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assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk (market risk). The Committee should design stress scenarios to measure the impact of unusual

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market conditions and monitor variance between the actual volatility of portfolio value and that predicted by the risk measures. The Committee should also monitor compliance of various risk parameters by operating Departments.

2.2 A prerequisite for establishment of an effective risk management system is the existence of a robust MIS, consistent in quality. The existing MIS, however, requires substantial upgradation and strengthening of the data collection machinery to ensure the integrity and reliability of data.

2.3 The risk management is a complex function and it requires specialised skills and expertise. Banks have been moving towards the use of sophisticated models for measuring and managing risks. Large banks and those operating in international markets should develop internal risk management models to be able to compete effectively with their competitors. As the domestic market integrates with the international markets, the banks should have necessary expertise and skill in managing various types of risks in a scientific manner. At a more sophisticated level, the core staff at Head Offices should be trained in risk modelling and analytical tools. It should, therefore, be the endeavour of all banks to upgrade the skills of staff.

2.4 Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework for management of risks in India. The design of risk management functions should be bank specific, dictated by the size, complexity of functions, the level of technical expertise and the quality of MIS. The proposed guidelines only provide broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise.

2.5 Internationally, a committee approach to risk management is being adopted. While the Asset - Liability Management Committee (ALCO) deal with different types of market risk, the Credit Policy Committee (CPC) oversees the credit /counterparty risk and country risk. Thus, market and credit risks are managed in a parallel two-track approach in banks. Banks could also set-up a single Committee for integrated management of credit and market risks. Generally, the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures.

2.6 Currently, while market variables are held constant for quantifying credit risk, credit variables are held constant in estimating market risk. The economic crises in some of the countries have revealed a strong correlation between unhedged market risk and credit risk. Forex exposures, assumed by corporates who have no natural hedges, will increase the credit risk which banks run vis-à-vis their counterparties. The volatility in the prices of collateral also significantly affects the quality of the loan book. Thus, there is a need for integration of the activities of both the ALCO and the CPC and consultation process should be established to evaluate the impact of market and credit risks on the financial strength of banks. Banks may also consider integrating market risk elements into their credit risk assessment process.

3. Credit Risk3.1 General3.1.1 Lending involves a number of risks. In addition to the risks related to creditworthiness of the counterparty, the banks are also exposed to interest rate, forex and country risks.

3.1.2 Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial

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transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a bank’s portfolio depends on both external and internal factors. The external factors are the state of the economy, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. The internal factors are deficiencies in loan policies/administration, absence of prudential credit concentration limits, inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in appraisal of borrowers’ financial position, excessive dependence on collaterals and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc.

3.1.3 Another variant of credit risk is counterparty risk. The counterparty risk arises from non-performance of the trading partners. The non-performance may arise from counterparty’s refusal/inability to perform due to adverse price movements or from external constraints that were not anticipated by the principal. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk.

3.1.4 The management of credit risk should receive the top management’s attention and the process should encompass:

a) Measurement of risk through credit rating/scoring; b) Quantifying the risk through estimating expected loan losses i.e. the amount of loan losses

that bank would experience over a chosen time horizon (through tracking portfolio behaviour over 5 or more years) and unexpected loan losses i.e. the amount by which actual losses exceed the expected loss (through standard deviation of losses or the difference between expected loan losses and some selected target credit loss quantile);

c) Risk pricing on a scientific basis; and d) Controlling the risk through effective Loan Review Mechanism and portfolio management.

3.1.5 The credit risk management process should be articulated in the bank’s Loan Policy, duly approved by the Board. Each bank should constitute a high level Credit Policy Committee, also called Credit Risk Management Committee or Credit Control Committee etc. to deal with issues relating to credit policy and procedures and to analyse, manage and control credit risk on a bank wide basis. The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The Committee should, inter alia, formulate clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Concurrently, each bank should also set up Credit Risk Management Department (CRMD), independent of the Credit Administration Department. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks may consider separate set up for loan review/audit. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio.

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3.2 Instruments of Credit Risk Management

Credit Risk Management encompasses a host of management techniques, which help the banks in mitigating the adverse impacts of credit risk.

3.2.1 Credit Approving Authority

Each bank should have a carefully formulated scheme of delegation of powers. The banks should also evolve multi-tier credit approving system where the loan proposals are approved by an ‘Approval Grid’ or a ‘Committee’. The credit facilities above a specified limit may be approved by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers and invariably one officer should represent the CRMD, who has no volume and profit targets. Banks can also consider credit approving committees at various operating levels i.e. large branches (where considered necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating powers for sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for better rated / quality customers. The spirit of the credit approving system may be that no credit proposals should be approved or recommended to higher authorities, if majority members of the ‘Approval Grid’ or ‘Committee’ do not agree on the creditworthiness of the borrower. In case of disagreement, the specific views of the dissenting member/s should be recorded.

The banks should also evolve suitable framework for reporting and evaluating the quality of credit decisions taken by various functional groups. The quality of credit decisions should be evaluated within a reasonable time, say 3 – 6 months, through a well-defined Loan Review Mechanism.

3.2.2 Prudential Limits

In order to limit the magnitude of credit risk, prudential limits should be laid down on various aspects of credit:a) stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio

or other ratios, with flexibility for deviations. The conditions subject to which deviations are permitted and the authority therefor should also be clearly spelt out in the Loan Policy;

b) single/group borrower limits, which may be lower than the limits prescribed by Reserve Bank to provide a filtering mechanism;

c) substantial exposure limit i.e. sum total of exposures assumed in respect of those single borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of capital funds. The substantial exposure limit may be fixed at 600% or 800% of capital funds, depending upon the degree of concentration risk the bank is exposed;

d) maximum exposure limits to industry, sector, etc. should be set up. There must also be systems in place to evaluate the exposures at reasonable intervals and the limits should be adjusted especially when a particular sector or industry faces slowdown or other sector/industry specific problems. The exposure limits to sensitive sectors, such as, advances against equity shares, real estate, etc., which are subject to a high degree of asset price volatility and to specific industries, which are subject to frequent business cycles, may necessarily be restricted. Similarly, high-risk industries, as perceived by the bank,

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should also be placed under lower portfolio limit. Any excess exposure should be fully backed by adequate collaterals or strategic considerations; and

e) banks may consider maturity profile of the loan book, keeping in view the market risks inherent in the balance sheet, risk evaluation capability, liquidity, etc.

3.2.3 Risk Rating

Banks should have a comprehensive risk scoring / rating system that serves as a single point indicator of diverse risk factors of a counterparty and for taking credit decisions in a consistent manner. To facilitate this, a substantial degree of standardisation is required in ratings across borrowers. The risk rating system should be designed to reveal the overall risk of lending, critical input for setting pricing and non-price terms of loans as also present meaningful information for review and management of loan portfolio. The risk rating, in short, should reflect the underlying credit risk of the loan book. The rating exercise should also facilitate the credit granting authorities some comfort in its knowledge of loan quality at any moment of time.

The risk rating system should be drawn up in a structured manner, incorporating, inter alia, financial analysis, projections and sensitivity, industrial and management risks. The banks may use any number of financial ratios and operational parameters and collaterals as also qualitative aspects of management and industry characteristics that have bearings on the creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the years to which they represent for giving importance to near term developments. Within the rating framework, banks can also prescribe certain level of standards or critical parameters, beyond which no proposals should be entertained. Banks may also consider separate rating framework for large corporate / small borrowers, traders, etc. that exhibit varying nature and degree of risk. Forex exposures assumed by corporates who have no natural hedges have significantly altered the risk profile of banks. Banks should, therefore, factor the unhedged market risk exposures of borrowers also in the rating framework. The overall score for risk is to be placed on a numerical scale ranging between 1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a quantitative definition of the borrower, the loan’s underlying quality, and an analytic representation of the underlying financials of the borrower should be presented. Further, as a prudent risk management policy, each bank should prescribe the minimum rating below which no exposures would be undertaken. Any flexibility in the minimum standards and conditions for relaxation and authority therefor should be clearly articulated in the Loan Policy.

The credit risk assessment exercise should be repeated biannually (or even at shorter intervals for low quality customers) and should be delinked invariably from the regular renewal exercise. The updating of the credit ratings should be undertaken normally at quarterly intervals or at least at half-yearly intervals, in order to gauge the quality of the portfolio at periodic intervals. Variations in the ratings of borrowers over time indicate changes in credit quality and expected loan losses from the credit portfolio. Thus, if the rating system is to be meaningful, the credit quality reports should signal changes in expected loan losses. In order to ensure the consistency and accuracy of internal ratings, the responsibility for setting or confirming such ratings should vest with the Loan Review function and examined by an independent Loan Review Group. The banks should undertake comprehensive study on migration (upward – lower to higher and downward – higher to lower) of borrowers in the ratings to add accuracy in expected loan loss calculations.

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3.2.4 Risk Pricing

Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting, borrowers with weak financial position and hence placed in high credit risk category should be priced high. Thus, banks should evolve scientific systems to price the credit risk, which should have a bearing on the expected probability of default. The pricing of loans normally should be linked to risk rating or credit quality. The probability of default could be derived from the past behaviour of the loan portfolio, which is the function of loan loss provision/charge offs for the last five years or so. Banks should build historical database on the portfolio quality and provisioning / charge off to equip themselves to price the risk. But value of collateral, market forces, perceived value of accounts, future business potential, portfolio/industry exposure and strategic reasons may also play important role in pricing. Flexibility should also be made for revising the price (risk premia) due to changes in rating / value of collaterals over time. Large sized banks across the world have already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans, which calls for data on portfolio behaviour and allocation of capital commensurate with credit risk inherent in loan proposals. Under RAROC framework, lender begins by charging an interest mark-up to cover the expected loss – expected default rate of the rating category of the borrower. The lender then allocates enough capital to the prospective loan to cover some amount of unexpected loss- variability of default rates. Generally, international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital covers 99% of the loan loss outcomes.

There is, however, a need for comparing the prices quoted by competitors for borrowers perched on the same rating /quality. Thus, any attempt at price-cutting for market share would result in mispricing of risk and ‘Adverse Selection’.

3.2.5 Portfolio Management

The existing framework of tracking the Non Performing Loans around the balance sheet date does not signal the quality of the entire Loan Book. Banks should evolve proper systems for identification of credit weaknesses well in advance. Most of international banks have adopted various portfolio management techniques for gauging asset quality. The CRMD, set up at Head Office should be assigned the responsibility of periodic monitoring of the portfolio. The portfolio quality could be evaluated by tracking the migration (upward or downward) of borrowers from one rating scale to another. This process would be meaningful only if the borrower-wise ratings are updated at quarterly / half-yearly intervals. Data on movements within grading categories provide a useful insight into the nature and composition of loan book.

The banks could also consider the following measures to maintain the portfolio quality:1) stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e. certain

percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5, etc.;

2) evaluate the rating-wise distribution of borrowers in various industry, business segments, etc.;

3) exposure to one industry/sector should be evaluated on the basis of overall rating distribution of borrowers in the sector/group. In this context, banks should weigh the pros and cons of specialisation and concentration by industry group. In cases where portfolio exposure to a

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single industry is badly performing, the banks may increase the quality standards for that specific industry;

4) target rating-wise volume of loans, probable defaults and provisioning requirements as a prudent planning exercise. For any deviation/s from the expected parameters, an exercise for restructuring of the portfolio should immediately be undertaken and if necessary, the entry-level criteria could be enhanced to insulate the portfolio from further deterioration;

5) undertake rapid portfolio reviews, stress tests and scenario analysis when external environment undergoes rapid changes (e.g. volatility in the forex market, economic sanctions, changes in the fiscal/monetary policies, general slowdown of the economy, market risk events, extreme liquidity conditions, etc.). The stress tests would reveal undetected areas of potential credit risk exposure and linkages between different categories of risk. In adverse circumstances, there may be substantial correlation of various risks, especially credit and market risks. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables to the use of highly sophisticated models. The output of such portfolio-wide stress tests should be reviewed by the Board and suitable changes may be made in prudential risk limits for protecting the quality. Stress tests could also include contingency plans, detailing management responses to stressful situations.

