banking financial services & insurance_2013

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Unnati Investment Management

and Research Group

Sector Report 2013

____________________________

Banking, Financial Services and Insurance

Prepared By:

Darshan Gandhi

Adit Agrawal

Unnati Investment Management & Research Group BFSI Sector Report

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Contents Banking ................................................................................................................................................ 5

What is a bank? ................................................................................................................................... 5

How does a bank function? ................................................................................................................ 5

Financial analysis of a bank ................................................................................................................. 5

Balance sheet ...................................................................................................................................... 5

Income statement ............................................................................................................................... 7

Understanding the Business model of a bank .................................................................................... 8

The Banking Sector in India ............................................................................................................... 11

Reserve Bank of India ........................................................................................................................ 11

Major Banking Sector Reforms since 1991 ....................................................................................... 11

Commercial banks ............................................................................................................................. 13

Specialized Banks .............................................................................................................................. 16

Institutional Banks ............................................................................................................................ 16

NBFCs ................................................................................................................................................ 16

Co-operative banks ........................................................................................................................... 16

Basel - Capital Accord Norms ............................................................................................................ 17

Basel I Norms .................................................................................................................................... 17

Basel II Norms ................................................................................................................................... 17

Basel III Norms .................................................................................................................................. 17

Major Differences between BASEL 2 and BASEL 3 Norms ................................................................ 18

Are Indian banks adequately prepared for migration to Basel III regime?....................................... 19

Classification of Assets ...................................................................................................................... 20

Provisioning of Assets ....................................................................................................................... 21

Menace of Rising NPAs ..................................................................................................................... 21

Corporate Debt Restructuring .......................................................................................................... 22

Financial Inclusion ............................................................................................................................. 23

Priority Sector Lending ...................................................................................................................... 23

Macroeconomic Factors affecting Banks .......................................................................................... 24

Current Account Deficit .................................................................................................................... 24

Poor Governance .............................................................................................................................. 24

Fiscal Deficit ...................................................................................................................................... 24

Inflation ............................................................................................................................................. 25


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GAAR ................................................................................................................................................. 26

Money Supply ................................................................................................................................... 26

Liquidity ............................................................................................................................................. 27

Quantitative Easing (Bond Buying Program/Asset Purchase Program) ............................................ 28

RBI liquidity tightening measures ..................................................................................................... 28

Insurance ........................................................................................................................................... 29

Classification of the insurance sector ............................................................................................... 29

Bank Insurance Model or Bancassurance ......................................................................................... 29

Overview of the insurance sector in India ........................................................................................ 30

New developments in the insurance industry .................................................................................. 31

Government Role in the Insurance Sector ........................................................................................ 31

Outlook for the Insurance Industry................................................................................................... 31

Non-Banking Financial Services ........................................................................................................ 33

The NBFC sector in India ................................................................................................................... 33

Regulations related to the NBFC sector in India ............................................................................... 35

Microfinance ..................................................................................................................................... 36

Mutual Funds .................................................................................................................................... 37

Other Financial Services .................................................................................................................... 38

RBI Credit and Monetary Policy ........................................................................................................ 39

Cash Reserve Ratio ............................................................................................................................ 39

Repo Rate .......................................................................................................................................... 39

Reverse Repo Rate ............................................................................................................................ 39

Statutory Liquidity Ratio ................................................................................................................... 39

Bank Rate .......................................................................................................................................... 40

Capital Adequacy Ratio(CAR) ............................................................................................................ 40

Other Financial Instruments ............................................................................................................. 41

Bonds and Debentures ...................................................................................................................... 41

Commercial papers ........................................................................................................................... 41

The Indian Debt Market .................................................................................................................... 41

Outlook of the Indian Debt Market .................................................................................................. 41

Credit Ratings .................................................................................................................................... 42

Currency Exchange ............................................................................................................................ 42

HDFC Bank ......................................................................................................................................... 44

Yes Bank ............................................................................................................................................ 45


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Sector Outlook .................................................................................................................................. 46


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Banking The Banking sector is one of the most important sectors of the Indian economy. As such, it is highly regulated with the responsibility being in the hands of The Reserve Bank of India (RBI). Given the ability of the banking sector to affect the economy, this sector is one of the most regulated sectors in India. A strong and viable banking industry is extremely necessary for economic progress while a weak banking sector is a cause for problems in the economy. Banking is used for policy transmissions and for sustaining economic growth.

What is a bank? A bank is a financial institution which acts as an intermediary between borrowers and lenders. It takes in deposits from lenders and gives it to borrowers. In the process, it earns the difference between interest received from borrowers and interest paid to lenders.

How does a bank function? A bank pools in money from a large number of lenders (known as depositors). In return, it gives them a return on investment which is commonly known as interest. The money which the bank receives from depositors is given to borrowers, who pay interest on the amount borrowed. The difference in the interest received and the interest paid is the income for the bank, which the bank uses to pay for its expenses and any amount left is profit for the bank. Banks take in money from a large number of depositors and lend money to a large number of borrowers. This creates a flow of money in the banking system while also spreading the risks associated with lending to a large number of borrowers. Banks charge money for acting as intermediary in managing this flow of money and any risks they are undertaking by the giving of loans.

Financial analysis of a bank Before the financial analysis of a bank we need to be clear about the various elements of a bank’s balance sheet and income statement.

Balance sheet A bank’s balance sheet summarizes its assets and liabilities at any point of time. These terms are explained below with respect to a bank's balance sheet. Capital and Liabilities: These include the Bank’s net worth and the obligations of the bank to external entities. These include – (a) Share Capital and Reserves and Surplus: Share Capital is the initial money put in by investors or raised through an IPO, FPO or a rights issue. Reserves and Surplus includes net profit transferred to the balance sheet. (b) Deposits: There are four types of deposit accounts, these are –


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i) Savings Account: This is the most basic account available with a bank. This is operated by individuals who use it to deposit their money and operate the account with a cheque book. There is generally a minimum balance requirement for these accounts with this amount differing based on the location of the branch in which the account is located. The interest rate on these accounts was fixed by RBI at 4% per annum, but was de-regulated in 2011 allowing banks to give higher rates of interest. Currently banks like Yes Bank, Indusind Bank and Kotak Mahindra Bank (to name a few) are paying higher interest rates than the standard 4%. Interest on a savings account is calculated on a daily basis. ii) Current Account: This is an account mainly used by businesses and has very frequent deposits and withdrawals. This account has no minimum balance and there is no limit on the number of withdrawals in a current account. Interest is also not paid on a current account. These accounts also allow for the facility of overdraft for businesses. This account is usually operated by means of cheque books. Savings account and current account are examples of demand deposit accounts. iii) Recurring deposit Account: This type of account is mostly used by individuals who want the benefits of a fixed deposit but do not have a lump sum to deposit at one time. Hence they deposit a relatively small amount every month. The interest paid on recurring deposits is paid on the amount that has been already deposited. The interest paid on these accounts is usually equal to the interest paid on fixed deposits. iv) Fixed deposit Account: This type of account reflects deposits that are made by depositing a lump sum amount for a fixed tenure. The interest rates offered are the highest for this type of account. This type of deposit is the most stable source of income for the bank. Recurring deposit account and fixed deposit account are examples of term deposit accounts. (c) Borrowings: In order to meet their obligations, banks also raise money through wholesale funding. This includes funds borrowed from RBI or raised through the capital debt market via instruments such as debentures, bonds, certificate of deposits, commercial papers and short term borrowings from other banks and financial institutions. The cost of debt raised by banks depends upon the credit rating of the bank. The cost of wholesale funding is generally high but banks raise money through this method when they need funds for expansion but are unable to get them through deposits which are a cheaper option. Banks may also raise funds from overseas debt market to take advantage of low interest rates. Banks like HDFC Bank, Bank of India and SBI have recently raised debt through this method. (d) Other Liabilities and provisions: This includes bills payable, interest accrued, contingent provisions against standard assets and proposed dividend (including tax on dividend). Assets: An asset is a resource that leads to a future inflow of economic benefits. For a bank, assets include - (a) Fixed Assets: These include office buildings (if owned), furniture, computers and other items such as ATM machines. However, it constitutes a very small part of assets for a bank because most of its branches run on rent/lease. (b) Loans and advances: Loan refers to money which is lent to a borrower by a bank. Banks charge interest on loans and this is their primary source of income. An advance is money given to you now


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but to be taken out of money you would make in the future. Loans can be categorized into short term/long term, secured/unsecured loans. These include mortgages, credit card loans, overdrafts etc. (c) Government Bonds and other approved securities: It is a statutory requirement that every bank in India has to maintain a certain percentage of its deposits in the form of gold or approved securities with the RBI. This requirement is known as statutory liquidity ratio (SLR). Currently the SLR rate is 23%. The sanctioned upper limit for SLR is 40 %. (d) Cash and cash equivalents and balances with RBI: This includes the cash that banks are required to keep with RBI. This is known as the cash reserve ratio (CRR). Currently this is 4.00 %. Banks do not earn any interest on this amount. (e) Other assets: This includes investment made by banks and can be a source of income for the bank.

Income statement This is the bank’s Profit and Loss account, the various elements of which are given as: (a) Interest income: The primary income of the bank comes from this category. This includes the interest earned on loans and advances. This also includes interest on loans given to other financial institutions and banks and deposits with the RBI, and any interest earned on bonds which the bank owns. (b) Non Interest income: This is income primarily derived from fees which the bank charges. This includes deposit and transaction fees, annual fees (for services like credit cards), brokerage fees etc. Non Interest is a less volatile form of income since it does not depend as much on interest rate changes as interest income. A higher proportion leads to more stable earnings. (c) Interest expense: This represents the interest paid by a bank on deposits, wholesale borrowings, and loans taken from RBI or from other financial institutions. (d) Operating expense: This includes expenses which are incurred in running the day to day operations of the bank, namely costs like salaries, rent, depreciation, advertising etc. (e) Provisions: Since not each and every loan will be paid back in full, banks have to make provisions for these loans. Banks thus set aside a percentage of their income to account for these possible losses. This ensures that the bank remains solvent and there are no sudden unexpected huge losses to the bank. The amount set aside for provisioning depends on the size of a bank's assets and the risk associated with each type of asset. The norms for provisioning are decided by the RBI.


