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NON-PERFORMING ASSETSCHALLENGE TO THE PUBLIC SECTOR BANKS INTRODUCTION After liberalization the Indian banking sector developed very appreciate. The RBI also nationalized good amount of commercial banks for proving socio economic services to the people of the nation. The Public Sector Banks have shown very good performance as far as the financial operations are concerned. If we look to the glance of the financial operations, we may find that deposits of public to the Public Sector Banks have increased from 859,461.95crore to 1,079,393.81crore in 2003, the investments of the Public Sector Banks have increased from 349,107.81crore to 545,509.00crore, and however the advances have also been increased to 549,351.16crore from 414,989.36crore in 2003. The total income of the public sector banks have also shown good performance since the last few years and currently it is 128,464.40crore. The Public Sector Banks have also shown comparatively good result. The gross profits of the Public Sector Banks currently 29,715.26crore which has been doubled to the last to last year, and the net profit of the Public Sector Banks is 12,295,47crore. However, the only problem of the Public Sector Banks these days are the increasing level of the non performing assets. The non performing assets of the Public Sector Banks have been increasing regularly year by year. If we glance on the numbers of non performing assets we may come to know that in the year 1997 the NPAs were 47,300crore and reached to 80,246crore in 2002. The only problem that hampers the possible financial performance of the Public Sector Banks is the increasing results of the non performing assets. The non performing assets impacts drastically to the working of the banks. The efficiency of a bank is not always reflected only by the size of its balance sheet but by the level of return on its assets. NPAs do not generate interest income for the banks, but at the same time banks are required to make provisions for such NPAs from their current profits. NPAs have a deleterious effect on the return on assets in several ways – • They erode current profits through provisioning requirements • They result in reduced interest income • They require higher provisioning requirements affecting profits and accretion to capital funds and capacity to increase good quality risk assets in future, and • They limit recycling of funds, set in asset-liability mismatches, etc. The RBI has also tried to develop many schemes and tools to reduce the non performing assets by introducing internal checks and control scheme, relationship managers as stated by RBI who have complete knowledge of the borrowers, credit rating system, and early warning system and so on. The RBI has also tried to improve the securitization Act and SRFAESI Act and other acts related to the pattern of the borrowings. Though RBI has taken number of measures to reduce the level of the non performing assets the results is not up to the

expectations. To improve NPAs each bank should be motivated to introduce their own precautionary steps. Before lending the banks must evaluate the feasible financial and operational prospective results of the borrowing companies. They must evaluate the business of borrowing companies by keeping in considerations the overall impacts of all the factors that influence the business. RESEARCH OPERATION 1. Significance of the study The main aim of any person is the utilization money in the best manner since the India is country were more than half of the population has problem of running the family in the most efficient manner. However Indian people faced large number of problem till the development of the full-fledged banking sector. The Indian banking sector came into the developing nature mostly after the 1991 government policy. The banking sector has really helped the Indian people to utilise the single money in the best manner as they want. People now have started investing their money in the banks and banks also provide good returns on the deposited amount. The people now have at the most understood that banks provide them good security to their deposits and so excess amounts are invested in the banks. Thus, banks have helped the people to achieve their socio economic objectives. The banks not only accept the deposits of the people but also provide them credit facility for their development. Indian banking sector has the nation in developing the business and service sectors. But recently the banks are facing the problem of credit risk. It is found that many general people and business people borrow from the banks but due to some genuine or other reasons are not able to repay back the amount drawn to the banks. The amount which is not given back to the banks is known as the non performing assets. Many banks are facing the problem of non performing assets which hampers the business of the banks. Due to NPAs the income of the banks is reduced and the banks have to make the large number of the provisions that would curtail the profit of the banks and due to that the financial performance of the banks would not show good results The main aim behind making this report is to know how Public Sector Banks are operating their business and how NPAs play its role to the operations of the Public Sector Banks. The report NPAs are classified according to the sector, industry, and state wise. The present study also focuses on the existing system in India to solve the problem of NPAs and comparative analysis to understand which bank is playing what role with concerned to NPAs.Thus, the study would help the decision makers to understand the financial performance and growth of Public Sector Banks as compared to the NPAs. 2. Objective of the study Primary objective: The primary objective of the making report is:  To know why NPAs are the great challenge to the Public Sector Banks Secondary objectives: The secondary objectives of preparing this report are:

