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  • 7/25/2019 KPMG CII Indian Banking

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    Indian Banking

    Maneuvering

    through Turbulence:

    Emergingstrategies

  • 7/25/2019 KPMG CII Indian Banking

    2/32 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    Foreword CII

    Sudhir DeorasChairman

    CII Eastern Region

    During the last two decades of

    unshackling its chains, the elephant

    that is Indian economy seldom came

    across such challenges as it does

    now. The twin tasks of reinvigorating

    economic growth and reining in

    ination during the times of dwindling

    rupee value, weak global demand

    and persistent current account decit

    present a mesh of problems that needimmediate and coordinated actions on

    the scal and monetary front.

    Indias economic growth that sunk to

    a decade low of 5 percent last year

    continues to plague the economy. While

    the performance of key sectors such

    as manufacturing, farm and mining

    are below par, the reforms process

    that began last year failed to generate

    enough momentum to restore the

    growth gures.

    Against this backdrop, the banking

    sector has an important role to play in

    stimulating economic growth. Banking,

    arguably the fulcrum of our nancial

    system, is a sector that can really help in

    deploying our national savings towards

    infrastructure development. This will in

    turn stimulate economic activity on one

    hand, and help sustain a high growth

    rate on the other.

    The bigger the challenges, more is the

    need for innovative ideas and strategies

    by bankers to counter risks. Banks also

    have a larger role to play in increasing

    nancial inclusion. Proposed licenses

    for new banks raise hope for increased

    penetration and enhanced credit

    availability.

    The central bank has taken several

    policy initiatives on compliance and

    governance something that could

    redene the contours of the sector and

    benet the economy in the long run.

    The volatile economic scenario has

    forced banks to try various business

    models either to increase their

    bottomline or manage risks better.

    Adoption of new technologies and

    a constant pursuit of innovation to

    improve products and services will be

    crucial.

    In this context, KPMG as our knowledge

    partner for Banking Colloquium 2013 has

    prepared a report. The study attempts

    to capture the current scenario and

    detail of the strategies being adopted

    by banks, way forward to compliance

    and governance, nancial inclusion,

    technology in banking, market risk

    hedging and proposed new banks.

    We hope the report will help the

    industry understand the emerging

    strategies needed to maneuver through

    these times of turbulence.

  • 7/25/2019 KPMG CII Indian Banking

    3/32 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    Foreword KPMG

    Ambarish DasguptaHead - Management Consulting

    KPMG in India

    Banks face challenges from many

    sourcesIndian economy slow-down

    is one of them. Few factors responsible

    for GDP growth rate of 5 percent could

    be an over-cautious monetary policy

    that could not deliver on lowering the

    ination rate but contributed to increase

    in the borrowing costs, governments

    pending decisions on a few strategic

    policies, high current account decit andoil prices. The sharp depreciation and

    uncertainty of the rupee in recent times

    has further aggravated the problems of

    the Indian economy.

    Slower economy leads to deteriorating

    asset quality which is already causing

    stress to the banking sector. The RBI

    estimates that the gross NPA ratio of

    banks may rise to 4.4 percent by March

    2014 as compared to 3.42 percent in FY

    13. NPA ratio was 2.94 percent in FY12.

    In an uncertain environment, banks are

    extremely concerned with liquidity risk

    and concentration & correlation risks

    and have to develop tools to calculate

    economic capital that will integrate

    credit and market risks. Currency

    volatility is also giving few bankers

    sleepless nights. Another challenge

    facing the banking sector is that of

    compliance and governance. Fit and

    proper guidelines were issued by the

    RBI for directors to ensure appropriate

    ofcials at the helm. To reduce systemicrisk, regulators have also placed lot of

    checks and balances in the sector.

    From tapping new segments in the

    SME sector to funding cross-country

    aspirations as Indian corporates go

    global, Indian banks are pursuing

    multiple strategies for growth in an

    uncertain environment.

    The Public sector banks (PSBs) are

    much ahead of the Private sector banks

    in their overseas presence, constituting

    over 90 percent of 171 overseas

    branches as of March 31st,2013.

    To meet these requirements and

    challenges, industry players are

    harnessing technology for creating

    innovative and cost-efcient operating

    models to sustain protability and

    viability. Discussions have been on

    branchless banking but a branch avatar

    will never go out of picture for less-

    technology savvy customers. Banks

    are also deliberating on social media

    initiatives to reach out to urban and

    emerging class and SMAC (social,

    mobile, analytics and cloud) on a whole

    could bring a new perspective on

    customer experience and on creating a

    sustainable business.

    RBIs objective of increasing nancial

    penetration and credit availability

    with reaching out to the bottom of

    the pyramid has resulted in giving out

    clear guidelines to the new banking

    entrants(whenever they are on

    board)open one in four branches in

    rural unbanked areas! The successful

    banking aspirants would have their

    task cut out as they balance the

    twin objective of reaching out to the

    emerging India in the Tier 3 to 6 cities

    while achieving nancial inclusion.

    This paper is an attempt to discuss the

    opportunities and challenges that lie

    ahead of the Indian banking industry.

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    Financial inclusion - Quest for

    protability

    13

    Emerging strategies of

    Banking sector

    01

    09

    Governance and Compliance

    Gearing up for the next level

    SMAC - Future of

    technology

    17

    19

    Hedging the market risk

    Merit in banking on

    new licenses

    21

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    Over the past couple of years,the Indian banking sector hasdisplayed a high level of re-

    silience in the face of high do-mestic ination, rupee depre-ciation and scal uncertainty in

    the US and Europe. This hasnecessitated the banks in India

    to concentrate much more onoperating efciency, outsourc-ing and cost optimization now

    than ever before. With deregu-lation of savings bank rate andbleak global economy, the

    banks are focusing on alterna-tive sources of revenue, like

    fee income, trade and vendornancing, geographic expan-sion et al to maximize their

    revenues. The Banking sec-tor in India has adopted andembraced technology to keep

    pace with the internationaldevelopment in the bankingindustry and offer quality prod-

    ucts to its clients. Technologyhas enabled banks to conceive

    and deliver products that aremore in line with the require-ments of its clients on the

    one hand and also more costefcient on the other. We have

    captured few emerging trendsin the Banking space that aregaining traction.

    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    Emergingstrategies of

    Banking sector

    1 RBI - Statistical Tables relating to Banking FY 12

    2 As per RBI denition - Rural: population less than 10,000; Semi-Urban: 10,000 and above and less than 1 lakh; Urban: 1 lakh and

    above and less than 10 lakh; Metropolitan: 10 lakh and above

    Focusing on the emerging IndiaBanks and regulators alike have woken up to the growing needs of emerging India.

    While the credit disbursal of all SCBs has doubled from FY08 to FY12 to INR 48,215

    bn1, the share of non metro regions in the incremental credit pie has increased from

    30 percent in FY09 to 39 percent in FY12, indicating that the Non-metro regions are

    increasingly gaining share.

    The number of bank branches in urban and semi-urban2areas has been growing at a

    fast pace. Fifty eight percent of ~25,000 branches opened in last ve years were in

    urban and semi-urban regions.

    Incremental credit disbursed by SCBs (INR bn)

    Source:RBI - Statistical Tables relating to Banks in India FY 12

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    CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies | 2

    Even the number of bank branches in urban and semi-urban areas has been growing

    at a fast pace. The growing economic activity and increasing per capita income have

    been crucial factors driving the credit growth in these regions. Fifty eight percent

    ~25,000 branches opened in last ve years were in urban and semi-urban regions.

    RBI is keen to improve the banking situation in rural areas and has mandated banks

    to allocate at least 25 percent of new branches in unbanked rural centers. Further,

    the increasing number of High Net worth Individuals (HNWIs) in the non metroareas is leading to an increase in demand for better or more sophisticated services,

    including Private banking and Wealth management; banks are not only focusing

    on numbers in the emerging markets within the country but also on the quality of

    services being delivered in these regions, based on type of clientele.

