Indian Banking. Maneuvering through Turbulence: Emerging strategies

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1 Indian Banking Maneuvering through Turbulence: Emerging strategies

2 Foreword CII During the last two decades of unshackling its chains, the elephant that is Indian economy seldom came across such challenges as it does now. The twin tasks of reinvigorating economic growth and reining in inflation during the times of dwindling rupee value, weak global demand and persistent current account deficit present a mesh of problems that need immediate and coordinated actions on the fiscal and monetary front. India s economic growth that sunk to a decade low of 5 percent last year continues to plague the economy. While the performance of key sectors such as manufacturing, farm and mining are below par, the reforms process that began last year failed to generate enough momentum to restore the growth figures. Against this backdrop, the banking sector has an important role to play in stimulating economic growth. Banking, arguably the fulcrum of our financial system, is a sector that can really help in deploying our national savings towards infrastructure development. This will in turn stimulate economic activity on one hand, and help sustain a high growth rate on the other. The bigger the challenges, more is the need for innovative ideas and strategies by bankers to counter risks. Banks also have a larger role to play in increasing financial inclusion. Proposed licenses for new banks raise hope for increased penetration and enhanced credit availability. The central bank has taken several policy initiatives on compliance and governance something that could redefine the contours of the sector and benefit the economy in the long run. The volatile economic scenario has forced banks to try various business models either to increase their bottomline or manage risks better. Adoption of new technologies and a constant pursuit of innovation to improve products and services will be crucial. In this context, KPMG as our knowledge partner for Banking Colloquium 2013 has prepared a report. The study attempts to capture the current scenario and detail of the strategies being adopted by banks, way forward to compliance and governance, financial inclusion, technology in banking, market risk hedging and proposed new banks. We hope the report will help the industry understand the emerging strategies needed to maneuver through these times of turbulence. Sudhir Deoras Chairman CII Eastern Region

3 Foreword KPMG Banks face challenges from many sources Indian economy slow-down is one of them. Few factors responsible for GDP growth rate of 5 percent could be an over-cautious monetary policy that could not deliver on lowering the inflation rate but contributed to increase in the borrowing costs, government s pending decisions on a few strategic policies, high current account deficit and oil prices. The sharp depreciation and uncertainty of the rupee in recent times has further aggravated the problems of the Indian economy. Slower economy leads to deteriorating asset quality which is already causing stress to the banking sector. The RBI estimates that the gross NPA ratio of banks may rise to 4.4 percent by March 2014 as compared to 3.42 percent in FY 13. NPA ratio was 2.94 percent in FY12. In an uncertain environment, banks are extremely concerned with liquidity risk and concentration & correlation risks and have to develop tools to calculate economic capital that will integrate credit and market risks. Currency volatility is also giving few bankers sleepless nights. Another challenge facing the banking sector is that of compliance and governance. Fit and proper guidelines were issued by the RBI for directors to ensure appropriate officials at the helm. To reduce systemic risk, regulators have also placed lot of checks and balances in the sector. From tapping new segments in the SME sector to funding cross-country aspirations as Indian corporates go global, Indian banks are pursuing multiple strategies for growth in an uncertain environment. The Public sector banks (PSBs) are much ahead of the Private sector banks in their overseas presence, constituting over 90 percent of 171 overseas branches as of March 31 st,2013. To meet these requirements and challenges, industry players are harnessing technology for creating innovative and cost-efficient operating models to sustain profitability and viability. Discussions have been on branchless banking but a branch avatar will never go out of picture for lesstechnology savvy customers. Banks are also deliberating on social media initiatives to reach out to urban and emerging class and SMAC (social, mobile, analytics and cloud) on a whole could bring a new perspective on customer experience and on creating a sustainable business. RBI s objective of increasing financial penetration and credit availability with reaching out to the bottom of the pyramid has resulted in giving out clear guidelines to the new banking entrants(whenever they are on board) open one in four branches in rural unbanked areas! The successful banking aspirants would have their task cut out as they balance the twin objective of reaching out to the emerging India in the Tier 3 to 6 cities while achieving financial inclusion. This paper is an attempt to discuss the opportunities and challenges that lie ahead of the Indian banking industry. Ambarish Dasgupta Head - Management Consulting KPMG in India

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5 Contents Emerging strategies of Banking sector Governance and Compliance Gearing up for the next level Financial inclusion - Quest for profitability 13 SMAC - Future of technology 17 Merit in banking on new licenses Hedging the market risk