 To understand what is Non Performing Assets and what are the underlying reasons for the emergence of the NPAs.  To understand the impacts of NPAs on the operations of the Public Sector Banks.  To know what steps are being taken by the Indian banking sector to reduce the NPAs?  To evaluate the comparative ratios of the Public Sector Banks with concerned to the NPAs. 2. Research methodology The research methodology means the way in which we would complete our prospected task. Before undertaking any task it becomes very essential for any one to determine the problem of study. I have adopted the following procedure in completing my report study. 1. Formulating the problem 2. Research design 3. Determining the data sources 4. Analysing the data 5. Interpretation 6. Preparing research report (1) Formulating the problem I am interested in the banking sector and I want to make my future in the banking sector so decided to make my research study on the banking sector. I analysed first the factors that are important for the banking sector and I came to know that providing credit facility to the borrower is one of the important factors as far as the banking sector is concerned. On the basis of the analysed factor, I felt that the important issue right now as far as the credit facilities are provided by bank is non performing assets. I started knowing about the basics of the NPAs and decided to study on the NPAs. So, I chose the topic “Non Performing Assts the great challenge before the Public Sector Banks”. (2) Research Design The research design tells about the mode with which the entire project is prepared. My research design for this study is basically analytical. Because I have utilised the large number of data of the Public Sector Banks. (3) Determining the data source The data source can be primary or secondary. The primary data are those data which are used for the first time in the study. However such data take place much time and are also expensive. Whereas the secondary data are those data which are already available in the market. These data are easy to search and are not expensive too.for my study I have utilised totally the secondary data. (4) Analysing the data The primary data would not be useful until and unless they are well edited and tabulated. When the person receives the primary data many unuseful data would also be there. So, I analysed the data and edited them and turned them in the useful tabulations. So, that can become useful in my report study. (5) Interpretation of the data With use of analysed data I managed to prepare my project report. But the analyzing of data would not help the study to reach towards its objectives. The interpretation of the data is required so that the others can understand the crux of the study in more simple way without any problem so I have added the chepter of analysis that would explain others to understand my study in simpler way. (6) Project writing This is the last step in preparing

the project report. The objective of the report writing was to report the findings of the study to the concerned authorities. 4. Limitations of the study The limitations that I felt in my study are:  It was critical for me to gather the financial data of the every bank of the Public Sector Banks so the better evaluations of the performance of the banks are not possible.  Since my study is based on the secondary data, the practical operations as related to the NPAs are adopted by the banks are not learned.  Since the Indian banking sector is so wide so it was not possible for me to cover all the banks of the Indian banking sector. INDIAN BANKING SECTOR Banking in India has its origin as early as the Vedic period. It is believed that the transition from money lending to banking must have occurred even before Manu, the great Hindu Jurist, who has devoted a section of his work to deposits and advances and laid down rules relating to rates of interest. During the Mogul period, the indigenous bankers played a very important role in lending money and financing foreign trade and commerce. During the days of the East India Company, it was the turn of the agency houses to carry on the banking business. The General Bank of India was the first Joint Stock Bank to be established in the year 1786. The others which followed were the Bank of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued till 1906 while the other two failed in the meantime. In the first half of the 19 th century the East India Company established three banks; the Bank of Bengal in 1809, the Bank of Bombay in 1840 and the Bank of Madras in 1843. These three banks also known as Presidency Banks were independent units and functioned well. These three banks were amalgamated in 1920 and a new bank, the Imperial Bank of India was established on 27 th January 1921. With the passing of the State Bank of India Act in 1955 the undertaking of the Imperial Bank of India was taken over by the newly constituted State Bank of India. The Reserve Bank which is the Central Bank was created in 1935 by passing Reserve Bank of India Act 1934. In the wake of the Swadeshi Movement, a number of banks with Indian management were established in the country namely, Punjab National Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank of Baroda Ltd, the Central Bank of India Ltd. On July 19, 1969, 14 major banks of the country were nationalised and in 15 th April 1980 six more commercial private sector banks were also taken over by the government .

