DEPARTMENT OF MANAGEMENT STUDIES IIT ROORKEE

Performance of Banks in India

Submitted By: Mayank Jain Enrolment No: 10810031

Under the guidance of Prof. V.K. Nangia

Performance of Banks in India

Contents
1. 2. Introduction .........................................................................................................................3 CAMELS Framework .........................................................................................................4 2.1 Capital Adequacy ..............................................................................................................4 2.2 Asset Quality .....................................................................................................................4 2.3 Management ......................................................................................................................4 2.4 Earnings ............................................................................................................................4 2.5 Liquidity............................................................................................................................4 2.6 Sensitivity to Market Risk .................................................................................................4 3. Objectives of Scheduled Commercial Banks in India ...........................................................4 3.1 Progress of Financial Inclusion ..........................................................................................5 3.2 Growth of Scheduled Commercial Banks ..........................................................................5 3.2.1 Deposits ......................................................................................................................6 3.2.2 Investments.................................................................................................................6 3.2.3 Advances ....................................................................................................................7 3.3 Banks and Stability in Financial System ............................................................................8 3.3.1 Capital Adequacy .......................................................................................................9 3.3.2 Non Performing Assets ............................................................................................. 10 3.3.3 Nonperforming Asset Recovery ................................................................................ 11 3.4 Financial Intermediation .................................................................................................. 11 3.5 Return ............................................................................................................................. 12 4. Progress in Banking ........................................................................................................... 13 4.1 Operating Environment ................................................................................................... 13 4.2 Favorable Factors for the Banking Sector ........................................................................ 15 4.3 Challenges ahead: Banking Industry ................................................................................ 16 5. 6. 7. Conclusion ........................................................................................................................ 17 Abbreviations .................................................................................................................... 18 Notes ................................................................................................................................. 18 Basel Accords ....................................................................................................................... 18 Return on Equity ................................................................................................................... 19 Net NPA ............................................................................................................................... 19 Cost of Funds ........................................................................................................................ 19 Return on Advances .............................................................................................................. 19 Return on Advances adjusted to Cost of Funds ...................................................................... 19 Mayank Jain (10810031) DoMS, IIT Roorkee Page 2 of 25

Performance of Banks in India 8 Data Charts........................................................................................................................ 20 8.1 Operational Statistics of SCBs In 2011 ............................................................................ 20 8.2 Progress of Financial Inclusion ........................................................................................ 20 8.3 Growth of Scheduled Commercial Bank Offices over the years ....................................... 21 8.4 SCB Business Growth over the years ............................................................................... 21 8.5 Deposit Composition ....................................................................................................... 22 8.6 Deposit & Credit by Geography....................................................................................... 22 8.7 Domestic Credit Portfolio Composition of SCBs ............................................................. 23 8.8 Credit Distribution over the years .................................................................................... 23 8.9 Component-wise Capital Adequacy of SCBs ................................................................... 24 8.10 Financial Intermediation ................................................................................................ 24 8.11Returns ........................................................................................................................... 24 8.12 Off Balance Sheet Exposure .......................................................................................... 24 References ................................................................................................................................ 25

1. Introduction
The banking sector is the core segment of the Indian financial system which decides the progress of the country. Banks play an important role in the mobilization and allocation of resources in an economy. The sound financial position of a bank is the guarantee not only to its depositors but equally important for the whole economy of the nation. Several committees have emphasized the need to improve the performance of the commercial banks. Indian banks, the dominant financial intermediaries in India, have made good progress over the last five years, as is evident from several parameters, including annual credit growth, profitability, and trend in gross non-performing assets (NPAs). While the annual rate of credit growth clocked 23% during the last five years, profitability (average Return on Net Worth) was maintained at around 15% during the same period, and gross NPAs fell from 3.3% as on March 31, 2006 to 2.3% as on March 31, 2011. Significantly, the improvement in performance has been achieved despite several hurdles appearing on the way, such as temporary slowdown in economic activity (in the second half of 2008-09), a tightening liquidity situation, increases in wages following revision, and changes in regulations by the Reserve Bank of India (RBI), some of which prescribed higher credit provisions or higher capital allocations. See Operational Statistics for SCB 2010-11 (Chart 8.1)

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India

2. CAMELS Framework
CAMELS is a uniform financial institution rating system to evaluate and monitor the banks. The CAMEL Methodology is practiced by the bank regulators to assess the financial and managerial soundness of commercial banks. The CAMELS framework was first used by the regulators in the United States. Based on this, they rated the banks on a scale of 5 the strongest was rated as 1; the weakest was rated as 5.

2.1 Capital Adequacy

This is a measure of financial strength, in particular its ability to cushion operational and Abnormal losses. It is calculated based on the asset structure of the bank, and the risk weights that have been assigned by the regulator for each asset class.

2.2 Asset Quality

This depends on factors such as concentration of loans in the portfolio, related party exposure and provisions made for loan loss.

2.3 Management
Management of the bank obviously influences the other parameters. Operating cost per unit of money lent and earnings per employee are parameters used.

2.4 Earnings
This can be measured through ratios like return on assets, return on equity and interest spread.

2.5 Liquidity
In order to meet obligations as they come, the bank needs an effective asset-liability management system that balances gaps in the maturity profile of assets and liabilities. However, if the bank provides too much liquidity, then it will suffer in terms of profitability. This can be measured by the Loans to Deposit ratio, separately for short term, medium term and long term.

2.6 Sensitivity to Market Risk

Longer the maturity of debt investments, more prone it is to valuation losses, if interest rates go up. More sensitive the portfolio is to market risk, the more risky the bank is.