6 1 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Emerging strategies of Banking sector Over the past couple of years, the Indian banking sector has displayed a high level of resilience in the face of high domestic inflation, rupee depreciation and fiscal uncertainty in the US and Europe. This has necessitated the banks in India to concentrate much more on operating efficiency, outsourcing and cost optimization now than ever before. With deregulation of savings bank rate and bleak global economy, the banks are focusing on alternative sources of revenue, like fee income, trade and vendor financing, geographic expansion et al to maximize their revenues. The Banking sector in India has adopted and embraced technology to keep pace with the international development in the banking industry and offer quality products to its clients. Technology has enabled banks to conceive and deliver products that are more in line with the requirements of its clients on the one hand and also more cost efficient on the other. We have captured few emerging trends in the Banking space that are gaining traction. Focusing on the emerging India Banks and regulators alike have woken up to the growing needs of emerging India. While the credit disbursal of all SCBs has doubled from FY08 to FY12 to INR 48,215 bn 1, the share of non metro regions in the incremental credit pie has increased from 30 percent in FY09 to 39 percent in FY12, indicating that the Non-metro regions are increasingly gaining share. The number of bank branches in urban and semi-urban 2 areas has been growing at a fast pace. Fifty eight percent of ~25,000 branches opened in last five years were in urban and semi-urban regions. Incremental credit disbursed by SCBs (INR bn) Source: RBI - Statistical Tables relating to Banks in India FY 12 1 RBI - Statistical Tables relating to Banking FY 12 2 As per RBI definition - Rural: population less than 10,000; Semi-Urban: 10,000 and above and less than 1 lakh; Urban: 1 lakh and above and less than 10 lakh; Metropolitan: 10 lakh and above

7 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 2 Even the number of bank branches in urban and semi-urban areas has been growing at a fast pace. The growing economic activity and increasing per capita income have been crucial factors driving the credit growth in these regions. Fifty eight percent ~25,000 branches opened in last five years were in urban and semi-urban regions. RBI is keen to improve the banking situation in rural areas and has mandated banks to allocate at least 25 percent of new branches in unbanked rural centers. Further, the increasing number of High Net worth Individuals (HNWIs) in the non metro areas is leading to an increase in demand for better or more sophisticated services, including Private banking and Wealth management; banks are not only focusing on numbers in the emerging markets within the country but also on the quality of services being delivered in these regions, based on type of clientele. Population wise incremental branches in last 5 years Source: RBI - Statistical Tables relating to Banks in India FY 12

8 3 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Country-wise branches of Indian Banks at overseas centres as on March 31, 2013 Banks are constantly trying to increase their overseas expansion to meet the growing trade demand Indian banks have been increasingly growing their international presence in the recent past. In part to cater to the growing Indian diaspora in foreign countries (estimated at ~ 20 mn persons) and in part to meet the growing demands from cross border trade and economic activity. The Public sector banks (PSBs) are much ahead of the Private sector banks in their overseas presence, constituting over 90 percent of 171 overseas branches as of March 31 st, Many of the private banks do not have branches, but are present through representative offices. Non resident Indians (NRIs) deposits aggregated USD 14.2 bn in the financial year ended March 2013, a y-o-y increase of 19 percent. The Indian Diaspora worldwide is estimated to be ~20 mn persons 4 and is on a constant rise. Others include: Afganistan, Australia, Bahamas, Bahrain, Bangladesh, Belgium, Cambodia, Cayman Islands, Channel Islands, France, Germany, Israel, Japan, Kenya, Maldives, Qatar, Saudia Arbia, Seychelles, South Africa, South Korea, Oman, Thailand, Top Exports Markets (FY 2013, USD bn) Top Imports Sources (FY 2013, USD bn) Source: Reserve Bank of India Source: Ministry of Commerce & Industry, Government of India The total trade, export and import, have clocked a 19 percent CAGR over the last year, period ending FY 13. The top trading partners are China, Middle East, US, HK, Singapore et al. The Banks have shown particular interest in opening branches in these regions which have a strong trade relationship with India. Total trade with China has grown at 17 percent CAGR from FY10 to FY13 and this has enticed banking players to open branches in China. For example, Axis Bank recently got permission from RBI to open a branch in China and ICICI Bank is awaiting RBI s approval for the same. ICICI Bank is looking for foreign expansion by opening branches in Australia, South Africa and Mauritius 5. PSBs are also aiming to expand their presence abroad. SBI wants to explore territories where Indian Banks haven t tread yet, like Latin America. Dena Bank is also awaiting RBI s permission to open branches in US, UK and Africa. Overseas expansion in PSBs might be constrained on account of the limited capital headroom they have for such ventures, and the Government being hard pressed to find funds for recapitalizing PSBs. Therefore, PSBs might be very careful in their selection of target markets compared to well capitalized PBs. 3 RBI Country-wise branches of Indian Banks at Overseas Centres as on March 31, Including Non Resident Indians and Person of Indian origin 5 Business Standard June, 2013;

