naren final full report

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EVALUATION OF BUSINESS STRATEGIES FOR

EFFECTIVE BANK BRANCH MANAGEMENT

THESIS

Submitted in partial fulfilment of the requirements of

BITS C421T/422T Thesis

By

NARENDRA KUMAR. D

2000B3A4564

Under the supervision of

Prof. Omvir Chaudhry

Faculty Member

Economics and Finance group

Birla Institute of Technology and Science, Pilani (Rajasthan)

May 2005


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EVALUATION OF BUSINESS STRATEGIES FOR

EFFECTIVE BANK BRANCH MANAGEMENT

THESIS

Submitted in partial fulfilment of the requirements of

BITS C421T/422T Thesis

By

NARENDRA KUMAR. D

2000B3A4564

M.Sc. (Hons.) Economics,

B.E. (Hons.) Mechanical Engineering.

Under the supervision of

Prof. Omvir Chaudhry

Faculty Member

Economics and Finance Group

Birla Institute of Technology and Science, Pilani (Rajasthan)

May 2005


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Acknowledgements

I would like to express my gratitude to Prof. Ravi Prakash, Dean, Research

and Consultancy Division, for giving me the opportunity to work on this thesis. I am

greatly indebt to Prof. Omvir Chaudhry, for guiding me and for giving constant

inputs and spending his valuable time on me in spite of a busy schedule.

I am also grateful to my examiner Prof. Prakash Singh who has constantly

supported me in bringing out this thesis. Their suggestions were invaluable and I tried

to incorporate them to the best of my ability.

Last but not least I would to thank Library staff, IPC Staff and my friends who

constantly helped me with their valuable suggestions.


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CERTIFICATE

This is to certify that the Thesis report entitled EVALUATION OF

BUSINESS STRATEGIES FOR EFFECTIVE BANK BRANCH

MANAGEMENTsubmitted by NARENDRA KUMAR.D (2000B3A4564)

in partial fulfillment of the requirements of BITS C421T/ 422T Thesis

embodies the work done by him. He has duly completed his thesis and

has fulfilled all the requirements of the course to my satisfaction.

(P rof. Omvir Chaudhry)

Date: 05-05-05 Economics and Finance Group

BITS, Pilani

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE

PILANI 333 031 (RAJASTHAN) INDIA


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Birla Institute of Technology and Science,

Pilani(Rajasthan).

Course Title: THESIS

Course No.: BITS C421T/ 422T

Duration: I SEMESTER, 2004-2005

Date of Submission: 5th MAY, 2005.

Thesis Title: EVALUATION OF BUSINESS STRATEGIES

FOR EFFECTIVE BANK BRANCH

MANAGEMENT

Name / ID No.: NARENDRA KUMAR.D 2000B3A4564

Thesis Guide: Prof. OMVIR CHAUDHRY

Key Words: Banking, venture capital, Branch

banking, challenges in banking

Abstract: This thesis report aims at understanding the Banking Industry

and the working of a Commercial Bank.This report also deals with the

services offered by a Commercial bank and about the Venture Capital

service in detail. Prior research has shown that Venture Capital (VC) plays

an important role for the commercialization of innovation in sectors such

as information and communication technologies, and biotech. These

sectors account for about two thirds of all VC investments and the report

deals with the problems faced by the VC in India and the management of

challenges faced by the banks in India. A case study about the

importance of branch banking also has been dealt.

Signature of Student Signature of Project Guide

Date: 05-05-05 Date: 05-05-05


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TABLE OF CONTENTS

Topic pg no

acknowledgements ..........................................................................................................i

Abstract 1. INTRODUCTION ......................................................................................................1

2. BANKING STRATEGIES OF TODAY.......................................................................2

3. MANAGEMENT CHALLENGES IN BANKING........................................................4

4. BRANCH BANKING: THE BACKBONE OF BANKING INDUSTRY - A CASE

STUDY .........................................................................................................................12

5. BUSINESS STRATEGIES UNDER CHANGING ENVIRONMENT........................16

5.1 HIKING DEPOSITS..........................................................................................165.2 BANKINGS PROBLEMS WITH GROWTH .................................................16

5.3 BANKING INDUSTRY IN A CHANGING SOCIETY...................................175.4 BANCASSURANCES ......................................................................................18

6. SERVICES OFFERED BY BANKS.........................................................................19

6.1 SERVICES BANKS HAVE DEVELOPED MORE RECENTLY...................20

7. AN INTRODUCTION TO VENTURE CAPITAL.....................................................23

7.1 VENTURE CAPITALISTS-NEED IN INDIA .................................................277.2 ROLE OF VENTURE CAPITALIST INDIAN CONTEXT...........................287.3 A SUCCESSFUL VENTURE CAPITALIST-INDIAN CONTEXT................297.4 INDIA STRATEGIC VENTURE CAPITAL IMPORTANCE......................337.5 CREATING AN ENVIRONMENT: DEVELOPING VENTURE CAPITAL ININDIA ......................................................................................................................347.6 SUCCESSFUL VENTURE CAPITAL INVESTMENT A BLUEPRINT.....427.7 AN UPDATE ON STRUCTURING VENTURE CAPITAL AND OTHERINVESTMENTS IN INDIA ....................................................................................477.8 VENTURE CAPITAL: TIME TO REFLECT ..................................................50

8. CONCLUSIONS.......................................................................................................55

BIBILIOGRAPHY ........................................................................................................56


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1. INTRODUCTION

Banks are an integrated and essential part of daily life of human being that we cannot

even imagine life without banks. This is the kind of service banking industry has been

providing to individuals and institutions. Banks are the most important financialinstitutions in the economy. World wide banks grant more installment loans to

consumers than any other financial institution. Banks are among the most important

sources of short-term working capital for business and have become increasingly

active in the recent years.

Today banking industry is in a change. Rather than being something in particular, it is

continually becoming something new- offering new services, merging and

consolidating into much larger and more complex businesses, adopting new

technologies that seem to change faster than most of us can comprehend, and facing a

new and changing set of rules as more and more nations cooperate to regulate and

supervise the banks that serve their citizens. Banking industry is one of most heavily

regulated industries in the world.

The purpose of this project is to get an insight into the banking industry and the latest

happenings of the industry and know where the industry is heading. The first part of

the project deals with the general aspects of the banks, the necessity of effective

branch management, the management challenges in banking industry, and the

business strategies deployed by banks under changing environment, whereas the later

part concentrates on venture capital and its importance in Indian context, the need of

Venture capital in India, the necessary condition that are ought to be met by a

successful VC and the problems faced by VCs in India.


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2. BANKING STRATEGIES OF TODAY

A banking strategy to exploit the potential of Internet is the move towards Account

Aggregation- an interactive financial manager. Account aggregation web sites, a

technology not heard of before, is becoming the buzzword of the banking industry.

What is account aggregation?

The concept necessitates customers to provide their user identifications (Ids) and

passwords to an aggregator, which then visits the web sites of their financial

institutions and "scrapes" relevant information from the provider's screens. The

information is then funneled into a single, easy-to-read page, accessible by customers

with one login.

From the above it can be seen that such a service benefits customers in obtaining a

consolidated snapshot of their financial relations with many providers. As customers

have different accounts with multiple financial service providers, such a service offers

them comprehensive financial information at one place. It is this convenience that is

making customers demand such a service from the banking sector. Bankers may not

wholeheartedly endorse account aggregation, but they may need to offer it. Account

aggregation holds the potential to create deeper and closer relationships with online

customers. Hence, though wary, banks are foraying into the service. New York based

Citigroup Inc. was the first bank to do so, on its Myciti.com web site. By providing a

complete online picture of the customer's financial status, it helps a financial

institution in cross-selling products This service offers a medium to learn about the

customer's overall financial position and then use this information to formulate

marketing strategies Concerns for banks. Account aggregation is a cause for concern

in such issues as privacy, security and disintermediation. As aggregators extract

customer relevant information without the bank's knowledge from their sites, banks

worry about the security and privacy of customer information. Also the existence of

middlemen could hamper customer relations for the bank. In spite of these concerns,

banks are willing to offer the services to customers to remain competitive.