    Population wise incremental branches in last 5 years

    Source:RBI - Statistical Tables relating to Banks in India FY 12

    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

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    Banks are constantly trying to increase their overseasexpansion to meet the growing trade demandIndian banks have been increasingly

    growing their international presence

    in the recent past. In part to cater

    to the growing Indian diaspora in

    foreign countries (estimated at ~ 20mn persons) and in part to meet the

    growing demands from cross border

    trade and economic activity.

    The Public sector banks (PSBs) are

    much ahead of the Private sector

    banks in their overseas presence,

    constituting over 90 percent of 171

    overseas branches as of March 31st,

    20133. Many of the private banks do not

    have branches, but are present through

    representative ofces.

    Non resident Indians (NRIs) deposits

    aggregated USD 14.2 bn in the nancial

    year ended March 2013, a y-o-y increase

    of 19 percent. The Indian Diaspora

    worldwide is estimated to be ~20 mn

    persons4 and is on a constant rise.

    3 RBI Country-wise branches of Indian Banks at Overseas

    Centres as on March 31, 2013

    4 Including Non Resident Indians and Person of Indian origin

    5 Business Standard June, 2013; http://www.business-

    standard.com/article/nance/icici-bank-for-more-branch-

    expansion-113062400758_1.html

    The total trade, export and import, have

    clocked a 19 percent CAGR over the

    last year, period ending FY 13. The top

    trading partners are China, Middle East,

    US, HK, Singapore et al. The Banks have

    shown particular interest in opening

    branches in these regions which havea strong trade relationship with India.

    Total trade with China has grown at

    17 percent CAGR from FY10 to FY13

    and this has enticed banking players to

    open branches in China. For example,

    Axis Bank recently got permission from

    RBI to open a branch in China and ICICI

    Bank is awaiting RBIs approval for the

    same. ICICI Bank is looking for foreign

    expansion by opening branches in

    Australia, South Africa and Mauritius5.

    PSBs are also aiming to expand their

    presence abroad. SBI wants to explore

    territories where Indian Banks havent

    tread yet, like Latin America. Dena

    Bank is also awaiting RBIs permission

    to open branches in US, UK and Africa.

    Overseas expansion in PSBs mightbe constrained on account of the

    limited capital headroom they have for

    such ventures, and the Government

    being hard pressed to nd funds for

    recapitalizing PSBs. Therefore, PSBs

    might be very careful in their selection

    of target markets compared to well

    capitalized PBs.

    Top Exports Markets (FY 2013, USD bn) Top Imports Sources (FY 2013, USD bn)

    Country-wise branches of Indian Banks at

    overseas centres as on March 31, 2013

    Source:Ministry of Commerce & Industry, Government of India

    Source:Reserve Bank of India

    Others include:

    Afganistan,

    Australia,

    Bahamas,

    Bahrain,

    Bangladesh,

    Belgium,

    Cambodia,

    Cayman Islands,

    Channel

    Islands, France,

    Germany, Israel,

    Japan, Kenya,

    Maldives, Qatar,

    Saudia Arbia,

    Seychelles,

    South Africa,

    South Korea,

    Oman, Thailand,

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    CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies | 4

    Supply Chain Financing (SCF) is gaining traction inIndiaSCF is rapidly gaining attention in international markets and is growing at a pace of

    30 40 percent at major international banks according to a research6. Key elements

    of SCF include factoring, invoice discounting/reverse factoring, purchase order/

    invoice data management, bank assisted open account, open account payment,

    export/seller nance and buyer side nance. All the products aiming at providingbetter liquidity to the corporates and their entire value chain at lower nancing

    rates. Currently, the growth in this domain comes from US and western European

    countries, but the future growth is expected to come from emerging economies

    like India and China.

    With various government policies supporting exporters in India, the export credit

    is growing at a rapid rate (Three year CAGR at 14 percent and ve year CAGR at 22

    percent). A part of this is also supplier nancing, which has been gaining popularity.

    Banks are increasingly focusing on increasing their business from SCF. This can be

    witnessed in growing number of branches in Industrial units. The banks are holding

    awareness campaigns and seminars to educate the corporate world of the benets

    of SCF. Certain players are focusing on developing expertise in particular sectors.

    Factoring and reverse factoring have not gained much momentum in India and

    still offers an untapped market. Factor products offer greater exibility compared

    to other instruments used for working capital nance. Although receivables enjoy

    property rights and are transferable, a statutory framework for factoring wasintroduced only in 2011 by way of the Factoring Regulation Bill.

    Outstanding advances of SCBs to exporters (INR bn)

    Source:Monetary policy department, RBI (http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14681)

    6 Demica Research, 2013

    In the context of serving our clients responsibly, value chain nancing is an

    integral part of our business strategy covering both, our corporate clients

    as well as their vendor partners, who are largely SMEs. We have further

    sharpened our focus on this format of supply-chain nancing to meet priority

    sector obligations, given that our distribution network limits direct access to

    such borrowers.

    Abhijit Sen CFO, Citibank

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    The Factoring bill essentially protects

    micro and small businesses from

    delayed payments for goods and

    services by larger entities. Traditional

    banks used to provide loans based on

    the borrowers (i.e. the MSME players)

    ability to service the loan. Factoring will

    however evaluate the lending decision

    based on the ultimate debtor (i.e. the

    ultimate customer of the MSME). This

    will greatly improve the liquidity and

    working capital problems of MSME

    players.

    With favourable legislations, factoring

    is gradually taking off in India. The

    Indian market constitutes a mere one

    percent of the worlds factoring market

    and 0.5 percent of the working capital

    requirement of Indian companies7and is

    constantly growing.

    As illustrated above, there is a huge gap between Indian factoring market and

    the international counterparts and offers a great opportunity for Indian banks to

    capture this gap. The factoring industry in India is dominated by PSBs and nancialinstitutions. SBI Global Factors is the market leader with 80 percent of the market

    share. Other players include CanBank Factors, DBS, Axis Bank, HSBC and Standard

    Chartered7.

    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    7 http://www.indiafactoring.in/Admin/DocFile/161-1204201

    2%20-%20nancial%20express.pdf

    Indian factoring market in the last decade

    Source:Factors Chain International

    Comparison with major Asian Markets

    Source:Factors Chain International

    International

    Domestic

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    7 | CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies

    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    8 Gartner Research- http://www.gartner.com/newsroom/id/2319115

    9 Reserve Bank of India

    Focus on improving operating efciencyand outsourcingWith increasing competition,

    emerging customer demands,

    regulatory interventions, technology-

    led disruptions, higher shareholder

    expectations, Indian banks are beingforced to constantly review and revisit

    their operating models. The resulting

    changes are making Indian banks

    nimbler, more cost efcient, better

    focused on customer services and

    witnessing good returns through fee

    based services and products.

    Indian banks are constantly optimising

    the use of technology as the change

    agent, in order to improve operational

    efciency and enhance customer

    experience. It is estimated that Indianbanking and securities companies will

    spend INR 416 bn (USD 6.75 bn) on IT

    products and services in 20138, which

    will be 13 percent increase from INR

    370 bn (USD 6.0 bn) spent in 2012.

    Emergence of low cost channels like

    internet banking, mobile banking, and

    mobile ATMs have been successfully

    implemented by many players and

    have also found wider acceptance in

    the customer base. This has led to

    enhanced focus on digital banking andself-service channel usage to reduce

    the cost of operations. The number of

    mobile banking transactions doubled to

    5.6 mln in January 2013 from 2.8 mln

    in January 20129. The value of these

    transactions increased three-fold to

    INR 625 Cr (USD 105.73 mln) during

    the month from INR 191 Cr (USD 32.31

    mln).