6) introduce discriminatory time schedules for renewal of borrower limits. Lower rated borrowers whose financials show signs of problems should be subjected to renewal control twice/thrice an year.

Banks should evolve suitable framework for monitoring the market risks especially forex risk exposure of corporates who have no natural hedges on a regular basis. Banks should also appoint Portfolio Managers to watch the loan portfolio’s degree of concentrations and exposure to counterparties. For comprehensive evaluation of customer exposure, banks may consider appointing Relationship Managers to ensure that overall exposure to a single borrower is monitored, captured and controlled. The Relationship Managers have to work in coordination with the Treasury and Forex Departments. The Relationship Managers may service mainly high value loans so that a substantial share of the loan portfolio, which can alter the risk profile, would be under constant surveillance. Further, transactions with affiliated companies/groups need to be aggregated and maintained close to real time. The banks should also put in place formalised systems for identification of accounts showing pronounced credit weaknesses well in advance and also prepare internal guidelines for such an exercise and set time frame for deciding courses of action.

Many of the international banks have adopted credit risk models for evaluation of credit portfolio. The credit risk models offer banks framework for examining credit risk exposures, across geographical locations and product lines in a timely manner, centralising data and analysing marginal and absolute contributions to risk. The models also provide estimates of credit risk (unexpected loss) which reflect individual portfolio composition. The Altman’s Z Score forecasts the probability of a company entering bankruptcy within a 12-month period. The model combines five financial ratios using reported accounting information and equity values to produce an objective measure of borrower’s financial health. J. P. Morgan has developed a portfolio model ‘CreditMetrics’ for evaluating credit risk. The model basically focus on estimating the volatility in the value of assets caused by variations in the quality of assets. The volatility is computed by tracking the probability that the borrower might migrate from one rating category to another (downgrade or upgrade). Thus, the value of loans can change over time, reflecting migration of the borrowers to a different risk-rating grade. The model can be used for promoting transparency in credit risk, establishing benchmark for credit risk

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measurement and estimating economic capital for credit risk under RAROC framework. Credit Suisse developed a statistical method for measuring and accounting for credit risk which is known as CreditRisk+. The model is based on actuarial calculation of expected default rates and unexpected losses from default.

The banks may evaluate the utility of these models with suitable modifications to Indian environment for fine-tuning the credit risk management. The success of credit risk models impinges on time series data on historical loan loss rates and other model variables, spanning multiple credit cycles. Banks may, therefore, endeavour building adequate database for switching over to credit risk modelling after a specified period of time.

3.2.6 Loan Review Mechanism (LRM)LRM is an effective tool for constantly evaluating the quality of loan book and to bring about qualitative improvements in credit administration. Banks should, therefore, put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and scope of LRM normally vary based on banks’ size, type of operations and management practices. It may be independent of the CRMD or even separate Department in large banks.

The main objectives of LRM could be:· to identify promptly loans which develop credit weaknesses and initiate timely corrective

action; · to evaluate portfolio quality and isolate potential problem areas; · to provide information for determining adequacy of loan loss provision; · to assess the adequacy of and adherence to, loan policies and procedures, and to monitor

compliance with relevant laws and regulations; and · to provide top management with information on credit administration, including credit

sanction process, risk evaluation and post-sanction follow-up.

Accurate and timely credit grading is one of the basic components of an effective LRM. Credit grading involves assessment of credit quality, identification of problem loans, and assignment of risk ratings. A proper Credit Grading System should support evaluating the portfolio quality and establishing loan loss provisions. Given the importance and subjective nature of credit rating, the credit ratings awarded by Credit Administration Department should be subjected to review by Loan Review Officers who are independent of loan administration.

3.2.7 Banks should formulate Loan Review Policy and it should be reviewed annually by the Board. The Policy should, inter alia, address:

· Qualification and Independence

The Loan Review Officers should have sound knowledge in credit appraisal, lending practices and loan policies of the bank. They should also be well versed in the relevant laws/regulations that affect lending activities. The independence of Loan Review Officers should be ensured and the findings of the reviews should also be reported directly to the Board or Committee of the Board.

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· Frequency and Scope of Reviews

The Loan Reviews are designed to provide feedback on effectiveness of credit sanction and to identify incipient deterioration in portfolio quality. Reviews of high value loans should be undertaken usually within three months of sanction/renewal or more frequently when factors indicate a potential for deterioration in the credit quality. The scope of the review should cover all loans above a cut-off limit. In addition, banks should also target other accounts that present elevated risk characteristics. At least 30-40% of the portfolio should be subjected to LRM in a year to provide reasonable assurance that all the major credit risks embedded in the balance sheet have been tracked.

· Depth of Reviews

The loan reviews should focus on:· Approval process; · Accuracy and timeliness of credit ratings assigned by loan officers; · Adherence to internal policies and procedures, and applicable laws / regulations; · Compliance with loan covenants; · Post-sanction follow-up; · Sufficiency of loan documentation; · Portfolio quality; and · Recommendations for improving portfolio quality

3.2.8 The findings of Reviews should be discussed with line Managers and the corrective actions should be elicited for all deficiencies. Deficiencies that remain unresolved should be reported to top management.

3.2.9 The Risk Management Group of the Basle Committee on Banking Supervision has released a consultative paper on Principles for the Management of Credit Risk. The Paper deals with various aspects relating to credit risk management. The Paper is enclosed for information of banks.

4. Credit Risk and Investment Banking

4.1 Significant magnitude of credit risk, in addition to market risk, is inherent in investment banking. The proposals for investments should also be subjected to the same degree of credit risk analysis, as any loan proposals. The proposals should be subjected to detailed appraisal and rating framework that factors in financial and non-financial parameters of issuers, sensitivity to external developments, etc. The maximum exposure to a customer should be bank-wide and include all exposures assumed by the Credit and Treasury Departments. The coupon on non-sovereign papers should be commensurate with their risk profile. The banks should exercise due caution, particularly in investment proposals, which are not rated and should ensure comprehensive risk evaluation. There should be greater interaction between Credit and Treasury Departments and the portfolio analysis should also cover the total exposures, including investments. The rating migration of the issuers and the consequent diminution in the portfolio quality should also be tracked at periodic intervals.

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4.2 As a matter of prudence, banks should stipulate entry level minimum ratings/quality standards, industry, maturity, duration, issuer-wise, etc. limits in investment proposals as well to mitigate the adverse impacts of concentration and the risk of illiquidity.

5. Credit Risk in Off-balance Sheet Exposure

5.1 Banks should evolve adequate framework for managing their exposure in off-balance sheet products like forex forward contracts, swaps, options, etc. as a part of overall credit to individual customer relationship and subject to the same credit appraisal, limits and monitoring procedures. Banks should classify their off-balance sheet exposures into three broad categories - full risk (credit substitutes) - standby letters of credit, money guarantees, etc, medium risk (not direct credit substitutes, which do not support existing financial obligations) - bid bonds, letters of credit, indemnities and warranties and low risk - reverse repos, currency swaps, options, futures, etc.

5.2 The trading credit exposure to counterparties can be measured on static (constant percentage of the notional principal over the life of the transaction) and on a dynamic basis. The total exposures to the counterparties on a dynamic basis should be the sum total of: 1) the current replacement cost (unrealised loss to the counterparty); and 2) the potential increase in replacement cost (estimated with the help of VaR or other methods

to capture future volatilities in the value of the outstanding contracts/ obligations).

The current and potential credit exposures may be measured on a daily basis to evaluate the impact of potential changes in market conditions on the value of counterparty positions. The potential exposures also may be quantified by subjecting the position to market movements involving normal and abnormal movements in interest rates, foreign exchange rates, equity prices, liquidity conditions, etc.

6. Inter-bank Exposure and Country Risk

6.1 A suitable framework should be evolved to provide a centralised overview on the aggregate exposure on other banks. Bank-wise exposure limits could be set on the basis of assessment of financial performance, operating efficiency, management quality, past experience, etc. Like corporate clients, banks should also be rated and placed in range of 1-5, 1-8, as the case may be, on the basis of their credit quality. The limits so arrived at should be allocated to various operating centres and followed up and half-yearly/annual reviews undertaken at a single point. Regarding exposure on overseas banks, banks can use the country ratings of international rating agencies and classify the countries into low risk, moderate risk and high risk. Banks should endeavour for developing an internal matrix that reckons the counterparty and country risks. The maximum exposure should be subjected to adherence of country and bank exposure limits already in place. While the exposure should at least be monitored on a weekly basis till the banks are equipped to monitor exposures on a real time basis, all exposures to problem countries should be evaluated on a real time basis.

7. Market Risk7.1 Traditionally, credit risk management was the primary challenge for banks. With progressive deregulation, market risk arising from adverse changes in market variables, such as interest rate,

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foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks. Market risk takes the form of:1) Liquidity Risk 2) Interest Rate Risk 3) Foreign Exchange Rate (Forex) Risk 4) Commodity Price Risk and 5) Equity Price Risk

8. Market Risk Management

8.1 Management of market risk should be the major concern of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. The Middle Office should comprise of experts in market risk management, economists, statisticians and general bankers and may be functionally placed directly under the ALCO. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management of Treasury. The Middle Office should apprise the top management / ALCO / Treasury about adherence to prudential / risk parameters and also aggregate the total market risk exposures assumed by the bank at any point of time.

8.2 Liquidity Risk

8.2.1 Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompasses the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defence mechanism from losses on fire sale of assets.

8.2.2 The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.

8.2.3 The liquidity risk in banks manifest in different dimensions:

i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);

ii) Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

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iii) Call Risk - due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

8.2.4 The first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia, should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting / reviewing, etc.

8.2.5 Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are:

i) Loans to Total Assets ii) Loans to Core Deposits iii) Large Liabilities (minus) Temporary Investments to Earning Assets (minus)

Temporary Investments, where large liabilities represent wholesale deposits which are market sensitive and temporary Investments are those maturing within one year and those investments which are held in the trading book and are readily sold in the market;

iv) Purchased Funds to Total Assets, where purchased funds include the entire inter-bank and other money market borrowings, including Certificate of Deposits and institutional deposits; and

v) Loan Losses/Net Loans.

8.2.6 While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on future behaviour of assets, liabilities and off-balance sheet items. In other words, banks should have to analyse the behavioural maturity profile of various components of on / off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance analysis, at least, once in six months to validate the assumptions. The assumptions should be fine-tuned over a period which facilitate near reality predictions about future behaviour of on / off-balance sheet items. Apart from the above cash flows, banks should also track the impact of prepayments of loans, premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallised.

8.2.7 The difference between cash inflows and outflows in each time period, the excess or deficit of funds, becomes a starting point for a measure of a bank’s future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis:

1. Cap on inter-bank borrowings, especially call borrowings;

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2. Purchased funds vis-à-vis liquid assets; 3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and

Loans; 4. Duration of liabilities and investment portfolio; 5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches across all time

bands; 6. Commitment Ratio – track the total commitments given to corporates/banks and other

financial institutions to limit the off-balance sheet exposure; 7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

8.2.8 Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc.

8.2.9 The liquidity profile of the banks could be analysed on a static basis, wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern and the sensitivity of these items to changes in market interest rates and environment are duly accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to: 1) Seasonal pattern of deposits/loans; 2) Potential liquidity needs for meeting new loan demands, unavailed credit limits, loan policy,

potential deposit losses, investment obligations, statutory obligations, etc.

8.2.10 Alternative Scenarios

The liquidity profile of banks depends on the market conditions, which influence the cash flow behaviour. Thus, banks should evaluate liquidity profile under different conditions, viz. normal situation, bank specific crisis and market crisis scenario. The banks should establish benchmark for normal situation, cash flow profile of on / off balance sheet items and manages net funding requirements.