Another emerging strategy amongst banks today is the move towards Wireless

Banking. Venturing into this medium would mean that banks have to redefine their

business channels. On the other hand banks cannot ignore this, as they would lose


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their customers to other banks offering such a service. According to Virginia

H.Philipp, a TowerGroup analyst, "Wireless banking is not about making money. It's

more an issue of keeping the right customers happy, namely the top 10-20% who

contribute to the bulk of bank profits". Customers having an option to choose, among

banks, would select the medium that is easy and cheap for them. In terms of

infrastructure and support, wireless banking offers one of the cheapest channels for

obtaining banking services.

Banks perspective of this new business medium.

Banks are keenly looking at developing wireless banking as the demographics of

wireless usage is broad, encompassing not only high net worth individuals, but also

middle class individuals attracted by the convenience. Adopting such a medium

would increase the customer base of the bank. This will have a positive impact on the

bank bottom line. Another interesting feature about wireless banking is that it can be

adopted by banks of all sizes. The bank has to make use of its already existing

infrastructure and technology. It needs to export its banking applications and spread it

across additional channels, to increase business volumes. Capital investment for such

a medium is minimal. Its affordability prompts banks to consider this strategy. For

instance, Bank of Montreal, which is a national bank with six million retail

relationships in Canada, has adopted wireless banking. At the same time, even First

Tech Credit Union, a bank that has around 80000 customers, and a regional market

also adopted wireless banking. As customers are becoming Internet and technology

savvy, the wide usage and success of wireless banking will not be mere hype, but a

reality.


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3. MANAGEMENT CHALLENGES IN BANKING

Recent developments have underscored the urgency to sensitize the banking industry

on emerging issues and quickly adapt to the change. There are two ways in which this

topic can be interpreted firstly, as challenges faced by bank management and

secondly as the management of challenges faced by banks. Both these issues are of

concern to us and although there is a common thread between the two topics, the

focus of the two would be different. Before the onset of the reform process, Indian

banking was operating in a relatively comfortable and protected environment. The

reform process has brought the Indian banking system into the era of intense

competition even though it paved the way for achieving remarkable improvement in

various parameters. Every aspect of functioning of the banking industry, be it

profitability, NPA management, customer service, risk management, human resourcedevelopment, etc. has to undergo the process of transformation to align with the

international best practices. Managing the challenges effectively becomes the most

urgent task for the banks management.

Profitability

An important indicator of the strength of any system is its profitability level. The

financial sector reform process brought in its wake measures like tightening of

prudential norms, which affected the profitability of banks in the initial years.

However, banks had responded well to the reform process. This has been possible due

to careful sequencing of introduction of various prudential norms by the Regulator as

also proper planning by the banks in adopting these norms.

Except for the year ended March 31, 2001, when public sector banks introduced

Voluntary Retirement Scheme (VRS), resulting in huge charge to their profit and loss

account and affecting their profitability, the operating and net profit of all bank groups

for the last three years ended March 31, 2000 to 2002, from the table below, hadshown remarkable improvement.


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Bank

GroupOperating profit (Rs crore)* Net profit (Rs. crore)

2000 2001 2002 2000 2001 2002

Public 13,042 13,801 21,672 5,116 4,316 8,301

sector

banks

(1.46) (1.34) (1.88) (0.57) (0.42) (0.72)

Private

sector

banks

2,576(1.95)

2,843(1.74)

4,628(1.73)

1,160(0.88)

1,141(0.70)

1,778(0.66)

Foreign 2,687 5,739 8,719 967 2,221 3,449

banks (3.24) (3.05) (3.13) (1.17) (0.93) (1.33)

Total18,305(1.66)

22,383(1.53)

35,019(1.94)

8,243(0.66)

7,678(0.49

13,528(0.75)

Table 3.1*Figures given in parenthesis are operating profit and net profit as a percentage to

total assets

As compared to March 2000, the operating and net profit of banks had almost doubled

by March, 2002.

However, we agree that there are still some factors/constraints, which affect

profitability levels in banks. One of them is NPAs, particularly in the public sector

banks and old private sector banks. Other factors are the large number of

unremunerative branches, low staff productivity and archaic methods of operations.

With increasing competition, margins will come under further pressure and therefore

banks have to build long-term strategies for increasing their profitability levels by:

rationalization of branch network

rationalization of manpower deployment

use of latest technology in banking for further reduction in cost of operations and

well concerted efforts to minimize the NPAs to the lowest possible level

NPA Management

The issue of NPA management continues to be the biggest challenge before the

banking sector. One of the major constraints of the competitive efficiency of banks is

the tendency to accumulate poor quality of assets. Nothing is more true indicator of

the quality of assets than the incidence and quantum of NPAs in relation to the total

portfolio. The level of gross NPAs of all groups of banks for the last three years from

the table below, is on the rise, though the rate of growth has decelerated.


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Table 3.2

*Figures given in parenthesis are gross NPAs as percentage of gross advances

While the steps taken by the banks in reducing the level of NPAs are noteworthy, it

still continues to be high by international standards. RBI / Government of India have

taken several steps to arrest the NPA levels. The steps taken have been preventive,

remedial and legal in nature. For instance, the Corporate Debt Restructuring (CDR)

mechanism has been introduced which is aimed at restructuring the debt of viable

corporate entities outside the purview of BIFR, DRT, etc. Further, efforts are being

made to make CDR mechanism more efficient. However, some banks have not joined

the CDR mechanism and those who have joined have not referred many cases to CDR

Cell.

Another major step in this direction has been the introduction of One Time Settlement

Schemes (OTS). The success of the OTS has been modest. Under both the OTS

schemes, i.e. upto Rs.5 crore and upto Rs.25, 000 banks could recover only around

Rs.3000 crore. Let us hope banks would make effective use of the forthcoming OTS

guidelines for NPAs upto Rs. 10 crore. The Securitisation and Reconstruction of

Financial Assets and Enforcement of Security Interest Ordinance, 2002 has been

another major initiative from the legal side. This legislation would provide a comfort

level to banks in tackling the problem of NPAs. While the steps taken by RBI /

Government of India will go a long way in reducing the level of NPAs, banks' Boards,

on their part should also formulate clear cut guidelines for monitoring NPA level,

refine their own appraisal systems and strengthen the loan review mechanism to

prevent incidence of fresh NPAs.


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Capital Adequacy

Ability of a bank to absorb unexpected shocks and losses is solely dependant upon its

capital base. Basle Capital Accord of 1988 played a positive role in strengthening the

soundness and stability of banks and enhanced the competitive equality among

international banks. While on the one hand ongoing refinement in the capital

adequacy norms had increased the capital requirements of our banks, there was

increased pressure on the bottom lines of banks in view of the demand for setting

aside profits for meeting the increased provisioning requirements. However, as

indicated in the table below, the system as a whole has managed to maintain capital

adequacy ratio of more than 11% over the last few years. However, there are still a

few banks in the system, which operate with a capital adequacy below the stipulatedlevel.

Year 98-99 99-00 2000-01 2001-02

Nationalised Banks 10.63 10.11 10.2 10.91

SBI Group 12.34 11.57 12.7 13.26

Public Sector Banks 11.25 10.66 11.15 11.76

Old Private Sector Banks 12.07 12.35 11.93 12.52

New Private Sector Banks 11.76 13.44 11.51 11.69

Foreign Banks 10.78 11.93 12.57 12.97

All Banks 11.27 11.1 11.39 11.92

Table 3.3

The introduction of 90 days delinquency norm for recognition of loan impairment

effective from March 31, 2004, reduction in the transition period for migration of a

sub-standard asset into doubtful category from 18 months at present to 12 months

effective from March 31, 2005, making adequate provision to cover country risk, etc.

would put increased pressure on the capital adequacy and bottom lines of banks.