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Understanding the Business model of a bank As explained above, a bank functions by giving loans to individuals, corporates and other entities and charging interest on the amount lent. This amount is raised by taking deposits from individuals, corporates and other entities along with loans from other banks and financial institutions and RBI. It pays interest on this amount. Besides this, other sources of income for banks include income from treasury operations, advisory, trade finance and retail fees. However, for most banks these sources contribute only a small but growing portion of their income as compared to interest income. Majority of the profits for the bank are associated with the difference between interest received and the interest paid. Net Interest margin (NIM): This is a measure of profitability of a bank. This is the difference between the interest income received and the interest paid out of relative assets. A higher NIM means that the bank is generating higher income from its assets.

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CASA ratio: As discussed earlier, there are many different types of deposit accounts available in a bank. These include savings account, current account, term deposits (recurring and fixed deposit). Out of these four accounts, the highest interest is paid on term deposits while the lowest interest is paid on current and savings account. While most banks don’t pay any interest on the current account, they pay a low rate of interest on savings accounts. Hence, higher the CASA ratio, higher the amount of cheap funds available to the bank, which means a higher operating efficiency due to higher Net Interest Margin (NIM). Let us now look at the balance sheet and P&L account of a bank in order to understand its operations in a better manner. The following table shows the various assets and liabilities listed under the balance sheet of a bank:

(Figures in Mn. INR)

Particulars Average balance

Assets:

Cash and balances with RBI 635000

Loans Given: I

Housing Mortgage 1800000

Consumer loans (includes auto, education and personal loans) 600000

Credit card loans 16000

Loans given to enterprises and corporate 8000000

Investments in Government bonds :II 4340000

Investments in other interest earning assets: III 347000

Total Earning Assets (I+II+III) 15103000

Fixed Assets 120000

Total Assets 15858000

Liabilities:


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Share Capital 20000

Reserves and Surplus 1400000

Interest Bearing liabilities (Deposits): I

Savings account deposits 3500000

Current account deposits 2100000

Recurring account deposits 800000

Fixed Deposits 5300000

Borrowings: II

From RBI 80000

From other financial institutions 1500000

Total interest Bearing liabilities: I+II 13280000

Non interest bearing liabilities 1158000

Total Liabilities 15858000

Since most of the income and expense of a bank is in the form of interest and the interest rates for each type of asset or liability is known, a bank's balance sheet is very important and to a fairly large extent determines its income statement. This is unlike other businesses where there is no direct relation between balance sheet and the income statement and income and expenditure cannot be estimated from balance sheet. Now let us look at how the balance sheet may be used to estimate the income statement of a bank:


Particulars Average balance

Rate of Interest Interest

Income / (Expense)

Assets:

Cash and balances with RBI 635000 0.00% 0

Loans Given: I

Housing Mortgage 1800000 11.50% 2,07,000

Consumer loans (includes auto, education and personal loans)

600000 12.30% 73,800

Credit card loans 16000 20.00% 3,200

Loans given to enterprises and corporates 8000000 14.00% 11,20,000

Investments in Government bonds :II 4340000 8.00% 3,47,200

Investments in other interest earning assets: III

347000 9.00% 31,230

Total Earning Assets (I+II+III) 15103000 11.80% 17,82,430

Fixed Assets 120000 0.00% 0

Total Assets 15858000 17,82,430

Liabilities:

Share Capital 20000 0.00% -

Reserves and Surplus 1400000 0.00% -

Interest Bearing liabilities (Deposits): I


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Savings account deposits 3500000 4.00% (1,40,000)

Current account deposits 2100000 0.00% -

Recurring account deposits 800000 8.50% (68,000)

Fixed Deposits 5300000 9.00% (4,77,000)

Borrowings: II

From RBI 80000 7.25% (5,800)

From other financial institutions 1500000 8.50% (1,27,500)

Total interest Bearing liabilities: I+II 13280000 6.16% (8,18,300)

Non interest bearing liabilities 1158000 0.00% -

Total Liabilities 15858000 (8,18,300)

Now we have the interest income and expense of bank from its balance sheet and it can be used to construct its income statement as given. The values for interest income and expenditure have been taken directly from the calculations done in the balance sheet.


Particulars Current

Interest Earned 17,82,430

Interest Expenditure 8,18,300

Net Interest income 9,64,130

Other income 1,58,000

Total Income 11,22,130

Operating expense 3,00,000

Provisions for bad debts 1,00,000

Total Expenditure 4,00,000

Earnings before Tax 7,22,130

Taxes 2,38,303

Earnings after Tax 4,83,827

It is clearly visible from the above tables that most of the income of a bank comes from interest on its assets and hence balance sheet is the most important accounting statement when evaluating a bank. Hence, the size of bank depends upon the size of balance sheet.


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The Banking Sector in India The banking sector in India is controlled by the Reserve Bank of India (RBI).

Reserve Bank of India The Reserve Bank of India (RBI), which commenced operations on April 1, 1935, is at the centre of India’s financial system. Hence it is called the Central Bank. It has a fundamental commitment of maintaining the nation’s monetary and financial stability. It started as a private shareholders’ bank but was nationalized in 1949, under the Reserve Bank (Transfer of Public Ownership) Act, 1948. RBI is banker to the Central Government, State Governments and Banks. Key functions of RBI include: Monetary policy formulation Supervision of Banking companies, Non-banking Finance companies and Financial Sector,

Primary Dealers and Credit Information Bureaus Regulation of money market, government securities market, foreign exchange market and

derivatives linked to these markets Management of foreign currency reserves of the country and its current and capital account Issue and management of currency Oversight of payment and settlement systems Development of banking sector Research and statistics While RBI performs these functions, the actual banking needs of individuals, companies and other establishments are majorly met by banking institutions (called commercial banks) and nonbanking finance companies that are regulated by RBI. RBI exercises its supervisory powers over banks under the Banking Companies Act, 1949, which later became Banking Regulation Act, 1949.

Major Banking Sector Reforms since 1991

The economic reforms initiated in 1991 also embraced the banking system. Following are the major reforms aimed at improving efficiency, productivity and profitability of banks:

New banks licensed in private sector to inject competition in the system - 10 in 1993 and 2 more in 2003. Another lot of new banks will be licensed in the next few months

Aggregate foreign investment (FDI, FII and NRI) up to 74% allowed in private sector banks Listing of PSBs on stock exchanges and allowing them to access capital markets for augmenting

their equity, subject to maintaining Government shareholding at a minimum of 51%. Private shareholders represented on the Board of PSBs

Progressive reduction in statutory pre-emption (SLR and CRR) to improve the resource base of banks so as to expand credit available to private sector. SLR currently at 23% (38.5% in 1991) and CRR at 4% (15% in 1991)

Adoption of international best practices in banking regulation. Introduction of prudential norms on capital adequacy, IRAC (income recognition, asset classification, provisioning), exposure norms etc.

Phased liberalisation of branch licensing. Banks can now open branches in Tier 2 to Tier 6 centres without prior approval from the Reserve Bank

Deregulation of a complex structure of deposit and lending interest rates to strengthen competitive impulses, improve allocative efficiency and strengthen the transmission of monetary policy

Base rate (floor rate for lending) introduced (July 2010). Prescription of an interest rate floor on savings deposit rate withdrawn (October 2011)

Functional autonomy to PSBs


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Use of information technology to improve the efficiency and productivity, enhance the payment and settlement systems and deepen financial inclusion

Improvements in the risk management culture of banks

Next are the various types of banking and nonbanking financial institutions which function under

the guidelines laid by RBI.

The general overview of India's banking sector can be given as:

RBI

Commercial Banks

Nationalized Banks

SBI and Associate

Banks

Private Sector Banks

Old Private Sector Banks

New Private Sector Banks

Regional Rural Banks

Foreign Banks

Specialized Banks

Land Mortgage

Rural Credit

Industrial Development

Housing Finance

EXIM Bank

NABARD

SIDBI

Institutional Banks

IFCI

SFCs

IRBI

Non Banking Financial

Institutions

Asset Finance

companies

Investment companies

Loan companies

Infrastructure Finance

companies

Systematically important

core investment companies

Co-operative Banks

Primary Credit

societies

State Co-operative

banks

Central co-operative

banks


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Commercial banks A commercial bank may be defined as a financial institution that provides services, such as accepting

deposits, giving business loans and auto loans, mortgage lending, and basic investment products like

savings accounts and certificates of deposit. In addition to giving short-term loans, commercial banks

also give medium-term and long-term loans to business enterprises.

Commercial banks are of the following five types: Nationalized banks SBI and associates Regional rural banks Private sector banks Foreign banks

The distribution of deposits, credit given and national coverage is shown below:

Source: RBI, Quarterly Statistics on Deposits and Credit of Scheduled Commercial Banks: December 2012


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Public sector banks (Nationalized, SBI and associates) These are banks where majority stake (minimum 51%) is held by the Government of India. IDBI Bank, State Bank of India and its five associates and 19 nationalized banks fall under this segment. These banks are listed in the stock market. State Bank of India and its associates are - State Bank of India, State Bank of Bikaner and Jaipur, State Bank of Hyderabad, State Bank of Mysore, State Bank of Patiala and State Bank of Travancore. Together, they have the largest number of bank branches in India with a network of almost 20,000 branches and over 35,000 ATMs. They have the largest share of public deposits with 22.5% of deposits and 22.6% of credit. This group is also the country’s biggest in terms of asset size - about Rs. 21.8 lakh crores worth of assets wherein SBI’s assets are worth Rs. 16.2 lakh crores. Other Nationalized Banks are - Allahabad Bank, Andhra Bank, Bank of Baroda, Bank of India, Bank of Maharashtra, Canara Bank, Central Bank of India, Corporation Bank, Dena Bank, Indian Bank, Indian Overseas Bank, Oriental Bank of Commerce, Punjab & Sind Bank, Punjab National Bank, Syndicate Bank, UCO Bank, Union Bank of India, United Bank of India and Vijaya Bank. Many of these banks were private banks earlier but were nationalized by the government in pursuance with its socialist objectives. The primary objective of nationalized banks is to meet the social requirements of providing financial inclusion and services to the weaker sections of the society. Private Sector Banks These are banks for which majority of share capital is held by private individuals. These banks can be classified into two categories: Old Private Sector Banks The private banks, which existed and were not nationalized at the time of bank nationalization that took place during 1969 and 1980, are known to be the old private sector banks. These were not nationalized, because of their small size and regional focus. Some of the main old private sector banks are Catholic Syrian Bank, Federal Bank, ING Vysya Bank, Dhanlaxmi Bank and Karnataka Bank. New Private Sector Banks These are the Private Banks which were set up post liberalization, with the introduction of reforms in the banking sector. The entry of new private sector banks was permitted after the Banking Regulation Act was amended. Banking licenses were given in two phases. In the first phase, in 1994 banks like HDFC and ICICI were given licenses. In the next round of bank licenses, in 2004 banks like Yes Bank were set up. The prominent new private sector banks are HDFC Bank, ICICI Bank, Axis Bank, Yes Bank and Kotak Mahindra Bank. Foreign Banks Foreign banks have their registered and head offices in a foreign country but operate their branches in India. The RBI permits these banks to operate either through branches; or through wholly-owned subsidiaries. The primary activity of most foreign banks in India has been in the corporate segment. In addition to the entry of the new private banks in the mid-90s, the increased presence of foreign banks in India has also contributed to boosting competition in the banking sector. As of 31st March 2013, there were 43 Foreign Banks who had branches in India; 46 banks had representative offices in India. There were a total of 331 branches of foreign banks in India with Standard Chartered Bank (101) having the highest number of branches.