8.2.11 Estimating liquidity under bank specific crisis should provide a worst-case benchmark. It should be assumed that the purchased funds could not be easily rolled over; some of the core deposits could be prematurely closed; a substantial share of assets have turned into non-performing and thus become totally illiquid. These developments would lead to rating down grades and high cost of liquidity. The banks should evolve contingency plans to overcome such situations.

8.2.12 The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank, general perception about risk profile of the banking system, severe market disruptions, failure of one or more of major players in the market, financial crisis, contagion, etc. Under this scenario, the rollover of high value customer deposits and purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. The banks could also sell their investment with huge discounts, entailing severe capital loss.

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8.2.13 Contingency PlanBanks should prepare Contingency Plans to measure their ability to withstand bank-specific or market crisis scenario. The blue-print for asset sales, market access, capacity to restructure the maturity and composition of assets and liabilities should be clearly documented and alternative options of funding in the event of bank’s failure to raise liquidity from existing source/s could be clearly articulated. Liquidity from the Reserve Bank, arising out of its refinance window and interim liquidity adjustment facility or as lender of last resort should not be reckoned for contingency plans. Availability of back-up liquidity support in the form of committed lines of credit, reciprocal arrangements, liquidity support from other external sources, liquidity of assets, etc. should also be clearly established.

9. Interest Rate Risk (IRR)9.1 The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose banks’ NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility.

9.2 Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE), caused by unexpected changes in market interest rates. Interest Rate Risk can take different forms:

9.3 Types of Interest Rate Risk

9.3.1 Gap or Mismatch Risk:

A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.

9.3.2 Basis Risk

Market interest rates of various instruments seldom change by the same degree during a given period of time. The risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. The Loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios. When the variation in market interest rate causes the NII to expand, the banks have experienced favourable basis shifts and if the interest rate movement causes the NII to contract, the basis has moved against the banks.

9.3.3 Embedded Option Risk

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Significant changes in market interest rates create another source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. The embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks’ NII. Thus, banks should evolve scientific techniques to estimate the probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to realistically estimate the risk profiles in their balance sheet. Banks should also endeavour for stipulating appropriate penalties based on opportunity costs to stem the exercise of options, which is always to the disadvantage of banks.

9.3.4 Yield Curve RiskIn a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curves would affect the NII. The movements in yield curve are rather frequent when the economy moves through business cycles. Thus, banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income.

9.3.5 Price Risk

Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks which have an active trading book should, therefore, formulate policies to limit the portfolio size, holding period, duration, defeasance period, stop loss limits, marking to market, etc.

9.3.6 Reinvestment Risk

Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions.

9.3.7 Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors contributing towards profitability of banks. When banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rates adjust downwards. Thus, banks with positive net interest positions will experience a reduction in NII as the market interest rate declines and increases when interest rate rises. Thus, large float is a natural hedge against the variations in interest rates.

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9.4 Measuring Interest Rate Risk

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9.4.1 Before interest rate risk could be managed, they should be identified and quantified. Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to measure the degree of risks to which banks are exposed. It is also equally impossible to develop effective risk management strategies/hedging techniques without being able to understand the correct risk position of banks. The IRR measurement system should address all material sources of interest rate risk including gap or mismatch, basis, embedded option, yield curve, price, reinvestment and net interest position risks exposures. The IRR measurement system should also take into account the specific characteristics of each individual interest rate sensitive position and should capture in detail the full range of potential movements in interest rates.

9.4.2 There are different techniques for measurement of interest rate risk, ranging from the traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings), Duration (to measure interest rate sensitivity of capital), Simulation and Value at Risk. While these methods highlight different facets of interest rate risk, many banks use them in combination, or use hybrid methods that combine features of all the techniques.

9.4.3 Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Investment or Banking Books. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic value changes are the main focus of banking book.

9.5 Trading Book

The top management of banks should lay down policies with regard to volume, maximum maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for classifying securities in the trading book. While the securities held in the trading book should ideally be marked to market on a daily basis, the potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models. The VaR method is employed to assess potential loss that could crystalise on trading position or portfolio due to variations in market interest rates and prices, using a given confidence level, usually 95% to 99%, within a defined period of time. The VaR method should incorporate the market factors against which the market value of the trading position is exposed. The top management should put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions, derivative products, etc.) which is then disaggregated across different desks and departments. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. The potential loss in Present Value Basis Points should be matched by the Middle Office on a daily basis vis-à-vis the prudential limits set by the Board. The advantage of using VaR is that it is comparable across products, desks and Departments and it can be validated through ‘back testing’. However, VaR models require the use of extensive historical data to estimate future volatility. VaR model also may not give good results in extreme volatile conditions or outlier events and stress test has to be employed to complement VaR. The stress tests provide management a view on the potential impact of large size market movements and also attempt to estimate the size of potential losses due to stress events, which occur in the ’tails’ of the loss distribution. Banks may also undertake

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scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical, simultaneous and related changes in multiple risk factors present in the trading portfolio to determine the impact of moves on the rest of the portfolio. VaR models could also be modified to reflect liquidity risk differences observed across assets over time. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-statistical concepts such as stop loss and gross/net positions can be used.

9.6 Banking Book

The changes in market interest rates have earnings and economic value impacts on the banks’ banking book. Thus, given the complexity and range of balance sheet products, banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. The variety of techniques ranges from simple maturity (fixed rate) and repricing (floating rate) to static simulation, based on current on-and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk, embedded option risk, yield curve risk, etc.

9.7 Maturity Gap Analysis

9.7.1 The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes interest rate sensitive assets, liabilities and off-balance sheet positions into a certain number of pre-defined time-bands according to their maturity (fixed rate) or time remaining for their next repricing (floating rate). Those assets and liabilities lacking definite repricing intervals (savings bank, cash credit, overdraft, loans, export finance, refinance from RBI etc.) or actual maturities vary from contractual maturities (embedded option in bonds with put/call options, loans, cash credit/overdraft, time deposits, etc.) are assigned time-bands according to the judgement, empirical studies and past experiences of banks.

9.7.2 A number of time bands can be used while constructing a gap report. Generally, most of the banks focus their attention on near-term periods, viz. monthly, quarterly, half-yearly or one year. It is very difficult to take a view on interest rate movements beyond a year. Banks with large exposures in the short-term should test the sensitivity of their assets and liabilities even at shorter intervals like overnight, 1-7 days, 8-14 days, etc.

9.7.3 In order to evaluate the earnings exposure, interest Rate Sensitive Assets (RSAs) in each time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a repricing ‘Gap’ for that time band. The positive Gap indicates that banks have more RSAs than RSLs. A positive or asset sensitive Gap means that an increase in market interest rates could cause an increase in NII. Conversely, a negative or liability sensitive Gap implies that the banks’ NII could decline as a result of increase in market interest rates. The negative gap indicates that banks have more RSLs than RSAs. The Gap is used as a measure of interest rate sensitivity. The Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the Earnings at Risk (EaR). The EaR method facilitates to estimate how much the earnings might be impacted by an adverse movement in interest rates. The changes in interest rate could be estimated on the basis of past trends, forecasting of interest rates, etc. The banks should fix EaR

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which could be based on last/current year’s income and a trigger point at which the line management should adopt on-or off-balance sheet hedging strategies may be clearly defined.

9.7.4 The Gap calculations can be augmented by information on the average coupon on assets and liabilities in each time band and the same could be used to calculate estimates of the level of NII from positions maturing or due for repricing within a given time-band, which would then provide a scale to assess the changes in income implied by the gap analysis.

9.7.5 The periodic gap analysis indicates the interest rate risk exposure of banks over distinct maturities and suggests magnitude of portfolio changes necessary to alter the risk profile. However, the Gap report quantifies only the time difference between repricing dates of assets and liabilities but fails to measure the impact of basis and embedded option risks. The Gap report also fails to measure the entire impact of a change in interest rate (Gap report assumes that all assets and liabilities are matured or repriced simultaneously) within a given time-band and effect of changes in interest rates on the economic or market value of assets, liabilities and off-balance sheet position. It also does not take into account any differences in the timing of payments that might occur as a result of changes in interest rate environment. Further, the assumption of parallel shift in yield curves seldom happen in the financial market. The Gap report also fails to capture variability in non-interest revenue and expenses, a potentially important source of risk to current income.

9.7.6 In case banks could realistically estimate the magnitude of changes in market interest rates of various assets and liabilities (basis risk) and their past behavioural pattern (embedded option risk), they could standardise the gap by multiplying the individual assets and liabilities by how much they will change for a given change in interest rate. Thus, one or several assumptions of standardised gap seem more consistent with real world than the simple gap method. With the Adjusted Gap, banks could realistically estimate the EaR.

9.8 Duration Gap Analysis

9.8.1 Matching the duration of assets and liabilities, instead of matching the maturity or repricing dates is the most effective way to protect the economic values of banks from exposure to IRR than the simple gap model. Duration gap model focuses on managing economic value of banks by recognising the change in the market value of assets, liabilities and off-balance sheet (OBS) items. When weighted assets and liabilities and OBS duration are matched, market interest rate movements would have almost same impact on assets, liabilities and OBS, thereby protecting the bank’s total equity or net worth. Duration is a measure of the percentage change in the economic value of a position that will occur given a small change in the level of interest rates.

9.8.2 Measuring the duration gap is more complex than the simple gap model. For approximation of duration of assets and liabilities, the simple gap schedule can be used by applying weights to each time-band. The weights are based on estimates of the duration of assets and liabilities and OBS that fall into each time band. The weighted duration of assets and liabilities and OBS provide a rough estimation of the changes in banks’ economic value to a given change in market interest rates. It is also possible to give different weights and interest rates to assets, liabilities and OBS in different time buckets to capture differences in coupons and maturities and volatilities in interest rates along the yield curve.

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9.8.3 In a more scientific way, banks can precisely estimate the economic value changes to market interest rates by calculating the duration of each asset, liability and OBS position and weigh each of them to arrive at the weighted duration of assets, liabilities and OBS. Once the weighted duration of assets and liabilities are estimated, the duration gap can be worked out with the help of standard mathematical formulae. The Duration Gap measure can be used to estimate the expected change in Market Value of Equity (MVE) for a given change in market interest rate.

9.8.4 The difference between duration of assets (DA) and liabilities (DL) is bank’s net duration. If the net duration is positive (DA>DL), a decrease in market interest rates will increase the market value of equity of the bank. When the duration gap is negative (DL> DA), the MVE increases when the interest rate increases but decreases when the rate declines. Thus, the Duration Gap shows the impact of the movements in market interest rates on the MVE through influencing the market value of assets, liabilities and OBS.

9.8.5 The attraction of duration analysis is that it provides a comprehensive measure of IRR for the total portfolio. The duration analysis also recognises the time value of money. Duration measure is additive so that banks can match total assets and liabilities rather than matching individual accounts. However, Duration Gap analysis assumes parallel shifts in yield curve. For this reason, it fails to recognise basis risk. 9.9 Simulation

9.9.1 Many of the international banks are now using balance sheet simulation models to gauge the effect of market interest rate variations on reported earnings/economic values over different time zones. Simulation technique attempts to overcome the limitations of Gap and Duration approaches by computer modelling the bank’s interest rate sensitivity. Such modelling involves making assumptions about future path of interest rates, shape of yield curve, changes in business activity, pricing and hedging strategies, etc. The simulation involves detailed assessment of the potential effects of changes in interest rate on earnings and economic value. The simulation techniques involve detailed analysis of various components of on-and off-balance sheet positions. Simulations can also incorporate more varied and refined changes in the interest rate environment, ranging from changes in the slope and shape of the yield curve and interest rate scenario derived from Monte Carlo simulations.