Indian banking industry is playing a significant role in the financial intermediation

process and as the pace of economic development is accelerated, the ratio of the bank

credit to GDP is likely to be doubled from the existing ratio of about 25% to 50%


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within next 5 years which implies that the bank credit would increase two fold. Added

to this, the big thrust being accorded to infrastructure sector requires substantial

support from the banking system in the form of long-term loans. Hence, banks would

be required to increasingly explore avenues to raise capital from the market.

Banks have, in recent years, placed greater reliance on subordinated debt to meet the

increased capital requirements. However, scope for raising capital through

subordinated debt is also limited in view of the prudential limit that subordinated debt

cannot exceed 50% of Tier I capital. Added to this, there is a constraint for public

sector banks to raise capital from the market. A Quantitative Impact Study (QIS) has

been conducted by the Reserve Bank of India in seven banks and the impact

assessment is being evaluated. In the meanwhile, the banks have to refine their

existing systems with a view to ensuring smooth transition to the New Accord.

Management

Recent developments in the country have brought to the fore the need for banks

management to exercise proper vigilance and supervision over the functioning of their

respective banks. Corporate governance, which represents the value framework, the

ethical framework and the moral framework under which business decisions are

taken, calls for transparency in decision-making and accountability to stakeholders.

In the context of the Indian banking system, though much greater autonomy and

powers have been entrusted to the Boards of banks and financial institutions to lay

down effective internal guidelines and procedures for transparency, disclosure, risk

management, etc. Boards of some banks have not lived up to the expectation.

Reserve Bank of India had set-up a Consultative Group under the Chairmanship of

Dr. A.S. Ganguly to review the supervisory role of Boards of banks and financial

institutions and obtain feed back on the functioning of the Boards vis--vis

compliance, transparency, disclosures, audit committees etc. and give

recommendations for making the role of Board of Directors more effective with a

view to minimising risks and over exposure. The recommendations of the Group have

been benchmarked with international best practices as enunciated by the Basel

Committee on Banking Supervision, as well as of other committees and advisory

bodies, to the extent applicable to the Indian environment.


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Corporate Governance not only calls for greater responsibility of the Board. In fact,

the role of the CEO also becomes equally crucial in sensitising not only the Board but

the institution as a whole to appreciate the importance of corporate governance and

supplement it. CEOs should therefore pay importance to building a team of

performers and motivate the organisation as a whole.

Fraud

The reason to stress upon bank frauds is that banks in recent times have not adhered to

the laid down systems and procedures thus giving rise to incidence of fraud. Practices

in some banks like release of funds by lower level functionaries on oral instructions of

the top management with no record maintained on such instructions, had contributed

to the perpetration of frauds. In many cases the Board of Directors had in a routinemanner ratified, post facto, the credit decisions of CMDs or other functionaries taken

in excess of their delegated authorities. In many such cases, the loans had turned into

NPAs later on.

In as many as 23 cases of large value frauds for Rs.10 crore and above, cases filed for

more than 5 years ago are yet to reach their logical end. This is the reason for urging

the banks, particularly CEOs to ensure that laid down systems and procedures are

followed and there should be quick disposal of cases relating to large value frauds of

say Rs. 1 crore and above within the time limit of 4 months as prescribed by CVC.

There is justification in the demand being made by banks that appropriate legislative

amendment to Public Servants Act should be brought out to provide for dismissal of a

public servant, through a focused enquiry lasting not more than a week in case of

large frauds. This would, besides serving as a deterrent, would also ensure that

fraudulent officials are not allowed to stay around to commit further mischief and

tamper records.

Customer service

The reform process has resulted in shift from highly regulated banking to deregulation

and liberalization of the banking sector. The objective was to evolve a level of

banking services which is efficient, effective and customer-oriented and which should

seek to emulate the best practices in the industry the world over. Indian banking,


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realizing the challenges thrown by global competition is undergoing significant

developments and improvements in the field of customer service. This has by and

large been possible due to increased use of technology in banking resulting in branch

computerization, growth of retail banking and automation of banking processes.

Extension of reach of customer service and rationalization of costs of operations were

the by-products of this process.

For instance, ATM has emerged as an alternative banking channel which facilitates

low-cost transactions vis-a vis traditional branch banking. The increased use of

modern technology by foreign banks and new private sector banks has helped them to

increase their market share vis-a-vis public sector banks. Modern clearing operations,

electronic funds transfer system and centralized funds management systems are some

projects receiving priority of RBI to enhance customer service in the banking sector.

Banks should not be satisfied only with introducing latest technology towards

providing better customer service. The level of service still needs improvement.

Complaints about delay in crediting proceeds of outstation instruments by banks and

fraudulent encashment of instruments by unscrupulous persons after opening deposit

accounts in the name/s similar to already established concern/s resulting in erroneous

and unauthorised debit of drawers' accounts continue to be received. In such cases,

there have been instances where banks have also not restored funds promptly to

customers even in bona-fide cases but deferred action till completion of either

departmental action or police interrogation.

There is a lot more to be done to enhance customer service in banks. Best way to

come up to the customers' expectations would be to obtain regular feedback from

them especially from rural and non-metro branches, and filling the gaps wherever

exist. Banks' Boards should, in particular, review the policies regarding customer

service at periodical intervals to fine tune them in line with customer needs.

Complaints redressal mechanism should be quick, responsive and prompt.

Future road map

For a diverse and vast banking system like the one in India, it is important to build a

future road map for the banking system. The future of Indian banking system needs a

long term strategy which would broadly cover areas like structural aspects, business


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strategies, prudential standards, control systems, integration of markets, technology

issues, credit delivery mechanism, information sharing, etc.

With increasing competition and globalisation the need for specialised one window

service concept will grow. Banks would, therefore be required to draw business

strategies keeping in view their risk bearing capacity and need for additional capital.

Banks would also have to explore new markets and strive to achieve consolidation of

their operations taking into account the client profile, business opportunities, etc. In

recent times, RBI has taken a number of initiatives keeping in mind the future road

map of the banking system. Introduction of Prompt Corrective Action framework is

one among them.

Under the PCA framework, RBI can initiate certain structured actions in respect of

banks which have hit the trigger points in terms of CRAR, net NPA and ROA. RBI,

at its discretion, will resort to additional actions (discretionary actions) as indicated

under each of the trigger points. It would be better for banks to avoid coming under

PCA framework. The CEO and the banks Board have to work together to ensure that

banks business is not conducted in such a way that trigger points under PCA

framework are attracted by it. As the saying goes, prevention is better than cure.

RBI is in the process of evolving fair practices code on lenders liability. The same has

been put on the RBI website for comments from the public. Under the proposed

guidelines, banks would be required to follow proper procedures with respect to loan

application, such as acknowledging receipt of all loan applications, conveying reasons

for rejection of loans, timely disbursement of loans etc. Banks would be given the

freedom to draft fair practices code. However, it should be ensured that RBI

guidelines are not diluted. For this, Board of banks should lay down clear policy on

all loan sanction and loan disbursement matters.


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4. BRANCH BANKING: THE BACKBONE OF BANKING INDUSTRY -

A CASE STUDY

Is branch-banking back in business? Has the banking industry realised the limitations

of using non-branch channels and banking on technology? A case study by an

international consultant Booze Allen Hamilton on international banking, has

thrown some interesting findings on these issues. Though the basic survey has been

conducted in an international setting, it has some universal findings, which will of

interest to the domestic banking industry, which is undergoing a paradigm shift with

technology networking and reaching out to mass retail customers. To a basic question,

whether state-run banks with a large branch network or private sector banks with

sleek technology will call the shots in terms of customer loyalty and profitability,

some pointers have been offered in this study.

Booz Allen Hamiltons research shows that after withering for 20 years, branch

banking is making a comeback. And there is a good reason for this revival: branches

are significant growth engines, helping acquire up to 90 per cent of new customers .