    Banks have either centralised mid/

    back ofce processes through a shared

    services center or have outsourced

    their technology requirements to a third

    party. In addition to focus, this also gives

    banks a huge cost advantage.

    For example, Indian market has

    witnessed an increasing number of

    ATMs under outsourcing management.

    By outsourcing their ATM management

    to service providers like Fidelity NationalInformation Services (FIS), the bank

    is able to focus on its core business

    expansion and customer service

    initiatives - allowing for more rapid

    growth while ensuring its customers

    have a high-quality, reliable ATM

    service. FIS the market leader and

    worlds largest provider of banking and

    payments technology manages about

    11000 ATMS across India.

    Karnataka Bank is the latest to join

    more than half of Indias top 30 banks

    who rely on FIS. By outsourcing the

    management of its ATM estate to FIS,

    Karnataka Bank would be in a position

    to release vital capital to redeploy on

    core activities, increase operational

    efciencies, provide better service

    to its customers and insulate itself

    from technology obsolescence. The

    announcement made by Karnataka Bank

    in May 2013 underscores a growing

    trend in India for banks to contract

    non-differentiating services, such asATM driving, to expert providers such

    as FIS. Banks benet by redirecting

    investments tied up in ATM equipment

    and operations to more strategic areas,

    thus deriving operational efciencies.

    In addition, banks can leverage the ATM

    driving expertise of FIS to deliver a high-

    quality and reliable ATM service to their

    customers.

    While transaction based banking

    operations are being successfully

    streamlined, Priority Sector Lendingand Financial Inclusion still remain a

    challenge. The section on Financial

    Inclusion in the report elaborates on

    how to create a protable model to

    deliver rural credit.

    Indian banks are now getting

    to be somewhat mature users

    of technology and are investing

    signicantly in good data mining

    solutions to understand the

    behavioral trends of customers

    and offer intelligent cross sell

    solutions to customers, primarily

    to improve productivity. There is

    also concurrently an increasing

    trend towards outsourcing to retain

    exibility, manage scale moreefciently and cut operating costs,

    essentially to leverage on partners

    strengths in specic areas

    Jaideep Iyer Group President, Financial

    Management, Yes Bank

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    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    Max Life insurance. With the increasing

    trends in insurance penetration on both

    life and general insurance side, banks

    identify this as one of the key drivers of

    fee income growth.

    Retail fee income is another area where

    banks have increased focus to augment

    their growth. Retail fee income of banks

    typically comprises commissions they

    earn from sale of third-party products,

    like insurance and mutual funds,

    transaction charges on savings and

    current accounts, processing fees on

    consumer loans and credit cards, and

    fees from foreign exchange transactions

    and remittances.

    Private sector banks are specically

    focusing on income on foreign exchange

    transactions and remittances. Axis

    Bank, the third largest private sector

    lender in the country, reported close to

    43 percent rise in retail fee income in

    FY13.

    CII-KPMG Indian Banking Maneuvering through Turbulence: Emerging strategies | 8

    Changing dynamicsof fee based incomeportfolioFee income has gained signicant

    focus as a source of revenue in the past

    decade. With the rising pressure on

    cost of funds, it is imperative for banks

    to look at other avenues to boost their

    income. The fee income in FY 13 for

    67 banks in our sample set10was INR

    64,418 Cr; clocking a three year CAGR

    of 12 percent and ve year CAGR of 15

    percent.

    PSBs have constituted a large part

    (60 percent) of this basket since the

    beginning, owing to their reach and size.

    Pressure on fee based income

    However, in recent times with the

    overall pressure on the economy and

    changing regulations, the fee based

    incomes of banks have come under

    pressure. Banks earned lower corporate

    banking fees due to slowdown in project

    nance. Also, with The Reserve Bank of

    Indias (RBI) recent measures to tighten

    liquidity and curb volatility in foreign

    exchange rates have led to a rise in

    bond yields leading to a drop in treasury

    incomes for banks. On the retail side,fee income earned by banks on account

    of sale of gold coins has dried up with

    the government banning sale of gold

    coins by banks. These factors have

    necessitated banks to revamp their fee

    based product portfolio.

    Emerging trends

    Banks looking to increase fee-based

    income are shifting focus to selling

    life insurance and general insurance

    policies (through bancassurance tie upsor as insurance brokers). Indian bank

    recently partnered with United India

    Insurance and launched a web portal

    for its Arogya Raksha group mediclaim

    insurance policies. Moving forward,

    the bank is in talks with a life insurance

    company for a similar tie-up in the life

    insurance space. The bank expects a

    30 percent11growth in income from

    insurance this scal. Some of the other

    recent bancassurance tie-ups include

    PNB with Metlife and Axis Bank with

    10 The sample set comprises of 26 PSBs, 18 PBs, and 23 Foreign banks

    11 http://articles.timesondia.indiatimes.com/2013-06-14/india-business/39975382_1_fee-income-fee-based-income-fy-13

    Fee Income (INR Cr)

    Source:KPMG-Business Today Best Banks December 2012

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    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    The banking sector is crucial foran economy since it channelisessavings into investments. It

    provides credit to the productivesectors and nances the

    needs of the real economy. Foremerging economies, banks aremore important since they are

    important drivers of nancialinclusion and economic growth.Banks by nature are highly

    leveraged and interconnected.Hence, poor governance orfailure in banks can trigger

    bigger crisis and threatenstability of the economy.

    Banks in India are wellregulated with The ReserveBank of India adopting a

    forward looking yet cautiousapproach. In the 1990s, thetone of banking regulation

    shifted from prescriptive toprudential, shifting the onusfrom regulations to corporate

    governance. Various guidelineswere issued over the years to

    improve corporate governancein banks. To get competentdirectors on board, the RBI

    issued t and proper criteriafor directors which said that

    private banks should carry outdue diligence to determine thesuitability of the person for

    appointment as a director basedon qualication, expertise, trackrecord and integrity.

    Governance andCompliance

    Gearing up forthe next level

    In 2005, the Ganguly Committee recommended separation of Chairman and MD

    roles. The recommendation was implemented in private banks. The RBI also issued

    guidelines on ownership and governance in private banks to ensure that ownership

    and control of banks are well diversied and thus not detrimental to depositors

    interest. Moreover, any acquisition of shares in private sector banks resulting in

    a shareholding of 5 percent or more of the paid up capital requires the RBIs prior

    approval. Banks are also mandated to have committees on audit, nominations andremuneration, fraud monitoring, and customer services. All these provisions put the

    corporate governance framework adopted by Indian banks on par with international

    standards.

    Although improving regulatory landscape is a welcome move, regulation in isolation

    is not enough. It is a necessary but not a sufcient condition for good governance.

    Regulation can complement governance, not replace it. Good governance has to be

    institutionalized by individual banks for it to be effective. While broadly Indian banks

    have good governance standards, there is room for improvement.

    In the sections below, we take a brief look at the important issues in governance

    and compliance in Indian banks and how they can be addressed.

    Governance in Indian banksThe nancial crisis of 2008 brought inadequate governance in banks and other

    nancial institutions in sharp focus. Experts argue that simplistic assumptions

    and lack of rigorous questioning by bank boards led to the crisis. Banks boards,

    management, and employees faced conict of interest routinely in their jobs. When

    faced with a conicting situation, compensation structures in the nancial sector,

    which should have ideally pushed the decision makers towards the better choice,

    instead encouraged excessive risk taking.

    Once the crisis started in one area of the nancial sector, it spread to other

    areas quickly due to blurred boundaries between banking, insurance and asset

    management businesses. Although Indian banks came out of the crisis relatively

    unscathed, they (particularly the public sector banks) face peculiar governance

    challenges in the form of government control.