9 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 4 Supply Chain Financing (SCF) is gaining traction in India SCF is rapidly gaining attention in international markets and is growing at a pace of percent at major international banks according to a research 6. Key elements of SCF include factoring, invoice discounting/reverse factoring, purchase order/ invoice data management, bank assisted open account, open account payment, export/seller finance and buyer side finance. All the products aiming at providing better liquidity to the corporates and their entire value chain at lower financing rates. Currently, the growth in this domain comes from US and western European countries, but the future growth is expected to come from emerging economies like India and China. With various government policies supporting exporters in India, the export credit is growing at a rapid rate (Three year CAGR at 14 percent and five year CAGR at 22 percent). A part of this is also supplier financing, which has been gaining popularity. Outstanding advances of SCBs to exporters (INR bn) Source: Monetary policy department, RBI (http://www.rbi.org.in/scripts/publicationsview.aspx?id=14681) Banks are increasingly focusing on increasing their business from SCF. This can be witnessed in growing number of branches in Industrial units. The banks are holding awareness campaigns and seminars to educate the corporate world of the benefits of SCF. Certain players are focusing on developing expertise in particular sectors. Factoring and reverse factoring have not gained much momentum in India and still offers an untapped market. Factor products offer greater flexibility compared to other instruments used for working capital finance. Although receivables enjoy property rights and are transferable, a statutory framework for factoring was introduced only in 2011 by way of the Factoring Regulation Bill. In the context of serving our clients responsibly, value chain financing is an integral part of our business strategy covering both, our corporate clients as well as their vendor partners, who are largely SMEs. We have further sharpened our focus on this format of supply-chain financing to meet priority sector obligations, given that our distribution network limits direct access to such borrowers. Abhijit Sen CFO, Citibank 6 Demica Research, 2013

10 5 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies

11 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 6 The Factoring bill essentially protects micro and small businesses from delayed payments for goods and services by larger entities. Traditional banks used to provide loans based on the borrower s (i.e. the MSME player s) ability to service the loan. Factoring will however evaluate the lending decision based on the ultimate debtor (i.e. the ultimate customer of the MSME). This will greatly improve the liquidity and working capital problems of MSME players. With favourable legislations, factoring is gradually taking off in India. The Indian market constitutes a mere one percent of the world s factoring market and 0.5 percent of the working capital requirement of Indian companies 7 and is constantly growing. Indian factoring market in the last decade Source: Factors Chain International Comparison with major Asian Markets Domestic International Source: Factors Chain International 7 2%20-%20financial%20express.pdf As illustrated above, there is a huge gap between Indian factoring market and the international counterparts and offers a great opportunity for Indian banks to capture this gap. The factoring industry in India is dominated by PSBs and financial institutions. SBI Global Factors is the market leader with 80 percent of the market share. Other players include CanBank Factors, DBS, Axis Bank, HSBC and Standard Chartered 7.