Call-centers and the Web are fine for routine transactions, but the branch needs to be

the centerpiece of the customers interaction with the bank because it is the best place

to get personalised information and attention, and to conduct complex bankingactivities. It is also the best channel to encourage customers to entrust more of their

assets to the bank as their needs change with time.

But the moot question is that can large retail banks revive the branch system without

letting it become a costly drag on their profits? Absolutely, but only if they reinvent

the management model so it can profitably deliver what consumers expect: choice,

convenience, and customization, feels the study. Booz Allen Hamiltons research

shows that up to 90 per cent of customer relationships are won or lost in branches. For

todays consumer banks, reinventing local branches as a hub to attract and retain

customers is essential to profit and growth. It is not enough for retail banks simply to

open up more branches that run like existing ones or to redesign them to resemble hip

retail stores. The successful branch bank of the future must be a financial-services

resource center. Financial advisors could conduct seminars after hours on topics as


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managing debt, savings strategy, or how to transition from paycheck-to-paycheck

banking to accumulating wealth.

For the mass affluent customer - the person who is already saving and investing -

the branch can offer light relationship management. For example, a bank specialist

who sold one financial product to a customer could periodically review that

customers needs and recommend other appropriate products. Booz Allen Hamiltons

research in 2003 shows that there is a good reason for the revival of branch systems:

they are significant growth engines for retail banks. Moreover, the study found a high

correlation between branch visits and sales. Banks are reinventing the management

model in a bid to profitably deliver what demanding consumers expect: choice,

convenience, and customization. In the customer-centric, federation business model,

the study proposes that the branch is the hub of an integrated multi-channel banking

framework designed to maximize local responsiveness. In 2003, the consultant

collected data and conducted on-site observations of branch operations that show the

enormous value of the branch. For example, evidence that customers favor branches

over other channels for purchasing financial-services products was overwhelming.

The survey showed 12 per cent of customers, who were seeking a home loan obtained

information over the Internet, but 49 per cent closed the sale in a branch.

In one recent client study, Booz Allen Hamilton found that 90 per cent of a super-

regional banks new customers were acquired in a branch. Equally important, almost

all accounts were closed at a branch, suggesting that branches can be a first line of

defence in retaining customers. Customers often provide predictable clues before they

close their accounts. Banks spend heavily on customer relationship management

(CRM) systems to predict customer defections, but a vigilant branch staffer can just as

effectively use the personal touch to solve a problem and keep a customer from

leaving. The branch customer service representatives handle simple product sales and

know when to refer customers to a branch-based specialist. Customers perceive the

value of consulting a banker, and the bank gets more involved with customers.

When they are planning and optimizing their choices, not just when theyre shopping

for products.


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To deliver consultation services economically, branches must offer a set of

standardised products targeted for different life stages or for immediate needs. Banks

can package existing products and information in a new way in order to focus on the

80 per cent of the customers, who need advice when planning for college tuitions,

maximising retirement savings, and so on. Focussing on local demographics, a

customer-focused branch economically also requires tailoring branch services to local

market needs. This micromarket alignment is typically driven by age and income, and

incorporates factors as area population concentration, branch proximity to business

centers, and customers ethnicity.

Achieving this alignment drives decisions regarding branch staffing, skills, product

configurations, and customer sales/retention targets. Proposing a federation model,

Booze Allen Hamilton says that many large banks pursuit of scale has come at a

huge loss of control over local capabilities and costs. These banks have achieved

neither the cost savings of monoline banks nor the deeper wallet penetration and

service quality of small local banks. Booz Allen Hamiltons federation model

addresses these issues by striving for efficient centralised management and greater

responsiveness to micromarkets. It calls for central controls at corporate headquarters

that exploit product, infrastructure, and administrative scale, but the center delegates

decision making to the branch manager, who knows the local market and is

empowered to make resource, incentive, and pricing decisions locally.

The branch is accountable for its own P&L. If branch managers are offered the right

inducements for instance, compensation and perks based on performance the

international consultant believes that they will work smarter to customise their

operations to be more competitive. Applying the federation model is not merely a

matter of making organisational adjustments. Nor is it the same as franchising. By

giving each branch responsibility for managing its own P&L and retaining some

centralized management, banks allow branch managers to run their own businesses

and to leverage the brand and infrastructural power of the institution. The federation

model can increase revenue between 35 per cent and 65 percent per branch.

This improvement stems mostly from increased product cross-selling due to the

availability of financial service product packages and greater customer retention as


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customer satisfaction rises. There are higher costs for staff training, performance

incentives, and technology investments, but much of these cost increases can be

recovered through lower staff changeover and reduced layers of management.

To implement the federation business model, action is required in four areas.

People: Hiring, training, and certification of front-line employees; significantly

improving branch management; making major modifications to incentives. Internal

Benchmarking: understanding branch performance; aligning to micromarkets;

increasing readiness for change. Geographic specialization: determining local

resource needs and establishing sales focus based on demographic, purchasing

behavior, and the local growth trajectory. Structure: establishing mechanisms to

coordinate local versus central decision rights; refining roles and responsibilities

within the branch network.

The days of the branch bank as weve known are over. But something better is

emerging. In creating a multiproduct, multichannel federation, retail banks have an

opportunity to provide greater value to their customers and to make branch banking a

profitable, winning strategy, concludes Booz Allen Hamilton.


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5. BUSINESS STRATEGIES UNDER CHANGING ENVIRONMENT

Deposits strategies for hiking deposits.

Banc Assurances 6 steps that will guide banks on how to introduce cross selling of

insurance products through their branches.

5.1 HIKING DEPOSITS

A host of commercial banks are now raising their short term deposit rates to woo

customers. Banks have been forced to hike short term rates since the growth in

deposit rates has not kept pace with credit growth. Different banks have adopted

different strategies to woo back depositorssweeteners like free credit cards,

accident insurance and so on are being offered.

Attracting fresh deposits is a challenge. While banks offer shorter maturity

deposits, the administered interest rates are coming as a big challenge to these banks.

5.2 BANKINGS PROBLEMS WITH GROWTH

Investors seek higher interest rates while they are depositing their money and they

crave for lesser interest rates while they take loans.

Present scenario banks have started begging for deposits and not loans any more.

The reason being the industrys credit port folio is growing at a scorching pace far

ahead of its deposit growth. In the first nine months of the fiscal year 2004-05 non

food credit of all scheduled commercial banks grew by Rs1,92,548 crore. On a year

basis (that is between Dec-2003 and Dec 2004) the non food credit growth was even

higher Rs2,58,274 crore. Against this, the deposit growth is Rs 1,61,1041 crore and

Rs 2,43,561 crore, respectively.

These statistics reveal that the Indian banking systems incremental credit deposit

(CD) ratio for the past one year has been over 100%. In percentage terms, the

aggregate deposit growth in the first nine month of the year has been 10.7% against

23.9% credit growth. Nonetheless, it is a significant trend. The banks have finally

come back to their bread and butter business of giving loans. With the first sign of


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rising interest rates, Indian banks have shifted focus from investment in government

securities to loans. On an outstanding basis, the credit deposit ratio is 62.54. In other

words, for every Rs100 worth of deposit in the system, Rs 62.54 is being disbursed as

credit, which didnt happen at least in the past one decade.

Companies and high net worth individuals have started bargaining for a few paise

more on their deposits and banks are obliging them without making a fuss. Banks are

also offloading their excess statutory liquidity ratio (SLR) holdings to generate

liquidity to support new loan asset creation. Despite a small rise in lending rates,

corporations are lapping up bank funds but savers are going to greener pastures like

post office run small savings schemes that offer better returns. The next battle on the

Indian banking turf will be fought for deposits. The present trend of the corporate

players is such that they have started auctioning deposits to the highest interest payers.

Companies and high net worth individuals also look for safety, because only up to Rs

1 lakh of deposit gets insurance cover and any money over this can vanish into the

blue if a financial intermediary crumbles.