Indian Banking: A Paradigm shift-A regulatory point of view The decade gone by witnessed a wide range of financial sector reforms, with many of them still in the process of implementation. Some of the recently initiated measures by the RBI for risk management systems, anti money laundering safeguards and corporate governance in banks, and regulatory framework for non bank financial companies, urban cooperative banks, government debt market and forex clearing and payment systems are aimed at streamlining the functioning of these instrumentalities besides cleansing the aberrations in these areas. Further, one or two all India development financial institutions have already commenced the process of migration towards universal banking set up. The banking sector has to respond to these changes, consolidate and realign their business strategies and reach out for technology support to survive emerging competition. Perhaps taking note of these changes in domestic as well as international arena All of we will agree that regulatory framework for banks was one area which has seen a sea-change after the financial sector reforms and economic liberalisation and globalisation measures were introduced in 1992-93. These reforms followed broadly the approaches suggested by the two Expert Committees both set up under the chairmanship of Shri M. Narasimham in 1991 and 1998, the recommendations of which are by now well known. The underlying theme of both the Committees was to enhance the competitive efficiency and operational flexibility of our banks which would enable them to meet the global competition as well as respond in a better way to the regulatory and supervisory demand arising out of such liberalisation of the financial sector. Most of the recommendations made by the two Expert Committees which continued to be subject matter of close monitoring by the Government of India as well as RBI have been implemented. Government of India and RBI have taken several steps to :- (a) Strengthen the banking sector, (b) Provide more operational flexibility to banks, (c) Enhance the competitive efficiency of banks, and (d) Strengthen the legal framework governing operations of banks. Regulatory measures taken to strengthen the Indian Banking sectors The important measures taken to strengthen the banking sector are briefly, the following: • Introduction of capital adequacy standards on the lines of the Basel norms, • prudential norms on asset classification, income recognition and provisioning, • Introduction of valuation norms and capital for market risk for investments • Enhancing transparency and disclosure requirements for published accounts , • Aligning exposure norms – single borrower and group-borrower ceiling – with international best practices • Introduction of off-site monitoring system and strengthening of the supervisory framework for banks. (A) Some of the important measures introduced to provide more

operational flexibility to banks are: • Besides deregulation of interest rate, the boards of banks have been given the authority to fix their prime lending rates. Banks also have the freedom to offer variable rates of interest on deposits, keeping in view their overall cost of funds. • Statutory reserve requirements have significantly been brought down. • The quantitative firm-specific and industry-specific credit controls were abolished and banks were given the freedom to deploy credit, based on their commercial judgment, as per the policy approved by their Boards. • The banks were given the freedom to recruit specialist staff as per their requirements, • The degree of autonomy to the Board of Directors of banks was substantially enhanced. • Banks were given autonomy in the areas of business strategy such as, opening of branches / administrative offices, introduction of new products and certain other operational areas. (b) Some of the important measures taken to increase the competitive efficiency of banks are the following: • Opening up the banking sector for the private sector participation. • Scaling down the shareholding of the Government of India in nationalised banks and of the Reserve Bank of India in State Bank of India. (c) Measures taken by the Government of India to provide a more conducive legal environment for recovery of dues of banks and financial institutions are: • Setting up of Debt Recovery Tribunals providing a mechanism for expeditious loan recoveries. • Constitution of a High Power Committee under former Justice Shri Eradi to suggest appropriate foreclosure laws. • An appropriate legal framework for securitisation of assets is engaging the attention of the Government, Due to this paradigm shift in the regulatory framework for banks had achieved the desired results. The banking sector has shown considerable degree of resilience. (a) The level of capital adequacy of the Indian banks has improved: the CRAR of public sector banks increased from an average of 9.46% as on March 31, 1995 to 11.18% as on March 31, 2001. (b) The public sector banks have also made