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Bank Country Of

origin Number of Branches

Standard Chartered Bank UK 101

HSBC Limited Hong Kong 50

Citibank N.A. USA 42

The Royal Bank of Scotland N.V. Netherlands 31

Deutsche Bank Germany 18

The other major foreign banks are DBS Bank, Barclays and BNP Paribas. As per new Government regulations, foreign banks with more than 20 branches will have to conform to priority sector lending norms of providing 40% credit to the priority sector which includes agriculture, micro and small enterprises, education, housing and export credit. Till recently, the 40% priority sector loan norm was applicable to local banks; for foreign banks it was 32%. Even within this, 12% could have been given as export credit. Now, the credit option has also been removed and only export credit to the priority sector will be treated as priority sector credit. The new norms come into effect from August, 2018.

Specialized Banks There are some banks, which cater to the requirements and provide overall support for setting up business in specific areas of activity. EXIM Bank, SIDBI and NABARD are examples of such banks. They engage themselves in some specific area or activity and thus, are called specialized banks.

Institutional Banks These are banks which were set up by the Government with the purpose of catering to the needs of the Industry. These banks provide low cost funds to borrowers. Examples include institutions like IFCI and the State Financial Corporations (SFCs).

NBFCs Non-Banking Financial institutions or NBFCs are those financial institutions which provide financial services without meeting the general definition of bank. These institutions do not hold a banking license. Despite this, they provide a wide range of financial services and are regulated by the RBI. NBFCs offer most of the services offered by the conventional banking system including loans and credit facilities, education funding, retirement plans, wealth management and trading in money markets. NBFCs can accept public deposits but they cannot demand deposits. NBFCs do not form a part of the payment and settlement system and hence cannot issue cheques drawn on self. NBFCs are discussed in more detail later in the report.

Co-operative banks A co-operative bank is a financial entity which belongs to its members, who are at the same time the owners and the customers of their bank. Co-operative banks are often created by persons belonging to the same local or professional community or sharing a common interest. Co-operative banks generally provide their members with a wide range of banking services (loans, deposits, banking accounts, etc.). Co-operative banks are formed under the Co-operative societies act. Co-operative banks are run on not for profit basis.


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Basel - Capital Accord Norms Basel, a city in Switzerland is the headquarters of Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. Every two months, BIS hosts a meeting of the governor and senior officials of central banks of member countries. Currently there are 27 member nations in the committee which also includes India. Basel guidelines refer to broad supervisory standards formulated by this group of central banks - called the Basel Committee on Banking Supervision (BCBS). The set of agreements by the BCBS, which mainly focuses on risks to banks and the financial system, is called the Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system.

Basel I Norms In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel I. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets with different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. The G-10 countries agreed to apply the common minimum capital standards to their banking industries by end of 1992. India adopted Basel I guidelines in 1999.

Basel II Norms In June 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters, which the committee calls it as pillars: 1. Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets. 2. Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risk that a bank faces, viz. credit, market and operational risk. 3. Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc. to the central bank.

Basel III Norms In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

Capital Adequacy Ratio ( R) = Tier 1 Capital + Tier 2 Capital

Risk weighted assets


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Tier 1 Capital: Tier I capital is equal to sum of equity capital and disclosed reserves. Tier 2 Capital: Tier 2 capital is secondary bank capital that includes items such as undisclosed reserves, loss reserves, term debts etc. Significance of Tier 1 and Tier 2 Capital: Tier 1 capital absorbs losses without a bank being required to cease trading and Tier 2 capital absorbs losses if the bank winds-up its business. Thus, Capital adequacy ratio acts as a cushion in the event of loss or default, and protects the depositors.

Major Differences between BASEL 2 and BASEL 3 Norms

Basel II Requirements Basel III*

8% Minimum Ratio of Total Capital to Risk Weighted Assets 11.5%

2% Minimum Ratio of Common Equity to Risk Weighted Assets 4.5% to 7%

4% Tier 1 Capital to Risk Weighted Assets 6%

None Capital Conservation Buffer Capital to Risk Weighted Assets 2.5%

None Leverage Ratio 3%

None Countercyclical Buffer 0% to 2.5%

None Minimum Liquidity Coverage Ratio 100%

None Minimum Net Stable Funding Ratio 100%

* Basel III requirements will be phased-in progressively till 2018 Changes proposed in BASEL III over BASEL II norms: (a) Better Capital Quality: One of the key elements of Basel III is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress. (b) Capital Conservation Buffer: Another key feature of Basel III is that now banks will be required to hold a capital conservation buffer. The buffer will be an additional 2.5% Common Equity Tier 1 capital requirement. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress. (c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5% and will extend the capital conservation buffer previously described. (d) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 11.5% when combined with the capital conservation buffer.


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(e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of Tier 1 capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018. (f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in a phased manner starting 2015 and 2018, respectively. The goal of the liquidity coverage ratio (LCR) is to ensure that banks have adequate, high quality liquid assets to survive a short-term stress scenario. The definition of the standard is as follows:

. stock of high-quality liquid assets . ≥ 100%

total net cash outflows over the next 30 calendar days The goal of the net stable funding ratio (NSFR) is to protect banks over a longer time horizon. The net stable funding ratio promotes a sustainable maturity structure for assets and liabilities by creating incentives for banks to use more stable funding sources.

available amount of stable funding ≥ 100%

required amount of stable funding Available stable funding sources (ASF) include Capital, preferred stock with a maturity of more than one year, liabilities with an effective maturity of more than one year, non-maturity deposits and time deposits that would be expected to stay at the bank in periods of extended stress, the proportion of wholesale funds that would be expected to stay at the bank in periods of extended stress. The building blocks of Basel III are by and large higher and better quality capital; an internationally harmonised leverage ratio to constrain excessive risk taking; capital buffers which would be built up in good times so that they can be drawn down in times of stress; minimum global liquidity standards; and stronger standards for supervision, public disclosure and risk management.

Are Indian banks adequately prepared for migration to Basel III regime? With Commercial banks having already adopted standardized approaches under Basel II, by and large barring some, Indian Private Banks will be in a comfortable position to adjust to the new capital rules both in terms of quantum and quality. However, Public Sector banks might find themselves on a slippery ground, doubt is reinforced with the data of last quarter which has shown a significant increase in NPA’s in some of the Public Sector Banks. According to RBI estimates, Indian Banks will need an additional capital of Rs 500,000 crores to meet the Basel 3 norms. Out of this, the total equity capital would be Rs 175,000 crores while the rest would be non-equity capital. Government Banks would require Rs 90,000 crores of infusion from the Government in the form of equity if it has to retain its present ownership of Public Sector Banks. Basel III requires higher and better quality capital and since, the cost of equity capital is high. The average Return on Equity (RoE) of the Indian banking system for the last three years has been approximately 14%. Implementation of Basel III is expected to result in a decline in Indian banks' RoE in the short-term.


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Classification of Assets 1. Standard Assets: Assets which do not disclose any problem and do not carry more than the normal risk attached to the business. Such assets are not non-performing assets. 2. Non-performing Assets (NPA) The definition of NPA as given by RBI is “an asset, which ceases to generate income for a bank”. Hence it is a loan, the payment of which is unlikely to be received. Any loan is recognized as NPA only when the receipt of payment for it 'remains due' for a specified period of time. A NPA is a loan or advance where: a. Interest or instalment remains overdue for over 90 days in case of a term loan. b. The account remains 'out of order' in case of overdraft/cash credit facility. A current account is

treated as 'out of order' if outstanding balance is in excess of sanctioned limits or when it is within sanctioned limits and there are no credits for 90 days or are not enough to cover the charges for interest debited.

c. The bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted.

d. Agricultural loans are classified as NPAs, if, for short duration crops, instalment of principal or interest remains overdue for two crop seasons; for long duration crops, this period is taken to be one crop season.

e. In case of derivative and liquidity transactions, if the dues for these remain unpaid for 90 days. According to norms, any income received from NPAs is recorded only when it is received. Banks are required to classify non-performing assets further into the following three categories based on the period for which the asset has remained non-performing and the realisability of the dues: a. Sub-standard assets: A sub-standard asset would be one, which has remained NPA for a period less than or equal to 12 months. Such an asset will have well defined credit weaknesses that jeopardise the liquidation of the debt and is characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.

b. Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as sub-standard, with the added characteristic that the weaknesses make collection or liquidation in full - on the basis of currently known facts, conditions and values - highly questionable and improbable. c. Loss assets: An asset would be considered as a loss asset if loss has been identified by the bank or by internal / external auditors or by RBI inspection, but the amount has not been written off, wholly or in part. Such assets are considered uncollectible and of so little value that their continuance as bankable assets is not warranted, even though there may be some salvage or recovery value.


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Provisioning of Assets Provisioning Coverage Ratio (PCR) - 70% is essentially the ratio of provisioning to gross non-performing assets and indicates the extent of funds a bank has kept aside to cover loan losses so that it does not find itself out of cash when that asset is actually written-off. According to RBI Norms, Sub-standard assets require a provision of 15%, doubtful assets, depending on their age, carry a provision of 25%-100%, while banks are required to make 100% provision for loss assets.

Menace of Rising NPAs The gross NPA ratio (the ratio of loans accounts which have defaulted on interest or principle

beyond 90 days to the total bank loans) of Indian banks as on March 2013, was at 3.23 % and the net

NPA ratio works out to 1.56 %.

Cumulatively, the standard restructured loans and NPAs of the banking system, as of March 2013,

account for 9.25% as against 7.6 % in March 2012 of the total advances. The share of public sector

bank is higher which has raised asset quality concerns. This proportion is rising at a faster pace as the

system’s loan growth is moderating, but problem loans continue to be on the rise.