3. Objectives of Scheduled Commercial Banks in India

Foster Financial Inclusion Contribute to GDP Growth Effectively Allocate Capital and Manage Stability Efficiently Manage Intermediation Cost Return Shareholder Value

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India

3.1 Progress of Financial Inclusion

Out of every 1000 persons, only 99 had a credit account and 600 had a deposit account as at endMarch 2011. This underlined the need to strengthen the financial inclusion drive through well thought out policies. See Key Financial Inclusion Statistics (Chart 8.2) Financial inclusion has been one of the top priorities of the Reserve Bank during the recent years. Accordingly, the Reserve Bank has been encouraging the banking sector to expand the banking network both through setting up of new branches and also through BC model by leveraging upon the information and communication technology (ICT). Key tools of Reserve bank for financial inclusion are Directed credit for lending to priority sector and weaker sections: The goal here is to facilitate/enhance credit flow to employment intensive sectors such as agriculture, micro and small enterprises (MSE), as well as for affordable housing and education loans. Lead Bank Scheme: A commercial bank is designated as a lead bank in each district in the country and this bank is responsible for ensuring banking development in the district through coordinated efforts between banks and government officials. The Reserve Bank has assigned a Lead District Manager for each district who acts as a catalytic force for promoting financial inclusion and smooth working between government and banks. Sector specific refinance: The Reserve Bank makes available refinance to banks against their credit to the export sector. In exceptional circumstances, it can provide refinance against lending to other sectors.

3.2 Growth of Scheduled Commercial Banks

Prior to nationalization, banking services were largely confined to metropolitan areas, and a major consequence of nationalization was the spread of services to suburban and rural areas. Thus at the end of 1964 only 10% of commercial banks were located in rural areas. This proportion increased to 45% in 1994. As a result, the number of bank branches increased from 8262 in 1969 to around 60000 in 1991, and the population served per branch declined from 65000 in 1969 to around 12000 in 1991. See Chart 8.3 North Eastern Region, Eastern Region and Central region are lagging in terms of banking penetration as compared with rest of country. See Chart 8.4 The consolidated balance sheet of SCBs recorded higher growth in 2010-11 as compared with the previous year. This is in contrast to the trend observed during the last two years and signals a revival from the peripheral effects of global financial turmoil.

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India On the liability side of the balance sheet, the growth was driven mainly by borrowings, capital, and other liabilities and provisions. The recapitalisation of public sector banks by the Central Government and the mobilisation of funds from the stock market through public issues by PSBs were the main factors behind the growth of capital of SCBs in 2010-11. On the asset side of the balance sheet, the growth was primarily driven by loans and advances. There was a revival in credit growth across all the bank groups except old private sector banks in 2010-11 as compared with the previous year despite the tight interest rate environment. 3.2.1 Deposits Deposits, which constitute 78 per cent of total liabilities of the banking sector registered higher growth in 2010-11 in contrast to the trend observed in the recent years. This was mainly because of the accelerated deposit mobilization of new private sector banks in 2010-11 over the previous year. See Deposit Composition (Chart 8.5) The higher growth in deposits emanated mainly from term deposits. There was also a deceleration in the growth of savings bank deposits and demand deposits with the corresponding acceleration in the growth of term deposits. This could be due to the prevailing higher interest rate environment, making term deposits more attractive as compared with demand and savings deposits. While accelerated growth rate of term deposits is a welcome development from the point of view of stability of balance sheet as it strengthens the retail deposit base and reduces asset liability mismatches; it may increase the interest expenses of the banking sector, thus, adversely impacting profitability. Also the current account and savings account (CASA) deposits, which are least cost sources, recorded deceleration in 2010-11. It is pertinent to note that despite the increased remuneration on savings deposits based on a daily product basis with effect from April 1, 2010, the savings deposit mobilisation decelerated in 2010-11 across all the bank groups as compared with the previous year. Shift of funds to term deposits due to higher interest rates is one of the reasons for this trend. However, the upward revision in the savings deposit rate from 3.5 per cent to 4.0 per cent in April 2011 and deregulation of interest rate on savings deposits in October 2011, may improve the savings deposit mobilisation going forward. However, in a competitive environment, with the deregulation of interest rates, savings deposits will no longer be as less expensive as they were in the past.

3.2.2 Investments Due to the accommodation of higher credit growth, there was an overall deceleration in the growth of investments in securities in 2010-11 as compared with the previous year. In 2010-11, almost three fourths of the total investments of the banking sector were in Government securities held in India, mainly to meet the SLR requirements prescribed by the Reserve Bank and to raise Mayank Jain (10810031) DoMS, IIT Roorkee Page 6 of 25

Performance of Banks in India funds from the short term money market. However, investments of the banking sector in government securities held in India recorded lower growth in 2010-11 as compared with the previous year in tune with the reduction in SLR requirements from 25 per cent to 24 per cent with effect from December 18, 2010. The non-SLR investments of SCBs witnessed a decline in March 2011 as compared with those during the corresponding period of the previous year. This was primarily due to a decline in the investments in commercial paper in 2010-11 over those during the previous year. Investments in commercial paper are short-term investments of the banking sector to reap economic gain out of short-term surplus funds. The decline in such investments reflected tight liquidity conditions during 2010-11. On the other hand, banks investments in shares witnessed increase in 2010-11 over the previous year. Alongside, banks investments in bonds/debentures also witnessed a marginal increase during 2010-11 as compared with the previous year

3.2.3 Advances Historically, the banking sectors credit portfolio has been growing at over 20% per annum over the last several years (except in 2009-10, when the growth rate moderated to 17% mainly because of the decline in ICICI Banks credit portfolio). Over the years, credit growth has outpaced deposits growth; the credit portfolio reported a CAGR of 24% over the last eight years, while deposits achieved a CAGR of 19% and the investment portfolio of 14% over the same period. The higher growth in credit could be achieved because of the slower growth in investments and the increase in capital. In 2010-11, while deposits growth for SCBs slowed down to 17%, credit growth was maintained at 21% with the growth in investments being just 13%. The higher credit growth versus deposits growth led to an increase in the credit deposits ratio (CD ratio) from 72.2% as in March 2010 to 75.7% as in March 2011, although the CD ratio moderated to 74.2% as on May 27, 2011, largely because of the slow credit growth in comparison with deposits during the first two months of 2011-12. Total banking credit stood at close to Rs. 39 trillion as on March 25, 2011 and reported a strong 21.4% growth in 2010-11, led by credit to the infrastructure sector and to NBFCs.