9.9.2 The output of simulation can take a variety of forms, depending on users’ need. Simulation can provide current and expected periodic gaps, duration gaps, balance sheet and income statements, performance measures, budget and financial reports. The simulation model provides an effective tool for understanding the risk exposure under variety of interest rate/balance sheet scenarios. This technique also plays an integral-planning role in evaluating the effect of alternative business strategies on risk exposures.

9.9.3 The simulation can be carried out under static and dynamic environment. While the current on and off-balance sheet positions are evaluated under static environment, the dynamic simulation builds in more detailed assumptions about the future course of interest rates and the unexpected changes in bank’s business activity.

9.9.4 The usefulness of the simulation technique depends on the structure of the model, validity of assumption, technology support and technical expertise of banks.

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9.9.5 The application of various techniques depends to a large extent on the quality of data and the degree of automated system of operations. Thus, banks may start with the gap or duration gap or simulation techniques on the basis of availability of data, information technology and technical expertise. In any case, as suggested by RBI in the guidelines on ALM System, banks should start estimating the interest rate risk exposure with the help of Maturity Gap approach. Once banks are comfortable with the Gap model, they can progressively graduate into the sophisticated approaches.

9.10 Funds Transfer Pricing

9.10.1 The Transfer Pricing mechanism being followed by many banks does not support good ALM Systems. Many international banks which have different products and operate in various geographic markets have been using internal Funds Transfer Pricing (FTP). FTP is an internal measurement designed to assess the financial impact of uses and sources of funds and can be used to evaluate the profitability. It can also be used to isolate returns for various risks assumed in the intermediation process. FTP also helps correctly identify the cost of opportunity value of funds. Although banks have adopted various FTP frameworks and techniques, Matched Funds Pricing (MFP) is the most efficient technique. Most of the international banks use MFP. The FTP envisages assignment of specific assets and liabilities to various functional units (profit centres) – lending, investment, deposit taking and funds management. Each unit attracts sources and uses of funds. The lending, investment and deposit taking profit centres sell their liabilities to and buys funds for financing their assets from the funds management profit centre at appropriate transfer prices. The transfer prices are fixed on the basis of a single curve (MIBOR or derived cash curve, etc) so that asset-liability transactions of identical attributes are assigned identical transfer prices. Transfer prices could, however, vary according to maturity, purpose, terms and other attributes.

9.10.2 The FTP provides for allocation of margin (franchise and credit spreads) to profit centres on original transfer rates and any residual spread (mismatch spread) is credited to the funds management profit centre. This spread is the result of accumulated mismatches. The margins of various profit centres are:

· Deposit profit centre:

Transfer Price (TP) on deposits - cost of deposits – deposit insurance- overheads.

· Lending profit centre:

Loan yields + TP on deposits – TP on loan financing – cost of deposits – deposit insurance - overheads – loan loss provisions.

· Investment profit centre:

Security yields + TP on deposits – TP on security financing – cost of deposits – deposit insurance - overheads – provisions for depreciation in investments and loan loss.

· Funds Management profit centre:

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TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads.

For illustration, let us assume that a bank’s Deposit profit centre has raised a 3 month deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and one year @ 8% and 10.5% p.a., respectively. Let us also assume that the bank’s Loan profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and mismatch spreads of bank is as under:

Profit Centres TotalDeposit Funds Loan

Interest Income 8.0 10.5 13.5 13.5Interest Expenditure 6.5 8.0 10.5 6.5Margin 1.5 2.5 3.0 7.0Loan Loss Provision (expected) - - 1.0 1.0Deposit Insurance 0.1 - - 0.1Reserve Cost (CRR/ SLR) - 1.0 - 1.0Overheads 0.6 0.5 0.6 1.7NII 0.8 1.0 1.4 3.2

Under the FTP mechanism, the profit centres (other than funds management) are precluded from assuming any funding mismatches and thereby exposing them to market risk. The credit or counterparty and price risks are, however, managed by these profit centres. The entire market risks, i.e interest rate, liquidity and forex are assumed by the funds management profit centre.

9.10.3 The FTP allows lending and deposit raising profit centres determine their expenses and price their products competitively. Lending profit centre which knows the carrying cost of the loans needs to focus on to price only the spread necessary to compensate the perceived credit risk and operating expenses. Thus, FTP system could effectively be used as a way to centralise the bank’s overall market risk at one place and would support an effective ALM modelling system. FTP also could be used to enhance corporate communication; greater line management control and solid base for rewarding line management.

10. Foreign Exchange (Forex) Risk

10.1 The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks’ balance sheets.

10.2 Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premia/discounts of the currencies concerned. 10.3 In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallisation does not cause principal loss, banks may have to

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undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one centre and the settlement of another currency in another time-zone. The forex transactions with counterparties from another country also trigger sovereign or country risk.

10.4 Forex Risk Management Measures

1. Set appropriate limits – open positions and gaps. 2. Clear-cut and well-defined division of responsibility between front, middle and back offices.

The top management should also adopt the VaR approach to measure the risk associated with exposures. Reserve Bank of India has recently introduced two statements viz. Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of forex risk exposures. Banks should use these statements for periodical monitoring of forex risk exposures.

11. Capital for Market Risk

11.1 The Basle Committee on Banking Supervision (BCBS) had issued comprehensive guidelines to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. The banks have been given flexibility to use in-house models based on VaR for measuring market risk as an alternative to a standardised measurement framework suggested by Basle Committee. The internal models should, however, comply with quantitative and qualitative criteria prescribed by Basle Committee.

11.2 Reserve Bank of India has accepted the general framework suggested by the Basle Committee. RBI has also initiated various steps in moving towards prescribing capital for market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments in Government and other approved securities, besides a risk weight each of 100% on the open position limits in forex and gold. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks. As the ability of banks to identify and measure market risk improves, it would be necessary to assign explicit capital charge for market risk. In the meanwhile, banks are advised to study the Basle Committee’s paper on ‘Overview of the Amendment to the Capital Accord to Incorporate Market Risks’ – January 1996 (copy enclosed). While the small banks operating predominantly in India could adopt the standardised methodology, large banks and those banks operating in international markets should develop expertise in evolving internal models for measurement of market risk.

11.3 The Basle Committee on Banking Supervision proposes to develop capital charge for interest rate risk in the banking book as well for banks where the interest rate risks are significantly above average (‘outliers’). The Committee is now exploring various methodologies for identifying ‘outliers’ and how best to apply and calibrate a capital charge for interest rate risk for banks. Once the Committee finalises the modalities, it may be necessary, at least for banks operating in the international markets to comply with the explicit capital charge requirements for interest rate risk in the banking book.

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12. Operational Risk

12.1 Managing operational risk is becoming an important feature of sound risk management practices in modern financial markets in the wake of phenomenal increase in the volume of transactions, high degree of structural changes and complex support systems. The most important type of operational risk involves breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial loss through error, fraud, or failure to perform in a timely manner or cause the interest of the bank to be compromised.

12.2 Generally, operational risk is defined as any risk, which is not categoried as market or credit risk, or the risk of loss arising from various types of human or technical error. It is also synonymous with settlement or payments risk and business interruption, administrative and legal risks. Operational risk has some form of link between credit and market risks. An operational problem with a business transaction could trigger a credit or market risk.

12.3 Measurement

There is no uniformity of approach in measurement of operational risk in the banking system. Besides, the existing methods are relatively simple and experimental, although some of the international banks have made considerable progress in developing more advanced techniques for allocating capital with regard to operational risk.

Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring, the magnitude (or severity) of the effect of the operational risk on business objectives and the options available to manage and initiate actions to reduce/ mitigate operational risk. The set of risk factors that measure risk in each business unit such as audit ratings, operational data such as volume, turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue volatility, could be related to historical loss experience. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. Some of the international banks have already developed operational risk rating matrix, similar to bond credit rating. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals. Banks, over a period, should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framework.

Indian banks have so far not evolved any scientific methods for quantifying operational risk. In the absence any sophisticated models, banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue, fee income, operating costs, managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables.

12.4 Risk Monitoring

The operational risk monitoring system focuses, inter alia, on operational performance measures such as volume, turnover, settlement facts, delays and errors. It could also be incumbent to

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monitor operational loss directly with an analysis of each occurrence and description of the nature and causes of the loss.

12.5 Control of Operational Risk

Internal controls and the internal audit are used as the primary means to mitigate operational risk. Banks could also explore setting up operational risk limits, based on the measures of operational risk. The contingent processing capabilities could also be used as a means to limit the adverse impacts of operational risk. Insurance is also an important mitigator of some forms of operational risk. Risk education for familiarising the complex operations at all levels of staff can also reduce operational risk.

12.6 Policies and Procedures

Banks should have well defined policies on operational risk management. The policies and procedures should be based on common elements across business lines or risks. The policy should address product review process, involving business, risk management and internal control functions.

12.7 Internal Control

12.7.1 One of the major tools for managing operational risk is the well-established internal control system, which includes segregation of duties, clear management reporting lines and adequate operating procedures. Most of the operational risk events are associated with weak links in internal control systems or laxity in complying with the existing internal control procedures.

12.7.2 The ideal method of identifying problem spots is the technique of self-assessment of internal control environment. The self-assessment could be used to evaluate operational risk alongwith internal/external audit reports/ratings or RBI inspection findings. Banks should endeavour for detection of operational problem spots rather than their being pointed out by supervisors/internal or external auditors.

12.7.3 Alongwith activating internal audit systems, the Audit Committees should play greater role to ensure independent financial and internal control functions.

12.7.4 The Basle Committee on Banking Supervision proposes to develop an explicit capital charge for operational risk.

13. Risk Aggregation and Capital Allocation13.1 Most of internally active banks have developed internal processes and techniques to assess and evaluate their own capital needs in the light of their risk profiles and business plans. Such banks take into account both qualitative and quantitative factors to assess economic capital. The Basle Committee now recognises that capital adequacy in relation to economic risk is a necessary condition for the long-term soundness of banks. Thus, in addition to complying with the established minimum regulatory capital requirements, banks should critically assess their internal capital adequacy and future capital needs on the basis of risks assumed by individual

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lines of business, product, etc. As a part of the process for evaluating internal capital adequacy, a bank should be able to identify and evaluate its risks across all its activities to determine whether its capital levels are appropriate.13.2 Thus, at the bank’s Head Office level, aggregate risk exposure should receive increased scrutiny. To do so, however, it requires the summation of the different types of risks. Banks, across the world, use different ways to estimate the aggregate risk exposures. The most commonly used approach is the Risk Adjusted Return on Capital (RAROC). The RAROC is designed to allow all the business streams of a financial institution to be evaluated on an equal footing. Each type of risks is measured to determine both the expected and unexpected losses using VaR or worst-case type analytical model. Key to RAROC is the matching of revenues, costs and risks on transaction or portfolio basis over a defined time period. This begins with a clear differentiation between expected and unexpected losses. Expected losses are covered by reserves and provisions and unexpected losses require capital allocation which is determined on the principles of confidence levels, time horizon, diversification and correlation. In this approach, risk is measured in terms of variability of income. Under this framework, the frequency distribution of return, wherever possible is estimated and the Standard Deviation (SD) of this distribution is also estimated. Capital is thereafter allocated to activities as a function of this risk or volatility measure. Then, the risky position is required to carry an expected rate of return on allocated capital, which compensates the bank for the associated incremental risk. By dimensioning all risks in terms of loss distribution and allocating capital by the volatility of the new activity, risk is aggregated and priced. 13.3 The second approach is similar to the RAROC, but depends less on capital allocation and more on cash flows or variability in earnings. This is referred to as EaR, when employed to analyse interest rate risk. Under this analytical framework also frequency distribution of returns for any one type of risk can be estimated from historical data. Extreme outcome can be estimated from the tail of the distribution. Either a worst case scenario could be used or Standard Deviation 1/2/2.69 could also be considered. Accordingly, each bank can restrict the maximum potential loss to certain percentage of past/current income or market value. Thereafter, rather than moving from volatility of value through capital, this approach goes directly to current earnings implications from a risky position. This approach, however, is based on cash flows and ignores the value changes in assets and liabilities due to changes in market interest rates. It also depends upon a subjectively specified range of the risky environments to drive the worst case scenario. 13.4 Given the level of extant risk management practices, most of Indian banks may not be in a position to adopt RAROC framework and allocate capital to various businesses units on the basis of risk. However, at least, banks operating in international markets should develop, by March 31, 2001, suitable methodologies for estimating economic capital.