The above cited reason may become a reason to relatively weaker banks to raise

deposits even if they offer competitive rates. It is these players that will feel the heat if

they are on a massive asset building mission.

5.3 BANKING INDUSTRY IN A CHANGING SOCIETY

Till social control on banks in1968 and the subsequent nationalization of the 14 major

Indian banks took place in 1969, the scheduled banks were directing their advances to

the large and medium scale industries and big business houses. Since then there has

been a stupendous expansion in the banking industry. With the rapid expansion in the

banking network there has been a steady deterioration in bank service and efficiency.

Worse it also opened up opportunities for corrupt officials of the banks and for other

unscrupulous individuals, jointly or otherwise to commit fraud on the banks. The bank

unions have made it very difficult for bank managements to discipline their

employees. In fact the face of the onslaught of the unions and the corruption within

their own ranks, bank managements have buckled in very badly.


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It was reported that the profitability of the Indian banks is low and is getting

progressively eroded. In contrast 16 foreign banks made an after tax profit in the same

year out of their aggregate earnings.

The reasons are explicit:

Lack of cost consciousness in nationalized banks

Inefficiency

Frauds, and

Poor yields on advances

The Reserve Bank of India has taken a number of adhoc measures to improve the

profitability of the banks by increasing the rates of interest payable to them on their

cash balances and food advances but to no avail. Despite its statutory powers of

control and regulation it is neither able to resist political pressures nor keep a close

watch on banking operations. The spread of social banking has brought about the

politicization of banking industry in several unfortunate ways. Apart from the loss of

profit, it has encouraged frauds and corrupt practices. The rate at which deposits and

advances is growing means that, the risk of fraud is also increasing.

5.4 BANCASSURANCES

6 Steps to implement insurance selling in banks are as follows:

1.

To project the fee income potential through insurance products over 5 years for

the entire bank.

2. Create internal awareness in all layers of the hierarchy about this new initiative

and its relevance.

3. Banks should make internal changes in the parameters for evaluating performance

of branches to include fee based income through cross selling. (New age bank

customers look for convenience and informed advice from the branch manager and

they prefer banks that display this attitude at the front desk.)

4.

Banks should enter into a distribution alliance with an insurance company after

evaluating its product profile, after sale service standards, overall commitment to

training and other relevant factors.

5. Bank should create the best sales team at the front desk level and equip them withskills to undertake cross selling. This is the most complex part and banks abroad often

undertake this talk with the help ofprofessional agencies.


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6. Lastly banks should acknowledge efforts made by staff in cross selling and

consider rewarding the best performers.

The best form of motivation is to openly acclaim the good work done, and give wide

publicity through internal forums.

6. SERVICES OFFERED BY BANKS

Carrying out currency exchanges: Banks trade one form of currency, such as

dollars, for another form such as francs or pesos or rupees. This is very important to

travelers and people involved in exports and imports. In todays financial

marketplace, trading in foreign currency is usually carried out primarily by the largest

banks due to the risk involved and the expertise required to carry out such

transactions.

Discounting commercial notes and making Business loans: Early in their history,

bankers began discounting commercial notes- in effect; making loans to local

merchants who sold the debts (accounts receivable) they held against their customers

to a bank in order to raise cash quickly.

Offering Savings Deposits: Making loans proved so profitable that banks began

searching for ways to raise additional loanable funds. One of the earliest sources of

funds consisted of offering savings deposits interest bearing funds left with banks

for a period of weeks, months or years.

Safekeeping of Valuables: Banks began practice of holding gold, securities and other

valuables owned by their customers in secure vaults. Today the safekeeping of

customer valuables is usually handled by a banks safety deposit department.

Supporting Government activities with credit: Banks are required to purchase

government bonds with a portion of any deposits they received. So this helps the

government raise money for developmental activities. The government can control the

ratio of deposits (held by banks) so that the banks can come to rescue of the

government when there is a crisis.


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Offering Checking Accounts (Demand Deposits): Demand Deposit is a checking

account that permitted the depositor to write drafts in payment for goods and services

that the bank had to honor immediately. Offering demand deposits improved the

efficiency of the payments process, making business transactions easier, faster, and

safer.

Offering Trust Services: For many years banks have managed the financial affairs

and property of individuals and business firms in return for a fee that is often based on

the value of properties or the amount to funds under management. This property

management function is known as Trust services. Most banks offer both personal trust

services to individuals and families and commercial trust services to corporations and

other business.

6.1 SERVICES BANKS HAVE DEVELOPED MORE RECENTLY

Granting consumer loans: Early in this century, however bankers began to rely

more heavily on consumers for deposits to help fund their large corporate loans. Then,

too heavily competition for business deposits and loans caused bankers increasingly

to turn to the consumer as a potentially more loyal customer. So now banks grant a

variety of consumer loans including housing loans, vehicle loans etc

Financial Advising: Bankers have long been asked for financial advice by their

customers, particularly when it comes to the use of credit and the saving or investing

of funds. Many banks today offer a wide range of financial advisory services, from

helping to prepare tax returns and financial plans for individuals to consulting about

marketing opportunities at home and abroad for their business customers.

Cash management: Cash management services are services in which banks agree to

handle cash collections and disbursements for a business firm and to invest any

temporary cash collections and disbursements for a business firm and to invest any

temporary cash surpluses in short-term interest bearing securities and loans until the

cash is needed to pay the bills.


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Offering Equipment Leasing: Many banks have moved aggressively to offer their

business customers the option to purchase needed equipment through a lease

arrangement in which the bank buys the equipment and rents it to the customer.

Making Venture Capital Loans: Increasingly, banks have become active in

financing the start-up costs of new companies, particularly in high-tech industries.

Because of the added risk involved in such loans, this is generally done through a

venture capital firm that is a subsidiary of a bank holding company and other

investors are often brought in to share the risk.

Selling Insurance Services: For many years, banks have sold credit life insurance to

customers receiving loans, thus guaranteeing repayment of the loan if the customer

dies or becomes disabled. Banks now make insurance policies available to their

customers usually through joint ventures or franchise agreements.

Selling Retirement Plans: Bank trust departments are active in managing the

retirement plans that most businesses make available to their employees, investing

incoming funds and dispensing payments to qualified receipts who have reached

retirement or become disabled.

Offering Security Brokerage Investment Services: In todays financial market

place many banks are striving to become true financial department stores offering

a sufficiently wide array of financial services to permit customers to meet all of their

financial needs at one location. This is one of the main reasons banks have begun to

market security brokerage services, offering their customers the opportunity to buy

individual stocks, bonds, and other securities without having to go to a security dealer.

Offering Investment Banking and Merchant Banking Services: Banks today are

following in the footsteps of leading financial institutions all over the globe in

offering investment banking and merchant banking services to larger corporations.

These services include possible merger targets, financing acquisitions of other

companies, dealing in a customers securities (i.e. new security underwriting),

providing strategic marketing advice, and offering hedging services to protect their


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customers against risk from fluctuating world currency prices and changing interest

rates.

The list clearly shows that banks are offering a wide range of services to the

customers. Still the bankers service menu is growing rapidly with new product

innovation. New types of loans and deposits are being developed, new service

delivery methods like the Internet and smart cards with digital cash are expanding,

and whole new service lines are being launched every year. Customers can satisfy

virtually all their financial service needs at one financial institution in one location.

Truly, banks are the financial department stores of the modern era which unify

banking, fiduciary, insurance, and security brokerage services under one roof a

trend often referred to as Universal banking.


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7. AN INTRODUCTION TO VENTURE CAPITAL

The origin of venture capital: In the 1920's & 30's, the wealthy families of and

individuals investors provided the start up money for companies that would later

become famous. Eastern Airlines and Xerox are the more famous ventures they

financed. Among the early VC funds set up was the one by the Rockfeller Family

which started a special fund called VENROCK in 1950, to finance new technology

companies.