Domestic Credit Portfolio Composition of SCBs During 2010-11, the infrastructure sector, particularly power, and NBFCs were the key drivers of the credit growth achieved by the banking sector. Credit to the power sector reported a growth of 43%, while other infrastructure credit grew by 34% during 2010-11, against an overall credit growth of 21%. As in March 2011, the infrastructure sector (including power) accounted for 14% of the total credit portfolio of banks. See Chart Credit Composition (Chart 8.7)
Within the power sector, historically banks have been taking exposure to State power utilities as well as independent power producers (IPPs). Going forward, with many banks approaching the exposure cap on lending to the power sector and given the concerns hovering over the prospects Mayank Jain (10810031) DoMS, IIT Roorkee Page 7 of 25

Performance of Banks in India of the sector itself, the pace of growth of credit to this segment could slow down. However, in the short to medium term, the undisbursed sanctions to power projects are likely to provide for a moderate growth. As for bank credit to NBFCs, the same increased by 55% in 2010-11 and accounted for around 5% of the banks total credit portfolio as in March 2011. Moreover, around half of this went to infrastructure related entities, and the rest mainly to NBFCs engaged in retail financing. Most of the NBFCs are focused on secured assets classes, have reported low NPA percentages, and are well-capitalized. As for banks retail lending, this continued to lag overall credit growth during 2010-11. Retail credit grew by 17% in 2010-11 against the overall credit growth of 21%, although the 17% figure marked a significant increase over the 4.1% reported in 2009-10. Credit to commercial real estate also increased in 2010-11, reporting a 21% growth that year as against nil in 2009-10. Large government borrowings may allow for just 17-18% credit growth in 2011-12 the RBIs tight monetary stance may exert a downward pressure on the demand for credit, considering the anticipated GDP growth (around 8%), investments in infrastructure and lower funds flow from the capital markets, credit demand could still remain high. However, banks capacity to meet credit demand could get constrained by the volume of deposits they are able to mobilize and by the large amount of funds they would need to keep aside to fund the government deficit.

Credit Distribution Credit to Individuals is increasing on account of increased home loans, education loans and lucrative personal loans. See Chart Credit Distribution Trends (Chart 8.8)
The critical role and place of the MSME sector in the Indian economy in employment generation, exports and economic empowerment of a vast section of the population is well known. The sector accounts for 45 per cent of the manufactured output and 8 per cent of the Gross Domestic Product (GDP). MSMEs contributed close to 40 per cent of all exports from the country and employ nearly 6 crore people which is next only to the agricultural sector. MSME is the best vehicle for inclusive growth, to create local demand and consumption.

3.3 Banks and Stability in Financial System

The banking sector in India emerged largely unscathed from the global financial crisis of 200708, but faced a slowdown in the momentum of growth due to the weakening of trade, finance and confidence channels. However, post crisis, the economic growth in most emerging market economies (EMEs) including India recovered, while growth remains anemic in advanced economies. Instability of sovereign debt markets in the Euro zone, political turmoil in the Middle East and North African (MENA) region, calamities in Japan, sovereign debt downgrade of the United States in August this year and the persistently elevated levels of commodity prices have together led to an accentuation of downside risks to global growth.

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India Also because of the maturity mismatch between their assets and liabilities, banks are subject to the possibility of runs and systemic risk. By the very nature of their business, banks are highly leveraged. They accept large amounts of uncollateralized public funds as deposits in a fiduciary capacity and further leverage those funds through credit creation. Banks are interconnected in diverse, complex and opaque ways underscoring their contagion potential. If a corporate fails, the fallout can be restricted to the stakeholders. If a bank fails, the impact can spread rapidly through to other banks with potentially serious consequences for the entire financial system and the macro economy. While regulation has a role to play in ensuring robust corporate standards in banks, the point to recognize is that effective regulation is a necessary, but not a sufficient condition for good corporate governance. In this context, the relevant issues pertaining to corporate governance of banks in India are bank ownership, accountability, transparency, ethics, compensation, splitting the posts of chairman and CEO of banks and corporate governance under financial holding company structure, which should engage adequate attention. Enhancing efficiency and performance of public sector banks (Public sector banks) is a key objective of economic reforms in many countries including India. It is believed that private ownership helps improve efficiency and performance. Accordingly, the Indian government started diluting its equity in PSB from early 1990s in a phased manner. As a part of financial sector reforms and with a view to giving the Public sector banks operational flexibility and functional autonomy the stake of the Indian government was diluted to 51 per cent. The Reserve Bank of India (2003) stated that dilution of government stake could provide greater operational freedom to banks which could have a positive impact on their efficiency. 3.3.1 Capital Adequacy The Reserve Bank has instructed banks to maintain adequate capital on a continuous basis. The adequacy of capital is measured in terms of Capital to Risk-Weighted Assets Ratio (CRAR). Under the recently revised framework, banks are required to maintain adequate capital for credit risk, market risk, operational risk and other risks. Good internal capital generation, reasonably active capital markets, and governmental support ensured good capitalisation for most banks during the period under study, with overall capital adequacy touching 14% as on March 31, 2011. At the same time, high levels of public deposit ensured most banks had a comfortable liquidity profile. Though all SCBs migrated to Basel II framework, the parallel run of Basel I is also continuing as a backstop measure. The CRAR of all bank groups under Basel I remained well above the stipulated regulatory norm of 9 per cent in 2010-11. The CRAR, however, declined in 2010-11 over the previous year mainly owing to a decline in Tier II CRAR ratio. Among the bank groups, foreign banks registered the highest CRAR, followed by private sector banks and PSBs in 2010-11. Under Basel II also, the CRAR of SCBs remained well above the required minimum in 2010-11. This implies that, in the short to medium term, SCBs are not constrained by capital in extending credit. See Chart Capital Adequacy (Chart 8.9) Mayank Jain (10810031) DoMS, IIT Roorkee Page 9 of 25