12 7 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Indian banks are now getting to be somewhat mature users of technology and are investing significantly in good data mining solutions to understand the behavioral trends of customers and offer intelligent cross sell solutions to customers, primarily to improve productivity. There is also concurrently an increasing trend towards outsourcing to retain flexibility, manage scale more efficiently and cut operating costs, essentially to leverage on partners strengths in specific areas Jaideep Iyer Group President, Financial Management, Yes Bank Focus on improving operating efficiency and outsourcing With increasing competition, emerging customer demands, regulatory interventions, technologyled disruptions, higher shareholder expectations, Indian banks are being forced to constantly review and revisit their operating models. The resulting changes are making Indian banks nimbler, more cost efficient, better focused on customer services and witnessing good returns through fee based services and products. Indian banks are constantly optimising the use of technology as the change agent, in order to improve operational efficiency and enhance customer experience. It is estimated that Indian banking and securities companies will spend INR 416 bn (USD 6.75 bn) on IT products and services in , which will be 13 percent increase from INR 370 bn (USD 6.0 bn) spent in Emergence of low cost channels like internet banking, mobile banking, and mobile ATMs have been successfully implemented by many players and have also found wider acceptance in the customer base. This has led to enhanced focus on digital banking and self-service channel usage to reduce the cost of operations. The number of mobile banking transactions doubled to 5.6 mln in January 2013 from 2.8 mln in January The value of these transactions increased three-fold to INR 625 Cr (USD mln) during the month from INR 191 Cr (USD mln). Banks have either centralised mid/ back office processes through a shared services center or have outsourced their technology requirements to a third party. In addition to focus, this also gives banks a huge cost advantage. For example, Indian market has witnessed an increasing number of ATMs under outsourcing management. By outsourcing their ATM management to service providers like Fidelity National Information Services (FIS), the bank is able to focus on its core business expansion and customer service initiatives - allowing for more rapid growth while ensuring its customers have a high-quality, reliable ATM service. FIS the market leader and world s largest provider of banking and payments technology manages about ATMS across India. Karnataka Bank is the latest to join more than half of India s top 30 banks who rely on FIS. By outsourcing the management of its ATM estate to FIS, Karnataka Bank would be in a position to release vital capital to redeploy on core activities, increase operational efficiencies, provide better service to its customers and insulate itself from technology obsolescence. The announcement made by Karnataka Bank in May 2013 underscores a growing trend in India for banks to contract non-differentiating services, such as ATM driving, to expert providers such as FIS. Banks benefit by redirecting investments tied up in ATM equipment and operations to more strategic areas, thus deriving operational efficiencies. In addition, banks can leverage the ATM driving expertise of FIS to deliver a highquality and reliable ATM service to their customers. While transaction based banking operations are being successfully streamlined, Priority Sector Lending and Financial Inclusion still remain a challenge. The section on Financial Inclusion in the report elaborates on how to create a profitable model to deliver rural credit. 8 Gartner Research- 9 Reserve Bank of India

13 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 8 Changing dynamics of fee based income portfolio Fee income has gained significant focus as a source of revenue in the past decade. With the rising pressure on cost of funds, it is imperative for banks to look at other avenues to boost their income. The fee income in FY 13 for 67 banks in our sample set 10 was INR 64,418 Cr; clocking a three year CAGR of 12 percent and five year CAGR of 15 percent. PSBs have constituted a large part (60 percent) of this basket since the beginning, owing to their reach and size. Pressure on fee based income However, in recent times with the overall pressure on the economy and changing regulations, the fee based incomes of banks have come under pressure. Banks earned lower corporate banking fees due to slowdown in project finance. Also, with The Reserve Bank of India s (RBI) recent measures to tighten liquidity and curb volatility in foreign exchange rates have led to a rise in bond yields leading to a drop in treasury incomes for banks. On the retail side, fee income earned by banks on account of sale of gold coins has dried up with the government banning sale of gold coins by banks. These factors have necessitated banks to revamp their fee based product portfolio. Fee Income (INR Cr) Emerging trends Banks looking to increase fee-based income are shifting focus to selling life insurance and general insurance policies (through bancassurance tie ups or as insurance brokers). Indian bank recently partnered with United India Insurance and launched a web portal for its Arogya Raksha group mediclaim insurance policies. Moving forward, the bank is in talks with a life insurance company for a similar tie-up in the life insurance space. The bank expects a 30 percent 11 growth in income from insurance this fiscal. Some of the other recent bancassurance tie-ups include PNB with Metlife and Axis Bank with Source: KPMG-Business Today Best Banks December 2012 Max Life insurance. With the increasing trends in insurance penetration on both life and general insurance side, banks identify this as one of the key drivers of fee income growth. Retail fee income is another area where banks have increased focus to augment their growth. Retail fee income of banks typically comprises commissions they earn from sale of third-party products, like insurance and mutual funds, transaction charges on savings and current accounts, processing fees on consumer loans and credit cards, and fees from foreign exchange transactions and remittances. Private sector banks are specifically focusing on income on foreign exchange transactions and remittances. Axis Bank, the third largest private sector lender in the country, reported close to 43 percent rise in retail fee income in FY The sample set comprises of 26 PSBs, 18 PBs, and 23 Foreign banks 11