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    Governments control over publicsector banks

    The Indian banking sector is character-

    ised by the dominance of PSBs which

    account for approximately 70 percent of

    the industry1. The government through

    its agencies owns majority stakes

    in these banks and exerts inuence

    through its monetary policy and direc-

    tives.

    In the context of PSBs, it is difcult to

    adhere to public ownership and yet give

    near total autonomy to their boards

    as compared to private sector banks

    where the board has autonomy and all

    shareholders are treated at par.

    Bank Subsidiary Model needs to bereassessed

    Another governance related issue in

    Indian banks is the corporate structure

    they follow. Currently in India, the bank

    subsidiary model is popular. Under this

    model, non-banking activities such

    as insurance, asset management etc

    are done in separately constituted

    subsidiaries of the bank. This model

    has its own set of problems and

    disadvantages. E.g. rstly, losses of

    subsidiaries could substantially damage

    the nancial health of the bank and

    risk the safety of deposits. Secondly,since the bank will be responsible for

    equity infusion in the subsidiaries and

    their management, having several

    subsidiaries could stretch the banks

    nances and other resources. Thirdly,

    the proportion of foreign holding

    in holding banking company is not

    taken into account for the purpose of

    calculating the cap of foreign holding in

    subsidiaries. And nally, the subsidiary

    model could lead to excessive leverage

    by the downstream afliates.

    The Shyamala Gopinath Working

    Group appointed by the Reserve Bank

    recommended that the nancial holding

    company model should be preferred for

    the nancial sector in India.

    Revising the compensation structureto improve governance

    After the 2008 nancial crisis,

    compensation structure in banks came

    under sharp focus and criticism. Now it

    is widely acknowledged that aggressive

    and irrational incentives and excessive

    risk taking by bank executives fuelled

    the crisis. The compensation structure

    at times encouraged compromising

    long-term interests for short-term gains.

    To check excessive risk-taking behavior,

    the RBI issued guidelines which

    aligned compensation structures with

    prudent risk taking and instituted a

    claw back mechanism. However, as

    of now there is no consensus on what

    is a good compensation structure for

    non-executive directors. Currently

    non-executive directors are paid sitting

    fees. There is a school of thought that

    believes that non-executive directors

    should be paid a regular or a xed

    contractual remuneration. Although this

    is a good idea, it is difcult to implement

    in practice. Firstly, non-executive

    directors typically serve for shorter

    periods and have term limits. Secondly,

    in banks the results of risks taken

    manifest after a long gap. And nally

    since non-executive directors serve

    on several committees comprising ofmany directors, it is difcult to apportion

    responsibility on them individually.

    Hence, aligning non-executive directors

    compensation structure with outcomes

    of corporate governance is still a grey

    area.

    Separating the roles of Chairmanand Managing Director

    In 2005 the Ganguly Committee

    appointed by the RBI recommended

    that the posts of the chairman of theboard and the CEO of the bank should

    be bifurcated. The committee argued

    that this will bring about more focus

    and vision and necessary thrust to the

    functioning of the top management

    of the bank and also provide effective

    checks and balances. The committees

    recommendations were implemented in

    private sector banks in 2007. However,

    the nance ministry did not favor the

    proposal and hence it was not adopted

    in public sector banks except in SBI and

    associates.

    Allowing corporates into the bankingspace

    The RBI has received 26 applications

    for new banking licences2. However,

    there is a lot of debate on whether

    large corporates should be allowed to

    start a bank. International experience

    in this regard has been mixed. While

    corporates can bring in professional

    management experience and capital,

    many experts fear that they will use the

    bank as a private pool of readily available

    funds.

    However, to avoid this, the RBI has built

    in several safeguards in the new banking

    licence guideline. To keep non-serious

    players at bay, the guideline says that

    the applicant entity/group should have

    a past record of sound credentials and

    integrity, should be nancially sound

    and have a successful track record of 10

    years. It also underlines the importance

    of diversied ownership. It says that

    a Non-Operative Financial Holding

    Companies (NOFHC) should set up newbanks. The NOFHC should retain their

    equity capital in the bank at a minimum

    of 40 percent for fuveyears after which

    they should reduce to 15 percent within

    12 years. The guideline also has criteria

    on nancial inclusion.

    The above provisions clearly show that

    the regulator wants new banks to have

    good governance standards. Failing to

    meet the aforementioned conditions

    could have serious repercussions for

    new banks.

    1 Reserve Bank of India

    2 RBI Press Release RBI discloses the names of applicants

    for new bank licences in the private sector, Jul 2013

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    Importance ofcompliance at banksCompliance for banks is given a lot of

    importance as they are the engines of

    a countrys economy and, therefore,

    also more regulated. In fact, post the

    nancial crisis regulatory supervisionof banks has increased noticeably,

    underscoring the increasing importance

    of regulatory compliance for banks.

    Evolution of banking regulations and

    enforcement

    In 2010, Basel Committee on

    Banking Supervision (BCBS) issued

    comprehensive Basel III guidelines to

    improve the banking sectors ability to

    absorb shocks arising from nancial

    and economic stress. The guidelinesrecommend more stringent capital

    and liquidity requirements apart from

    suggesting enhancements to Basel

    II and market risk frameworks. In the

    same year the US introduced Dodd-

    Frank Act to enhance nancial stability,

    orderly liquidation and other host of

    measures to ensure measures directed

    at hedge funds, insurance companies

    and banks.

    Similarly, in India, RBI has been

    issuing a host of directives to improvegovernance and compliance at Indian

    banks in the last two years. Specically,

    the regulator has issued key directives

    aimed at enhancing corporate

    governance at NBFCs, enhancing

    know your customer (KYC)/anti-money

    laundering (AML) norms, tightening

    regulatory oversight at foreign banks by

    making CEOs of such banks responsible

    for compliance, structuring the credit

    approval process by recommending a

    board-level credit committee, etc. Thenew guidelines for issuance of banking

    licenses are also indicative of this trend.

    RBI is also strengthening its

    enforcement efforts. Its recent orders

    penalising 19 commercial banks for

    mis-selling derivative products to clients

    and 3-4 banks for violation of KYC/

    AML norms is indicative of this trend.

    Additionally, RBI recently constituted a

    High-Level Steering Committee which

    recommends the regulator to transition

    to a risk-based supervision (RBS)approach, which entails determining

    the intensity of supervision based

    on a banks risk prole. This would

    necessitate banks to strengthen their

    governance, risk management and

    compliance frameworks.

    Banking communitys response to

    this evolution

    Often, companies tend to respond to

    more regulations, increased scrutiny and

    instances of wrong doing with another

    checklist or another layer of control or

    redundant procedures. This may or may

    not address the issue permanently.

    More importantly, this spontaneous

    reaction could create multiplicity in

    rules, increased compliance costs,

    unwanted bureaucracy and delayed

    decisions.

    The spontaneous reaction is to acertain extent because organisations

    view compliance as a mere cost of

    doing business and as an impediment

    to their operations. This could be

    counterproductive and often lead to

    misdirected compliance and control.

    This in turn could lead to overlapping

    and inconsistent rules and regulations

    that are difcult to comprehend or

    requirements that without a clear

    purpose or intention and remain merely

    on paper.

    In fact, banks stand to gain more if

    they leverage compliance as a value

    driver and comply with laws of the

    land in sprit. This comes from a good

    understanding of the consequences of

    non-compliance on the bank and on

    the industry/economy as a whole at all

    levels of the organization.

    Compliance as a value driver

    In order to leverage it as a value-driver,

    banks should adopt a complianceframework that is proactive, rigorous,

    co-operative and pervasive.

    Proactive:Addressing compliance

    proactively involves a two-pronged

    strategy of assessing compliance

    risks, including upcoming ones,

    and inducing appropriate changes

    in policies, processes and controls

    to address these risks. It involves

    implementing best practices by

    complying with the spirit of the

    regulations than merely the letterof it.