General Doriot, a professor at Harvard Business School, in 1946 set up the American

Research and Development Corporation (ARD), the first firm, as opposed to a private

individual, at MIT to finance the commercial promotion of advanced technology

developed in the US Universities. ARD's approach was a classic VC in the sense that

it used only equity, invested for long term, and was prepared to live with losers.

ARD's investment in Digital Equipment Corporation (DEC) in 1957 was a watershed

in the history of VC financing. While in its early years VC may have been associated

with high technology, over the years the concept has undergone a change and as it

stands today it implies pooled investment in unlisted companies.

VC in India: This activity in the past was possibly done by the developmental

financial institutions like IDBI, ICICI and State Financial Corporations. These

institutions promoted entities in the private sector with debt as an instrument of

funding. For a long time funds raised from public were used as a source of VC. This

source however depended a lot on the market vagaries. And with the minimum paid

up capital requirements being raised for listing at the stock exchanges, it became

difficult for smaller firms with viable projects to raise funds from public. In India, the

need for VC was recognized in the 7th five year plan and long term fiscal policy of

GOI. In 1973 a committee on Development of small and medium enterprises

highlighted the need to faster VC as a source of funding new entrepreneurs and

technology. VC financing really started in India in 1988 with the formation of

Technology Development and Information Company of India Ltd. (TDICI) -

promoted by ICICI and UTI.

The first private VC fund was sponsored by Credit Capital Finance Corporation

(CFC) and promoted by Bank of India, Asian Development Bank and the


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Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the

same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were

started by state level financial institutions. Sources of these funds were the financial

institutions, foreign institutional investors or pension funds and high net-worth

individuals. Though an attempt was also made to raise funds from the public and fund

new ventures, the venture capitalists had hardly any impact on the economic scenario

for the next eight years.

How VCs differ from banks: Conventional financing generally extends loans to

companies, while VC financing invests in equity of the company. Conventional

financing looks to current income i.e. dividend and interest, while in VC financing

returns are by way of capital appreciation. Assessment in conventional financing is

conservative i.e. lower the risk, higher the chances of getting loan. On the other handVC financing is a risk taking finance where potential returns outweigh risk factors.

Venture Capitalists also lend management support and provide entrepreneurs with

many other facilities. They even participate in the management process. VCs

generally invests in unlisted companies and make profit only after the company

obtains listing. VCs extend need based support in a number of stages of investments

unlike single round financing by conventional financiers. VCs are in for long run

and rarely exit before 3 years. To sustain such commitment VC and private equity

groups seek extremely high returns. A return of 30% in dollar terms. A bank or an FI

will fund a project as long as it is sure that enough cash flow will be generated to

repay the loans. VC is not a lender but an equity partner. Venture capitalists take

higher risks by investing in an early-stage company with little or no history, and they

expect a higher return for their high-risk equity investment. Internationally, VCs look

at an internal rate of return (IRR) north of 40% plus. In India, the ideal benchmark is

in the region of an IRR of 25% for general funds and more than 30% for IT-specific

funds. With respect to investing in a business, institutional venture capitalists look foraverage returns of at least 40 per cent to 50 per cent for start-up funding. Second and

later stage funding usually requires at least a 20 per cent to 40 per cent return

compounded per annum. Most firms require large portions of equity in exchange for

start-up financing.


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Tax benefits : In terms of section 10(23 F) of IT Act income by exemptions way of

dividend and long term capital gains received by approved VC Companies/Funds

from investment made by way of equity shares in a VC undertaking are exempt from

tax.

IT rules amended on 18th July 1995 introduced a rule 2(D) which allowed tax

exemption under the aforementioned section provided, among others,

(1) An application is made to Director of IT (Exemptions) by the VCC or VCF

(2) VCF/VCC is registered with SEBI.

(3) Not less than 80% of the fund corpus/paid up capital is invested by year 3.

(4) The VCC/VCF does not invest more than 5% of paid up capital/fund corpus in one

VC undertaking.

(5) VCC/VCF does not invest more than 40% in equity capital of one VC

undertaking.

Types of VCs: Generally there are three types of organized or institutional venture

capital funds: venture capital funds set up by angel investors, that is, high net worth

individual investors; venture capital subsidiaries of corporations and private venture

capital firms/ funds. Venture capital subsidiaries are established by major

corporations, commercial bank holding companies and other financial institutions.

Venture funds in India can be classified on the basis of the type of promoters

Financial institutions led by ICICI ventures, RCTC, ILFS, etc.

Private venture funds like Indus, etc.

Regional funds: Warburg Pincus, JF Electra (mostly operating out of Hong Kong).

Regional funds dedicated to India: Draper, Walden, etc.

Offshore funds: Barings, TCW, HSBC, etc.

Corporate ventures: venture capital subsidiaries of corporations Angels: high net worth individual investors

Merchant bankers and NBFCs who specialize in "bought out" deals also fund

companies.


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Making a VC invest in your venture: In the USA, only one or two business plans in

100 results in successful financing. And of every 10 investments made, only one or

two are successful. But this is enough to recover investments made by the venture

capital (VC) in all 10 start-ups in addition to an average 40-50% return. Securing an

investment from an institutional venture capital fund is extremely difficult. It is

estimated that in the US only five business plans in 100 are viable investment

opportunities and only three in 100 result in successful financing. In fact, the odds

could be as low as one in 100. More than half of the proposals to venture capitalists

are usually rejected after a 20-30 minute scanning, and 25 per cent are discarded after

a lengthier review. The remaining 15 per cent are looked at in more detail, but at least

10 per cent of these are dismissed due to irreconcilable flaws in the management team

or the business plan.

A Venture Capitalist looks at various aspects before investing in any venture.

A strong management team - each member of the team must have adequate level of

skills, commitment and motivation that creates a balance between members in areas

such as marketing, finance, and operations, research & development, general

management, personnel management, and legal and tax issues. A viable idea -

establish the market for the product or service, why customers will purchase the

product, who the ultimate users are, who the competition is, and the projected growth

of the industry. Business plan: the plan should concisely describe the nature of the

business, the qualifications of the members of the management team, how well the

business has performed, and business projections and forecasts. So while approaching

a venture fund one needs to be fully prepared and keep the above requirements in

mind while submitting the business plan.

The VC Philosophy

As against Bought out deals (BODs) , VCs carry out very detailed due diligence and

make 2-7 year investments. The VCs also hand-hold and nurture the companies theyinvest in besides helping them reach IPO stage when valuations are favourable. VCFs

help entrepreneurs at four stages: idea generation, start-up, ramp-up and finally in the

exit, which is done through M&As.

According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the

total venture capital investment is in start-up projects followed by Rs 4478.60 m in


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later stage projects and only Rs 82.95 in turnaround projects. Majority have invested

in only three stages of investment, indicating that most VCs in India have not started

developing niches for investing with regard to the stages of projects.

The main difficulty in early stage funding are related to lack of exit opportunities as

probability of an IPO or buy out by of VC stake is less due to lack of understanding

for evaluation of the knowledge based companies compared to the companies in the

traditional sectors. Some such VCs are: ICICI ventures, Draper, SIDBI and Angels.

Funding growth or mezzanine funding till pre IPO:

The size of investment is generally less than US$1mn, US$1-5mn, US$5-10mn, and

greater than US$10mn. As most funds are of a private equity kind, size of investments

has been increasing. IT companies generally require funds of about Rs30-40mn in an

early stage which fall outside funding limits of most funds and that is why the

government is promoting schemes to fund start ups in general, and in IT in particular.

Management of investee firms: The venture funds add value to the company by

active involvement in running of enterprises in which they invest. This is called

"hands on" or "pro-active" approach. Draper falls in this category. Incubator funds

like e-ventures also have a similar approach towards their investment. However there

can be "hands off" approach like that of Chase. ICICI Ventures falls in the limited

exposure category.