significant progress in enhancing their asset quality, enhancing their provisioning levels and improving their profits. • The gross and net NPAs of public sector banks declined sharply from 23.2% and 14.5% in 1992-93 to 12.40% and 6.7% respectively, in 2000-01. • Similarly, in regard to profitability, while 8 banks in the public sector recorded operating and net losses in 1992-93, all the 27 banks in the public sector showed operating profits and only two banks posted net losses for the year ended March 31, 2001. • The operating profit of the public sector banks increased from Rs.5628 crore as on March 31, 1995 to Rs.13,793 crore as on March 31, 2001. • The net profit of public sector banks increased from Rs.1116 crore to Rs.4317 crore during the same period, despite tightening of prudential norms on provisioning against loan losses and investment valuation. The accounting treatment for impaired assets is now closer to the international best practices and the final accounts of banks are transparent and more amenable to meaningful interpretation of their performance. WAY FORWARD RBI president recently recommended Indian banks to go for larger provisioning when the profits are good without frittering them away by way of dividends, however tempting it may be. As a method of compulsion, RBI has recently advised banks to create an Investment Fluctuation Reserve upto 5 per cent of the investment portfolio to protect the banks from varying interest rate regime. He further added that one of the means for improving financial soundness of a bank is by enhancing the provisioning standards of the bank. The cumulative provisions against loan losses of public sector banks amounted to a mere 41.67% of their gross NPAs for the year ended March 31, 2001. The amount of provisions held by public sector banks is not only low by international standards but there has been wide variation in maintaining the provision among banks. Some of the banks in the public sector had as low provisioning against loan losses as 30% of their gross NPAs and only 5 banks had provisions in excess of 50% of their gross NPAs. This is inadequate considering that some of the countries maintain provisioning against impaired assets at as high as 140%. Indian Banks should improve the provisioning levels to at least 50% of their gross NPAs. There should therefore be an attitudinal change in banks’ policy as regards appropriation of profits and full provisioning towards already impaired assets should become a priority corporate goal. He also suggested that banks should also develop a concept of building desirable capital over and above the minimum CRAR

which is insisted upon in developed regulatory regimes like UK. This can be at, say around 12 percent as practised even today by some of the Indian banks, so as to provide well needed cushion for growth in risk weighted assets as well as provide for unexpected erosion in asset values. As banks would have observed, the changes in the regulatory framework are now brought in by RBI only through an extensive consultative process with banks as well as public wherever warranted. While this serves the purpose of impact assessment on the proposed measures it also puts the banks on notice to initiate appropriate internal readjustment to meet the emerging regulatory prescriptions. Though adequate transitional route has been provided for switchover to new regulatory measures such as scaling down the exposure to capital market, tightening the prudential requirements like switch over to 90 day NPA norm, reduction in exposure norms, etc., I observe from the various quarters

from which RBI gets its inputs that the banks are yet to take serious steps towards implementation of these measures. The Boards of banks have been accorded considerable autonomy in regard to their corporate strategy as also several other operational matters. This does not; however, seem to have translated to any substantial improvement in customer service. It needs to be recognised that meeting the requirements of the customer – whether big or small – efficiently and in a cost effective manner, alone will enable the banks to withstand the global competition as also the competition from non-bank institutions. The profitability of the public sector banks is coming under strain. Despite the resilience shown by our banks in the recent times, the income from recapitalisation bonds accounted for a significant portion of the net profits for some of the nationalised banks. The Return on Assets (RoA) of public sector banks has, on an average, declined from 0.54 for the year ended March 31, 1999 to 0.43 for the year ended March 31, 2001. Therefore, the Boards’ attention needs to be focused on improving the profitability of the bank. The interest income of public sector banks as a percentage of total assets has shown a declining trend since 1996-97: it declined from 9.69 in 1996-97 to 8.84 in 2000-01. Similarly, the spread (net interest income) as a percentage of total assets also declined from 3.16 in 1996-97 to 2.84 in 2000-01. A disheartening feature is that a large number of public sector banks have recorded far below the median RoA of 0.4% for 2000-01 in their peer group. Incidentally the RoA recorded by new private banks and foreign banks ranged from 0.8% to 1% for the same period. An often quoted reason for the decline in profitability of public sector banks is the stock of NPAs which has become a drag on the bank’s profitability. As you are aware, the stock of NPAs does not add to the income of the bank while at the same time, additional cost is incurred for keeping them on the books. To help the public sector banks in clearing the old stock of chronic NPAs, RBI had announced ‘one-time non discretionary and non discriminatory compromise settlement schemes’ in 2000 and 2001. Though many banks tried to settle the old NPAs through this transparent route, the response was not to the extent anticipated as the banks had been bogged down by the usual fear psychosis of being averse to settling dues where security was available. The moot point is if the underlying security was not realised over decades in many cases due to extensive delay in