    Rigorous: Adopting a zero-

    tolerance approach to non-

    compliance involves making

    efforts to curtail all sorts of non-

    compliance and not just material

    ones. Any non-compliance in

    regards to regulations is viewed

    seriously, regardless of the extent

    of the regulators supervision, and

    corrective actions are implemented

    in a timely manner to curtail any such

    future instances of non-compliance.

    Co-operative:Making the process

    co-operative involves leveraging

    the synergy of compliance

    initiatives across the organisations

    and avoiding any duplication of

    efforts. This reduces the cost,

    complications and inconsistencies

    in regulatory compliance for banks.

    One of the ways to achieve this

    is by establishing an empowered,

    independent compliance

    function.

    Pervasive:Introducing a pervasive

    approach involves making

    compliance with regulations or the

    banks internal rules everyones

    responsibility. The banks employee

    performance system accords as

    much importance to compliance

    KPIs as given to business KPIs.

    It also involves timely training

    and communication to educate

    employees on the intent behind

    regulations and the banks internal

    rules.

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    ConclusionIndian banking sector is at an

    inexion point. To meet the demands

    of Indias huge potential, heavy

    infrastructure spending, and the

    governments ambitious nancial

    inclusion plan the banking sector will

    have to gear up for unprecedented

    challenges. To prepare for

    the upcoming challenges, the

    government formed a commission

    with a task of overhauling the

    regulatory landscape of nancialsector. The commission Financial

    Sector Legislative Reforms

    Commission drafted a code called

    the Indian Financial Code (IFC).

    The IFC has called for a unied

    regulator for the nancial services

    sector which will regulate insurance,

    capital market, pension funds and

    commodities derivatives market.

    It has recommended that the RBI

    should continue to exist outside

    the unied regulator althoughwith modied functions of setting

    monetary policy, regulating banks

    and payment systems.

    To what extent the RBIs functions

    will be modied is not known yet.

    However, one of the most important

    challenges the sector is likely to

    face is the challenge of governance

    and compliance. Achieving optimal

    growth, balancing stakeholder

    expectations and complying with

    regulations is likely to be a tight

    rope walk for the sector. However,

    with support from the RBI and

    the government, it is likely to be arewarding experience.

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    Financial exclusion has beenan area of concern and castsshadows over the long-term

    sustainable growth of theIndian economy. Thoughthe country has had a large

    unorganized sector (consistingof money lenders, chit funds,

    etc.) providing the nancialservices for a long time, thereach of the organized sector

    (banks, NBFCs, MFIs, NGOs,etc.) remained limited. Theunregulated unorganised

    sector players, with theirstrong focus on earning

    prots, did little to bring in thenancially excluded people inthe mainstream.

    The central bank prescribes thefollowing four basic nancialservices to be provided to any

    individual to count heras nancially included.

    Access to basic savingsaccount

    Availability of affordablecredit

    Access to remittance

    services

    Opportunity to buy

    insurance and investmentproducts.

    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    Financialinclusion - Quest

    for profitability

    Data released by the World Bank depicts that on an average Indians over the age

    of 15 years remain considerably under-banked as compared to their global peers.

    While almost half the global population above 15 years has an account at a formal

    institution, the gure is only 35 percent in India. The scenario is even worse in case

    of female population. Looking at the same metric for the bottom 40 percent of the

    population by income, 41 percent population globally has an account as compared

    with 27 percent in case of India.

    Financial inclusion status for population above 15 years: global comparison (in %)

    Source:India Commercial Banking Report - New Permits To Boost Competit ion In Underbanked Economy, ISI Emerging Markets,

    accessed on 26 August 2013

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    Even the extent of nancial exclusion in India is

    widespread as reected in the following facts.1

    Highest number of households (145 million)excluded from banking

    50 percent of the population does not havebank account

    Only 34 percent of the population engaged

    in formal banking

    Only 17 percent of population has any creditexposure especially in remote villages

    Out of 600,000 villages, only 30,000 (5percent of total villages) have commercial

    bank branch

    Only 10 percent have life insurance coverwhile just 9.6 percent have any non-life

    insurance.

    The policy makers have adopted a multi-

    pronged approach to address the issue of

    nancial exclusion. Key elements of the

    strategy include:

    Evolving regulatory guidelines withdevelopment perspective

    Deepening banking reach and coverage

    Introduction of Innovative products

    Encouraging use of technology

    Financial literacy and nancial inclusion-synced approach.

    There has been an intense debate on the

    appropriate model for FI. RBI has favored

    bank-led model instead of the technology-

    led model which has been successful in

    many other countries. The model allows the

    country to leverage existing branch base for aplanned, structured and sustained FI process.

    It also reduces the risk given the low literacy

    levels (and even lower nancial literacy) of

    the potential set of customers leaving them

    vulnerable to players either not regulated at all

    or not regulated by the RBI.

    Till date, India has had a limited success in

    achieving FI with the model. However, given

    the Indian scenario, the model facilitates a

    consistent and planned move towards the goal

    of FI while maintaining the nancial stability.

    Challenges in reaching out to the under-banked Infrastructure:Both physical and digital connectivity are essential for institution

    to provide nancial services through a mix of channels depending on the cost

    and type of services offered. To illustrate, the widespread use of the kiosk

    banking has been inhibited by poor connectivity in the hinterland.

    In terms of credit, lack of credit history and limited collateral poses a

    challenge:Credit bureaus have not expanded their reach much to the rural

    areas; hence banks are hesitant to hand out loans to the under-banked with

    limited documentation in terms of proof of income. Also, asset ownership is

    limited and generally restricted to farm land with no clear documentation.

    Varied prole of consumers:Banking needs vary according to the customer

    proles and due to diversity in population, it becomes difcult for bankers to

    understand this segment.

    Global FI models and relevance for IndiaMany of the scalable and successful experiences globally have been led by telecom

    companies with the banks playing a secondary role.

    M-Pesa in Kenya:Parallel banking ecosystem managed by telecom companies,

    allowing the consumers to make majority of mobile banking payments, transfers

    and transactions on their mobile phones. It is a cost effective and adaptable

    system which has brought many people into the formal banking system and

    has grown rapidly with client base of around 10 million, roughly 40 percent of

    Kenyas adult population.

    USAID MABS in Philippines:Microenterprise Access to Banking Services

    (MABS) assists network of partner rural banks in the development and

    introduction of innovative products, including mobile nancial services. Its a

    successful model that has more than 90 MABS-supported rural banks managing

    around 250,000 microloan borrowers and 1.5 million micro-savings accounts.

    These banks have also registered more than 250,000 mobile phone bankingclients and have processed more than USD250 million in mobile banking

    transactions. This model could be used to provide training and technical

    assistance to rural banks in India which could give a boost to innovative product

    launches in the rural segment.

    MTN Mobile Money in South Africa: Mobile operator MTN and Standard

    Bank, through their joint venture MTN Banking, launched a mobile banking

    product MTN MobileMoney. Every MTN SIM card has an embedded banking

    application and only MTN subscribers can open MobileMoney accounts. Under

    MTN MobileMoney, 1.6 million people are registered users with over USD90

    million transacted every month. Although Indian banks have started teaming

    up with mobile operators for providing banking services to unbanked people,

    banking regulations do not permit a lead role for telecom companies in India.

    1 Financia l Inclusion and Financial Literacy Indian Way,

    Dr. KC Chakrabarty, RBI

    Our experience shows that the goal of nancial inclusion is better served

    through mainstream banking institutions as only they have the ability to

    offer the suite of products required to bring in effective/meaningful nancial

    inclusion.

    The development of the habit of banking would lead to an increase in savings

    and investment improve the efciency of allocation of capital and increase the

    ability of monetary authorities to stabilise the economy in times of crisis.