Performance of Banks in India

3.3.2 Non Performing Assets Over the last two years, Public sector banks Gross NPAs rose from 2% to 2.3%, while private banks NPAs declined from 2.9% to 2.3%. The Gross NPA percentage of the Public sector banks got impacted by slippages from restructured accounts, agri debt relief, and slippages because of automation of asset classification. In 2008-09, the RBI allowed a second time restructuring of corporate advances (excluding commercial real estate advances) and a one-time restructuring of commercial real estate advances. As part of this exercise, banks mostly allowed deferment of principal repayment by eligible borrowers by allowing a moratorium of six to 12 months. The exposure of banks to the power sector increased from Rs. 602 billion as in March 2006 (around 4% of total banking credit) to Rs. 2,692 billion as in March 2011 (around 7% of total banking credit). Banking credit to the power sector as a percentage of banks total net worth also increased from 33% as in March 2006 to 56% as in March 2011. The exposure to the power sector includes that to State power utilities and IPPs. Within these, loans given to fund the cash losses of State utilities are estimated at 30-40% of the total power-sector exposures. Since the financial health of the State power utilities remains poor, it is likely that they will find it difficult to service debt on time, and this could be a problem for banks unless power-sector reforms gain pace. Further, any reduction in credit flow from the banking system to such entities, with some banks hitting the exposure caps for the entities/sector, could also trigger defaults, although State government guarantees for some of the exposures would mitigate the eventual credit loss to an extent. In the context of power-sector reforms, the Government of India has set up a committee to assess the total losses of State power utilities. Timely assessment of such losses and speedy initiation of steps to lower them (via technical and commercial loss reduction measures, tariff revisions, etc.) would be critical for improving the financial viability of State utilities and also for reducing the counter-party credit risks of entities serving the power sector. Restructured advances accounted for around 4% of SCBs total advances as on March 31, 2011. For Public sector banks, restructured advances were higher at 4.5% as in March 2011 because of their higher lending to the corporate sector, while for private banks, such advances were lower at around 1% of their credit portfolio as in March 2011. Some of these restructured accounts have slipped into the NPA category over the last two years (in the range 8-20% for various banks), and with the operating environment deteriorating, slippages from restructured advances could continue into 2011-12 as well. During 2010-11, higher interest rate environment not only caused concerns about slowdown in credit growth, but also increased the possibility of deterioration in asset quality on the back of the possible weakening of the repayment capacities of borrowers in general. Mayank Jain (10810031) DoMS, IIT Roorkee Page 10 of 25

Performance of Banks in India 3.3.3 Nonperforming Asset Recovery The credit profiles of borrowers could weaken in 2011-12 because of a tight liquidity situation, higher interest rates, and moderation in GDP growth rate. The vulnerability of banks because of their increasing exposure to State power utilities is likely to increase, unless tariffs are revised upwards. However, these may not reflect in the Gross NPA percentage as there may be some regulatory respite. In 2010-11, there was 51 per cent increase in the number of cases referred to under the SARFAESI Act. Further, out of the total amount involved, more than one third was recovered in 2010-11. In 2010-11, the number of cases referred to DRT registered a whopping growth of 114 per cent over the previous year. Due to the speedy recovery in Lok Adalats, the number of cases referred to Lok Adalats is much more as compared with other channels of recovery. However, in 2010-11, the number of cases referred to Lok Adalats witnessed a decline over the previous year. Moreover, the percentage of amount recovered to amount involved was comparatively lower in Lok Adalats as compared with DRT in 2010-11, though there was an improvement over the previous year

3.4 Financial Intermediation

While maintaining profitability is a sine qua non for the financial soundness of the banking sector, efficient financial intermediation is important from the point of view of economic growth. On the other side, one of the indicators, which is used to assess efficiency of the banking sector is NIM. NIM indicates the margin taken by the banking sector while doing banking business. In this context, there is a need to bring down NIM from an efficiency point of view, nevertheless, from a profitability point of view; there is a need to increase it. A balanced approach would be to bring down NIM, which will improve efficiency of financial intermediation, along with an increase in income from other sources and reduction in operating expenses to maintain profitability (Subbarao, 2010). During the last one decade, NIM was in the range 2.5 per cent to 3.1 per cent. See Chart Financial Intermediation (Chart 8.10). The NIM, which witnessed a declining trend during the period 2004 to 2010, improved during 2010-11. The NIM of the Indian banking sector continues to be higher than some of the emerging market economies of the world. The decomposition of NIM into NIM from core banking business, (i.e., calculated as the difference between interest income from loans and advances minus interest expenses on deposits as a per cent of average total assets), and NIM from others (i.e., mainly the difference between all other interest income and interest expenses) showed that NIM from core banking business witnessed substantial increase during the last one decade. In contrast, NIM from others witnessed a decline, leaving the total NIM more or less stable during the same period. The increase in the NIM from core banking business indicates that the cost of financial intermediation increased in the economy during the last one decade. Thus, there is a need to bring down NIM from core banking business to bring the overall NIM down.