litigation process, should not the banks have taken advantage of the one time opportunity provided under RBI scheme to cleanse their books of chronic NPAs? This would have helped in realizing the carrying costs on such non-income earning NPAs and released the funds for recycling. If better steps are taken placed in this connection then the performance of the Public Sector Banks can show very good and healthy results in the shorter period. To make the better future of the Public Sector Banks, the Boards need to be alive to the declining profitability of the banks. One of the reasons for the low level of profitability of public sector banks is the high operating cost. The cost income ratio (which is also known as efficiency ratio of public sector banks) increased from 65.3 percent for the year ended March 31, 2000 to 68.7 per cent for the year ending March 31, 2001. The staff expenses as a proportion to total income formed as high as 20.7% for public sector banks as against 3.3% for new banks and 8.2% for foreign banks for the year ended March 31, 2001. There is thus an imperative need for the banks to go for cost cutting exercise and rationalise the expenses to achieve better efficiency levels in operation to withstand declining interest rate regime. Boards of banks have much more freedom now than they had a decade ago, and obviously they have to play the role of change agents. They should have the expertise to identify, measure and monitor the risks facing the bank and be capable to direct and supervise the bank’s operations and in particular, its exposures to various sectors of the economy, and monitoring / review thereof, pricing strategies, mitigation of risks, etc. The Board of the banks should also ensure compliance with the regulatory framework, and ensure adoption of the best practices in regard to risk management and corporate governance standards. The emphasis in the second generation of reforms ought to be in the areas of risk management and enhancing of the corporate governance standards in banks. THE INDIAN BANKING INDUSTRY The origin of the Indian banking industry may be traced to the establishment of the Bank of Bengal in Calcutta (now Kolkata) in 1786. Since then, the industry has witnessed substantial growth and radical changes. As of March 2002, the Indian banking industry consisted of 97 Commercial Banks, 196 Regional Rural Banks, 52 Scheduled Urban Cooperative Banks, and 16 Scheduled State Co-operative Banks. The growth of the banking industry in India may be studied in terms of two broad phases: Pre Independence (17861947), and Post Independence (1947 till date). The post independence phase may be further divided into three sub-phases: • Pre-Nationalisation Period (1947-1969) • Post-Nationalisation Period (1969-1991) • Post-Liberalisation Period (1991- till date) The two watershed events in the postindependence phase are the nationalisation of banks (1969) and the initiation of the economic reforms (1991). This section focuses on the evolution of the banking industry in India post-liberalisation. 1. Banking Sector Reforms - Post-Liberalisation