    Deepali-Pant Joshi ED, Reserve Bank of India

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    Way forwardA meaningful FI could be achieved only

    through a collaborative effort of all the

    stakeholders involved. Policymakers

    could help provide a facilitating policy

    framework, infrastructure support and

    enabling environment whereas serviceproviders should experiment with

    different models to serve the unbanked.

    Further, there has to be collaboration

    among service providers with nancial

    institutions partnering with telecom,

    technology, and consumer product

    providers to create an enabling

    environment.

    Government and regulators

    initiatives

    RBI has already made it very clearthat the new banks, that will be given

    licenses, have to open one in four

    branches in rural areas. Premises of

    allowing new banks in the sector is to

    reach out to the bottom of pyramid.

    Improve Financial Literacy:The

    GoI and RBI should put in place a

    country-wide strategy to provide

    nancial education using standard

    literacy material both as part of the

    school curriculum and as a part of

    the kit to educate adults.

    Aadhaar card:The nation-wide

    initiative to provide a unique

    identier to every Indian, could be

    integrated with the service delivery

    mechanism. It could help address

    the main issue of complying with theknow your customer (KYC) norms

    that banks perceive to be probably

    the biggest hurdle in expanding

    their reach. Successful integration

    of Aadhaar with banks database

    would also allow banks to have a

    360 degree view of their customers

    to better manage risk and cross sell

    more services.

    Bankers initiatives

    Simplicity is the key:Due tonancial ignorance, developing

    simple easy to understand product

    for the rural population is the key to

    success.

    Leverage technology to develop

    innovative operating models:As

    discussed above, technology-based

    initiatives are leading examples for

    success in FI. BC channels and other

    low cost delivery models such as

    mobile banking would help bankers

    reach out to the bottom of pyramid.

    2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

    Micronance sector has been quite

    successful (As a sector we reach

    around 2.5 crore women in India) to

    take nancial products to poor andexcluded but fallacy is that we are not

    considered an important channel of

    nancial inclusion as a very important

    nancial service i.e. acceptance of

    credit is beyond purview of MFIs.

    There is no reason to undervalue

    the potential of this channel, before

    looking to some other industry for

    solution.

    Chandra Shekhar Ghosh Chairman & MD,

    Bandhan Financial Services Pvt. Ltd.

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    Traditionally banks havebeen the pioneers inharnessing new technology

    trends. The applicability ofMoores law in the areas oftelecommunication, internet

    and mobility were signicantenablers for banks in achieving

    two extremely importantbusiness objectives revenue enhancement with

    cost efciencies. In existingtimes, the nancial servicesindustry is keenly exploring

    the transformation potentialof the new generation of

    technologies availablelike Social media, Mobile,Analytics and Cloud (SMAC).

    The increased commoditizationof service offerings from bankshas placed incessant demand

    on them to adopt variable coststructures, increase revenue,improve products and services,

    expand market share andachieve nonlinear revenue

    growth.

    The Indian banking industryhas to its credit a number

    of innovations, many of

    them driven by technologyinvestments.

    SMAC - Future oftechnology

    The Indian Capital Markets sector moved to a T+2 settlement cycle, long before

    many developed economies. Similarly the introduction of NEFT and RTGS were

    watershed moments in Indias payment landscape which enabled a signicant

    shift to electronic payment forms at a lower cost. The Pan India UID program when

    linked to nancial transactions is expected to signicantly plug the current leakages

    in Government welfare schemes.

    In the current environment, the key focus areas of bank are lowering cost of

    funds, faster rollout of products achieving nancial inclusion and priority sector

    lending targets in a protable manner, compliance with various national and global

    regulatory norms and increased customer satisfaction.

    Social mediaSocial media can be used as an effective tool to interact with the customers

    regarding queries and complaints. Once the queries or complaints have been

    posted on the social media page, the nancial institution representative can address

    it in a timely fashion. If the activity requires any exchange of sensitive information,

    the nancial institution may contact the customer directly using a secured channel

    of communication. Hence, social media can be efciently used as the rst level ofquery resolution and as this is a non core activity which is moved away from the

    branch and other delivery channels, it leads to cost savings for the rm.

    Social media, being multidirectional, allows customers to convey sentiments

    regarding the rm. Therefore, it would be prudent for nancial institutions to

    have presence on social media to gauge the attitude of the customers. In case of

    public airing negative sentiments, the nancial institution can act swiftly thereby

    containing the issue.

    The fundamental use that a social network can serve a nancial institution is

    brand awareness. Financial institutions can engage the users of social media in

    different ways such as by displaying special offers and discounts, asking questions

    or conducting polls, displaying industry related news and opinions, etc. Engaging

    the social media users effectively can result in increase in brand awareness at a

    signicantly lower investment compared to mainstream media.

    However social media is considered to be unchartered territory under the

    apprehension that it is still evolving and it would be prudent to engage only after it

    has reached a mature stage.

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    MobilityIn a land where almost a billion people

    own mobile phones, cash is still king

    and large swathes of the population

    have no formal bank account, mobile

    payments are quickly becoming a critical

    part of Indias economy. Mobile phonepenetration is booming and while

    levels have not quite reached that of

    some Asian or European countries few

    people in either the cities or the furthest

    reaches of the countryside are without

    some level of access to a mobile phone.

    Banks, on the other hand, are few and

    far in between; in fact, it is estimated

    that only about a quarter of all Indians

    have a bank account, while more than

    60 percent own a mobile phone. Faced

    with these dynamics, it does not takelong to realize that mobile payments will

    ultimately bring transformation to not

    only the payments industry, but society

    at large.

    One of the most promising signs of

    Indias leadership in mobile payments

    comes from the high level of

    cooperation within the industry itself.

    On both the banking and the telecoms

    sides, we are seeing players come

    together and put aside their competitive

    differences in order to develop commonstandards and approaches to mobile

    payments. All stakeholders - banks,

    telecoms operators, technology

    providers, regulators and government

    organizations - have created the Mobile

    Payments Forum of India (MPFI), and

    are collaborating to address the market

    needs.

    As a result, India has witnessed the

    ascendency of two initiatives that,

    together, are accelerating growth of

    the mobile payments market. InterbankMobile Payment Service (IMPS) - a

    platform developed by National Payment

    Corporation of India is already adopted

    by more than fty of Indias banks to

    offer instant payment and remittance

    services using SMS, WAP, and a range

    of mobile apps.

    CloudThe advent of cloud computing has

    resulted in the dismantling of traditional

    cost structures. It enables organizations

    to shift from a CAPEX heavy model to a

    variable cost model. Software licenses,

    servers, networking equipments,

    storage devices are typically considered

    to be the key CAPEX components. In

    a cloud model, the bank pays for what

    it needs when it needs it. Cloud also

    allows a bank to scale its business

    operations.

    Using cloud services, it is easier

    to collaborate with partners and

    customers, which can lead to

    improvements in productivity and

    increased innovation. Cloud-based

    platforms can bring together disparate

    groups of people who can collaborate

    and share resources, information and

    processes.

    The ability to respond to rapidly

    changing customer needs is a key

    competitive differentiator. Likecompanies in other industries, banks are

    continuously seeking ways to improve

    their agility and adjust to market

    demands. By enabling businesses

    to rapidly adjust processes, products

    and services to meet the changing

    needs of the market, cloud computing

    can facilitate rapid prototyping and

    innovation, which helps speed time to

    market.

    However the adoption of cloud in banks

    has not achieved the scale that wasoriginally envisaged. Security and Data

    Privacy concerns are attributed as some

    of the key reasons for this. Additionally

    banks are also concerned by risks of

    provider performance and downtime.

    The tax implications of using cloud

    services are also one area that some

    banks seek clarity on.

    AnalyticsThe role of analytics has evolved from

    being a simple support function to that

    of a key business differentiator.