Pure-play internet banking

For banks, as for other firms, the internet has opened up a new distribution channel and a new business model. The internet increases competition by enabling new entrants to compete with established banks in local markets, which can no longer be dominated simply by a bank’s physical presence. In practice, a bank can choose between two internet strategies. Most banks maintain their traditional network of branch offices while establishing a website that customers can use to complete transactions online. This business model is known as a ‘click-and-mortar’ strategy.

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DeYoung (2005) states that the strategic value of the click-and-mortar business model lies in channeling the routine, low value-added transactions through the internet, while channeling customized, high value-added transactions through the more costly branch network. The bank thus offers clients the option to conduct their transactions online, without losing those customers who prefer banking via branch office employees.

This paper focuses on the second strategy: the pure-play internet bank (PPI). In this business model, a bank establishes a virtual, branchless or internet-only bank (Furst et al. 2000). The strategic value of PPI derives from its lack of physical presence. First, the absence of an expensive branch network may lower overhead costs compared to traditional banks. This cost advantage can be further increased by offering a limited range of commoditized financial products. Second, internet banking may increase the scalability of banking operations, i.e. the ability to cope with increased business volumes without experiencing a negative effect on the contribution margin. Low costs and easy scalability allow internet banks to capture market share fast.

At a first glance, PPI and relationship banks share some traits. Both rely on deposit funding, are active in the retail segment and may engage in multiple transactions with one client, either across product ranges or over time (cf. Boot 2000). However, an important ingredient in relationship banking – a bank’s investment in obtaining proprietary or sector-specific client information – is not central to the PPI strategy. PPI banks do not engage in customized

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corporate lending, but mostly offer commoditized loans (mortgages) to households. In processing loan applications, PPI banks will typically rely on ‘hard information’, which is easy to quantify, store and transmit (Petersen 2004). The absence of a local physical presence precludes the collection of so-called ‘soft information’, which is qualitative, difficult to transfer and collected in person. Any client-specific information that a PPI bank collects, will require little investment and generate few rents. Thus, most mortgages originated (and often securitized) by large financial institutions or PPI banks can be characterized as transaction

loans.3

In terms of funding, the PPI business model is built on the ability to quickly capture market share in mature savings markets. If this strategy is successful, lack of funding is not an issue. In contrast to transaction banks, PPI banks therefore do not rely on wholesale funding.

Figure 2-1: Positioning of PPI banking

Investment in client-specific informationLarge Small

Cu

stom

er

ori

en

tati

on

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Consumers relationship banks PPI banks

SMEs relationship banks

Financialtransaction banks

markets

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support, computer networks, data processing or the underwriting of loans. Customers expect around-the-clock service, so operating a 24/7 call center is a basic necessity. PPI 42

labor costs are also higher. DeYoung (2001) finds that on average PPI banks pay $7,000 more per year than the average branch bank, as internet banking requires a more highly 43

educated and thus more expensive workforce. Finally, PPI banks’ marketing costs are higher, as they need to establish a brand without the promotional benefits of a physical branch 44

network. For non-financial retailers, Rosen and Howard (2000) find that online retailers spend ten times as much on marketing and advertising than physical retailers do. DeYoung’s (20045

1) sample contains many young banks, which have been testing a relatively new business model. This holds out the possibility that the model is viable, as banks progress along 46

the learning curve. In a follow-up paper, DeYoung (2005) argues that PPI banks may achieve scale economies in the future. In another, more recent publication, Cyree et al. 47

(2009) argue that although their accounting profits are still not up to par, the profit efficiency of internet banks is higher than that of bricks-and-mortar start-ups, thus attesting to 48

their potential once scale is achieved. Yet in a global sample, Delgado, Hernando and Dieto (2007) find that PPI banks have been outperformed by their traditional competitors. 49

The failure to find conclusive empirical evidence for the profitability of the PPI banking model contrasts with a number of academic case studies trumpeting the success of ING Dire50

ct, the largest global PPI, providing low-cost and high-interest financial services (Dermine 2005, Heskett 2005, Sequira et al. 2007, Verweire and Van den Berghe 2007).

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While the pre-crisis literature has focused on the presumed cost advantage of PPI banks, the credit crisis has drawn attention to the pros and cons of easy scalability in the banking industry. Analyzing the Northern Rock failure, Onado (2009, p. 102) points to aggressive growth as the fundamental cause of the crisis. This growth could only be maintained given an unlimited supply of funding to creditworthy banks in the wholesale markets. Due to their easy scalability in savings markets, PPI banks also have a strong potential for aggressive growth. As in the case of Northern Rock, this raises questions concerning their financial stability.

Introducing the PPI concept in a mature market can expose a bank to a mismatch in the scalability of assets and liabilities. The loan department may find it difficult to keep up with strong deposit growth and earn the high yield needed to satisfy its interest sensitive clients. As a result, either lending standards will be relaxed or funds will be reinvested in (risky) securities, introducing further financial instability on the asset side of the balance sheet.

PPI banks may also suffer from a less stable funding base compared to traditional banks. PPI banks are likely to attract relatively interest rate sensitive clients. DeYoung (2001) calls these the financially savvy ‘hit-and-run’ customers, who search the web for attractive deposit rates and are not interested in purchasing other services. Most banks initially try to attract savers with high teaser rates, which, over time, start to lag behind market rates. With hit-and-run customers this pricing strategy does not work. The interest rate sensitivity of PPI customers

15

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implies that PPI banks need to keep interest rates at high levels to keep customers or be faced with deposit outflow as well as inflow and thus a high volatility of its depositors-base.

To these micro-prudential concerns about the stability of the individual PPI bank one can add concerns about the stability of the market as a whole. By offering high rates whilst operating under deposit guarantee schedules, PPI banks may erode the funding base of the traditional relationship banks. When their savings are tapped by PPI banks, relationship banks will find it harder to extend credit to firms. Especially in an economic downturn, relationship banks are needed to reduce SMEs liquidity constraints and diminish their probability of bankruptcy, as shown by Ferri, Kang and Kim (2001) for Korean businesses during the Asian financial crisis. Finally, insofar as PPI banks are active as cross-border branches within the EU or EEA, they provide a challenge for supervisory authorities and complicate the system of deposit insurance. When the Icelandic banks failed, foreign savers had to rely on the ability of the Icelandic government to guarantee an amount of deposits which by far exceeded Icelandic GDP.

Summing up, PPI banking can be conceived as a hybrid business model, positioned in between the traditional relationships-oriented banking model and a transactions-oriented banking model. The pre-crisis literature has raised question marks as to the profitability of PPI banks. The credit crisis has added further doubts related to their financial stability. Below we will address these questions and doubts using the case of ING Direct.

The Impact of Internet Banking on Bank Performance and Risk: The Indian Experience

Internet technology holds the potential to fundamentally change banks and the banking industry. An extreme view speculates that the Internet will destroy old models of how bank services are developed and delivered (DeYoung, 2001a). The widespread availability of Internet banking is expected to affect the mixture of financial services produced by banks, the manner in which banks produce these services and the resulting financial performances of these banks. Whether or not this extreme view proves correct and whether banks take advantage of this new technology will depend on their assessment of the profitability of such a delivery system for their services. In addition, industry analysis outlining the potential impact of Internet banking on cost savings, revenue growth and risk profile of the banks have also generated considerable interest and speculation about the impact of the Internet on the banking industry (Berger, 2003).

Banking through internet has emerged as a strategic resource for achieving higher efficiency, control of operations and reduction of cost by replacing paper based and labour intensive methods with automated processes thus leading to higher productivity and profitability. However, to date researchers have produced little evidence regarding these potential changes. Nonetheless, recent empirical studies indicate that Internet banking is not having an independent effect on banking profitability, although these findings may change as the use of the Internet becomes more widespread.

More recently in India too, a wider array of financial products and services have become available over the Internet (Malhotra and Singh, 2004), which has thus become an important distribution channel for a number of banks. Banks boost technology investment spending strongly to address revenue, cost and competitiveness concerns. For some activities, banks hope to see a near-term impact on profitability. Other investments are motivated more by a desire to establish a competitive position or avoid falling behind the competition. The purpose of present study is to analyze such effects of Internet banking in India, where no rigorous attempts have been undertaken to understand this aspect of the banking business.

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The primary aim is to advance the understanding of how Internet banks are different from the non-Internet banks in terms of profitability, cost efficiency, asset quality and other characteristics by examining bank financial statements from year end 1998 to year end 2006. The present study tests not only whether the Internet delivery channel affected the financial performance of the commercial banks in our sample, but also how these changes happened. The study examines a comprehensive set of 10 measures of financial performance that allow us to “look inside the black box” of bank performance. By developing a deeper understanding of these phenomena, we can draw more insightful inferences about the impact of the Internet on banking business strategies, production processes and financial performance. Increasing this type of knowledge is vital for both academic literature and also for bank marketers who cannot count on the initial success achieved by the Internet banking investment.

The paper is organized as follows. The next section reports a brief review of the literature on Internet Banking, comparing and contrasting conclusions of previous research. Section 3 describes the data and current status of Internet banking in India. Section 4 explores whether there is a financial gap between the Internet and non-Internet banks in India by using univariate analysis on banks’ balance-sheet data collected by various regulatory authorities (Reserve Bank of India and Indian Banks Association). Section 5 explores whether Internet banking has had a noticeable impact on Indian Banks’ performance and risk, using multivariate (OLS model) analysis. Section 6 concludes the paper.

4. Internet and Non-Internet Banks: Comparison of Performance

Evaluating bank performance is a complex process that involves assessing interaction between the environment, internal operations and external activities. In general, a number of financial ratios are usually used to assess the performance of banks. Financial performance has been studied under different yardsticks of performance i.e., size, profitability, financing pattern, economic efficiency, operational efficiency, asset quality, diversification and cost of operations.

This section reports the results of univariate analysis to differentiate the Internet and non-Internet banks. The null hypothesis regarding the financial performance of Internet and non-Internet banks is:

H1: The financial performance of banks adopting Internet banking is not different from those of banks choosing not to adopt Internet banking, in terms of size, profitability, operating capability, financing, asset quality, diversification and cost of operations.

The decision to accept or reject null hypothesis is made on the basis of the value of the test statistic obtained from the data at hand. In the present study, the statistical significance of the means of various test statistics is determined by using the two independent samples t-statistic. For each pair of observations in a table, a probability (p) value is provided for the hypothesis that the means in the Internet and non-Internet samples are the same. A lower p-value indicates a greater likelihood that the two figures compared represent real differences between the two categories of banks (Internet vs. non-Internet, etc.).

4.1 Size

Table 3 shows the size variables for the Internet and non-Internet banking group. Internet banks are statistically and significantly larger than non-Internet banks in terms of total assets and employees. The results are similar to Furst et al. (2000a, 2000b, 2002a and 2002b), Hasan et al. (2002) and Hernando and Nieto (2005). Table 3 shows that Internet banks are larger in almost every category of bank.4.2. Profitability, Operating Efficiency and Financing

Table 4 compares the profitability, operating efficiency and financing pattern of Internet banks with non-Internet banks. On an average, Internet banks are more profitable than non-Internet banks and are operating with lower cost as compared to non-Internet banks, thus, representing the efficiency of the Internet banks. The results are similar to Furst et al. (2000a, 2000b, 2002a and 2002band Hernando and Nieto (2005).