Why is it Important – It hampers almost all forms of operations, some of which are:

Profitability: Declining net interest margins (NIMs), rising credit costs, money getting blocked

due to a weak macro-economic environment, large rupee depreciation, vulnerability of a large

number of infrastructure projects and the rising yields will have significant bearing on the

earnings and asset quality of the banks. The profitability of bank decreases not only by the

amount of NPAs but NPAs lead to opportunity cost as well equivalent to profit from this

projected invested in some other return earning project/asset. So NPAs not only affect current

profit but also future stream of profit, which may lead to loss of some long-term beneficial

opportunity. Another impact of reduction in profitability is low RoI (return on investment), which

adversely affects the current earning of a bank.

Liquidity: Money gets blocked; decreased profit leads to lack of enough cash at hand which

leads to borrowing money for shortest period of time which leads to an additional cost to the

company. Difficulty in operating the functions of a bank due to lack of money is another impact

of NPAs.

Involvement of management: Time and efforts of management is another indirect cost which

bank has to bear due to NPAs. Time and efforts of management in handling and managing NPAs

would have diverted to some fruitful activities, which would have given good returns. Nowadays

banks have special employees to deal and handle NPAs, which is an additional cost to the bank.

Public Sentiment: There is a definite loss of faith associated with the NPA numbers rising and

this cannot be compensated by larger profits. See SBI & its NPA Story for more information:

State Bank of India (SBI), the country's largest lender, topped the list of banks with the highest gross

NPAs (in percentage terms) during the quarter among BSE-Bankex constituents (13 Banks). The gross

NPA to advances for SBI, which has seen a steady increase in bad loans, surged to 5.56% in April-

June, the highest since the quarter ending March 2011. Gross NPAs have increased 81 basis points

(0.81%) for SBI during the quarter. Private sector banks have not seen much deterioration in asset

quality and have managed to maintain their NPAs at low levels.


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Corporate Debt Restructuring CDR is a framework to ensure timely and transparent mechanism for restructuring the corporate

debts of viable entities facing problems, outside the purview of BIFR, DRT and other legal

proceedings, for the benefit of all concerned. It is a pre-emptive effort by debtors as well as lenders

to steer clear the corporates from moving into a state from where recovery becomes almost an

elusive distant dream.

According to the new rules, promoter's contribution has been raised to 20% (from 15%) of the

sacrifice made by lenders or 2% of the restructured loan, whichever is higher. Besides, the money

has to be paid upfront. Banks will have to increase provisioning on restructured assets to 3.50% for

March 2014, and subsequently to 4.25% and 5% for March 2015 and March 2016, respectively. At

present, banks set aside 2.75% of their income as provisions. To discourage banks from liberally

restructuring loans, RBI has said that from April 2015 an account will have to be classified as sub-

standard as soon as it is restructured. However, for new projects RBI has relaxed the condition under

which a loan has to be categorised as a restructured asset. Currently, banks have to restructure

loans if the date of commencement of commercial operation is delayed by six months. The new

regulations have extended this to one year. Till then, the loan will be treated as a standard asset.

Debt restructuring is a tool to offer aid to borrowers in distress, owing to circumstances beyond the

borrower’s control such as a general downturn in the economy or a sector. It might also be

warranted by legal or other issues that cause delays, particularly in cases of project implementation.

As of June, lenders had approved CDR packages for 415 companies, with aggregate debt of Rs

2,50,279 crore.


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Financial Inclusion Financial Inclusion is the process of ensuring access to appropriate financial products and services needed by all sections of the society in general and vulnerable groups such as weaker sections and low income groups in particular at an affordable cost in a fair and transparent manner by mainstream institutional players. Key Regulatory Points

Domestic Scheduled Commercial Banks have been permitted to freely open branches in Tier 2 to Tier 6 centres. Banks have been mandated to open 25 % of all new branches in unbanked rural centres. It will end up giving an extreme impetus to the industry as whole, its reach and scope will strengthen its image and provide solidarity in bad times. Moreover, it will find many new applications for the banks apart from its regular day to day functionalities. However, it will pinch its bottom line in the short term and if banks are unable to achieve operational efficiency it will become a huge burden for the industry.

Priority Sector Lending Banks were assigned a special role in the economic development of the country, besides ensuring the growth of the financial sector. The banking regulator, the Reserve Bank of India, has hence prescribed that a portion of bank lending should be for developmental activities, which it calls the priority sector. For local banks and foreign banks with more than 20 branches, both the public and private sectors have to lend 40 % of their Adjusted Net Bank Credit to the priority sector as defined by RBI, foreign banks have to lend 32% of their ANBC to the priority sector, with 18% of the loans should be given to agriculture and 10% to the weaker sections of the society. Agriculture (Direct and Indirect finance): Direct finance to agriculture shall include short,

medium and long term loans given for agriculture and allied activities. Small Scale Industries (Direct and Indirect Finance): All loans given to SSI units which are

engaged in manufacture, processing or preservation of goods. Small Business / Service Enterprises: It shall include small business, retail trade, professional &

self-employed persons, small road & water transport operators and other service enterprises Micro Credit: Provision of credit and other financial services and products of very small amounts

not exceeding Rs. 50,000 per borrower to the poor in rural, semi-urban and urban areas. Education loans: Education loans include loans and advances granted to only individuals for

educational purposes up to Rs. 10 lakhs for studies in India and Rs. 20 lakhs for studies abroad. Housing loans: Loans to individuals up to Rs. 25 lakhs in metropolitan centres with population

above ten lakhs and Rs. 15 lakhs in other centres for purchase/construction of a dwelling unit per family excluding loans sanctioned to bank’s own employees and loans given for repairs to the damaged houses of individuals up to Rs.2 lakhs in rural and semi-urban areas and up to Rs.5 lakhs in urban areas.


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Macroeconomic Factors affecting Banks Indian banks are currently under lot of pressure from a large number of macroeconomic factors which are threatening to derail the growth of Indian Banks. These include

Current Account Deficit Current account deficit occurs when a country's total imports of goods, services and transfers is greater than the country's total export of goods, services and transfers. This situation makes a country a net debtor to the rest of the world. India's current account deficit (CAD) hit a record high 4.8 percent of gross domestic product (GDP) in FY13, fuelled by rising imports of oil and gold. The current account gap for the entire 2012-13 financial year was $87.8 billion, compared with $78.2 billion a year earlier. Ill-effects of rising CAD includes depreciating rupee, reducing foreign investors’ confidence, dearth of liquidity, Investment downgrades, lesser availability of capital for domestic players etc. The main reasons put forth by the Finance ministry for the widening of the CAD are lower exports and higher degree of imports of oil, coal and yellow metal gold. As otherwise, high imports of capital goods and equipment reflect the growth in an economy that though is not the case with the Indian economy. In order to keep the balance of payment intact, high CAD figures then have to be financed which thus increases the reliance on foreign funds or capital account. The Indian economy was safeguarded and in fact was at the mercy of the foreign capital which came in through FDI and FII. But global economic outlook which spares none of the economies has cast its effect strongly on India. The bond buying programme or quantitative easing (QE) measures that were undertaken by the US Federal Reserve in the wake of the sub-prime crisis of 2008-2009 is likely to be wind down as the economy has shown signs of recovery. What this means is that easy liquidity through QE measures would ensure that foreign institutional investors gradually pull off from the Indian markets, raising fresh worries for financing the CAD. High net fund inflows and increase in export activities could save the crisis-ridden Indian economy.

Poor Governance Government of India has largely been unable to boost the investment sentiments for domestic as well as foreign investors. With scams becoming every day news and the magnitude breaking all ceilings, India finds itself in a very precarious situation where a robust structural change is required to make ends meet, however what has been proposed falls largely out of place as they lack the complete majority to ensure their clearances. Also, scams and out of place regulations have created a lot of stress on the banks’ assets as more often than not they end up turning into NPAs, moreover there is an added pressure of credit downgrades across sectors, none of which is uncorrelated to our Banking Industry. There have been many fiscal incentive initiatives which impinges the country’s exchequer quite hard like MGNREGA, Food Security Bill etc. which diverts the money from the market to fund these activities and thus reducing the overall supply of money and subsequently increasing the cost of capital in the market.

Fiscal Deficit Every year, the Government puts out a plan for its income and expenditure for the coming year. This is known as the annual Union Budget. A budget is said to have a fiscal deficit when the Government's expenditure exceeds its income. When faced with deficits governments have one of the two options: To raise money through taxes in order to bridge the deficit To borrow more money in order to meet its spending requirements Economic effects of fiscal deficit The size of fiscal deficit has substantial effect on the economy of the India. While small amounts of fiscal deficits generally have a positive effect on the economy, large amounts are detrimental for the


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health of the economy. A large fiscal deficit is a hindrance to economic growth. Governments generally borrow more money thereby leading to a shortage of funds for the industry and a rise in interest rates. This hurts industrial growth in the country. Governments can also resort to printing money to pay off their debts and this could also increase inflation. The Indian Situation India’s fiscal deficit has remained high for the past six years and has exceeded budget estimates. From a low of 3.17% of the GDP in 2007-08 it has climbed to 4.89 % in 2012-13. Coupled with a high inflation, this has adversely affected the economic growth in the country. India’s fiscal deficit during the April’13-July’13 period was Rs. 3.41 trillion ($50.91 billion), or 62.8% of the full-year target (4.8% of GDP). Net tax receipts for the first four months of the current fiscal year to March 2014 touched Rs1.45 trillion while total expenditure was Rs5.21 trillion. The high interest rate along with lack of investments in the productive sectors of the economy has brought economic growth in the country to a 10 year low. The most worrying fact about this situation is that most of the deficit is due to high government spending on payment of interest on its debts, which effectively means that the deficit is not leading to any productive activity. Another downside associated with a high deficit is that rating agencies have threatened to downgrade India’s sovereign credit ratings. This would mean India losing its investment grade status (it has the lowest investment grading, BBB-). This would mean flight of foreign capital from India and pushing borrowing costs even higher which is not good for economic growth.