14 9 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Governance and Compliance Gearing up for the next level The banking sector is crucial for an economy since it channelises savings into investments. It provides credit to the productive sectors and finances the needs of the real economy. For emerging economies, banks are more important since they are important drivers of financial inclusion and economic growth. Banks by nature are highly leveraged and interconnected. Hence, poor governance or failure in banks can trigger bigger crisis and threaten stability of the economy. Banks in India are well regulated with The Reserve Bank of India adopting a forward looking yet cautious approach. In the 1990s, the tone of banking regulation shifted from prescriptive to prudential, shifting the onus from regulations to corporate governance. Various guidelines were issued over the years to improve corporate governance in banks. To get competent directors on board, the RBI issued fit and proper criteria for directors which said that private banks should carry out due diligence to determine the suitability of the person for appointment as a director based on qualification, expertise, track record and integrity. In 2005, the Ganguly Committee recommended separation of Chairman and MD roles. The recommendation was implemented in private banks. The RBI also issued guidelines on ownership and governance in private banks to ensure that ownership and control of banks are well diversified and thus not detrimental to depositors interest. Moreover, any acquisition of shares in private sector banks resulting in a shareholding of 5 percent or more of the paid up capital requires the RBI s prior approval. Banks are also mandated to have committees on audit, nominations and remuneration, fraud monitoring, and customer services. All these provisions put the corporate governance framework adopted by Indian banks on par with international standards. Although improving regulatory landscape is a welcome move, regulation in isolation is not enough. It is a necessary but not a sufficient condition for good governance. Regulation can complement governance, not replace it. Good governance has to be institutionalized by individual banks for it to be effective. While broadly Indian banks have good governance standards, there is room for improvement. In the sections below, we take a brief look at the important issues in governance and compliance in Indian banks and how they can be addressed. Governance in Indian banks The financial crisis of 2008 brought inadequate governance in banks and other financial institutions in sharp focus. Experts argue that simplistic assumptions and lack of rigorous questioning by bank boards led to the crisis. Banks boards, management, and employees faced conflict of interest routinely in their jobs. When faced with a conflicting situation, compensation structures in the financial sector, which should have ideally pushed the decision makers towards the better choice, instead encouraged excessive risk taking. Once the crisis started in one area of the financial sector, it spread to other areas quickly due to blurred boundaries between banking, insurance and asset management businesses. Although Indian banks came out of the crisis relatively unscathed, they (particularly the public sector banks) face peculiar governance challenges in the form of government control.

15 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 10 Government s control over public sector banks The Indian banking sector is characterised by the dominance of PSBs which account for approximately 70 percent of the industry 1. The government through its agencies owns majority stakes in these banks and exerts influence through its monetary policy and directives. In the context of PSBs, it is difficult to adhere to public ownership and yet give near total autonomy to their boards as compared to private sector banks where the board has autonomy and all shareholders are treated at par. Bank Subsidiary Model needs to be reassessed Another governance related issue in Indian banks is the corporate structure they follow. Currently in India, the bank subsidiary model is popular. Under this model, non-banking activities such as insurance, asset management etc are done in separately constituted subsidiaries of the bank. This model has its own set of problems and disadvantages. E.g. firstly, losses of subsidiaries could substantially damage the financial health of the bank and risk the safety of deposits. Secondly, since the bank will be responsible for equity infusion in the subsidiaries and their management, having several subsidiaries could stretch the bank s finances and other resources. Thirdly, the proportion of foreign holding in holding banking company is not taken into account for the purpose of calculating the cap of foreign holding in subsidiaries. And finally, the subsidiary model could lead to excessive leverage by the downstream affiliates. The Shyamala Gopinath Working Group appointed by the Reserve Bank recommended that the financial holding company model should be preferred for the financial sector in India. Revising the compensation structure to improve governance After the 2008 financial crisis, compensation structure in banks came under sharp focus and criticism. Now it is widely acknowledged that aggressive and irrational incentives and excessive risk taking by bank executives fuelled the crisis. The compensation structure at times encouraged compromising long-term interests for short-term gains. To check excessive risk-taking behavior, the RBI issued guidelines which aligned compensation structures with prudent risk taking and instituted a claw back mechanism. However, as of now there is no consensus on what is a good compensation structure for non-executive directors. Currently non-executive directors are paid sitting fees. There is a school of thought that believes that non-executive directors should be paid a regular or a fixed contractual remuneration. Although this is a good idea, it is difficult to implement in practice. Firstly, non-executive directors typically serve for shorter periods and have term limits. Secondly, in banks the results of risks taken manifest after a long gap. And finally since non-executive directors serve on several committees comprising of many directors, it is difficult to apportion responsibility on them individually. Hence, aligning non-executive directors compensation structure with outcomes of corporate governance is still a grey area. Separating the roles of Chairman and Managing Director In 2005 the Ganguly Committee appointed by the RBI recommended that the posts of the chairman of the board and the CEO of the bank should be bifurcated. The committee argued that this will bring about more focus and vision and necessary thrust to the functioning of the top management of the bank and also provide effective checks and balances. The committee s recommendations were implemented in private sector banks in However, the finance ministry did not favor the proposal and hence it was not adopted in public sector banks except in SBI and associates. Allowing corporates into the banking space The RBI has received 26 applications for new banking licences 2. However, there is a lot of debate on whether large corporates should be allowed to start a bank. International experience in this regard has been mixed. While corporates can bring in professional management experience and capital, many experts fear that they will use the bank as a private pool of readily available funds. However, to avoid this, the RBI has built in several safeguards in the new banking licence guideline. To keep non-serious players at bay, the guideline says that the applicant entity/group should have a past record of sound credentials and integrity, should be financially sound and have a successful track record of 10 years. It also underlines the importance of diversified ownership. It says that a Non-Operative Financial Holding Companies (NOFHC) should set up new banks. The NOFHC should retain their equity capital in the bank at a minimum of 40 percent for fuveyears after which they should reduce to 15 percent within 12 years. The guideline also has criteria on financial inclusion. The above provisions clearly show that the regulator wants new banks to have good governance standards. Failing to meet the aforementioned conditions could have serious repercussions for new banks. 1 Reserve Bank of India 2 RBI Press Release RBI discloses the names of applicants for new bank licences in the private sector, Jul 2013