In 1991, the Government of India (Gol) set up a committee under the chairmanship of Mr. Narasimaham to make an assessment of the banking sector. The report of this committee contained recommendations that formed the basis of the reforms initiated in 1991. The banking sector reforms had the following objectives: 1. Improving the macroeconomic policy framework within which banks operate; 2. Introducing prudential norms; 3. Improving the financial health and competitive position of banks; 4. Building the financial infrastructure relating to supervision, audit technology and legal framework; and 5. Improving the level of managerial competence and quality of human resources. 1.1 Impact of Reforms on Indian Banking Industry With the initiation of the reforms in the financial sector during the 1990s, the operating environment of banks and term-lending institutions has radically transformed. One of the fall-outs of the liberalisation was the emergence of nine new private sector banks in the mid1990s that spurred the incumbent foreign, private and public sector banks to compete more fiercely than had been the case historically. Another development of the economic liberalisation process was the opening up of a vibrant capital market in India, with both equity and debt segments providing new avenues for companies to raise funds. Among others, these two factors have had the greatest influence on banks operating in India to broaden the range of products and services on offer. The reforms have touched all aspects of the banking business. With increasing integration of the Indian financial markets with their global counterparts and greater emphasis on risk management practices by the regulator, there have been structural changes within the banking sector. The impact of structural reforms on banks' balance sheets (both on the asset and liability sides) and the environment they operate in is discussed in the following sections. 1.2 Reforms on the Liabilities Side • Reforms of Deposit Interest Rate Beginning 1992, a progressive approach was adopted towards deregulating the interest rate structure on deposits. Since then, the rates have been freed gradually. Currently, the interest rates on deposits stand completely deregulated (with the exception of the savings bank deposit rate). The deregulation of interest rates has helped Indian banks to gain more control on the cost of their deposits, the main source of funding for Indian banks. Besides, it has given more, flexibility to banks in managing their Asset-Liability positions. • Increase in Capital Adequacy Requirement During the 1990s, the Reserve Bank of India (RBI) adopted a strategy aimed at all banks attaining a Capital Adequacy Ratio (CAR) of 8% in a phased manner. On the recommendations of the Committee on Banking Sector Reforms, the minimum CAR was further raised to 9%, effective March 31, 2000.While the stipulation of a higher Capita! Adequacy' Ratio has increased the capital requirement of banks; it has provided more stability to the Indian banking system. 1.3 Reforms on the Asset Side

• Reforms on the Lending Interest Rate During 1975-76 to 1980-81, the RBI prescribed both the minimum lending rate and the ceiling rate. During 1981-82 to 1987-88. The RBI prescribed only the ceiling rate. During 198889 to 1994-95, the RBI switched from prescribing a ceiling rate to fixing a minimum lending rate. From 1991 onwards, interest rates have been increasingly freed. At present, banks can offer loans at rates below the Prime Lending Rate (PLR) to exporters or other creditworthy borrowers (including public enterprises), and have only to announce the FLR and the maximum spread charged over it. The deregulation of lending rates has given banks the flexibility to price loan products on the basis of their own business strategies and the risk profile of the borrower. It has also lent a competitive advantage to banks with lower cost of funds. • Lower Cash Reserve and Statutory Liquidity Requirements During the early 1980s, statutory pre-emption in the form of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) accounted for 42% of the deposits. In the 1990s, the figure rose to 53.5%, which during the post-liberalisation period has been gradually reduced. At present, banks are required to maintain a CRR of 4% of the Net Demand and Time Liabilities (NDTL) (excluding liabilities subject to zero CRR prescriptions). The RBI has indicated that the CRR would eventually be brought down to the statutory minimum level of 3% over a period of time. The SLR, which was at a peak of 38.5% during September 1990 to December 1992, now stands lower at the statutory minimum of 25%.A decrease in the CRR and SLR requirements implies an increase in the share of deposits available to banks for loans and advances. It also means that bank's now have more discretion in the allocation offunds, which if deployed efficiently, can have a positive impact on their profitability. By increasing the amount of invisible funds available to banks, the reduction in the CRR and SLR requirements has also enhanced the need for efficient risk management systems in banks. • Asset Classification and Provisioning Norms Prudential norms relating to asset classification have been changed post-liberalisation. The earlier practice of classifying assets of different quality into eight `health codes" has now been replaced by the system of classification into four categories (in accordance with the international norms): standard, sub-standard, doubtful, and loss assets. On 1st April 2000, provisioning requirements of a minimum of 0.25% were introduced for standard assets. For the sub-standard, doubtful and loss asset categories, the provisioning requirements remained at 10%, 20-50% (depending on the duration for which the asset has remained doubtful), and 100%, respectively, the recognition norms for NPAs have also been tightened gradually. Since March 1995, loans with interest and/or installment of principal overdue for more than 180 days are classified as non-performing. This period will be shortened to 90 days from the year ending 31st' March 2004. 1.4 Structural Reforms • Increased Competition