Internet banks in public sector, particularly, in nationalized bank category are more profitable than non-Internet banks. Comparatively, both the categories of private sector Internet banks are less profitable than

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non-Internet banks but the difference is not statistically significant. The lower profitability of these banks may be due to higher operating expenses, both fixed cost as well as labour cost.

4.3. Asset Quality and Diversification

Asset quality indicators measure the changes in the bank’s loan quality. The Internet banks show higher asset quality as compared to non-Internet banks. Internet banks are having lower net Non Performing Assets (NPAs) to net advances as compared to non- Internet banks. Differences in the business strategies of Internet and non-Internet banks also are evident. The second column shows the ratio of non-interest income to total income, which is a rough proxy for the amount of revenue generated by “nontraditional” activities. Internet banks generated a lower proportion of their income from non-traditional activities compared to non-Internet banks. However, the difference is not statistically significant. Internet banks in public sector particularly nationalized banks and banks in private sector particularly new private sector rely more heavily on non-traditional sources of income.

4.4. Cost of Operations

In addition to revenue enhancement, Internet banking may enable banks to reduce costs of operation, in particular, by allowing them to reduce expenditures on “brick and mortar.” To the extent this may be so, Internet banking could be considered acausal factor in generating lower expenses related to maintaining physical branches. On the other hand, banks with relatively high expenses in maintaining their branch networks may be expected to have the incentive to adopt Internet banking. The adoption of Internet banking would thus be the effect of existing characteristics of banks (Furst et al., 2002). The data in Table 6 shows that, consistent with the first hypothesis, overall Internet banks had lower expenses for building and equipment. While, nationalized Internet banks and Internet banks in private sector follow the second hypothesis. This difference may indicate that these banks with high costs of maintaining a branch network are motivated to adopt Internet banking by the prospect of future cost savings.5. Multivariate Analysis

Although, the univariate analyses depict a tremendously higher performance by banks in the Internet group(s) relative to non Internet bank group, however, it is hard to make any conclusive statement on the actual impact of the Internet adoptions on firm performance without a multivariate analysis. Here a multivariate regression model is estimated to investigate whether there is a link between offering Internet banking and bank’s performance and risk.

The focus of the investigation is to see if Internet banking has an effect on bank performance and risk. A dummy variable (INTERNET) was created that takes a value of 1 if the bank has adopted Internet banking activities; otherwise it takes a value of zero. The coefficient associated with this Internet Adoption dummy will indicate the possible association between the Internet adoption by banks and their overall performance. The other variables affecting the banks’ performance have been developed from the available literature on determinants of banks’ performance (e.g. Scholtens, 2000; Naceur, 2003; Camilleri, 2005; Demirgüç-Kunt and Huizinga, 1999; Athanasoglou et al., 2005; Shanmugam and Dass, 2004; Barth et al., 1997; Goddard et al., 2004; Alzaidanin, 2003; Hassan and Bashir, 2003; Claeys and Vennet, 2004; DeYoung and Rice, 2003; Buser et al., 1981; Bashir, 2000; Caprio and Summers, 1993; Stiglitz and Marilou, 1996; Short, 1979; Bourke, 1989; Molyneux and Thornton, 1992; Demirguc-Kunt and Huizinga, 2000 and many more) and literature on Internet banking performance (Furst et al., 2002a; Carlson et al., 2001; DeYoung, 2001c and 2005; Hasan et al., 2002; Delgado et al., 2004 and 2006; Hernando and Nieto, 2005; Sathye, 2005; DeYoung et al., 2006).

Return on Assets and Return on Equity are used as performance measures and Ratio of Net NPAs to net advances has been used as a measure of bank risk. In selecting potential factors associated with performance and risk, various bank characteristics are used as proxies for the banks’ internal measures, e.g., size, capital, risk management and expenses management ratios and bank ownership dummies while macro-economic indicators are used to represent the external measures.

A linear equation, relating the performance measures to a variety of financial indicators is specified. Following model has been used to examine the relationship between the performance of banks and adoption of Internet banking after controlling the other variables affecting the performance and risk.

Yit = c + α*INTERNETit + ∑βiXit + εit (1)55

Where Yit presents profitability and bank risk measures of bank i at time t, c is a constant term, the Χ it are explanatory variables and εit is the disturbance term. The subscript i indexes bank level observations and the subscript t indexes time in years. INTERNET is a dummy variable equal to 1 for Internet banks and thecoefficient α provides the main static test. A statistically significant value for α indicates a financial performance gap between the Internet banks and the non-Internet banks at the means of the data. The coefficients are estimated by employing OLS regressions on a sample of all banks as well as samples of different categories of banks.

Indian Banking Industry: Challenges and Opportunities5. CHALLENGES FACED BY INDIAN BANKING INDUSTRYDeveloping countries like India, still has a huge number of people who do not have access to banking services due to scattered and fragmented locations. But if we talk about those people who are availing banking services, their expectations are raising as the level of services are increasing due to the emergence of Information Technology and competition. Since, foreign banks are playing in Indian market, the number of services offered has increased and banks have laid emphasis on meeting the customer expectations.

Now, the existing situation has created various challenges and opportunity for Indian Commercial Banks. In order to encounter the general scenario of banking industry we need to understand the challenges and opportunities lying with banking industry of India.

5.1 Rural MarketBanking in India is generally fairly mature in terms of supply, product range and reach, even though reach in rural India still remains a challenge for the private sector and foreign banks. In terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent balance sheets relative to other banks in comparable economies in its region.

Consequently, we have seen some examples of inorganic growth strategy adopted by some nationalized and private sector banks to face upcoming challenges in banking industry of India. For example recently, ICICI Bank Ltd. merged the Bank of Rajasthan Ltd. in order to increase its reach in rural market and market share significantly. State Bank of India (SBI), the largest public sector bank in India has also adopted the same strategy to retain its position. It is in the process of acquiring its associates. Recently, SBI has merged State Bank of Indore in 2010.

5.1 Management of RisksThe growing competition increases the competitiveness among banks. But, existing global banking scenario is seriously posing threats for Indian banking industry. We have already witnessed the bankruptcy of some foreign banks.

According to Shrieves (1992), there is a positive association between changes in risk and capital. Research studied the large sample of banks and results reveal that regulation was partially effective during the period covered. Moreover, it was concluded that changes in bank capital over the period studied was risk-based [1].

Wolgast, (2001) studied the Merger and acquisition activity among financial firms. The author focused bank supervisors in context with success of mergers, risk management, financial system stability and market liquidity. The study concluded that large institutions are able to maintain a superior level of risk management [2].

Al-Tamimi and Al-Mazrooei (2007) examined the risk management practices and techniques in dealing with different types of risk. Moreover, they compared risk management practices between the two sets of banks. The study found the three most important types of risk i.e. commercial banks foreign exchange risk, followed by credit risk, and operating risk [3].

Sensarma and Jayadev (2009) used selected accounting ratios as risk management variables and attempted to gauge the overall risk management capability of banks. They used multivariate

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statistical techniques to summarize these accounting ratios. Moreover, the paper also analyzed the impact of these risk management scores on stock returns through regression analysis. Researchers found that Indian banks' risk management capabilities have been improving over time. Returns on the banks' stocks appeared to be sensitive to risk management capability of banks. The study suggest that banks want to enhance shareholder wealth will have to focus on successfully managing various risks [4].

5.3 Growth of BankingZhao, Casu and Ferrari (2008) used a balanced panel data set covering the period of 1992-2004 and employing a Data Envelopment Analysis (DEA)-based Malmquist Total Factor Productivity (TFP) index. The empirical study indicated that, after an initial adjustment phase, the Indian banking industry experienced sustained productivity growth, which was driven mainly by technological progress. Banks' ownership structure does not seem to matter as much as increased competition in TFP growth. Foreign banks appear to have acted as technological innovators when competition increased, which added to the competitive pressure in the banking market. Finally, our results also indicate an increase in risk-taking behaviour, along with the whole deregulation process [5].

It was found in the study of Goyal and Joshi (2011a) that small and local banks face difficulty in bearing the impact of global economy therefore, they need support and it is one of the reasons for merger. Some private banks used mergers as a strategic tool for expanding their horizons. There is huge potential in rural markets of India, which is not yet explored by the major banks. Therefore ICICI Bank Ltd. has used mergers as their expansion strategy in rural market. They are successful in making their presence in rural India. It strengthens their network across geographical boundary, improves customer base and market share [6].

5.4 Market Discipline and TransparencyAccording to Fernando (2011) transparency and disclosure norms as part of internationally accepted corporate governance practices are assuming greater importance in the emerging environment. Banks are expected to be more responsive and accountable to the investors. Banks have to disclose in their balance sheets a plethora of information on the maturity profiles of assets and liabilities, lending to sensitive sectors, movements in NPAs, capital, provisions, shareholdings of the government, value of investment in India and abroad, operating and profitability indicators,

the total investments made in the equity share, units of mutual funds, bonds, debentures, aggregate advances against shares and so on [7].

5.5 Human Resource ManagementGelade and Ivery (2003) examined relationships between human resource management (HRM), work climate, and organizational performance in the branch network of a retail bank. Significant correlations were found between work climate, human resource practices, and business performance. The results showed that the correlations between climate and performance cannot be explained by their common dependence on HRM factors, and that the data are consistent with a mediation model in which the effects of HRM practices on business performance are partially mediated by work climate [8].

Bartel (2004) studied the relationship between human resource management and establishment performance of employees on the manufacturing sector. Using a unique longitudinal dataset collected through site visits to branch operations of a large bank, the author extends his research to the service sector. Because branch managers had considerable discretion in managing their operations and employees, the HRM environment could vary across branches. Site visits provided specific examples of managerial practices that affected branch performance. An analysis of responses to the bank’s employee attitude survey that controls for unobserved branch and manager characteristics shows a positive relationship between branch performance and employees’ satisfaction with the quality of performance evaluation, feedback, and recognition at the branch—the “incentives” dimension of a high-performance work system. In some fixed effects specifications, satisfaction with the quality of communications at the branch was also important [9].

5.6 Global BankingIt is practically and fundamentally impossible for any nation to exclude itself from world economy.

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Therefore, for sustainable development, one has to adopt integration process in the form of liberalization and globalization as India spread the red carpet for foreign firms in 1991. The impact of globalization becomes challenges for the domestic enterprises as they are bound to compete with global players.

If we look at the Indian Banking Industry, then we find that there are 36 foreign banks operating in India, which becomes a major challenge for Nationalized and private sector banks. These foreign banks are large in size, technically advanced and having presence in global market, which gives more and better options and services to Indian traders.

5.7 Financial InclusionFinancial inclusion has become a necessity in today’s business environment. Whatever is produced by business houses, that has to be under the check from various perspectives like environmental concerns, corporate governance, social and ethical issues. Apart from it to bridge the gap between rich and poor, the poor people of the country should be given proper attention to improve their economic condition.

Dev (2006) stated that financial inclusion is significant from the point of view of living conditions of poor people, farmers, rural non-farm enterprises and other vulnerable groups. Financial inclusion, in terms of access to credit from formal institutions to various social groups. Apart from formal banking institutions, which should look at inclusion both as a business opportunity and social responsibility, the author conclude that role of the self-help group movement and microfinance institutions is important to improve financial inclusion. The study study suggested that this requires new regulatory procedures and de-politicisation of the financial system [10].

5.8 Employees’ RetentionThe banking industry has transformed rapidly in the last ten years, shifting from transactional and customer service-oriented to an increasingly aggressive environment, where competition for revenue is on top priority. Long-time banking employees are becoming disenchanted with the industry and are often resistant to perform up to new expectations. The diminishing employee morale results in decreased revenue. Due to the intrinsically close ties between staff and clients, losing those employees completely can mean the loss of valuable customer relationships. The retail banking industry is concerned about employee retention from all levels: from tellers to executives to customer service representatives because competition is always moving in to hire them away.

The competition to retain key employees is intense. Top-level executives and HR departments spend large amounts of time, effort, and money trying to figure out how to keep their people from leaving.