Inflation Effect of Inflation on Banking of India

Inflation figures released by the government based on the Wholesale Price Index – WPI climbed to 5.79% for July 2013 as compared to the same month in 2012. The globally more preferred Consumer Price Index (CPI) - that is calculated by looking at prices at retail markets, from where consumers buy goods – is no longer the main marker of inflation (what is called as headline inflation) by the government was considerably high at 9.87%. The rate of food inflation in particular has been high for quite a long period, with latest figures in July (WPI) showing a near 12% increase in prices since a year ago. Vegetable prices in particular have shown a whopping 47% increase over the year, so much so, that news reports point out that even middle class families have cut down on their vegetable expenses, and are narrowing down their preferred diet. With depreciation of rupee, it will increase further. Inflation is one the major factors which affects Indian Economy on a very vast scale and scope. Higher inflation has led to a depreciating currency vis-a-vis its counterpart. Inflation has a profound effect on the sentiments and savings-investment pattern of households of the country, a higher inflation leaves less with people to save or invest, moreover with high inflation people demand more of their investments and savings pushing the cost of deposit in the upward direction. Also, they become more risk averse and has tendency to rely more on physical assets rather than on financial assets. For example, there is huge demand for gold in our country which has made our Balance of Payments (BoP) go out of sync and has led to huge currency depreciations and it also makes the money unavailable for other productive purposes. High Inflation is thus a major worry for RBI. So, RBI frames its monetary policies in a manner which has a focus of having a balancing act between growth and inflation and the same has a direct impact on the funding rates available to banks and subsequently the economy.


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GAAR GAAR stands for General Anti Avoidance Rules. GAAR provides the tax authorities the power to deny

tax benefits to any entity if it has carried out a transaction with the sole intention of tax avoidance.

GAAR also proposes to tax investments coming in through the Mauritius route into India. Mauritius

is the largest source of foreign investments into India, because of a double taxation treaty between

India and Mauritius. Another problem with GAAR is that the onus lies on the assessee to prove that

there was no tax avoidance related to a transaction.

Implications for India

The proposal to tax investments from Mauritius has scared off the foreign investors who invest into

India mainly through the Mauritius route due to a double taxation treaty. Moreover investors from

other countries also fear being unjustly targeted by what they see is an unjust tax law. Hence if

GAAR is implemented, there is expected to be a decrease in foreign investment in the country

leading to a slowdown in the economy which would adversely affect the banking sector.

However, implementation of GAAR has been postponed to 1st April, 2016.

Money Supply M1 (Narrow Money): Currency notes and coins with public ( excluding cash in hand of all banks)

+ Demand deposit (excluding interbank deposit) + Deposit held with RBI ( excluding IMF,PF, guarantee fund & adhoc liabilities

M2 = M1 + Saving deposit with post office saving bank M3 (Broad Money) = M1 + Time deposit of commercial bank & cooperative bank (excluding

inter-bank deposit) + It includes net bank credit to government +bank credit to commercial sector + net foreign exchange assets + government currency liability to the public.

The M3 money supply as on 9th August, 2013 was 87,69,700 crores out of which 13% is currency held by the public and rest are the time and demand deposits with the banks.

A look at the interest rates around the world Interest Rates vary widely across the countries from developed countries like US to developing

countries like India, Indonesia, etc. Interest rates are generally high in developing nations as there is

significant dearth of capital in the market and demand is high which pushes interest rates up.


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Source: www.fxstreet.com

Liquidity It is one of the most important concern for banks in emerging countries where there always dearth

of liquidity in the market. Liquidity in our country is mainly governed by RBI which has many tools in

its arsenal to tackle and control liquidity in the market like CRR, SLR and open market operations.

Banks in India have to abide by specific requirements every fortnight when their respective ratios

are checked. Banks falling short of money use windows (LAF and MSF) and instruments (money

market instruments) provided by RBI or otherwise to cater to these requirements.

Some measures are: 1. Liquidity adjustment facility (LAF)

Banks borrow money from Reserve bank of India to meet short term needs through repurchase agreements. Borrowing is taken out by auction process with interest rate of 7.25%. The maximum amount of money that can be borrowed under this facility is capped at 0.5% of NDTL to restrict liquidity in the banking system.

2. Collateralized Borrowing and Lending Obligation (CBLO)

A discounted instrument available in electronic book entry form with maturity period ranging from one day to ninety Days (can be made available up to one year as per RBI guidelines). A product developed by CCIL for the benefit of the entities who have either been phased out from interbank call money market or have been given restricted participation in terms of ceiling on call borrowing and lending transactions and who do not have access to the call money market. The CBLO interest rates were – 10.20% (as of EOD 2nd September 2013).

3. Marginal Standing Facility (MSF)

Banks can borrow up to 2% of their respective “Net Demand and Time Liabilities" after exhausting 0.5% of LAF window. This scheme is likely to reduce volatility in the overnight rates and improve monetary transmission. It is used over and above the LAF window as it does not require collateral as in the case of LAF. The current interest rate of MSF has been set to 10.25%.

0.10% 0.25% 0.50% 0.50%

5.00% 4.50%

6.00% 6.50%

7.25%

9.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

Interest Rates


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Quantitative Easing (Bond Buying Program/Asset Purchase Program) Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value. A central bank implements quantitative easing by purchasing financial assets from banks and other private sector businesses with new electronically created money. This action increases the excess reserves of the banks, and also raises the prices of the financial assets bought, which lowers their yield. Newest process of injecting liquidity in the economy by buying the assets from the market, QE gained popularity in the wake of mortgage crisis after which there has been multiple rounds of QE by ECB and US Fed. Tapering of Quantitative Easing by US Fed In light of encouraging macroeconomic results in US economy, be it reduced unemployment rate (7.4% as of August 2013), moderate growth rate (2.5%), etc., FED is contemplating to start tapering its monthly $85B asset purchase if the good data continues to come in. The first statement regarding tapering of bond buying program came in mid May. This tapering would have huge implication throughout the world as this means that cheap and abundant US dollars would not be available any more to stimulate the economies worldwide. Currency exchanges and equity markets have reacted very vigorously to these turn of events. Indian rupee has depreciated nearly 20% while Sensex has lost nearly 10% of its value since mid May.

RBI liquidity tightening measures To arrest the fall of Rupee amidst the panic in currency markets after the announcement of tapering of bond buying program, RBI came out with the following measures: 1. Increase the daily requirement of CRR from 70% to 99% 2. Increase the bank rate to 10.25% 3. Increase the MSF rates to 10.25% 4. Cap the LAF limit to 0.5% of NDTL. 5. Open market operations where it sold cash management bills and government securities 6. Restricted the banks to trade in exchange markets only when the order to trade is backed by a

certificate by a company to hedge its operations These measures sucked the liquidity out of the system and primarily shot up the short term interest rates. Due to shortage of liquidity and high interest rates, credit off take is affected which thereby affects the profitability of banks.


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Insurance

Insurance is a hedging mechanism wherein a large number of parties come together to share risk by the pooling of resources. All the parties involved in pooling pay a certain amount of money or premium to a third party generally called the insurer. The amount of premium paid is commensurate with the risk involved and the value of the asset insured. Insurance can be obtained for things like automobiles, home, health, accident, sickness, unemployment, life, credit and many other types of insurance. Any risk associated with any of these may be insured by paying a premium. This collective risk bearing is called insurance.

Classification of the insurance sector Life Insurance: This type of insurance is for long term. This protects an individual against risk of

death. It ensures financial security for the family members of the insured in case of his death, but also provides attractive investment and tax benefit options. Within life insurance a large no of options are also available and any potential customer has the flexibility to choose from them based on his requirements and priorities.

General Insurance: This type of insurance is for short term. This is for insuring property and casualty against some unforeseen events which result in a financial loss for the insured. This provides compensation to the individual in case of losses, to the extent of the loss suffered by the individual.

Re Insurance: It is the insurance that is purchased by an insurance company to mitigate some of the risks associated with its insurance business.

Bank Insurance Model or Bancassurance It is the partnership/relationship between a bank and an insurance company where an insurance company uses a bank’s sales channel in order to sell insurance products. Perceived Benefits It encourages customers of banks to purchase insurance policies and further helps in building better relationship with the bank. The people who are unaware of and/or are not in reach of insurance policies otherwise can be benefitted through widely distributed banking networks and better marketing channels of banks. Increase in number of providers and volumes means increase in competition and hence people can expect better premium rates and better services from bancassurance as compared to traditional insurance companies. Demerits Data management of an individual customer’s identity and contact details may result in the insurance company utilizing the details to market their products, thus compromising on data security. There is a possibility of conflict of interest between the other products of bank and insurance policies (like money back policy). This could confuse the customer regarding where he has to invest. Better approach and services provided by banks to customer is a hope rather than a fact. This is because many banks in India are known for their bad customer service and this fact turns worse when they are responsible to sell insurance products. Work nature to market insurance products require submissive attitude, which is a point that has to be worked on by many banks in India.


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Overview of the insurance sector in India The insurance in India has developed very fast with the recent economic growth due to growth of young working population. A large part of Indian population still remains uninsured which ensures that the long term growth story of insurance is strong. In the current fiscal, the growth of Indian insurance industry is estimated to be less than 5% in the current fiscal (FY 2013-14) according to CII. Until 2001 there were no private insurance companies in India but the opening up of the insurance sector brought in a large no of private players. As of now there are 24 life insurance companies. e.g.

o Life Insurance Corporation of India o Bajaj Allianz Life Insurance Company Limited

27 general insurance companies. e.g. o National Insurance Company

o New India Assurance Co Ltd

o Bharti AXA General Insurance

1 Re-insurance company- It is fully government controlled. Private sector is not allowed in re-insurance in India o GIC Re (General Insurance Corporation of India - Re-Insuer)

Currently, Insurance in India is $41B industry and allowed FDI is upto 49%. Even though a large number of private companies have come in, the largest insurance company in India is still the state owned LIC of India which now has approximately $213 billion of assets. Market share for insurance companies are reported in two ways: 1. Based on the number of policies. 2. Based on first year premiums income. LIC has 83% market share in terms of number of policies sold and more than 71% share in terms of premiums. Top Companies in the insurance sector The industry showed tremendous growth till 2010 (CAGR of approx 31 % in new business premium) while for the next 3 years the growth remained flat (CAGR of 2% in new business premium). During this period (FY2010-12), penetration and competitiveness increased. General insurance industry is showing more robust growth as compared to life insurance industry. It is poised to grow at 16% CAGR in next 8 years. The largest insurance companies in India terms of market share are:-

1. LIC 2. ICICI - Prudential 3. HDFC – Standard 4. SBI – Life 5. Max – Newyork 6. Bajaj Allianz 7. Birla Sunlife


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New developments in the insurance industry In order to boost the insurance sector in India, IRDA has recently taken the following measures: In March 2013, Life and general insurance companies were allowed to invest in Category 1

Alternative investment funds (AIF) o Category 1 AIF- venture capital funds, SME and infrastructure funds- These funds have

positive spill over effect on economy o Category 2 AIF- Private equity funds, real estate and debt funds

IRDA has allowed insurers to invest in category 2 alternative investment funds (private equity finds, debt funds, fund of funds). Under this category 51% should be invested in infrastructure entities, SME, venture capital undertakings, social venture entities.