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India The Indian banking sector has recorded an impressive improvement in productivity over the last 15 years; many of the productivity/efficiency indicators have moved closer to the global levels. There has been a particularly discernible improvement in banks operating efficiency in recent years owing to technology up-gradation and staff restructuring. However, to sustain high and inclusive growth, there is a need to raise the level of domestic savings and channel those savings into investment. This implies that banks need to offer attractive interest rates to depositors and reduce the lending rates charged on borrowers - in other words, reduce the net interest margin (NIM). The NIM of the Indian banking system is higher than that in some of the other emerging market economies even after accounting for mandated social sector obligations such as priority sector lending and credit support for the Governments anti-poverty initiatives. By far the most important task is to further improve operating efficiency on top of what has already been achieved by optimizing operating costs, i.e., non-interest expenses including wages and salaries, transaction costs and provisioning expenses. This will enable banks to lower lending rates while preserving their profitability.

3.5 Return
Despite widespread concerns with regard to profitability on account of higher interest expenses on the one hand and, higher nonperforming assets and the consequent higher provisioning requirements, and lower interest income on the other, the financial performance of SCBs improved in 2010-11 as compared with the previous year. The consolidated net profits of the banking sector recorded higher growth in 2010-11, in contrast to the deceleration experienced in 2009-10, primarily because of higher growth in interest income. The implementation of the Base rate system with effect from July 1, 2010, which prohibited sub-prime lending to the corporate sector might have contributed to the higher interest income in 2010-11 apart from robust credit growth. Although, interest expenses also witnessed accelerated growth in 2010-11 owing to the higher interest rate environment, it was considerably lower than the growth in interest income. Accordingly, the net interest margin (NIM) of SCBs improved in 2010-11 over the previous year. See Chart Returns (Chart 8.11) Resultantly, the consolidated net profits of the banking sector registered higher growth in 201011 as compared with the decelerating trend observed during the recent past. The return on assets of SCBs also marginally increased to 1.10 per cent in 2010-11 from 1.05 per cent in 2009-10, mainly owing to higher NIM. The return on equity also witnessed an improvement over the same period. However, the SBI group was an exception to this general trend. The marginal decline in both Return on Asset and Return on Equity recorded by the SBI group was partly on account of the provisioning requirements for housing loans extended at teaser interest rates. The Reserve Bank had increased provisioning requirements for such loans (classified as standard assets) in December 2010 due to the risk of delinquencies upon repricing of such loans going forward.

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India The high Return on Asset of foreign banks are attributable to their extremely high levels of offbalance-sheet transactions. At present under the WTO commitments, there is a limit that when the assets (on balance sheet as well as off-balance sheet) of the foreign bank branches in India exceed 15% of the assets of the banking system, licenses may be denied to new foreign banks. The recent global financial turmoil demonstrated the risk involved in accumulating large amount of off-balance sheet exposures (OBS). Recognising the risky and uncertain nature of OBS, the Reserve Bank tightened the prudential norms on OBS in August 2008. See Chart Off Balance Sheet Exposure (Chart 8.12)

4. Progress in Banking
The Indian banking sector performed better in 2010-11 over the previous year despite the challenging operational environment. The banking business of Scheduled Commercial Banks (SCBs) recorded higher growth in 2010-11 as compared with their performance during the last few years. Credit grew at 22.9 per cent and deposits grew at 18.3 per cent in 2010-11 over the previous year. Accordingly, the outstanding credit-deposit ratio of SCBs increased to 76.5 per cent in 2010-11 as compared with 73.6 per cent in the previous year. Despite the growing pressures on margins owing to higher interest rate environment, the return on assets (RoA) of SCBs improved to 1.10 per cent in 2010-11 from 1.05 per cent in 2009-10. The capital to risk weighted assets ratio under both Basel I and II frameworks at 13.0 per cent and 14.2 per cent, respectively in 2010-11 remained well above the required minimum of 9 per cent. The gross NPAs to gross advances ratio declined to 2.25 per cent in 2010-11 from 2.39 per cent in 2009-10, displaying improvement in asset quality of the banking sector. Though there was improvement in the penetration of banking services in 2010-11 over the previous year, the extent of financial exclusion continued to be staggering.

4.1 Operating Environment

During 2010-11, higher interest rate environment not only caused concerns about slowdown in credit growth, but also increased the possibility of deterioration in asset quality on the back of the possible weakening of the repayment capacities of borrowers in general. The tight interest rate environment also affected the profit prospects of commercial banks due to the possibility of lower margins in 2010-11. During the year, the large credit intake by some of the crucial sectors such as NBFCs and infrastructure, also raised concerns about financial soundness through the potential build up of sectoral credit booms. Large borrowings by the telecommunication companies to participate in the auction of 3G spectrum, reduction in Government spending as also the large currency holdings by the public due to high inflation made the liquidity conditions more stringent in 2010-11. Further, the need to migrate towards advanced approaches of capital calibration under Basel II was also a challenge that loomed large in the Indian banking sector. Alongside, there was also a pressing need to become more innovative to transform unbanked villages into profitable business locations thereby strengthening the financial inclusion process, to keep up with the latest technological developments and to improve the quality of customer service Mayank Jain (10810031) DoMS, IIT Roorkee Page 13 of 25