With the initiation of banking-sector reforms, a more competitive environment has been ushered in. Now banks are not only competing within themselves, but also with nonbanks, such as financial services companies and mutual funds. While existing banks have been allowed greater flexibility in expanding their operations, new private sector banks have also been allowed entry. Over the last decade nine new private sector banks have established operations in the country. Competition amongst Public Sector Banks (PSBs) has also intensified. PSBs are now allowed to access the capital market to raise funds. This has diluted Government's shareholding, although it remains the major shareholder in PSBs, holding a minimum 51% of their total equity. Although competition in the banking sector has reduced the share of assets and deposits of the PSBs, their dominant positions, especially of the large ones, continues. Although the PSBs will remain major players in the banking industry, they are likely to face tough competition, from both private sector banks and foreign banks. Moreover, the banking industry is likely to face stiff competition from other players like non-bank finance companies, insurance companies, pension funds and mutual funds. The increasing efficiency of both the equity and debt markets has also accelerated the process of financial disintermediation, putting additional pressure on banks to retain their customers. Increasing competition among banks and financial intermediaries is likely to reduce the Net Interest Spread of banks. • Banks entry into New Business Lines Banks are increasingly venturing into new areas, such as, Insurance and Mutual Funds, and offering a wider bouquet of products and services to satisfy the diverse needs of their customers. With the enactment of the Insurance Regulatory and Development Authority (IRBA) Act, 1999, banks and NBFCs have been allowed to enter the insurance business. The RBI has also issued guidelines for-banks' entry into insurance, according to which, banks need to obtain prior approval of the RBI to enter the insurance business. So far, the RBI has accorded its approval to three of the 39 commercial banks that had sought entry into insurance. Insurance presents a new business opportunity for banks. The opening up of the insurance business to banks is likely to help them emerge as financial supermarkets like their counterparts in developed countries. • Increased thrust on Banking Supervision and Risk Management To strengthen banking supervision, an independent Board for Financial Supervision (BFS) under the RBI was constituted in November 1994. The Board is empowered to exercise integrated supervision over all credit institutions in the financial system, including select Development Financial Institutions (DFIs) and Non Banking Financial Companies (NBFCs), relating to credit management, prudential norms and treasury operations. A comprehensive rating system, based on the CAMELS methodology, has also been instituted for domestic banks; for foreign banks, the rating system is based on CACS. This rating system has been supplemented by a technology-enabled quarterly offsite surveillance system. To strengthen the Risk Management Process in banks, in line with proposed Basel 11 accord, the RBI has issued guidelines for managing the various types of risks that banks are exposed to. To make risk management an integral part of the

Indian banking system, the RBI has also issued guidelines for Risk based Supervision (RBS) and Risk based Internal Audit (RBIA). These reform initiatives are expected to encourage banks to allocate funds across various lines of business on the basis of their Risk adjusted Return on Capital (RAROC). The measures would also help banks be in line with the global best practices of risk management and enhance their competitiveness. The Indian banking industry has come a long way since the nationalisation of banks in 1969. The industry has witnessed great progress, especially over the past 12 years, and is today a dynamic sector. Reforms in the banking sector have enabled banks explore new business opportunities rather than remaining confined to generating revenues from conventional streams. A wider portfolio, besides the growing emphasis on consumer satisfaction, has led to the Indian banking sector reporting robust growth during past few years. It is clear that the deregulation of the economy and of the Banking sector over the last decade has ushered in competition and enabled Indian banks to better take on the challenges of globalisation. 1.5 Operational and Efficiency Benchmarking • Benchmarking of Return on Equity Return on Equity (ROE) is an indicator of the profitability of a bank from the shareholder's perspective. It is a measure of Accounting Profits per unit of Book Equity Capital. The ROE of Indian banks for the year ended 31st March 2003, was in the range of 14 - 40%; the median ROE. Being 23.72% for the same period. On the other hand, the global benchmark banks had a median ROE of 12.72% for the year ended 31st December 2002. In recent years, Indian banks have reported unusually high trading incomes, driven mainly by the scope to booking profits that arise from a sharply declining interest rate environment. However, such high trading income may not be sustainable in future. The adjusted median ROE for Indian banks (adjusted for trading income) stands at 5.42% for Indian banks for FY2003 as compared with 11.77% for the global benchmark banks.After adjusting for trading income, the median ROE of Indian hanks stands lower than the same for the global benchmark banks, thus implying that the contribution of trading income to the RoE of Indian banks is significant. Further, the ROE benchmarking method favors banks that operate with low levels of equity or high leverage. To assess the impact of the leverage factor on the ROE of banks, "Equity Multiplier” is presented in the next section. • Benchmarking of Equity Multiplier Equity Multiplier (EM) is defined as "Total Assets divided by Net Worth". This is the reciprocal of the Capital-to-Asset ratio, which indicates the leverage of a bank (amount of Assets of a bank pyramided on its equity capital). Banks with a higher leverage will be able to post a higher ROE with a similar level of Return on Asset (ROA), because of the multiplier effect. However, the banking industry is safer with a lower leverage or a higher proportion of equity capital in the total liability. Capital is important for banks for two main reasons: Firstly, capital is viewed as the ultimate line of protection against any