16 11 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Importance of compliance at banks Compliance for banks is given a lot of importance as they are the engines of a country s economy and, therefore, also more regulated. In fact, post the financial crisis regulatory supervision of banks has increased noticeably, underscoring the increasing importance of regulatory compliance for banks. Evolution of banking regulations and enforcement In 2010, Basel Committee on Banking Supervision (BCBS) issued comprehensive Basel III guidelines to improve the banking sector s ability to absorb shocks arising from financial and economic stress. The guidelines recommend more stringent capital and liquidity requirements apart from suggesting enhancements to Basel II and market risk frameworks. In the same year the US introduced Dodd- Frank Act to enhance financial stability, orderly liquidation and other host of measures to ensure measures directed at hedge funds, insurance companies and banks. Similarly, in India, RBI has been issuing a host of directives to improve governance and compliance at Indian banks in the last two years. Specifically, the regulator has issued key directives aimed at enhancing corporate governance at NBFCs, enhancing know your customer (KYC)/anti-money laundering (AML) norms, tightening regulatory oversight at foreign banks by making CEOs of such banks responsible for compliance, structuring the credit approval process by recommending a board-level credit committee, etc. The new guidelines for issuance of banking licenses are also indicative of this trend. RBI is also strengthening its enforcement efforts. Its recent orders penalising 19 commercial banks for mis-selling derivative products to clients and 3-4 banks for violation of KYC/ AML norms is indicative of this trend. Additionally, RBI recently constituted a High-Level Steering Committee which recommends the regulator to transition to a risk-based supervision (RBS) approach, which entails determining the intensity of supervision based on a bank s risk profile. This would necessitate banks to strengthen their governance, risk management and compliance frameworks. Banking community s response to this evolution Often, companies tend to respond to more regulations, increased scrutiny and instances of wrong doing with another checklist or another layer of control or redundant procedures. This may or may not address the issue permanently. More importantly, this spontaneous reaction could create multiplicity in rules, increased compliance costs, unwanted bureaucracy and delayed decisions. The spontaneous reaction is to a certain extent because organisations view compliance as a mere cost of doing business and as an impediment to their operations. This could be counterproductive and often lead to misdirected compliance and control. This in turn could lead to overlapping and inconsistent rules and regulations that are difficult to comprehend or requirements that without a clear purpose or intention and remain merely on paper. In fact, banks stand to gain more if they leverage compliance as a value driver and comply with laws of the land in sprit. This comes from a good understanding of the consequences of non-compliance on the bank and on the industry/economy as a whole at all levels of the organization. Compliance as a value driver In order to leverage it as a value-driver, banks should adopt a compliance framework that is proactive, rigorous, co-operative and pervasive. Proactive: Addressing compliance proactively involves a two-pronged strategy of assessing compliance risks, including upcoming ones, and inducing appropriate changes in policies, processes and controls to address these risks. It involves implementing best practices by complying with the spirit of the regulations than merely the letter of it. Rigorous: Adopting a zerotolerance approach to noncompliance involves making efforts to curtail all sorts of noncompliance and not just material ones. Any non-compliance in regards to regulations is viewed seriously, regardless of the extent of the regulator s supervision, and corrective actions are implemented in a timely manner to curtail any such future instances of non-compliance. Co-operative: Making the process co-operative involves leveraging the synergy of compliance initiatives across the organisations and avoiding any duplication of efforts. This reduces the cost, complications and inconsistencies in regulatory compliance for banks. One of the ways to achieve this is by establishing an empowered, independent compliance function. Pervasive: Introducing a pervasive approach involves making compliance with regulations or the bank s internal rules everyone s responsibility. The bank s employee performance system accords as much importance to compliance KPIs as given to business KPIs. It also involves timely training and communication to educate employees on the intent behind regulations and the bank s internal rules.