The total exposure to AIFs should not exceed 3% and 5% of total funds in case of life insurance companies and general insurance companies respectively

Equity investment cap in equity has been raised from 10% to 12% and 15% depending upon the size of the controlled fund. LIC is allowed to invest 15%. It is proposed to make a special relaxation of 30% just for LIC as it has exhausted its limit in various blue chip stocks.

Relaxation to LIC to invest upto 25% in debt instruments It has been proposed to raise the FDI limit in insurance sector to 49% from to 26%. Any policy holder is allowed to transfer his rights under a policy either totally or partially to a

third party. It has now been made possible for banks to sell insurance products of more than one insurer

which was not allowed earlier.

Government Role in the Insurance Sector The IRDA act passed in the year 1999 established IRDA as the regulator for insurance business in India. Any insurance company to operate must be registered under the relevant provisions of the Companies Act, 1956. Capital Requirements: Minimum paid up equity capital of Rs 100 crores for life insurance and

general insurance companies. For companies in the reinsurance business this shall be Rs 200 crores. For health insurance company, it is set to Rs 50 crores.

The maximum foreign ownership allowed in an insurance company is 26%. Foreign re insurance companies are allowed only to set up re insurance companies in India in

association with government of India. These companies would be allowed to raise capital from markets in future for capital needs as long as the government holdings remain more than 51%.

The bill also allows nationalised general insurance companies and the General Insurance Companies to raise capital with permission of the government.

Outlook for the Insurance Industry In the general insurance space, motor insurance constitutes more than 40 percent of total premium followed by health at 23 percent followed by fire insurance at 10 percent. The insurance industry in India is still relatively underdeveloped, and hence offers tremendous scope for growth. India’s economic growth has brought a large no of people into the middle class. With rising

income and increased awareness more and more people are buying insurance schemes. Due to relaxation in investment norms in equity and Alternate Investment Funds (AIFs) by IRDA,

the insurance companies will get more leeway to generate better returns on their investments After IRDA approval to banks to sell insurance policies of multiple insurers, penetration of

insurance is likely to increase along with the competition among insurers Increased focus on rural areas for increasing penetration. With the aggressive penetration of

banks post issue of banking licences, insurance business in rural areas stands to gain a lot


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The proposed increase in FDI limit to 49% in the insurance sector would provide insurance companies with much needed capital needed for expansion and would boost insurance density in India.

Government spending on health sector during the 12th five year plan is expected to be around 2% of the GDP from the current 1%. This would increase the total expenditure on health to 4% of GDP.

Health insurance accounts for only 10% of overall healthcare spending of $30B in India. This leaves for lot of scope for development in this area. Only 5% of the total population of India has health cover compared to almost 75% in USA and only 6% have life insurance.

The insurance penetration in the country stands at around 4% for life insurance and 0.75% for non-life insurance of the country’s GDP in terms of total premium written annually. This is way below the insurance penetration in the developed countries. According to CII estimates, insurance industry is set to grow at the rate of 5% for FY2013-14 of which major growth driver would be non life insurance.


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Non-Banking Financial Services Non-Banking Financial institutions or NBFCs are those financial institutions which provide financial services without meeting the general definition of bank. These institutions do not hold a banking license. Despite this, they provide a wide range of financial services and are regulated by the RBI. However, to avoid dual regulation institutions registered with other regulatory institutions are exempted from registering from the RBI. These include Venture capital fund, merchant banking companies, stock broking companies which are registered with SEBI or companies registered with IRDA. NBFCs offer most of the services offered by the conventional banking system including loans and credit facilities, education funding, retirement plans, wealth management and trading in money markets. NBFCs can accept public deposits but they cannot demand deposits. They are not part of the payment and settlement system and hence cannot issue cheques. The difference between banks and NBFCs are as follows: 1. An NBFC cannot accept demand deposits (demand deposits are deposits payable on demand such as current account and savings account).

2. An NBFC is not a part of the payment and settlement system and as such an NBFC cannot issue cheques drawn on itself.

3. Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available for NBFC depositors unlike in case of banks i.e. the security of deposits made by customers in these institutions is not guaranteed by the government.

Requirement for registering as a NBFC with the RBI The company should be incorporated under the Companies Act, 1956 and should have a minimum net owned fund of Rs 200 lakhs. “Owned fund” is the aggregate of paid up equity capital and disclosed free reserves after deducting the balance of accumulated loss, deferred revenue expenditure and other intangible assets. “Net Owned Fund" is the amount as arrived at above minus the amount of investments of such company in shares of its subsidiaries, companies in the same group and all other NBFCs and the book value of debentures, bonds, outstanding loans and advances made to and deposits with subsidiaries and companies in the same group, to the extent it exceeds 10% of the owned fund.

The NBFC sector in India The NBFCs registered with the RBI may be classified as:- Asset Finance Company (AFC): AFC is defined as any company which is engaged in financing of

physical assets supporting economic activity like automobiles, tractors and machines etc. Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising there from is not less than 60% of its total assets and total income respectively.

Investment Company (IC): An investment company means any company which is a financial institution carrying on as its principal business the acquisition of securities.

Loan Company (LC): LC is a company which is a financial institution carrying on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own. This does not include companies in financing of physical assets which are different.


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Infrastructure Finance Companies (IFC): An IFC is defined as non-deposit taking NBFC that fulfils the criteria mentioned below: o A minimum of 75 % of its total assets should be deployed in infrastructure loans o Net owned funds of Rs. 300 Crore or above o Minimum credit rating 'A' or equivalent of CRISIL, FITCH, CARE, ICRA or equivalent rating by

any other accrediting rating agencies o CRAR of 15 % with tier 1 capital at 10%

Systemically Important Core Investment Companies (SICIC):

o It holds not less than 90% of its Total Assets in the form of investment in equity shares, preference shares, debt or loans in group companies;

o Its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its Total Assets;

o It does not trade in its investments in shares, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment;

o It does not carry on any other financial activity except investment in bank deposits, money market instruments, government securities, loans to and investments in debt issuances of group companies or guarantees issued on behalf of group companies.

o Its asset size is Rs 100 crore or above and o It accepts public funds

Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC): IDF-NBFC is a company

registered as NBFC to facilitate the flow of long term debt into infrastructure projects. IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5 year maturity. Only Infrastructure Finanace Companies (IFC) can sponsor IDF-NBFCs.

Non-Banking Financial Company: Micro Finance Institution (NBFC-MFI): NBFC-MFI is a non-deposit taking NBFC having not less than 85% of its assets in the nature of qualifying assets which satisfy the following criteria: o loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not

exceeding Rs. 60,000 or urban and semi-urban household income not exceeding Rs. 1,20,000;

o loan amount does not exceed Rs. 35,000 in the first cycle and Rs. 50,000 in subsequent cycles;

o total indebtedness of the borrower does not exceed Rs. 50,000; o tenure of the loan not to be less than 24 months for loan amount in excess of Rs. 15,000

with prepayment without penalty; o loan to be extended without collateral; o aggregate amount of loans, given for income generation, is not less than 75 per cent of the

total loans given by the MFIs; o loan is repayable on weekly, fortnightly or monthly instalments at the choice of the

borrower

Non-Banking Financial Company - Factors (NBFC-Factors): NBFC-Factor is a non-deposit taking NBFC engaged in the principal business of factoring. The financial assets in the factoring business should constitute at least 75 percent of its total assets and its income derived from factoring business should not be less than 75 percent of its gross income.

The NBFC sector in India has seen massive growth, with the growth in economy. As of now it has grown to over Rs 921,000 crores and now is an important means of providing financial services to the public.


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Regulations related to the NBFC sector in India The various NBFCs present are part of a huge network of financial institutions which serve to provide financial services, accessibility and inclusion to the Indian public. The large no of NBFCs operating in India means that Indian people have a huge variety of options when it comes to financial services. The NBFCs in India can be broadly categorised as –

a. NBFCs accepting public deposits b. NBFCs not accepting deposits

The total number of deposit taking NBFCs in India as on 24th June 2013 254 deposit taking NBFCs (12104 non deposit taking NBFCs). Deposit taking NBFC are only 2% of the total NBFCs in India. A different class is RNBCs (Residuary non-banking companies). The primary business of the RNBCs is to take deposits and invest it into approved securities and not investments or financing. RBI has a series of regulations related to the NBFC sector so as to safeguard the interests of the public along with ensuring business viability of this business sector. Some of the regulations related the NBFC sectors in India are given as:- A NBFC must be registered under the Companies Act, 1956. It must be registered with RBI or

with any other regulatory agency such as SEBI or IRDA. It must have minimum net owned fund of Rs 200 lakhs.

For accepting public deposits a NBFC must hold a valid Certificate of Registration along with authorisation to accept public deposits.

NBFCs authorised to accept/hold public deposits besides having minimum stipulated Net Owned Fund (NOF) should also comply with the Directions such as investing part of the funds in liquid assets, maintain reserves, rating etc. issued by the RBI.

NBFC can accept public deposits as- o Category of NBFC having minimum NOF of Rs 200 lakhs

AFC (Asset Finance Company) maintaining CRAR (Capital to Risk Assets Ratio) of 15% without credit rating- 1.5 times of NOF (Net Owned Funds) or 10 crore whichever is less

AFC with CRAR of 12% and having minimum investment grade- 4 times of NOF LC/IC (Loan Company/ Investment Company) with CRAR of 15% and having

minimum investment grade credit rating- 1.5 times of NOF o Category of NBFC having NOF more than Rs 25 lakhs but less than 200 lakhs

AFCs maintaining CRAR of 15% without credit rating- Equal to NOF AFCs with CRAR of 12% and having minimum investment grade credit rating –

1.5 times of NOF LCs/ICs with CRAR of 15% and having minimum investment grade credit rating-

equal to NOF The deposits with and NBFCs are not insured and repayment of deposits are not guaranteed by

RBI. NBFC (except some AFCs) should have minimum investment credit rating In case of downgrade of a NBFC to below minimum investment grade rating it has to stop

accepting public deposits and within 3 years of deposit bring the existing public deposit to nil or within prescribed limit.

The NBFCs are allowed to accept/renew public deposits for a minimum period of 12 months and maximum period of 60 months. They cannot accept deposits repayable on demand. For RNBCs the minimum deposit period is 12 months and maximum is 84 months.

The maximum interest an NBFC can offer is 12.5 % per annum, while for a RNBC the minimum interest cannot be less than 5% for term deposits and 3.5% on daily deposits.

Deposit taking NBFCs have a minimum liquid asset requirement of 15% of outstanding public deposits. Out of this 15%, minimum 10% must be invested in government approved securities while the remaining may be invested in term deposits in any scheduled commercial banks.