Performance of Banks in India The Performance of banks may be attributed to Implementation of SARFAESI Act 2002. Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest, 2002 (SARFAESI Act, 2002) was enacted to provide banks and financial institutions with a more effective framework to enforce the security structure underlying loans and advances given by them, and recover their dues expeditiously. It addresses the regulation of Securitisation, Reconstruction of Financial Assets and Enforcement of Security Interest Setting up of Credit Information Bureaus. The Government of India and the Reserve Bank of India to improve the functionality and stability of the Indian financial system by containing Non Performing Assets (NPAs) while improving credit grantors portfolio quality made effort to establish Credit Information Bureaus. These are the repository of information which has been pooled in by all Banks and lending Institutions operating in India. The aim of these Information Bureaus is to fulfill the need of credit granting institutions for comprehensive credit information by collecting, collating and disseminating credit information pertaining to both commercial and consumer borrowers, to a closed user group of Members. CIBIL is Indias first Credit Bureau. Banks, Financial Institutions, Non Banking Financial Companies, Housing Finance Companies and Credit Card Companies use CIBILs services. Data sharing is based on the Principle of Reciprocity, which means that only Members who have submitted all their credit data, may access Credit Information Reports from CIBIL. The relationship between CIBIL and its Members is that of close interdependence. CIBIL provides a vital service, which allows its Members to make informed, objective and faster credit decisions. Internal improvements such as upgrade of Technology Infrastructure. During the recent years, the pace and quality of banking was changed by the technological advancements made in this area. Computerisation as well as the adoption of core banking solutions was one of the major steps in improving the efficiency of banking services. The new private sector banks and most of the foreign banks, which started their operations in the mid nineties followed by liberalisation, were the front runners in adopting technology. For old private sector banks and public sector banks adoption of technology was an arduous job because of the historical records and practices. However, it is important to note that presently almost 98 per cent of the branches of public sector banks are fully computerised, and within which almost 90 per cent of the branches are on core banking platform. Further, introduction of automated teller machines (ATMs) enabled customers to do banking without visiting the bank branch. In 2010-11 the number of ATMs witnessed a growth of 24 per cent over the previous year. More than 65 per cent of the total ATMs belonged to the public sector banks as at end March 2011

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India

Tightening of the Appraisal and Monitoring Processes. As the nations financial regulator, the Reserve Bank makes use of several supervisory tools including On-site inspections, Off-site surveillance by making use of required reporting by the regulated entities and Thematic inspections, scrutiny and periodic meetings Strengthened Prudential Norms. The Reserve Bank has prescribed prudential norms to be followed by banks in several areas of their operations. It keeps a close watch on developing trends in the financial markets, and fine-tunes the prudential policies. In order to strengthen the balance sheets of banks, the Reserve Bank has been prescribing appropriate prudential norms for them in regard to income recognition, asset classification and provisioning, capital adequacy, investments portfolio and capital market exposures, to name a few. In order to maintain the quality of their loans and advances, the Reserve Bank requires banks to classify their loan assets as performing and non-performing assets (NPA), primarily based on the record of recovery from the borrowers. NPAs are further categorised into Sub-standard, Doubtful and Loss Assets depending upon age of the NPAs and value of available securities. Banks are also required to make appropriate provisions against each category of NPAs. Banks are also required to have exposure limits in place to prevent credit concentration risk and limit exposures to sensitive sectors, such as, capital markets and real estate. For Investments the Reserve Bank requires banks to classify their investment portfolios into three categories for the purpose of valuation: Held to Maturity (HTM), Available for Sale (AFS) and Held for Trading (HFT). The securities held under HFT and AFS categories have to be marked-to-market periodically and depreciation, if any, needs appropriate provisions by banks. Securities under HTM category must be carried at acquisition /amortised cost, subject to certain conditions.

4.2 Favorable Factors for the Banking Sector

Enhanced the Payment System. Good Internal Capital Generation. Reasonably Active Capital Markets . Governmental Support Ensured Good Capitalisation for PSB. High Levels of Public Deposit. Good Economic Growth over the Last Decade. Mayank Jain (10810031) DoMS, IIT Roorkee Page 15 of 25

Performance of Banks in India

4.3 Challenges ahead: Banking Industry

Increase in Interest Rates and Deregulation of Interest Rates on Saving Deposits. Saving deposits are estimated to account for 22-23% of total bank deposits (as of March 31, 2011). The increase in interest rate on saving deposits could raise the cost of deposits. In May 2011, the RBI decided to raise the saving deposit interest rate from 3.5% to 4.0%. Tighter monetary policy and large government deficit. Large government borrowings may allow for just 17-18% credit growth in 2011-12 the RBIs tight monetary stance may exert a downward pressure on the demand for credit, considering the anticipated GDP growth (around 8%), investments in infrastructure and lower funds flow from the capital markets, credit demand could still remain high. However, banks capacity to meet credit demand could get constrained by the volume of deposits they are able to mobilize and by the large amount of funds they would need to keep aside to fund the government deficit.

Increasing Infrastructure Loans and Increased stress in some sectors (such as, State utilities, airlines, and microfinance). During 2010-11, the infrastructure sector, particularly power, was the key driver of the credit growth achieved by the banking sector. Credit to the power sector reported a growth of 43%, while other infrastructure credit grew by 34% during 2010-11, against an overall credit growth of 21%. As in March 2011, the infrastructure sector (including power) accounted for 14% of the total credit portfolio of banks. Within the power sector, historically banks have been taking exposure to State power utilities as well as independent power producers (IPPs). Going forward, with many banks approaching the exposure cap on lending to the power sector and given the concerns hovering over the prospects of the sector itself, the pace of growth of credit to this segment could slow down. Restructured loan accounts, Unamortized pension/gratuity liabilities. In 2010-11, PSBs reopened the pension option for employees who had not opted for pension earlier (including retired employees) and also enhanced the gratuity limits from Rs. 3.5 lakh to Rs. 10 lakh following the amendment to the Payment of Gratuity Act, 1972. For the 24 PSB the total unamortised pension and gratuity liabilities were around Rs. 203 billion (11% of their net worth). If the unamortised liability is adjusted against the Tier I capital of PSBs as on March 2011, then the Tier I capital declines by 30-35 bps from the 9% level. With the likely switch to International Financial Reporting Standards (IFRS) from April 1, 2013 (as scheduled for the Indian banking industry), the full unamortised liability would be knocked off from the opening balance of reserves, and consequently, banks may have to absorb the entire liability over the next two to three financial years. Mayank Jain (10810031) DoMS, IIT Roorkee Page 16 of 25