17 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 12 Conclusion Indian banking sector is at an inflexion point. To meet the demands of India s huge potential, heavy infrastructure spending, and the government s ambitious financial inclusion plan the banking sector will have to gear up for unprecedented challenges. To prepare for the upcoming challenges, the government formed a commission with a task of overhauling the regulatory landscape of financial sector. The commission Financial Sector Legislative Reforms Commission drafted a code called the Indian Financial Code (IFC). The IFC has called for a unified regulator for the financial services sector which will regulate insurance, capital market, pension funds and commodities derivatives market. It has recommended that the RBI should continue to exist outside the unified regulator although with modified functions of setting monetary policy, regulating banks and payment systems. To what extent the RBI s functions will be modified is not known yet. However, one of the most important challenges the sector is likely to face is the challenge of governance and compliance. Achieving optimal growth, balancing stakeholder expectations and complying with regulations is likely to be a tight rope walk for the sector. However, with support from the RBI and the government, it is likely to be a rewarding experience.

18 13 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Financial inclusion - Quest for profitability Financial exclusion has been an area of concern and casts shadows over the long-term sustainable growth of the Indian economy. Though the country has had a large unorganized sector (consisting of money lenders, chit funds, etc.) providing the financial services for a long time, the reach of the organized sector (banks, NBFCs, MFIs, NGOs, etc.) remained limited. The unregulated unorganised sector players, with their strong focus on earning profits, did little to bring in the financially excluded people in the mainstream. The central bank prescribes the following four basic financial services to be provided to any individual to count her as financially included. Access to basic savings account Availability of affordable credit Access to remittance services Opportunity to buy insurance and investment products. Data released by the World Bank depicts that on an average Indians over the age of 15 years remain considerably under-banked as compared to their global peers. While almost half the global population above 15 years has an account at a formal institution, the figure is only 35 percent in India. The scenario is even worse in case of female population. Looking at the same metric for the bottom 40 percent of the population by income, 41 percent population globally has an account as compared with 27 percent in case of India. Financial inclusion status for population above 15 years: global comparison (in %) Source: India Commercial Banking Report - New Permits To Boost Competition In Underbanked Economy, ISI Emerging Markets, accessed on 26 August 2013