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Microfinance Microfinance is usually understood to entail the provision of financial services to micro-entrepreneurs and small businesses, which lack access to banking and related services due to the high transaction costs associated with serving these client categories. The two main mechanisms for the delivery of financial services to such clients are

i. relationship-based banking for individual entrepreneurs and small businesses; and ii. group-based models, where several entrepreneurs come together to apply for loans and

other services as a group. All MFIs will have to register themselves with the Reserve Bank of India (RBI). The central bank can specify lending rates and margins that can be charged by an MFI, the recovery methods to be followed, the processing fees, the tenure and ceiling of the loan. They generally dole out petty loans with interest rates in the range of 24%-36%. Some of the Indian Microfinance Giants are SKS, ShriKshetraDharmasthala Rural Development Project, Cashpor Micro Credit (CMC) etc. AP (Andhra Pradesh) act & its implication on Microfinance Institutions In October 2010, the Government of Andhra Pradesh issued the Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Ordinance, 2010 (passed into law in December 2010) which effectively shut down all private sector microfinance operations in the state. The passage of this act dealt a major blow to the entire microfinance industry across India since Andhra Pradesh, which is widely regarded as the birthplace of private sector microfinance in India, accounted for 30% of all loans by MFIs across India according to some estimates. RBI is working on fixing the upper limit for interest rates in the range of 24-26% for MFIs.


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Mutual Funds A mutual fund is a trust that pools money taken from a large number of investors, who themselves do not have the skills or the resources to invest money in the financial markets. The money collected is invested the fund managers in financial instruments such as equities, debt instruments etc. The income earned by this investment is then shared among the investors in the proportion of their investment in the fund, after charging of the necessary fees by the fund.

Mutual funds may be open end or closed end funds, the definitions for which are given as follows:

Open end funds: Open end funds are those mutual funds in which investors may invest and withdraw at any time. These are the most common type of mutual funds.

Closed end Funds: Close end funds are those mutual funds in which the investor’s money is locked in for a particular period. Investors who want their money back cannot get it back directly from the fund. They will have to sell their assets in the funds to other investors.

Mutual funds industry in India The first mutual fund in India was the Unit Trust of India (UTI) set up in 1963. Privatisation was allowed in 1993. As of now there are over 44 mutual funds operating in India. The regulatory body for mutual funds in India is SEBI. The total assets under management for the industry are Rs 832,572 crores.


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Other Financial Services Financial services are the economic services provided by the finance industry, which encompasses a broad range of organizations that manage money, including credit unions, banks, credit card companies, insurance companies, finance companies, stock brokerages, investment funds and some government sponsored enterprises. Intermediary Advisory Services

These services involve stock brokers (private client services) and discount brokers. Stock brokers assist investors in buying or selling shares. Primarily internet-based companies are often referred to as discount brokerages, although many now have branch offices to assist clients. These brokerages primarily target individual investors. Full service and private client firms primarily assist and execute trades for clients with large amounts of capital to invest, such as large companies, wealthy individuals, and investment management funds. Ex- Sharekhan, AnandRathi, etc.

Private Equity Private equity funds are typically closed-end funds, which usually take controlling equity stakes in businesses that are either private, or taken private once acquired. Private equity funds often use leveraged buyouts (LBOs) to acquire the firms in which they invest. The most successful private equity funds can generate returns significantly higher than provided by the equity markets. Greater activity in this segment supports Banking Institutions as they very often use debt in their deals; also they create a very sound environment of investment which indirectly boosts requirement for BIs. Ex- Warburg Pincus, Blackstone, etc.

Conglomerates A financial services conglomerate is a financial services firm that is active in more than one sector of the financial services market e.g. life insurance, general insurance, health insurance, asset management, retail banking, wholesale banking, investment banking, etc. A key rationale for the existence of such businesses is the existence of diversification benefits that are present when different types of businesses are aggregated i.e. bad things don't always happen at the same time. As a consequence, economic capital for a conglomerate is usually substantially less than economic capital is for the sum of its parts. Ex – Indiabulls, India Infoline, MotilalOswal etc.


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RBI Credit and Monetary Policy Monetary policy is the process by which the monetary authority of our country, i.e. the RBI controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. Since the money supply in an economy has a large impact on the economic activity of that particular economy. The RBI through monetary policy tries to control the economic activity in the best interests of the country. Depending on the conditions the goal of the monetary policy can be to promote economic growth or to suppress inflation. The various mechanisms by which RBI implements monetary policy are control of interest rates, increasing or decreasing the amount of statutory reserves or through open market operation.

Cash Reserve Ratio The Cash Reserve Ratio (CRR) refers to the liquid cash that banks have to maintain with the RBI as a certain percentage of their demand and time liabilities. For example if the CRR is 5% then a bank with net demand and time deposits of Rs. 1,00,000 will have to deposit Rs. 5,000 with the RBI as liquid cash. The RBI also does not pay any interest on this cash to banks. Effectively this means that for a bank, a part of its funds are unusable and they also don’t generate any income by interest. By means of the CRR the RBI can decrease the amount of cash with the banks thus reducing the amount the banks can lend and hence this decreases the money supply in the economy. The RBI can also change the CRR to pump more liquidity or to suck out liquidity from the economy if the need be. Earlier interest was paid on CRR, but the rate was very high causing CRR to become unproductive. As a result the interest was gradually reduced and was finally abolished in 2007. Some bankers have also demanded that the CRR be abolished but it has been refused by the RBI. Current CRR=4 %

Repo Rate When banks have any shortage of funds, they can borrow it from RBI or from other banks. The rate at which the RBI lends money to commercial banks is called repo rate, a short term for repurchase agreement. Repo is a collateralized lending i.e. the banks which borrow money from RBI to meet short term needs have to sell securities, usually bonds to RBI with an agreement to repurchase the same at a predetermined rate and date. In this way for the lender of the cash (usually RBI) the securities sold by the borrower are the collateral against default risk and for the borrower of cash (usually commercial banks) cash received from the lender is the collateral. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. Current Repo Rate = 7.25%

Reverse Repo Rate Reverse repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system. According to norms laid down by RBI, the reverse repo rate is less than the repo rate by 100 bps. (1 bp = 0.01%) Current Reverse Repo Rate =6.25 %

Statutory Liquidity Ratio Statutory Liquidity Ratio (SLR) is the percentage of its deposits in the form of cash, gold or approved securities that a bank has to maintain with the RBI. This requirement is known as SLR. The sanctioned upper limit for SLR is 40%.An increase in SLR also restricts the bank’s leverage position to


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pump more money into the economy, while a cut on the SLR increases the cash available with bank which it can use to lend to borrowers. Current SLR= 23%.

Bank Rate It is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. It is however, different from repo rate. While repo rate is on short term borrowings, bank rate is for long term borrowings. A high bank rate pushes up interests on loans and hence slows down the economy. It can however also be an inflation control mechanism used by the central bank. Current Bank Rate is 10.25%

Capital Adequacy Ratio(CAR) Capital Adequacy Ratio (CAR) also known as Capital to Risk (weighted) Assets Ratio is the ratio of a bank’s capital to its risk. It is a measure of Bank’s core capital as a percentage of its risk weighted assets. The assets may include both Tier 1 and Tier 2 capital. CAR is used to determine the ability of banks to absorb some reasonable amount of loss without facing the risk of bankruptcy. Having a minimum level of CAR is also a statutory requirement although this may vary according to different regulations. The current mandatory CAR is 9%. The CAR according to the proposed Basel 3 norms is 11.5%.


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Other Financial Instruments

Bonds and Debentures These consist of those issued by government and those issued by corporate houses for raising funds from the market. These are essentially certificates which state that the issuer of the bond or debenture owes a certain amount of money to the bearer. The terms and conditions of repayment including term, interest rate applicable are given. Bonds and debentures can usually be traded on the secondary market. While both correspond to financial instruments of the debt market, the main difference between bonds and debentures is that debentures are usually unsecured, while bonds are secured borrowings. Since bonds are secured borrowings and government bonds are backed by sovereign guarantee, hence government bonds are regarded as the safest and are the preferred choice of those looking for a fixed income without any risk. Hence, in times of global financial crisis we see a flight of capital to the US bond market since they are regarded as the safest. Yield of a bond is the income on investment that the buyer of the bond receives from the seller. It is usually expressed as a percentage of investment cost, current market value or face value. Bonds have different types of yield: Coupon: The interest rate fixed at the time the bond was issued. Current: The bond interest rate as a percentage of the current price of the bond. Yield to maturity (YTM): An estimate of what an investor will receive if the bond is held to its

maturity date.

Commercial papers Commercial papers (CP) are unsecured money market instruments issued in the form of a promissory note. These are short term borrowings and are issued for a minimum period of 7 days to maximum period of one year. The issuer of the CP should obtain credit rating from suitable credit agency and for issuing CP; the minimum credit rating should be A-2. These are issued at discount to face value.

The Indian Debt Market Indian debt market consists of debt issued by government of India and Indian corporate. In India, Government debt market is much larger than corporate debt market. Debt is issued by government in the form of government bonds (also known as Government Securities (G-Sec)) which carry its sovereign guarantee. These can be short terms and long term maturity bonds. Treasury bills (T-Bills), Cash Management Bills (CMBs) and Dated Government Securities are some of the government securities. While T-bills and CMBs are short term securities, Dated Government Securities are long term securities. Corporate Bonds are issued by private or public sector companies to raise money from the market. Bonds are for long term investment with minimum investment period of a year. Bonds are generally listed in NSE and BSE. Government bonds are regarded as more secure than corporate bonds.

Outlook of the Indian Debt Market One of the RBI objectives is to develop Indian capital debt market to facilitate overall improvement in the strength of financial and economic system of the country. The strength of the government debt market is seen as the precursor of the strength of the corporate debt market which forms an important source of funding for the corporate of India. Formation of robust government debt


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market is important for efficient management and issue of debt by government while robust corporate debt market plays critical role in supporting economic development. Indian capital debt market is currently of the size of debt market is currently of 50,96,478 crores. Out of this, corporate debt market constitutes only 5.71% of this debt market. According to a Goldman Sachs report the Indian capital debt market has potential to reach $1.5 trillion in 2016. In line with this policy the government has hiked the FII limit for G-Secs by $5 Billion to $30 Billion. Out of these $30Billion- $10B would be in short term securities and $20B would be in long term securities. The FII limits for corporate debt market is $51B out of which $25B should be in infrastructure sector.