In general, venture funds who fund seed or start ups have a closer interaction with the

companies and advice on strategy, etc while the private equity funds treat their

exposure like any other listed investment. This is partially justified, as they tend to

invest in more mature stories.

7.1 VENTURE CAPITALISTS-NEED IN INDIA

India needs venture capital where capital meets great ideas in an informed manner.

This activity in the past was possibly done by the developmental financial institutions

like IDBI, ICICI and State Financial Corporations. These institutions promoted

entities in the private sector with debt as an instrument of funding under the erroneous

belief that debts are obligations to be repaid and hence safest have not been so and the


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result is non-performing assets to the tune of Rs840bn. Further stray venture capital

activities were for ventures not of the risk taking kind but more based on some entities

in that industry performing well, defeating the very role of a venture capitalist.

Venture Capitalists or for that matter Developmental Institutions have not given

management inputs and not ensured highly competent personnel working in providing

Corporate governance in the organizations. This has resulted in lack of transparency

in operations, weak monitoring and extra legal transactions becoming role models for

survival and success stories. The foreign institutions instead of setting standards have

followed the regressive practices set by the Indian counterparts resulting in

opportunistic deals and no sustainable role models save a few exceptions.

7.2 ROLE OF VENTURE CAPITALIST INDIAN CONTEXT

Venture capital is essentially one where capital meets great ideas and facilitates

improved corporate governance, finance and marketing. Venture capital has to be in

the form of informed equity capital provided directly to new and growing venture

where management follows capital as a matter of principle. It is indeed an imperative

to note what is needed is a strong management culture to convert ideation to strategies

and action instead of having covenants of loans. Possibly what is needed to be

appreciated is the role play of the Venture Capitalist and in this regard the definition

as given by the British Venture Capital Association is appropriate for the Indian

context namely: "Equity capital provided directly to new and growing unquoted

businesses by wealthy individuals usually acting as individuals or part of an informal

syndicate. These investors provide a wealth of experience and ideas to a new and

growing business and should look at them as partners in your business rather than just

investors."

Essentially what is being conveyed is that there is a need to have venture capitalists

that are in an engaging mode instead of an exchange mode - a mindset change which

needs to set in. The concept of innovation and newness itself needs to be redefined in

the context of emerging markets. There is a need of a private version of Venture

capital and not the conversion of Developmental Financial institutions into Universal

banks also involved in venture capital, as has been the recent trend in the country.

Also the Indian Venture Capitalist needs to look at small funding and providing

management inputs in strategy and implementation. This is a distinguishing factor as


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International Venture capitalists have high funds requirement based on cost of

management a requirement not observed in the Indian markets.

7.3 A SUCCESSFUL VENTURE CAPITALIST-INDIAN CONTEXT

All activities need contextual relevance. Venture capital financing is no exception tothis rule. There is a necessity to look at small amounts of funding, as ideation needs to

mature over a period of time. There is a great need for proper articulation and it is in

achieving this objective there is a need to invest in the right people first and business

plans later. The person behind the venture is a key input for the success of the project

itself.

The entity being funded either needs to have a management team or strengthened in

terms of fulfilling the requirements of leadership skills, vision, integrity andtransparency in operations. In conclusion it can be stated that India has opportunities

to be availed off for venture capitalists to act as angel investors for first round of

funding. Venture capitalists can also perform white knight activities in the form of

turnaround funds. It is essential to look at quantum returns over a three to five year

time frame instead of looking at quick safe returns.

Location of the Headquarters of the Members of Indian Venture Capital

Association 19931998 and 2000

Table 7.3.1

Source: Indian Venture Capital Association Various Years; Nasscom 2000.


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Recent Government Efforts to Encourage Venture Investing

In the late 1990s, the Indian government became aware of the potential benefits of a

healthy venture capital sector. Thus in 1999 a number of new regulations were

promulgated. Some of the most significant of these related to liberalizing the

regulations regarding the ability of various financial institutions to invest in venture

capital. Perhaps the most important of these went into effect in April 1999 and

allowed banks to invest up to 5 percent of their new funds annually in venture capital.

However, as of 2001 they have not made any venture capital investments. This is not

surprising since bank managers are rewarded for risk-averse behavior. Lending to a

risky, fast-growing firm could be unwise because the loan principal is at risk while the

reward is only interest. In such an environment, even if bankers were good at

evaluating fledgling firms, itself a dubious proposition, extending loans would be

unwise. This meant that since banks control the bulk of discretionary financial savings

in the country, there is little internally generated capital available for venture

investing.

The bureaucratic obstacles to the free operation of venture capital remained

significant. There continued to be a confusing array of newly created statutes. The

main statutes governing venture capital in India included the SEBIs 1996 Venture

Capital Regulations, the 1995 Guidelines for Overseas Venture Capital Investments

issued by the Department of Economic Affairs in the Ministry of Finance, and the

Central Board of Direct Taxes (CBDT) 1995 Guidelines for Venture Capital

Companies (later modified in 1999). In early 2000, domestic venture capitalists were

regulated by three government bodies: the Securities and Exchange Board of India

(SEBI), the Ministry of Finance, and the CBDT. For foreign venture capital firms

there was even greater regulation in the form of the Foreign Investment Promotion

Board (FIPB), which approves every investment, and the Reserve Bank of India

(RBI), which approves every disinvestment. The stated aim of the Indian regulatory

regime is to be neutral with regard to the risk profile of investment recipients, but

concerns about misuse have not allowed for complete neutrality. Only six industries

have been approved for investment: software, information technology,

pharmaceuticals, biotechnology, agriculture, and industries allied to the first five.


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Statutory guidelines also limited investments in individual firms based on the firms

and the funds capital.

These regulations regarding venture capital were cumbersome and sometimes

contradictory. Income tax rules provided that venture capital funds may invest only up

to 40 percent of the paid-up capital of a recipient firm, and also not beyond 25 percent

of their own funds.

The Government of India guidelines also prescribed similar restrictions. Finally, the

SEBI regulations did not have any sectoral investment restrictions except to prohibit

investment in financial services firms. The result of these various restrictions was a

micromanagement of investment, complicating the activities of the venture capital

firms without either increasing effectiveness or reducing risk to any appreciable

extent.

Impediments to the development of venture capital also can be traced to Indias

corporate, tax, and currency laws. Indias corporate law did not provide for limited

partnerships, limited liability partnerships, or limited liability corporations (LP, LLP,

and LLC, respectively). Moreover, corporate law allowed equity investors to receive

payment only in the form of dividends (i.e., no in-kind or capital distributions are

allowed). Disclosure requirements were, however, consistent with best international

practice. However, in the absence of seasoned institutional investors, advanced-

country standards of investor protection that would normally be imposed by such

investors have not developed.

These regulations did not create an inviting environment for investors. For example,

all investors in the venture capital fund had limited liability, and there was no

flexibility in risk sharing arrangements. There were no standard control arrangements,

so they had to be determined by negotiation between management and investors in the

fund. Also, Indian regulations did not recognize limited life funds, so in India it was

relatively easy to terminate a trust, but this meant that the entire firm was closed

rather than a specific fund within the firm. Therefore, each fund had to be created as a

separate trust or company. This process is administratively and legally time-

consuming. Terminating a fund is even more cumbersome, as it requires court

approval on a case-by-case basis.


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Indias regulatory framework earlier inhibited practices used in the United States to

reward employees of startup firms. From 1998, however, founders and employees can

participate in employee stock option programs. Indias corporate laws allow for

flexible risk sharing, control and exit arrangements between financiers and firm

management, provided the firms in which they invest are private. These are defined as

firms having less than 50 outside shareholders (who are not employees). However, for

firms with more than 50 non-employee shareholders, Indias corporate law does not

provide flexibility in using equity to reward employees. While this may be

satisfactory for early-stage venture capital investors, it could discourage later-stage

investors who invest as parts of a consortium.