Performance of Banks in India

Implementation of Basel III. At an aggregate level, Indian banks fare well against the Basel III requirement for capital. Considering the stricter deductions from Tier I and the fact that some of the existing perpetual debt (around Rs. 250 billion) would become ineligible for inclusion under Tier I, some banks may need to infuse superior or core capital (equity capital or Tier I). Additional capital may also be required to support a growth rate that exceeds the internal capital generation rate, which is likely of March 2011.

5. Conclusion
Indian banks, the dominant financial intermediaries in India, have made good progress over the last five years. While banks have benefited from an overall good economic growth over the last decade, implementation of SARFAESI, setting up of credit information bureaus, internal improvements such as upgrade of technology infrastructure, tightening of the appraisal and monitoring processes, and strengthening of the risk management platform have also contributed to the improvement. Banks continued to manage growth with resilience during 2010-11 with ample reserves of capital and liquidity, improved performance in profitability and asset quality. With high growth potential of the Indian economy and favourable demographics, banks have immense opportunities to further expand their business both with traditional and innovative products and through financial inclusion using technology enabled sustainable business models. However, the prevailing interest rate environment and slowing growth in the near-term amidst somewhat skewed exposures to interest sensitive sectors will require adept management of such exposures going forward. Further, it will be challenging for banks to raise additional capital and liquidity to support higher growth and to comply with Basel III stipulations. This would require banks to use innovative and attractive market based funding channels, especially when capital continues to remain expensive and the Government support may be constrained by fiscal considerations. Given the focus on inclusive growth, banks are also expected to renew efforts to broaden the scope of financial inclusion and use viable business models to achieve their targets. Finally, sustained pursuit of forward looking strategies aimed at mitigating risks, diversifying revenue sources, containing asset-liability mismatches, providing effective response to changing global market environment and improving customer relationships should strengthen the overall growth of the banking sector in the medium term.

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India

6. Abbreviations
SCBs - Schedule Commercial Banks PSBs - Public Sector Banks NBs - Nationalised Banks OPRBs - Old Private Banks NPRBs - New Private Banks FBs - Foreign Banks NIM - Net Interest Margin

7. Notes
Basel Accords
The Basel Committee is a committee of bank supervisors consisting of members from each of the G10 countries. The Committee is a forum for discussion on the handling of specific supervisory problems. It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks' foreign establishments with the aim of ensuring effective supervision of banks activities worldwide. BIS fosters co-operation among central banks and other agencies in pursuit of monetary and financial stability. The Basel Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardized risk-based capital requirements for banks across countries. The Accord was replaced with a new capital adequacy framework (Basel II), published in June 2004.

Basel I The Basel Accord of 1988 (Basel I) focused almost entirely on credit risk. It defined capital, and a structure of risk weights for banks. Minimum requirement of capital was fixed at 8% of riskweighted assets. Basel II Basel II is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face. These three pillars are: Minimum capital requirements, which seek to refine the present measurement framework Supervisory review of an institution's capital adequacy and internal assessment process; Market discipline through effective disclosure to encourage safe and sound banking practices
The first Pillar Minimum Capital Requirements Three tiers of capital have been defined: Tier 1 Capital includes only permanent shareholders equity (issued and fully paid ordinary shares and perpetual non-cumulative preference shares) and disclosed reserves (share premium, retained earnings, general reserves, legal reserves) Tier 2 Capital includes undisclosed reserves, revaluation reserves, general provisions and loan-loss reserves, hybrid (debt / equity) capital instruments and subordinated term debt. A limit of 50% of Tier 1 is applicable for subordinated term debt. Mayank Jain (10810031) DoMS, IIT Roorkee Page 18 of 25

Performance of Banks in India Tier 3 Capital is represented by short-term subordinated debt covering market risk. This is limited to 250% of Tier 1 capital that is required to support market risk.

Return on Equity
= Net Profit / (Capital + Reserves and Surplus)

Net NPA
= Gross NPA (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending adjustment + Part payment received and kept in suspense account + Total provisions held)

Cost of Funds
= (Interest paid on deposits + Interest paid on borrowings) / (Deposits + Borrowings)

Return on Advances
= Interest earned on advances and bills / Advances

Return on Advances adjusted to Cost of Funds

= Return on Advances Cost of Funds

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India

8 Data Charts
8.1 Operational Statistics of SCBs In 2011
Public Sector Old Private Sector New Private Sector Foreign Banks SCB

No. of Banks No. of Offices No. of Employee

Business per Employee (in Rs Lakhs) Profit per Employee ( in Rs Lakhs)

26 64,412 7,57,535 1013.63 5.93

14 5011 55,075 814.90 5.63

7 6957 1,63,604 826.07 8.63

33 316 27,969 1559.74 27.59

80 76,696 10,04,182 987.38 7.00

Source: RBI Publication -A Profile of Banks, 2011

8.2 Progress of Financial Inclusion

No. 1 2 3 4 5 Indicator Credit-GDP Credit-Deposit Population per Bank Branch Population per ATM 2009-10 53.4 73.6 14,000 19,700 2010-11 54.6 76.5 13,466 16,243