Sekaran, U. (1989) studied a sample of 267 bank employees, this study traced the paths to the job satisfaction of employees at the workplace through the quality of life factors of job involvement and sense of competence. Results indicated that personal, job, and organizational climate factors influenced the ego investment or job involvement of people in their jobs, which in turn influenced the intra-psychic reward of sense of competence that they experienced, which then directly influenced employees' job satisfaction [11].

Mitchell, Holtom, Lee and Graske (2001) asserted in their study that people often leave for reasons unrelated to their jobs. In many cases, unexpected events or shocks are the cause. Employees also often stay because of attachments and their sense of fit, both on the job and in their community [12].

Saxena and Monika (2010) studied a case of 5 companies out of 1000 organizations and 8752 respondents surveyed across 800 cities in India by Business Today. The survey was on nine basic parameters like career and personal growth, company prestige, training, financial compensation and benefits and merit based performance evaluation. It was concluded that the biggest challenge for organizations is that when new employees appointed, it is difficult to merge them in organizational culture. Each organization has its own unique culture and most often, when brought together, these cultures clash. When there is no retention, employees point to issues such as identity, communication problems, human resources problems, ego clashes, and intergroup conflicts, which all fall under the category of “cultural differences” [13].

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5.9 Customer RetentionLevesque and McDougall (1996) investigated the major determinants of customer satisfaction and future intentions in the retail bank sector. They identified the determinants which include service quality dimensions (e.g. getting it right the first time), service features (e.g. competitive interest rates), service problems, service recovery and products used. It was found, in particular, that service problems and the bank’s service recovery ability have a major impact on customer satisfaction and intentions to switch [14].

Clark (1997) studied the impact of customer-employee relationships on customer retention rates in a major UK retail bank. He revealed that employee and customer perceptions of service quality are related to customer retention rates and that employee and customer perceptions of service quality are related to each other [15].

Clark (2002) examined the relationship between employees’ perceptions of organizational climate and customer retention in a specific service setting, viz. a major UK retail bank. Employees’ perceptions of the practices and procedures in relation to customer care at their branch were investigated using a case study approach. The findings revealed that there is a relationship between employees’ perceptions of organizational climate and customer retention at a micro-organizational level. He suggested that organizational climate can be subdivided into five climate themes and that, within each climate theme, there are several dimensions that are critical to customer retention [16].Hansemark and Albinsson (2004) explored how the employees of a company experience the concepts of customer satisfaction and retention. They used phenomenological method, allowing the informants’ own interpretations to be discovered. Satisfaction was discussed from three perspectives: definition of the concept, how to recognise when a customer is satisfied, and how to enhance satisfaction. The informants’ experience pertaining to these three categories varied, and a total of seven ways to define, recognise or enhance satisfaction were discovered. These were: service, feeling, chemistry, relationship and confidence, dialogue, complaints and retention. All except the first two of these categories of experience were found to enhance retention, implying that the informants have found that strategies for enhancing both satisfaction and retention are similar [17]. The strongest connection between retention and satisfaction strategies turned out to be in terms of relationship and confidence.

5.10 Environmental ConcernsIt is quite clear from the recently formed Copenhagen Climate Council (CCC) that there is a severe need for environmental awareness among all the countries of the world. CCC published Thought Leadership Series on Climate Change which is a collection of inspirational, concise and clearly argued pieces from some of the world's most renowned thinkers and business leaders on climate change. The objective of the pieces is to assist in enhancing the public and political awareness of the actions that could have a significant impact on global emissions growth and to disseminate the message that it is time to act. The Thought Leadership Series was aimed at explaining and spreading awareness of the key elements in the business and policy response to the climate problem. The rationale for the Thought Leadership Series was to change the focus of people.

5.11 Social and Ethical AspectsThere are some banks, which proactively undertake the responsibility to bear the social and ethical aspects of banking. This is a challenge for commercial banks to consider the these aspects in their working. Apart from profit maximization, commercial banks are supposed to support those organizations, which have some social concerns.

Benedikter (2011) defines Social Banks as “banks with a conscience”. They focus on investing in community, providing opportunities to the disadvantaged, and supporting social, environmental, and ethical agendas. Social banks try to invest their money only in endeavours that promote the greater good of society, instead of those, which generate private profit just for a few. He has also explained the main difference between mainstream banks and social banks that mainstream banks are in most cases focused solely on the principle of profit maximization whereas, social banking implements the triple principle of profit-people-planet [18].

Goyal and Joshi (2011b) have concluded in their study on social and ethical aspects of Banking

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Industry that Banks can project themselves as a socially and ethically oriented organization by disbursement of loans merely to those organizations, which has social, ethical and environmental concerns [19].

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HEALTH INSURANCE: TECHNOLOGY AS A KEY GROWTH DRIVER

ABSTRACT

The insurance sector in India has grown at faster rate after liberalization. Total premium is significantly lower than Asian peers, like South Korea, Taiwan, Japan and Hong Kong which boast an insurance density greater than 10%; growth potential remains promising. As a transaction-intensive industry, health insurance has benefitted, and will continue to benefit, from the efficiencies that technology brings to traditionally paper-driven processes. The industry is at a crossroads. It not only must improve existing processes, it must also develop new processes and capabilities to meet new customer demands (http://www.insurancetech.com). Health insurance companies consider technology as an enabler tool to respond challenges and opportunities. The business and IT agenda become interchangeable. Technology becomes a driving force for health insurers interacting with customers having new expectations like to be able to manage transactions how, when and where they want.

This research paper is descriptive in nature and an attempt to through light on importance

of technology in growth of health insurance sector.

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INTRODUCTIONThe insurance sector in India has grown at faster rate after liberalization. Total premium grew

at a CAGR of 25% and reached total of $67 billion, yet, Indian Insurance penetration,

measured as ratio of premium underwritten to GDP was only at 5.2 % in 2010, significantly

lower than Asian peers, like South Korea, Taiwan, Japan and Hong Kong which boast an

insurance density greater than 10%; growth potential remains promising. As a transaction-

intensive industry, health insurance has benefitted, and will continue to benefit, from the

efficiencies that technology brings to traditionally paper-driven processes. The industry is at a

crossroads. It not only must improve existing processes, it must also develop new processes

and capabilities to meet new customer demands (http://www.insurancetech.com).

PRESENT POSITIONThere are between 800 and 900 million people in India who do not have any medical cover;

expenditure on medical treatment is one of the constraints in poverty alleviation, expansion of

universal health insurance can be a good intervention. The coverage of health insurance continues

to be very low and only around 25% population receives any kind of health insurance (Choudhari,

2013). National and state wise health insurance coverage in 2010 was as follows:

Source: Choudhary, 2013.

CHALLENGESInsurance awareness is lower especially in health insurance. The perceived value of buying

insurance products remains low due to high expectations on returns to which other financial

products normally offer and the belief that risk coverage is not needed. It makes insurance a

push product rather than a pull product in India (http://www.irda.gov.in). Reaching out to the

potential willing buyers and servicing them becomes challenge due to the scattered and

spread population, especially outside the metros and Tier-I cities. The insurance industry faces

challenges in acquiring and retaining internal and external channel teams considering the

huge gap between the demand and supply of dependable and skilled personnel, resulting into

high cost of customer acquisition and operations.

RationalDespite the unexplored potential, insurance companies will continue to be confronted by different

challenges to achieve top-line and even in bottom-line performances. Apart from struggling to

maintain growth, insurance companies are called upon to meet the ever increasing dynamic needs

of price and service conscious insurance consumers, meet regulatory demands, enhance risk

management capabilities, re-evaluate business partnerships and joint ventures, adopt new

distribution models and build capabilities in more enabling but technology driven environment. Due

to the challenges and threats, accessing the next phase of growth requires identification and better

understanding of technology factor.

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TECHNOLOGICALHealth insurance companies consider technology as an enabler tool to respond challenges

and opportunities. The business and IT agenda become interchangeable. Technology

becomes a driving force for health insurers interacting with customers having new

expectations like to be able to manage transact io ns how, when and where t hey want (ht tp://

www.insurancetech.com). Advances in software and hardware transform big and large data

into actionable insights. As the insurance industry reaps productivity gains from wave of

automation, new technologies are significantly enhancing operational efficiencies, revenue

opportunities, and improving customer experience through growth in smart phones and

tablets; cloud computing, constant access to internet, exploded increase of computing power

and storage, enabling accumulation and analysis of large data and growth in active sensors

and devices connected through internet (CISCO, 2011). Technology makes health insurance

service-centric rather than server-centric architecture to create flexible, responsive and agile

business models and capabilities. Analysts rated technology at 91 percent as either critical or

important; current technology performance as poor and advised major improvement (http:/

/www.accenture.com). Cloud computing has yet to make greater impact in insurance as many

insurers are saddled with rigid and costly legacy systems that cannot be easily moved into

more agile and responsive, commercial systems, business processes. Cloud Investment

Intentions among Insurers is illustrated below:

(Source: Enterprise and SMB Hardware Survey, 2009).

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By 2020, different biotechnologies will be available at nano-scale, providing ability to embed

devices and sensors unobtrusively within human body. Nanotechnology drug delivery market

is expected to grow impacting health insurance (http://www.researchandmarkets.com).

Consumers will use personalized medicine to create highly customized unique healthcare

solutions that actively change the body's biochemistry putting an impact on health insurance

sector. Medical advances will flatten cost curve as mortality and morbidity rates are

dramatically improving and reduce litigation costs as medical product manufacturers provide

evidence on efficacy of drugs trial. Risk management trend is to deepen and expand. Carriers

will move from passively identifying and pricing risk, and reactively paying claims proactively

under strategic decisions using big data in simulation techniques, real-time sensor data,

unstructured data from social networks and multimedia (http://www.fide.org). In the US, 10

percent of all property and casualty claims are fraudulent, yet only 20 percent of those are

detected (National Insurance Crime Bureau, 2013). Data analytics can improve the situation.

49% expected new sources and techniques in data analytics to be the key competitive

differentiator (http://www.pwc.com).

CONCLUSIONTechnological factors have an impact on health insurance but not all changes will affect insurers

positively. Forward-looking health insurers in developed countries are likely to grow in local

markets by exploiting socio-demographic, technological, economical, environmental, eco-political,

administrative advancement and simultaneously targeting emerging markets for growth by

reshaping health insurance products for local markets while expanding on globally by building

technical expertise and real time working. The pace and nature of growth is to observe changes in

behaviors and dynamics of demand and supply; demand is increasing and supply is playing market

making role. Growth comes at a cost; private insurers have to incur high expenses in increasing

health insurance need-awareness, developing brand strength, establishing distribution channels

and setting-up branch net-work and other infrastructure like on line sale-purchase facility. Insurers'

plans of obtaining break-even within first 7 to 9 years of operations are burdened with threats and

challenges (http://www.deloitte.com).

Three basic sets of tools can be applied to health care industry: Internet applications;

enterprise systems; and mobile technologies. These tools can be used by health care

organizations to store internal organizational information based upon its different business

modules, including finance and accounting, human resources, payroll information, etc. Health

care organizations can use these numerous technologies to provide better patient care, by not

only obtaining more information from patients, but also giving more information on self-care

and disease management to patients (http://www.cs.cmu.edu).

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SUGGESTIONSKey trends critical in next five years are: reflexive and appropriate IT security that identifies and prioritizes gaps and vulnerabilities. A risk-based approach to customer data privacy is to be adopted. Social platforms to drive business intelligence and create new customer channels should be used. User experience should be used as driver of new products, services and marketing (http://www.insurancetech.com). The key megatrends- technology is likely to influence health insurance sector as below:

TECHNOLOGICALTechnology playing leading role on frontier of health insurance can help in detecting fraud.