Credit Ratings A credit rating is a measure to evaluate the credit worthiness of a debtor. The debtor generally includes a company or a sovereign government. The process involves assessing the issuer’s capacity to generate cash from operations and assessing whether this cash would be able to service the obligations of the issuer regarding the debt issued by him. Credit ratings are issued by credit rating agencies. The globally accepted credit rating agencies are Standard and Poor’s, Moody’s and Fitch. Ratings are issued for short term as well as for long term debt. There are also specific Indian rating agencies like CRISIL, ICRA and CARE etc. The procedure of assigning credit rating to a company involves estimating making estimates of both business risk, financial risk and industrial risk. Business risk: The business risk that an issuer is exposed to is a combination of the industry risk

in its major product segments and its competitive position within the industry Industry risk: This relates to the attractiveness of the industry of the industry in which the issuer

operates. The aspects examined include expected demand and supply situation, intensity of competition, and overall outlook for the industry.

Financial risk: The objective in this case is to determine the debt profile and financial risk profile. Some of the parameters to do this are operating profit, leverage, debt service coverage ratios, working capital analysis, cash flow analysis, accounting quality, off balance sheet liabilities etc.

Currency Exchange One of the functions of a central bank entails controlling the forex market by making interventions to maintain the stability of the exchange rate. Different countries have different type of mechanisms for determining the exchange rate of the currency. Some of the different exchange rate regimes are: Floating Exchange Rate A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. In this case the exchange rate is determined by market forces. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles. Even in float there are different types of regimes such as free float and managed float. Free float is when the central bank does not intervene in any way to control the exchange rate in case of appreciation or depreciation of the currency. Managed float is when the currency is allowed to float, but the central bank may and does intervene to control the exchange rate, through open market operations if the currency appreciates or depreciates more than what the central deems not harmful for the economy. The USA has a free float while India has a managed float regime.


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Fixed Exchange Rate A fixed exchange rate is when the exchange rate of a currency is kept constant with respect to other currencies. The fixed exchange rate mechanism may be implemented by – Gold standard or reserve currency standard. There are two methods of implementing a fixed exchange rate. One is that the central bank may buy or sell its own currency in the open market. The forex reserves are used by the central banks in implementing this strategy. When the exchange rate falls below what the government deems desirable, the central bank buys its own currency in the market increasing demand and causing the exchange rate to rise. If the exchange rate rises higher than what the government deems desirable the central bank sells its own currency and buys dollars increasing its forex reserves and causing the currency to fall. The second method could be that the government could make it illegal to exchange currency at any other rate except the fixed rate decided by the government. Both fixed exchange rate have their own advantages and disadvantages and central banks choose to have a fixed or floating rate based on their assessment of all underlying factors.


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HDFC Bank

HDFC Bank was incorporated on August 1994 by the name of 'HDFC Bank Limited', with its registered

office in Mumbai, India. HDFC Bank commenced operations as a Scheduled Commercial Bank in

January 1995. The Housing Development Finance Corporation (HDFC) was amongst the first to

receive an 'in principle' approval from the Reserve Bank of India (RBI) to set up a bank in the private

sector, as part of the RBI's liberalization of the Indian Banking Industry in 1994.

HDFC showed a strong net profit growth of 30.18 (YoY) in line with its long term trend of 32% CAGR

growth over the past 10 years. The CASA which is the main source of low cost funds for a bank stood

at 47.43% which is one of the best in industry keeping its NIM (net interest margin) high at 4.5%. Net

NPA for HDFC bank was also very low at 0.2% indicating the prudent provisioning by the

management and good assessment while giving out loans. Credit to deposit ratio also showed

improvement of 171 bps and now stands at 80.92%. Non Interest Income also showed a robust

growth of 18.4 percent year on year driven by commission, exchange and brokerage income (19.8%

growth YoY) which forms the majority of the non interest income. The high P/B ratio of 4.41 can be

explained by continuous high growth that the stock is showing consistently for the last 10 year.

The fundamentals of the company remain solid with excellent operational efficiency. This makes

HDFC a good long term investment.

Market Cap 147317.27

Price 616.3

P/E 22.32

P/BV 4.41

Net Interest Income (%) 4.18

CASA (%) 47.4

Net NPA (%) 0.2

Shareholding Pattern (%) Operating and Capital Ratios

Promoter 22.74 NIM(%) 4.5 EPS (Rs) 28.27

Institutions 43.1 DPS (Rs) 5.5

Non – Institutions 17.13 ROA (%) 1.82 Total CAR (Basel II) % 16.8

Bodies Corporates 8.08 ROE (%) 20.34 Tier 1 ratio (Basel II) % 11.1

Individual Shareholders 8.54 ROCE (%) 20.63 Tier 2 ratio (Basel II) % 5.7

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HDFC Bank Price Chart


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Yes Bank

Yes Bank, incorporated in 2004 by Rana Kapoor and Late Ashok Kapur, is a new age private sector bank. Since inception Yes Bank has fructified into a „“Full Service Commercial Bank” that has steadily built Corporate and Institutional Banking, Financial Markets, Investment Banking, Corporate Finance, Branch Banking, Business and Transaction Banking, and Wealth Management business lines across the country, and is well equipped to offer a range of products and services to corporate and retail customers.

Higher interest income and robust loan growth helped Yes Bank report a 38 percent jump in net profit at Rs 401 crore in the April-June quarter. The private sector bank had posted a profit of Rs 290 crore in the year-ago quarter. Net interest income (difference between interest earned and spent) increased 40 percent at Rs 659 crore on the back of higher margins and advances growth. Other income rose 53 percent to Rs 442 crore. During the quarter, the net interest margin increased to 3 percent, against 2.8 percent in the corresponding quarter last fiscal. As on June 30, 2013, total advances grew 24 percent year-on-year to Rs 47,898 crore. Deposit growth was higher by 30 percent at Rs 65,245 crore. Gross non-performing assets (NPAs), or bad loans, dipped marginally to 0.22 percent (0.28 percent). Net NPAs also fell to 0.03 percent (from 0.06 percent). However, provisioning during the quarter trebled to Rs 97 crore (Rs 30 crore). Capital adequacy ratio, as per Basel III norms, declined to 15.4 percent (17 percent).

Despite strong first quarter results, the RBI short-term liquidity tightening measures announced has

adversely impacted the bank’s scrip and stock is on a high watch alert.

Market Cap 10550.42

Price 292.75

P/E 11.82

P/BV 2.65

Net Interest Income (%) 2.57

CASA (%) 18.95

Net NPA (%) 0.01

Shareholding Pattern Operating and Capital Ratios

Promoter 25.64 NIM(%) 2.36 EPS (Rs) 36.27

Institutions 61.71 10.73 DPS (Rs) 6

Non - Institutions 12.64 ROA (%) 1.51 Total CAR (Basel II) % 18.3

Bodies Corporates 1.91 ROE (%) 24.81 Tier 1 ratio (Basel II) % 9.5

Individual Shareholders 9.45 ROCE (%) 15.09 Tier 2 ratio (Basel II) % 8.8

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Yes Bank Price Chart


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Sector Outlook

Banking and Financial Services

Sector Outlook: Negative

Driving Factors:

RBI Announcements – CRR, LAF and MSF

RBI has asked Banks to maintain a minimum daily CRR balance of 99% of the requirement up

from a minimum of 70% earlier.

MSF Rate has been hiked from Repo + 100 bps to Repo + 300 bps (wef 15 July 13).

Each bank can now borrow 0.5% of their net demand and time liabilities (NDTL) through LAF

(wef 24 July 13).

This has resulted in driving overnight rates (say Call, Mibor) towards the 10.25% marginal

standing facility (MSF) rate.

Rise in Bond Yields and Consequent MTM hits

On account of Profit Booking by FIIs in June and lately due to RBI’s actions pertaining to borrowing

rates, the Bond Yields have suffered badly. For instance, the 5 year Benchmark Gsec’s yield has risen

from 7.97% (2 April 13) to 8.90% (5 Sep 13) and was at a low of 7.26% (24 May 13). As a result, Banks

have faced high MTM losses in their Trading Books.


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Wholesale Borrowing Books to take a hit

Many Banks (NBFCs and Financial Services companies) that have a high reliance on short term

borrowings in the form of (CP/CD/LAF/CBLO/Inter-Bank) have taken a big hit with respect to the

Borrowing Rate. In case of LAF, 0.5% of NDTL as the borrowing limit is playing a hindrance whereas

the Rates in case of CP/CD/CBLO and Inter-Bank have risen by the magnitude of around 250-300 bps.

Likely fall in NIMs

On account of a slow GDP growth scenario, rising Borrowing Rates and a struggling currency, the Net

Interest Margin will get impacted and the profits are thereby likely to take a hit.

Probability of a rise in NPAs

A slow economic recovery scenario coupled with rising rates, will impact market sentiments and

shall have a high impact in terms of lower Loans and Interest Repayment Rate. The direct

consequence will be a rise in NPAs as more assets shall fall under the category of stressed assets.

Raghuram Rajan and new policy initiatives

Raghuram Rajan took charge as the new RBI Governor on 4th September 2013. He has come in with

some positive initiatives which include: New Banking Licenses likely to be announced around January

2014; Foreign Currency Non Resident (Banks) deposits at 3.5% (Indian Banks) for over 3-year

deposits - current US$15.1bn - inflow of US$10bn expected; Stressed the need to reduce the pre-

emption of deposits via the SLR (23%); A committee will suggest a comprehensive reform of financial

inclusion targets for banks (currently 40%); Recognized the need to address the NPL situation.


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Insurance

The Indian Insurance sector has a high growth potential majorly on account of increasing middle

class and disposable income, increasing awareness and very low penetration. Indian insurance

industry will get a huge boost if proposal to pass FDI (49% from 26%) is passed in Rajya Sabha.

Additionally, easing of norms and opening up of avenues of investment by IRDA and Finance

Ministry will increase the return for insurance companies over their assets.

Key Takeaway

As India is suffering through a rough macro-economic environment - low growth, high CAD, high

Fiscal Deficit, high inflation, depreciating INR - the highest impact is being felt by the Indian Banking

sector. Now, the expectations from the new RBI Governor have increased and this is something that

will be very closely monitored by investors, both domestic and international.

So, now the focus in the next quarter shall be on investing in the right stocks (stocks having a low

dependence on wholesale borrowing, better credit portfolio) rather than the sector as a whole. As

and when more clarity starts coming in from RBI and Fed, investors shall start forming a firm

direction for the market.

banking financial services & insurance_2013

Documents

basel capital accord

bank function

indian banks

commercial banks

specialized banks

institutional banks

major banking sector

research group sector