potential losscredit, market, or operating risks. While loan and investment provisions are associated with expected losses, capital is a cushion against unexpected losses. Secondly, capital allows banks to pursue their growth objectives; a bank has to maintain a minimum capital adequacy ratio in accordance with regulatory requirements. A bank with insufficient capital may not be able to take advantage of growth opportunities offered by the external operating environment the same way as another bank with a higher capital base could. • Benchmarking of Return on Assets ROA is defined as Net Income divided by Average Total Assets. The ratio measures a bank's Profits per currency unit of Assets. The median ROA for Indian banks was 1.15% for FY2003. For the global benchmark banks, the ROA ranged from 0.05% to 1.44% for the year ended December 2002, with the median at 0.79%. For the year ended December 2002, Bank of America reported the highest ROA (1.44%) among the global benchmark banks, followed by Citi group Inc. (1.42%). The median value for Indian banks at 1.15% was higher than that of ABN AMRO Bank, Deutsche Bank, Rabo Bank and Standard Chartered Bank. Two banks, namely Bank of America and Citigroup Inc., posted higher ROAs as compared with the European and other banks for both FY2003 and FY2002 primarily on the strength of higher Net Interest Margins. The reasons for the Net Interest Margins being higher are discussed in the sections that follow. As with the ROE analysis, here too adjustments for non-recurring income/expenses must be made while comparing figures on banks' ROA. Adjusting for trading income, for both Indian banks and the global benchmark banks, the median works out to be lower for Indian banks vis-a-vis the global benchmark banks for FY 2003. I have further analysed the effect of adjustment for trading income on the ROAs of both Indian Banks and the Global Benchmark Banks. Here, it must be noted that the global benchmark banks have a more diversified income portfolio as compared with Indian banks, and a decline in interest rate could have increased profitability of global benchmark banks indirectly in more ways than one. However, from the disclosures available in the annual reports of the global banks, it is not possible to quantify the impact of declining interest rates on their profitability (`thus, the same has not been adjusted for in this analysis). Nevertheless, to further analyse the profitability (per unit of assets) of Indian banks vis-a-vis the global benchmark banks, ICRA has conducted a ROA decomposition analysis. 1.6 Decomposition of Return on Assets • Net Interest Margin Net Interest Margin (NIM) measures the excess income of a bank's earnings assets (primarily loans, fixed-income investments, and interbank exposures) over its funding costs. To the past, for banks NIM was the main source of earnings, which were therefore directly correlated with the margin levels. But with NIM declining significantly in many countries, banks are now trying to compensate the "lost" margins with non-fund based fee incomes and trading income. Despite these changes, net interest income continues to account for a significant share of the earnings of most banks. The median NIM for Indian banks was 3.16% for FY2003 and 3.92% for FY2002. The figures compare favorably with those of the global benchmark banks. Before drawing inferences on the NIM

benchmarking results, three aspects must be considered, namely: (a) The external operating environment, (b) The quality and type of assets, and (c) Accounting policies followed by banks. The three aspects are explored in detail in the subsequent paragraphs. (a) External Operating Environment