Percentage of Population having 55.8 61.2 deposit accounts Percentage of Population having 6 9.3 9.9 credit accounts Percentage of Population having 7 15.2 18.8 debit cards Percentage of Population having 8 1.53 1.49 credit cards Source: RBI Publication - Operations and Performance of Commercial Banks 2010-11, RBI

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DoMS, IIT Roorkee

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Performance of Banks in India

8.3 Growth of Scheduled Commercial Bank Offices over the years

Year 1969 1975 74 1980 75 1985 81 1990 74 1995 88 2000 101 2005 88 2011 80

No. of SCBs 73 (Excluding RRBs) No. of Offices Growth Rate of Offices ( YoY %)

8,262 18,575 124.82

32,412 52,638 60,515 63,817 67,339 54,063 76,993 74.49 62.40 14.96 5.46 5.52 (19.72) 42.41

Source: RBI publication -Statistical Tables Relating to Banks of India, 2011

8.4 SCB Business Growth over the years

All SCB Aggregates (in Rs. Crore) Items 2005-06 2006-07 Deposits Deposit Growth Rate (YoY %) Investments Investment Growth Rate (YoY %) Advances Advances Growth Rate (YoY %) 21,64,682 26,96,937 24.59 8,66,508 9,50,982 9.75 15,16,811 19,81,236 30.62 2007-08 2008-09 2009-10 2010-11

33,20,062 40,63,201 47,46,920 56,16,432 23.10 22.38 16.83 18.32

11,77,330 14,49,551 17,29,006 19,16,053 23.80 23.12 19.28 10.82

24,76,936 29,99,924 34,96,720 42,98,704 25.02 21.11 16.56 22.94

Source: RBI Publication - A Profile of Banks, 2011

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DoMS, IIT Roorkee

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Performance of Banks in India

8.5 Deposit Composition

(in percent) (as ON 31 MARCH 2011)

Public Sector Demand Saving Term Total Deposits 9.38 24.77 65.86 100.00

Old Private Sector 9.17 18.80 72.03 100.00

New Private Sector 18.24 24.30 57.46 100.00

Foreign Banks 30.29 16.47 53.24 100.00

SCB 11.43 24.07 64.5 100.00

Source: RBI Publication - A Profile of Banks, 2011.

8.6 Deposit & Credit by Geography

(as ON 31 MARCH 2011)

Per Capita Deposit ( in Rs) Northern Region North Eastern Region Eastern Region Central Region Western Region Southern Region Total ( All India) 83,485 21,597 23,727 20,174 1,01,940 46,963 46,321

Per Capita Credit ( in Rs) 69,039 7,086 12,139 9,554 79,572 44,169 34,800

Credit Deposit Ratio ( in %) 82.7 32.8 51.2 47.4 78.1 94.1 75.1

Source: RBI Publication - A Profile of Banks, 2011. .

Mayank Jain (10810031)

DoMS, IIT Roorkee

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Performance of Banks in India

8.7 Domestic Credit Portfolio Composition of SCBs

(as ON 31 MARCH 2011)

Credit Portfolio

As % of Total Credit 13 % 3% 5% 7% 7%

Credit Portfolio

As % of Total Credit 9% 7% 2% 47%

Agriculture and Allied Activities Commercial Real Estate Loans Loans to NBFC Power Sector Loans Other infrastructure Loans

Housing Loan Other Retail Loan Vehicle Loan Other Corporate Loans

Source: RBI Publication - A Profile of Banks, 2011.

8.8 Credit Distribution over the years

Source: RBI publication -Statistical Tables Relating to Banks of India, 2011

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DoMS, IIT Roorkee

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Performance of Banks in India

8.9 Component-wise Capital Adequacy of SCBs

(as ON 31 MARCH 2011)

( in percent) Basel I Basel II 2011 11.8 % 13.3 % 15.5 % 17.7 % 2010 13.3 % 14.9 % 18.0 % 17.3 % 2011 13.1 % 14.6 % 16.9 % 17.0 %

Bank group 2010 Public Sector Old private Sector New private sector Foreign banks 12.1 % 13.8 % 17.3 % 18.1 %

Schedule Commercial 13.6 % 13.0 % 14.5 % 14.2 % Banks Source: RBI publication Report on Trends and Progress of Banking in India 2010-11

8.10 Financial Intermediation

Foreign Bank Cost of Fund 3.1 % New Private Sector 4.3% 8.4% 4.2% SBI Group 4.8% 8.2% 3.4% Nationalised Bank 4.9% 8.5% 3.6% Old Private Sector 5.5% 9% 3.5%

Return on Fund 8.1% Spread 5%

Source: RBI publication Report on Trends and Progress of Banking in India 2010-11

8.11 Returns
Public Sector Return on 0.96 Asset Old Private Sector Bank 1.12 New Private Sector Bank 1.51 Foreign Bank 1.74 Scheduled Commercial Bank 1.1

Return on 16.9 14.11 13.62 10.28 14.96 Equity Source: RBI publication Report on Trends and Progress of Banking in India 2010-11

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DoMS, IIT Roorkee

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Performance of Banks in India

8.12 Off Balance Sheet Exposure

Off Balance Sheet Item Forward Exchange Contract Acceptance Guarantees

Percent

86.8 %

12.5 % 0.7 %

Source: RBI publication Report on Trends and Progress of Banking in India 2010-11

References
Publications from Reserve Bank of India, www.rbi.org.in ICRA Report Indian Banking Sector, June 2011 Speech D Subbarao (2010), Five Frontier Issues in Indian Banking, Speech delivered at BANCON 2010, Mumbai, December. NCFM, Commercial Banking in India Module, June 2011 NCFM, Banking Sector Module, June 2011 Indian Banking 2020 , BCG http://www.cibil.com

Mayank Jain (10810031)

DoMS, IIT Roorkee

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