Card-based payment can drive speed and efficiency of transaction processing (http://

www.insurancetech.com). As internet ensures real-time information and big data, insurers

should exploit it for better pricing, underwriting, and loss controlling to have competitive

advantage. Global investment in advanced analytical techniques is needed to develop

capabilities to process large unstructured and multimedia data as continuous real-time video,

life blogging and social chatter. Advances in artificial intelligence techniques, as machine

learning, natural language understanding and intelligent decision-making should be used to

advance transaction processing to decision-making. The health insurance industry must

improve existing processes; develop new processes and capabilities to meet new customer

demands by; Cloud Computing: The Cloud can change health insurance scenario by moving

at speed and scale to address new opportunities, improve responsiveness and enhance

processes like, underwriting. It permits scalable faster quote processing and more accurate

risk pricing. Cloud and digital mobile channels enables health insurer to 'stretch the walls' of

computing capacities and respond to peak demands at lower cost. Insurers can master huge

internal and external data to improve processes, enhance customer service, create products

around customer and meet regulations through cloud where security and data privacy permit

to maximize gain in productivity and profitability; Architecture around Business Goals: The

insurers are to move from architecture based servers to architecture built around service to

achieve business goals. Data should be used as platform to be distributed wherever it is

needed. The architecture should allow decoupling distribution from manufacturing to create

more agile and flexible systems that respond faster to product development and launch of

product factories. Insurers should provide product management staff with ability to configure

products using various variable inputs; test them and decide to launch or abandon without

referring supportive technical team.

Front office systems can be aggregated and integrated to deliver seamless channel experiences to

customers (http://www.insurancetech.com); Preventative Business Modeling: From reactive to

preventative business model shifting needs to be ensured. Connected devices and sensors to

develop and improve risk and loss management system to improve productivity

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are needed in health insurance industry; Nano-technology Usage: Nano technologies,

having potential to dramatically improve health outcomes through enhanced monitoring

and preventive control over chronic disease be considered for envisioning health

insurance sector (http://www.researchandmarkets.com); Customized Health Care

Services: Medical service and treatment model needs to be evolved towards

customization of healthcare service to reduce cost and increase effectiveness; Loss and

Risk Management: Loss and risk management in health insurance needs more

sophisticated risk modeling and innovativeness in structuring risk-sharing and transfer

deals. Workable insights reduce losses and provide better risk management for good

customer experience and competitive advantage. New sensing, monitoring devices and

technology, together with risk transfer mechanisms, can extend general health, cushion

insurers and reinsurers against abnormal losses (http:// www.fide.org);

Data Analytics: Data analytical techniques can be used for decisions using unstructured data

as social media devices, video and audio. Complementing structured data should be ensured

in strategic forward-looking decisions to achieve enhanced customer insight and more efficient

business processes. Predictive and behavioral analytics integrated with business processes

can address changing customer behavior. Service product innovation becomes more effective

and faster when analytics are in the mix. Data analytics can assess likely take-up of health

insurance product. It can model the impact of price changes and different features; and create

real-time insights; fine-tune service products; and detect fraud in claims. Healthcare

organizations are increasingly using analytics to consume, unlock and apply new insights from

information. New methods of analytics can be used to drive clinical and operational

improvements to meet business challenges. From a traditional baseline of transaction

monitoring using basic reporting tools, spreadsheets and application reporting modules,

analytics in healthcare is moving toward a model that will eventually incorporate predictive

analytics and enable organizations to "see the future," create more personalized healthcare,

allow dynamic fraud detection and predict patient behavior(https://www.ibm.com).

IMPLICATIONSIt implies that insurance is risk minimizing and mitigating financial product. Awareness and

financial inclusion especially in health care insurance is increasing due to IRDA. Technology is

playing a dynamic role in health insurance sector. Demand and supply in health care

insurance both are increasing in favorable environment but a lot is to be still covered.

TECHNOLOGY IN FUTUREElectronic Health Records is a safe and confidential record of care that nurses, doctors,

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nurse practitioners, other health care provider, and clinical office staff use to manage and document health

care assessments, interventions, and treatments. Electronic Prescribing gives prescribers the ability to write

and instantly send prescriptions directly to your pharmacy without the limitations and errors of paper

prescription, such as legibility, allergy, duplication, and other problems. These systems may be having an

ability to check whether your insurance covers the prescribed drug, and even recommends substitutes

(http://www.nursingworld.org). Radio frequency identification technology tracks patients throughout the

hospital, and links lab and medication tracking through a wireless communications system. It is neither mature

nor widely available, but may be an alternative to bar coding (http://www.medpac.gov).

CONSUMER ALERTPROTECT YOURSELF: BUYING INSURANCE ON THE INTERNET

The accessibility and ease of the Internet has revolutionized the shopping world. Everything from pet food to furniture is available 24 hours a day, seven days a week, from the comfort of your home. That same convenience now extends into the insurance industry. Here are some tips from the National Association of Insurance Commissioners (NAIC) to help you protect yourself when buying insurance on the Internet.

1. RESEARCH, RESEARCH, RESEARCH

Research is by far your best protection. Fortunately, the Internet is also a great research agent. Determine which insurance cover-age best fits your needs, then shop around for companies, agents, premiums and coverage.

2. DOUBLE-CHECK THE COMPANY AND AGENT

In order to sell insurance in your state, the company and the agent must be licensed. To confirm the credibility of a company or agent, check with your state insurancedepartment for the following the facts:ix) Is the company licensed in your state? x) Is the company licensed to sell the line of insurance you are interested in purchasing? xi) Is the agent licensed in your state and a legitimate representative of the company? xii) Does the company have a good record of handling policy com-plaints? Your state insurance department can provide a list of companies and agents that are licensed in your state.

3. PURCHASING ON THE INTERNET

Once you’ve checked your facts and found the company, agent and policy that suits your needs, you’re ready to purchase. At this point, security is the name of the game. Take some extra precautions to protect your personal information:

2.7 Update your browser. The newer browsers are equipped

with more current security measures. One way to check if you are transmitting across a secure site is by checking the address. A secure site address may begin with https:// instead of the usual http://. Or, the site may have a small key or closed lock icon located somewhere in the bottom left or right corner of the screen. 2.8 If you cannot confirm the security of the browser, contact the company or agent and submit your paperwork via fax or mail. 2.9 Take extra precautions when paying with a credit card. Some credit cards may be equipped with antitheft protections. Re-view your credit card agreement for antitheft provisions.

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4. THE PROOF IS IN THE PAPERWORK

As you complete your research and purchase, it’s important to keep detailed records. Get all rate quotes and key information in writing for your file. Also, once you decide to purchase online, keep a copy of all paperwork you complete and sign, as well as any correspondence, special offers and payment receipts.Please note: You should receive a copy — not a photocopy— of your new policy within 30 to 60 days of purchase. If you do not receive your copy, contact the insurance com-pany immediately.

5. INSURANCE “RED FLAGS”Here are some quick “red flags” to warn you against pos-sible insurance fraud:3.1.3 Don’t submit to high-pressure tactics. If you are being over-whelmed with offers from a particular group or agent that make you uncomfortable or aggravated, trust your instincts and steer clear. 3.1.4 Do your research. Scam artists may try to convince you to change coverage quickly without giving you the opportunity to do adequate research. 3.1.5 Seek advice. If a particular policy requires a large sum de-posit in an account, ask a third party — such as a reputable local insurance agent, an accountant or financial advisor — for advice. 3.1.6 If it seems too good to be true, it probably is!

6. GET MORE INFORMATION

Information is your best policy. Visit your state insurance department for more information on company and agent requirements, as well as products. You can link to your state insurance department’s Web site by visiting www.naic.org. Click on “State Insurance Regulators Web Sites,” then click on your state.

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Historical developments in the Indian general insurance industryThe overall general insurance industry growth has kept pace with the GDP growth in the country and general insurance penetration has varied in a narrow band

After liberalisation of the Indian insurance industry in the year 1999-2000, the Indian general insurance industry has witnessed rapid growth. The industry, in terms of gross direct premium, has grown from INR 11,446 crore in FY02 to INR 57,964 crore in FY12, which corresponds to a compounded annual growth rate (CAGR) of 17.6 percent. Insurance density, which is defined as the ratio of premium underwritten in a given year to the total population, has increased from USD 2.4 in 2001 to USD10 in 2011. The growth in the general insurance industry has kept pace with the nominal GDP

growth rate resulting in general insurance penetration remaining stable in the range of 0.55% to

0.75% over the last 10 years.

Exhibit 1: Growth in the Indian general insurance industry

Source: Handbook on Indian Insurance Statistics 2011-2012

Overall, while the industry achieved significant growth over the past 5 years, the profitability of industry deteriorated sharply

A multitude of factors adversely impacted the industry profitability over the last five years

· Price detariffication provided freedom to general insurance companies to decide the premium rates in most of the product segments

· Between FY06 and FY12, 10 new companies have entered the general insurance business. Intensifying competition and focus on growth by the new entrants led to competitive pricing pressure

Focus on growth by the insurers across the industry led to higher bargaining power of the intermediaries and limited control on the claims cost Limited or no increase in the TP premium rates for a number of years coupled with issues pertaining to third party liability caps as under The Motor Vehicles Act, led to extraordinarily high claims ratio in the segment which impacted the overall profitability and solvency requirements for the general insurance companies.

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Exhibit 3: Relative growth and profitability of the general insurance product segments

Source: IRDA annual reports 2010, 2011 and 2012

Note: Size of the bubble indicates segment size (GDP in INR Cr)

Future growth and profitability trends in the General Insurance IndustryGeneral insurance industry in India presents significant headroom for growthWhile the Indian general insurance industry has evolved significantly over the past decade or so, the insurance penetration and insurance density levels are significantly lower than the developed as well as comparable developing countries. The under-penetration is driven by lack of overall financial awareness, lack of understanding of general insurance products, low perceived benefits, and propensity to purchase insurance based on reactive drivers such as insistence by financers, statutory requirements, etc.

Exhibit 4A: General insurance penetration in percentage (Ratio of Premium to GDP)

Exhibit 4B: General insurance density (Ratio of premium in USD to population)

Source: Swiss Re, Sigma Volumes 2/2011 and 3/2012,Note: Data for India pertains to FY12 whereas for other countries, it pertains to the year 2011

Source: Swiss Re, Sigma Volumes 2/2011 and 3/2012,Note: Data for India pertains to FY12 whereas for other countries, it pertains to the year 2011

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Study of global benchmarks reveals a strong correlation between GDP per capita and insurance penetration. The correlation suggests that the insurance penetration may increase up to 1 percent to 1.2 percent by FY20 considering the likely increase in the GDP per capita.

India’s expenditure pattern on healthcare suggests significant headroom for growth for substitution of out-of-pocket expenditure by health insurance

Exhibit 5: Sources of Healthcare Expenditure

Source: World Health Statistics 2012 published by World Health Organization, KPMG Analysis, data pertains to year 2010

In India, the share of out-of-pocket expenditure in overall healthcare expenditure is significantly higher than comparable developing countries as well as the developed countries. Moreover, the government focus on healthcare spending is focussed on low income and below the poverty line segments. Considering the rising healthcare cost inflation and changing disease pattern more towards lifestyle diseases in the urban areas, the health insurance market would have significant headroom for growth as it would replace the out-of-pocket expenditure.

Competitive strategies could considerably impact the growth and profitability of the overall general insurance industry

Competitive strategies adopted by players would have considerable impact on the growth and profitability trends in the general insurance industry. Different competition segments have different strategic imperatives based on the historical business performance, capabilities developed over the period of time and strategic objectives of the promoters.

New entrants targeting broad based presence

New entrants focussing on high growth across segments are likely to have low profitability in the initial years as their aim would mainly be on price or channel payout-based competition. These players may rapidly replicate the industry best practices since they would have limited legacy operating structures and assets. The same could enable profitability and growth for these players in the medium term.

New entrants with niche focus

New entrants who are currently focussing on niche product-market segments may bring the international best practices in products, managed care models, ancillary services such as wellness and disease management in the medium to long

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