The restrictions on venture capital extend beyond the framework of corporate law. For

instance, tax restrictions on corp rations require that corporations paying dividends

must pay a 10 percent dividenddistribution tax on the aggregate dividend.13 On the

other hand trusts granting dividends are exempt from dividend tax. An optimal

environment for venture capital requires a tax regime that is fiscally neutral from the

viewpoint of tax revenue. The environment should also be tax-competitive with other

domestic uses of institutional and private equity finance, particularly the domestic

mutual funds sector. However, the tax code in 2001 was disadvantageous from the

viewpoint of the international venture capital investor. Earnings from an international

venture capital investor are taxed even if it is a tax exempt institution in its country of

origin.

Another significant impediment to developing a vibrant venture capital industry was

Indias foreign currency regulations. Even in 2001, the Indian rupee was

nonconvertible. The lack of convertibility hampered venture capital inflows from

offshore because specific, time-consuming governmental approvals from multiple

agencies were required for each investment and disinvestment. Just as the currency

regime inhibited international venture capital firms from investing in India, domestic

venture capital firms were not allowed to invest offshore. Synergistic investments in

overseas firms that collaborate with domestic firms were next to impossible. The

currency regime also frustrated exit strategies. For example, in early 1999, Armedia,

an Indian manufacturer of high-technology telecommunications equipment, was in


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discussion with Broadcom, a U.S. firm, about being acquired, and it also was seeking

an investment from an Indian venture capitalist. However, since Indian venture capital

firms cannot own offshore shares, the deal with Broadcom would have had to be

changed from a pooling of interests transaction to a cash acquisition. Broadcom,

therefore, offered a significantly smaller sum to Armedia, because of the Indian

venture capital firms involvement. Fortunately for Armedia, it was able to obtain

bridge funding offshore and did not have to use an Indian venture capital firm (Dave

1999). The Indian legal and regulatory environment continued to inhibit venture

capital investors from maximizing their returns.

7.4 INDIA STRATEGIC VENTURE CAPITAL IMPORTANCE

During the last three months, India played hosts to two separate groups of General

Partners from leading global venture firms. Participants included General Partners

from among others New Enterprise Associates, Mayfield, Sequoia, Bessemer, US

Venture Partners, Bay Partners, Battery Ventures, and JP Morgan Partners who

collectively manage in excess of $20 billion. These trips underscored the growing

importance of India in the global venture capital landscape.

The first trip was organized and sponsored by Silicon Valley Bank, while TiE took

the lead in organizing the second trip. The US-India Venture Capital Association (US-IVCA) played an important role in helping organize both events. The US-IVCA was

established in 2002 with a mission to promote and strengthen US-India cross-border

investing by providing an organized forum for venture capitalists, entrepreneurs and

other key players to network and collaborate. US-IVCA today has 21 members

including leading firms such as NEA, Sequoia, Battery Ventures and Warburg Pincus.

While recent success stories emerging from India have been from the Business

Processing Outsourcing services space, most delegates felt that India is well poised to

play an important role in product success stories of future as well. Key reasons for

India becoming critical for product companies include:

Leveraging Indian development skills can reduce the capital intensity of startups

with cost reductions ranging from 40-60% compared to Silicon Valley.

India is also fast emerging as an important technical talent base with Indian

centers of several product companies becoming their worldwide centers of excellence.


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India is increasingly being able to attract mid and senior level managers to come

back and work in India increasing the attractiveness of India as a design and

development centre.

7.5 CREATING AN ENVIRONMENT: DEVELOPING VENTURE CAPITAL

IN INDIA

In the last decade, one of the most admired institutions among industrialists and

economic policymakers around the world has been the U.S. venture capital industry.

A recent OECD (2000) report identified venture capital as a critical component for the

success of entrepreneurial high-technology firms and recommended that all nations

consider strategies for encouraging the availability of venture capital. With such

admiration and encouragement from prestigious international organizations has come

various attempts to create an indigenous venture capital industry. This article

examines the efforts to create a venture capital industry in India.

The possibility and ease of cross-national transference of institutions has been a

subject of debate among scholars, policymakers, and industrialists during the entire

twentieth century, if not earlier. National economies have particular path dependent

trajectories, as do their national systems of innovation (NIS). The forces arrayed

against transfer are numerous and include cultural factors, legal systems, entrenched

institutions, and even lack of adequately trained personnel. Failure to transfer is

probably the most frequent outcome, as institutional inertia is usually the default

option. In the transfer process, there is a matrix of possible interactions between the

transferred institution and the environment. There are four possible outcomes: A) The

institution can be successfully transferred with no significant changes to either the

institution or the environment. B) The institutional transfer can fail. C) The institution

can be modified or hybridized so that it is able to integrate into the new environment.

D) The institution can modify the new environment. Though A and B are

exclusionary, it is possible for transfer to yield a combination of C and D.

The establishment of any institution in another environment can be a difficult trial and

error learning process. Even in the United States, state and local government policies

to encourage venture capital formation have been largely unsuccessful, i.e., outcome


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B (Florida and Smith 1993). Similarly, efforts in the 1980s by a number of European

governments to create national venture capital industries also failed. Probably the only

other nation to develop a fully Silicon Valley-style venture capital industry is Israel.

Taiwan, perhaps, is the only other country that appears to have developed a venture

capital industry, though there has been little research on the dynamics of this process

in Taiwan. Given the general difficulties in more wealthy and developed nations, it

would seem that India would have poor prospects for developing a viable venture

capital community.

India is a significant case study for a number of reasons. First, in contrast to the

United States, India had a history of state-directed institutional development that is

similar, in certain ways, to such development in Japan and Korea, with the exception

that ideologically the Indian government was avowedly hostile to capitalism.

Furthermore, the governments powerful bureaucracy tightly controlled the economy,

and the bureaucracy had a reputation for corruption. Such an environment would be

considered hostile to the development of an institution dependent upon a stable,

transparent institutional environment. India did have a number of strengths. It had an

enormous number of small businesses and a public equity market. Wages were low,

not only for physical labor, but also for trained engineers and scientists, of which

there was a surfeit. India also boasted a homegrown software industry that began in

the 1980s, and became visible upon the world scene in the mid-1990s.

Experiencing rapid growth, some Indian software firms became significant successes

and were able to list on the U.S. NASDAQ. Finally, beginning in the 1980s, but

especially in the 1990s, a number of Indian engineers who had immigrated to the

United States became entrepreneurs and began their own high-technology firms. They

were extremely successful, making them multimillionaires or even billionaires, and

some of them then became venture capitalists or angel investors. So there was a group

of potential transfer agents.

For any transfer process, there has to be some match between the environment and the

institution. Also, there must be agents who will mobilize resources to facilitate the

process, though these agents can be in the public or private sector. Prior to 1985, the

development of venture capital in India was very unlikely. However, the environment


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began to change after 1985, and continues to change. Even in the United States,

venture capital is only a small component of the much larger national system of

innovation (NIS), and as such is dependent on many other institutions. In the United

States and in India the development of venture capital has been a co-evolutionary

process. This is particularly true in India, where it remains a small industry

precariously dependent upon other institutions, particularly the government, and

external actors such as international lending agencies, overseas investors, and

successful Indian entrepreneurs in Silicon Valley. The growth of Indian venture

capital must be examined within the context of the larger political and economic

system in India. As was true in other countries, the Indian venture capital industry is

the result of an iterative learning process, and it is still in its infancy. If it is to be

successful it will be necessary not only for it to grow, but also for its institutional

context to evolve.

General Indian Economic and Financial Environment

From its inception, the Indian venture capital industry has been affected by

international and domestic developments; its current situation is the result of the

evolution of what initially appeared to be unrelated historical trajectories. To create a

venture capital industry in India through transplantation required the existence of a

minimal set of supportive conditions. They need not necessarily be optimal, because,

if the industry survived, it would likely set in motion a positive feedback process that

would foster the emergence of successful new firms, encourage investment of more

venture capital, and support the growth of other types of expertise associated with the

venture capital industr

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