    Analytics today can be effectively

    deployed at every stage of the

    consumer lifecycle. The Know your

    customer (KYC) activity in the customer

    onboarding process is increasingly

    dependent on analytics tools to identify

    the right set of customers. Anti-money

    laundering (AML) monitoring is another

    aspect where complex algorithms are

    used to identify reportable transactions.Similarly consumer spend analysis can

    assist banks in identifying cross sell and

    up sell opportunities. Loan originators

    and servicers can differentiate

    themselves in the marketplace with

    superior underwriting techniques and

    sophisticated models that can predict

    potentially non performing portfolios

    with a high degree of accuracy.

    Analytics also is playing a signicant role

    in optimal product pricing.

    The banking industry is replete with

    examples of retail banking service

    providers that have harnessed the

    capabilities of analytics. As the banking

    industry gets more complex, analytics

    is forecasted to have a even more

    signicant play.

    Way forwardThe collective usage of SMAC has

    a multiplier effect on the benets

    delivered. These tools can be applied

    at different stages of any typical

    banking process. For example, the

    data generated by users social media

    postings can be coupled with location-

    based data from their mobile devices,

    which can, in turn, be analysed in

    real time on a virtual cloud platform.

    The explosion of data and analytics

    technology allows banks to store,

    manipulate, and analyse greater

    volumes of data and extract meaningfulinsights about customers preferences.

    This comprehensive view of the

    customer can be used to effectively

    engage existing and potential

    customers through tailored marketing

    strategies. Services and products can

    be presented based on customers

    preferences. Individualised sales and

    marketing strategies can help banks

    target different customers for easy

    mobile deposits, mortgage loans, small

    business loans, and so on.

    Ultimately, this granular, 360-degree

    customer view made possible through

    SMAC technologies can improve the

    loyalty of existing customers, help

    banks engage these customers in new

    services, and increase the market share

    for banks by attracting new customers.

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    Banks have long faced the riskof losses from undesirablemarket movements. This

    signies that institutionsshould have the best possibleapproaches to understand,

    model and manage marketrisk and to estimate capital

    reserves they need to provideas buffer against their marketexposures. As Indian banks

    moves towards the Value atRisk (VaR) based approachto capture trading book risks,

    this chapter captures someof the challenges banks need

    to focus on before the banksmigrate to the new regime.

    Hedging themarket risk

    The trading book supervisory regime introduced in 1996, requires nancial

    institutions to measure risks resulting from the transactions held in their trading

    book and to cover market risks by regulatory capital. Market risk includes: interest

    rate risk, equity position risk, settlement and counterparty risk and foreign exchange

    risk. This regime offers rms the use of either a standardised approach or an

    internal models approach to calculate the capital requirements associated with the

    trading book. Most of the internationally active banks favour the internal modelsapproach, built on the Value at Risk (VaR) methodology. Both the general risk, arising

    from general market movements, and the specic risk, related to changes in the

    credit quality of issuers, to be covered by adequate capital.

    During the 2008 nancial crisis it became evident that many banks had built up

    materially undercapitalised trading book exposures. The revisions introduced under

    Basel 2.5 aimed to reduce cyclicality of the market risk framework and to increase

    the overall levels of market risk capital held by banks, particularly for those areas

    exposed to credit risk. It introduced measures through incremental risk charge

    (IRC). However, regulators are still of the view that the market holds inappropriate

    levels of capital with regards to the Trading Book. The Basel III requires banks to

    carry out Credit Valuation Adjustment (CVA) capital charge to protect themselvesagainst the potential mark to market losses associated with deterioration in the

    creditworthiness of the counterparty, if the deals are done in OTC market.

    Complete assessment of risks in trading bookIn addition to the increase in default risk, the growing presence in trading book,

    of corporate bonds and structured products, which are generally less liquid, has

    resulted in an escalation of certain types of risk. The latter, which include liquidity

    risk, concentration risk and correlation risk, are not fully addressed in current

    regulations on market risk.

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    Going forwardThe Basel Committee is also

    considering replacing Value at risk

    (VaR) measurement by expected

    shortfall (ES). ES is a method of

    measuring the riskiness of a position by

    considering both the size and likelihoodof losses. ES has advantages over VaR

    as it captures tail risks.

    The current volatility in Currency

    Market is clear demonstration of

    how abruptly market conditions and

    volatility can change. In fact far from

    extreme events, the high volatility has

    become almost a part of the normal

    market conditions. Being concerned

    about the situation, RBI in a draft circular

    last month, has put the onus to banks

    on measuring the effect of volatilityto its corporate clients. Based on the

    impact on the earnings of its clients,

    banks have to enhance the provisioning

    requirements and in high volatile

    cases (where earnings are affected

    by over 70 percent) the risk weights

    to corresponding client increases by

    25 percent. With the current volatility,

    decline in asset qualities and new

    capital norms (Basel III), many banks

    are looking to raise fresh capital. The

    banks also need to strengthen theOversight Board to review the trading

    book positions and take appropriate

    actions swiftly to save the interest

    of the institution. To aid the process,

    strong technology platform along with

    appropriate analytics are essential pre-

    requites.

    But if the cost of doing business

    remains high the business could simply

    be switched into unregulated or more

    lightly regulated institutions such as

    hedge funds. Perhaps the pendulumis shifting too far to the side of

    conservatism and will make traditional

    banking difcult and bring about newer

    models of delivery of nancial products

    in the global economy.

    Liquidity risk

    The liquidity of a nancial instrument

    plays a key role in determining the

    holding period for a bank of such an

    instrument and therefore in assessing

    the regulatory capital requirement to

    which it is subject. In general, credit risk

    in the trading book is subject to lower

    regulatory capital requirements than

    in the banking book. The difference

    in capital can be mainly attributed to

    the different time horizons on which

    the risks are assessed: one year for

    credit risk (corresponding to a horizon

    for estimating the probability of default

    of the issuer) and ten days for market

    risk (corresponding to a horizon for the

    closing out or hedging of positions).

    The preferential treatment granted tothe trading book can be ascribed to

    the fact that the positions are held for

    short-term sale and they can be easily

    unwound or hedged on the market.

    However, in practice, this is often not

    the case. Many of the instruments held

    by the bank in trading book may not be

    very liquid. The market liquidity also

    varies according to economic cycles.

    Nevertheless, the assumption that

    positions can be closed out or hedged

    within ten days, which is currently

    used as a basis for calculating capitalrequirements using Value at Risk

    (VaR) models, may prove inappropriate

    for the increasingly frequent case of

    illiquid positions. The inclusion of such

    positions in the trading book therefore

    generally results in insufcient capital

    requirements.

    Concentration and Correlation risks

    Concentration risk is another risk, which

    is not captured appropriately by the

    institutions. Indeed, most corporatebonds include the same names in

    their reference portfolio, giving rise to

    concentration risk on an entity and/or a

    sector associated with their widespread

    use in institutions active credit portfolio

    management.

    Another, correlated risk, which needs

    to be captured, is correlation between

    different risk types (credit, interest,

    currency, equity risks). An increase in

    trading in such instruments, mispriced

    in relation to the real risks incurred,would constitute structural risks.

    Economic capital andstress testingTo overcome some of the challenges,

    one of the solutions the leadings banks

    have been considering is to developing

    tools for calculating economic capital,

    which will integrate credit and marketrisks and their different components.

    Economic capital for all types of risk

    is generally calculated at the one-year

    horizon with a condence interval

    determined by the bank on the basis of

    the probability of default corresponding

    to its current or targeted rating. While

    the main tool for measuring economic

    capital associated with market risk

    often remains a VaR calculation based

    on a 10-day holding period, some

    regulators have devised complementaryapproaches using stress testing and/or

    scaling up the VaR to reect a horizon

    for closing out or hedging positions

    assumed to exceed ten days.