19 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies 14 Even the extent of financial exclusion in India is widespread as reflected in the following facts. 1 Highest number of households (145 million) excluded from banking 50 percent of the population does not have bank account Only 34 percent of the population engaged in formal banking Only 17 percent of population has any credit exposure especially in remote villages Out of 600,000 villages, only 30,000 (5 percent of total villages) have commercial bank branch Only 10 percent have life insurance cover while just 9.6 percent have any non-life insurance. The policy makers have adopted a multipronged approach to address the issue of financial exclusion. Key elements of the strategy include: Evolving regulatory guidelines with development perspective Deepening banking reach and coverage Introduction of Innovative products Encouraging use of technology Financial literacy and financial inclusionsynced approach. There has been an intense debate on the appropriate model for FI. RBI has favored bank-led model instead of the technologyled model which has been successful in many other countries. The model allows the country to leverage existing branch base for a planned, structured and sustained FI process. It also reduces the risk given the low literacy levels (and even lower financial literacy) of the potential set of customers leaving them vulnerable to players either not regulated at all or not regulated by the RBI. Till date, India has had a limited success in achieving FI with the model. However, given the Indian scenario, the model facilitates a consistent and planned move towards the goal of FI while maintaining the financial stability. Challenges in reaching out to the under-banked Infrastructure: Both physical and digital connectivity are essential for institution to provide financial services through a mix of channels depending on the cost and type of services offered. To illustrate, the widespread use of the kiosk banking has been inhibited by poor connectivity in the hinterland. In terms of credit, lack of credit history and limited collateral poses a challenge: Credit bureaus have not expanded their reach much to the rural areas; hence banks are hesitant to hand out loans to the under-banked with limited documentation in terms of proof of income. Also, asset ownership is limited and generally restricted to farm land with no clear documentation. Varied profile of consumers: Banking needs vary according to the customer profiles and due to diversity in population, it becomes difficult for bankers to understand this segment. Global FI models and relevance for India Many of the scalable and successful experiences globally have been led by telecom companies with the banks playing a secondary role. M-Pesa in Kenya: Parallel banking ecosystem managed by telecom companies, allowing the consumers to make majority of mobile banking payments, transfers and transactions on their mobile phones. It is a cost effective and adaptable system which has brought many people into the formal banking system and has grown rapidly with client base of around 10 million, roughly 40 percent of Kenya s adult population. USAID MABS in Philippines: Microenterprise Access to Banking Services (MABS) assists network of partner rural banks in the development and introduction of innovative products, including mobile financial services. It s a successful model that has more than 90 MABS-supported rural banks managing around 250,000 microloan borrowers and 1.5 million micro-savings accounts. These banks have also registered more than 250,000 mobile phone banking clients and have processed more than USD250 million in mobile banking transactions. This model could be used to provide training and technical assistance to rural banks in India which could give a boost to innovative product launches in the rural segment. MTN Mobile Money in South Africa: Mobile operator MTN and Standard Bank, through their joint venture MTN Banking, launched a mobile banking product MTN MobileMoney. Every MTN SIM card has an embedded banking application and only MTN subscribers can open MobileMoney accounts. Under MTN MobileMoney, 1.6 million people are registered users with over USD90 million transacted every month. Although Indian banks have started teaming up with mobile operators for providing banking services to unbanked people, banking regulations do not permit a lead role for telecom companies in India. Our experience shows that the goal of financial inclusion is better served through mainstream banking institutions as only they have the ability to offer the suite of products required to bring in effective/meaningful financial inclusion. The development of the habit of banking would lead to an increase in savings and investment improve the efficiency of allocation of capital and increase the ability of monetary authorities to stabilise the economy in times of crisis. Deepali-Pant Joshi ED, Reserve Bank of India 1 Financial Inclusion and Financial Literacy Indian Way, Dr. KC Chakrabarty, RBI

20 15 CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies Way forward A meaningful FI could be achieved only through a collaborative effort of all the stakeholders involved. Policymakers could help provide a facilitating policy framework, infrastructure support and enabling environment whereas service providers should experiment with different models to serve the unbanked. Further, there has to be collaboration among service providers with financial institutions partnering with telecom, technology, and consumer product providers to create an enabling environment. Government and regulator s initiatives RBI has already made it very clear that the new banks, that will be given licenses, have to open one in four branches in rural areas. Premises of allowing new banks in the sector is to reach out to the bottom of pyramid. Improve Financial Literacy: The GoI and RBI should put in place a country-wide strategy to provide financial education using standard literacy material both as part of the school curriculum and as a part of the kit to educate adults. Aadhaar card: The nation-wide initiative to provide a unique identifier to every Indian, could be integrated with the service delivery mechanism. It could help address the main issue of complying with the know your customer (KYC) norms that banks perceive to be probably the biggest hurdle in expanding their reach. Successful integration of Aadhaar with banks database would also allow banks to have a 360 degree view of their customers to better manage risk and cross sell more services. Banker s initiatives Simplicity is the key: Due to financial ignorance, developing simple easy to understand product for the rural population is the key to success. Leverage technology to develop innovative operating models: As discussed above, technology-based initiatives are leading examples for success in FI. BC channels and other low cost delivery models such as mobile banking would help bankers reach out to the bottom of pyramid. Microfinance sector has been quite successful (As a sector we reach around 2.5 crore women in India) to take financial products to poor and excluded but fallacy is that we are not considered an important channel of financial inclusion as a very important financial service i.e. acceptance of credit is beyond purview of MFIs. There is no reason to undervalue the potential of this channel, before looking to some other industry for solution. Chandra Shekhar Ghosh Chairman & MD, Bandhan Financial Services Pvt. Ltd.

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