    Furthermore, although modeling credit

    risk correlations is not as yet common

    practice, progress is being made in this

    area. Some models now incorporate

    contagion effects, which allow banks

    using them to capture the impact on

    credit risk from declines in overall

    market liquidity, the failure of large rmsor adverse industry-level developments.

    Such approaches make it possible to

    better take into account extreme or tail

    risks as well as liquidity risk.

    Banking supervisors, in addition to the

    increase in the current VaR multiplier

    and/or considering stress scenarios,

    will enhance the review and the

    assessment of the methods developed

    by banks to calculate and monitor their

    economic capital modeling.

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    Banking turf is set to change.The RBI had set the ball rollingwhen they opened the stage

    with the intention to handout licenses to new entrants.Undoubtedly, the ofcial

    reason was to bring a largenumber of hitherto unbanked

    and under-banked populationin the formal nancial system,but how many aspirants will

    be allowed to get into the ringis RBIs prerogative. In 1993,when the RBI licensed some

    private banks, it received 113applications but only 10 banks

    got the license1.

    Till now, `nancial inclusionwas the responsibility of

    public sector banks but byusing inclusive growth asthe base for licenses, RBI has

    made private sector banksequally responsible in socialobjectives. As one can see

    from the table, currently,public sector banks have more

    branches than any other bankgroup in the rural and semi-urban areas.

    Merit inbanking on new

    licenses

    No. of branches of Scheduled Commercial Banks as on 31st March, 2013

    Bank Group Rural Semiurban Urban Metropolitan Total

    Public Sector 23286 18854 14649 13632 70421

    Private Sector 1937 5128 3722 3797 14584

    Foreign Banks 8 9 65 249 331

    Regional Rural

    Banks12722 3228 891 166 17007

    Total 37953 27219 19327 17844 102343

    Source: Department of Financial Services, June 2013

    One can argue, whether new banks are required in the Indian banking sector. If we

    look at statistics, India being one of the top 10 economies of the world and with

    relatively lower domestic credit to GDP percentage provides great opportunity for

    the banking sector to grow. Indian Banking is expected to become 5th largest by

    the year 2020 and 3rd

    largest by the year 2025. Banking credit is likely to grow at ~17percent CAGR in the medium term leading to increased credit penetration.

    1 Indias Aspiring Banks Line up for Licenses, January 17,

    2013 in India Knowledge@Wharton

    A large portion of rural populations still remains unbanked. Any new banking

    aspirant should create a business plan which will provide banking facilities

    and services for the bottom of the pyramid.

    This is a difcult task, so only those who are able to understand this specic

    market should establish rural branches, lest their portfolio may become sub-

    optimal and operations saddled with high cost.

    Hemant Kanoria CMD, SREI Infrastructure Finance Ltd.

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    In fact, rural and semi-urban areas

    are still under-penetrated with

    banking services and with increasing

    consumption they provide great

    opportunity for banking services to grow

    in these areas.

    As per Census 2011, 58.7 percent

    households are availing banking

    services in the country2. There are

    102,343 branches of Scheduled

    Commercial Banks (SCBs) in thecountry, out of which 37,953 (37

    percent) bank branches are in the rural

    areas and 27,219 (26 percent) in semi-

    urban areas, constituting 63 percent of

    the total numbers of branches in semi-

    urban and rural areas of the country.

    However, a signicant proportion of the

    households, especially in rural areas,

    are still outside the formal fold of the

    banking system. New banks would help

    in inclusive growth.

    Lets assume that licenses have been

    handed out and new entrants are in a

    competitive space, face-to-face with

    strong opponents that have been in

    the industry for eons. What will they

    do differently to succeed? The answer

    will denitely depend on the motive

    behind the banking application but can

    they survive by just being another bank?

    Each one of them has to differentiate,

    make a mark and establish a brandamongst hordes of other brands to

    ensure success. They have to manage

    the lending risk to ensure their success.

    Past experiences show that not all

    banks that got licenses have survived

    the grit and determination to scale

    businesses.

    The banking sector has had rough years

    since Lehman in 2008 but there is still

    lot of scope for new entrants in the

    private sector. What has attracted the

    new entrants to this sector? Economistsare positive that the dark clouds

    hovering over the Indian economy

    will move away and it will move to 7-9

    percent growth orbit in the next 10

    years. In the process of growth, banking

    sector will also benet and grow further.

    Apart from the fact that the

    opportunities are in galore in the banking

    sector (current and future), the ROA for

    private banks was 1.31 percent for FY13

    as compared to 0.73 percent for PSBs

    in the same period.3The average netNPAs to net advances for public sector

    banks as on FY13 was 1.99 percent as

    compared to 0.84 percent for private

    sector banks.4

    2 Department of Financia l Service, June 2013

    3 The average ROA for private sector excludes Ratnakar

    Bank and City Union. Source: Capitaline

    4 D Subbarao speech on Banking structure in India on 13th

    August, 2013

    Banking credit is expected to grow at CAGR ~17% in the medium term (INR Bn)

    Source:RBI, KPMG in India analysis

    Signicant head-room for growth

    Domestic credit to GDP (% 2011)

    Source:World Bank report 2012

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    Rural branches as the nal frontier

    Along with the above requirements,

    RBI requires new banks to open

    one in four branches in rural areas.

    However, various challenges inherent

    in rural nance have led to inadequate

    access to nancial services for therural population. How the new banks

    maneuver around the high risk and

    operational cost would be of great

    interest to the stakeholders. Rural

    economy is largely a cash economy,

    which adds to the complexity and risk

    of operations. New banks with strong

    rural strategies, cost-effective operating

    models, branches in tier-5 to 6 cities,

    strong alliances with MFIs and BCs with

    proper governance control and local

    market knowledge would spell successin the rural areas.

    Learning from the past to secure

    future!

    The RBI is cautious about the new

    banks as they are concerned about

    depositors money; therefore, they will

    review all the banking licenses from a

    t and proper angle. There is no doubt

    about the fact that governance and

    strong risk management processes will

    get priority when the RBI is deciding onlicenses. Post license, new banks have

    to adhere to strong risk management

    processes to ensure that there are

    no lapses in the regulatory norms and

    they are not the reason for triggering

    systemic risk in the banking system.

    ConclusionOperating in the niche area protably

    and creating a viable business would be

    the key concern for all new bankers as

    they have to adhere to all the statutory

    reserve requirements that may affect

    their credit availability:

    SLR (Statutory liquidity ratio)

    currently at 23 percent

    CRR (cash reserve ratio) norms

    currently at 4 percent

    Banks have to be Basel-III

    compliant.

    Banks have to lend 40 percent of

    their advances to the priority sector

    Dynamic Provisioning.

    The new governor, Mr. RaghuramRajan, has indicated that the bank

    licenses would be handed out before or

    within January 2014. How new banks

    would change the enviornment would

    be of interest to all stakeholders.

    Success of new banks would depend

    on:

    Sectoral expertise/ knowledge

    The new players have to make their

    mark on customers who already are

    banking with other eminent players.

    What will set them apart? Whatwill ensure success for new banks?

    Sectoral expertise/ knowledge based

    on products (asset-based nance,

    commodity-based nance), on industry

    (engineering, infrastructure, telecom,

    media, technology etc), nature of

    their work (transporters, distributors,

    exporters, importers etc) or on

    geography (North, South, East or West)

    will denitely put them ahead of the

    race and help them attain consumers

    trust.In case of retail, asset-backed lending

    applicants who have an edge with their

    customer base, loan book and sectoral

    knowledge would be ahead in the race

    as opposed to other applicants who

    have to start from scratch. The transition

    from an NBFC to a bank will depend

    on strong management as they would

    be moving in new businesses with

    uncharted risk areas.

    Customer segmentation is the ke