INDIAN BANKING SYSTEM: THE CURRENT STATE & ROAD AHEAD ANNUAL SURVEY September 2006 Federation of Indian Chambers of Commerce & Industry Federation House, Tansen Marg, New Delhi – 110 001 “Indian Banking System: The Current State and Road Ahead” 1 Executive Summary India’s banking sector is growing at a fast pace. It has become one of the most preferred banking destinations in the world. Indian markets provide growth opportunities, which are unlikely to be matched by the mature banking markets around the world. FICCI conducted a survey to analyze the potential offered by

Indian Banking System and achievement of global competitiveness by Indian banks. The questions largely revolved around where we are, how will India go about it, what structures need to be created and when will it happen? ?Some of the major strengths of the Indian banking industry, which have helped mark its place on the global banking scene as highlighted by our survey respondents were Regulatory Systems (84. 21%), Economic Growth Rate (63. 15%), Technological Advancement (52. 63%), Risk Assessment Systems (47%) and Credit Quality (42. 1%) Some of the areas that need to be geared up for future growth, identified by the survey respondents are Diversification of markets beyond big cities (84. 2%), HR Systems (63. 15%), Size of banks (52. 63%) High Transaction Costs (47. 3%), Banking Infrastructure (42%) and Labour Inflexibilities (42%). ?To a question on achieving global competitiveness, Consolidation in the financial sector has emerged to be the most significant measure required to create world class banking system followed by Strict Corporate Governance Norms, Regional Expansion, Higher FDI limits and FTA’s. On being asked to rate India on certain essential banking parameters (Regulatory Systems, Risk Assessment Systems, Technological Systems and Credit Quality) in comparison with other countries i. e China, Japan, Sinagapore, Russia, UK and USA, the following results emerged: ?Regulatory systems of Indian banks were rated better than China and Russia; at par with Japan and Singapore but less advanced than UK and USA. “Indian Banking System: The Current State and Road Ahead” 2 ?Respondents rated India’s Risk management systems more advanced han China and Russia; at par with Japan, and less advanced than Singapore, UK and USA. 83% of our respondents highlighted that Basel II implementation would take us a step ahead in global competitiveness. ?Technological systems of Indian banks have been rated more advanced than China and Russia; at par with Japan, but less advanced than Singapore, UK and USA. ?Majority of respondents quoted credit quality of Indian banks better in comparison with China, Japan and Russia; at par with Singapore but below par with UK and USA. ?75 per cent of the foreign bank’s respondents rated their working experience in

India as “ extremely good”. Given India’s potential over the next decade and beyond, 100 per cent foreign banks respondents stated that they have formulated strategies for future expansion in India. ?55 per cent of the respondents highlighted that the FTA’s signed by India till now have helped enhance global trade and thus been of help to banks in their global expansion strategy. ?On possible Comprehensive Economic Co-Operation Agreement (CECA) with EU, 85 per cent of domestic banks respondents also emphasized that India should not give full domestic status to EU based banks under the proposed

India-EU CECA. ?69 per cent of respondents stated that 20 – 30 % proportion of their total Income is constituted by fee-based incomes. Bancassurance and selling of mutual funds were recognized as the most tapped business opportunities by the bankers closely followed by Forex Management. Out of these selling of mutual funds was identified as the most profitable venture by 47 per cent of respondents. ?The penetration of banking services to Indian households stands at a mere 35. 5%. Some of the efforts highlighted to increase this penetration level were: Tapping the Rural markets (87. per cent respondents) and Opening more branches in Tier II and Tier III towns (62. 5 per cent respondents) “Indian Banking System: The Current State and Road Ahead” 3 On the question on the state of preparedness of Indian banking sector to tackle the challenges being faced by them, the following results emerged: ?In view of increased competition, Implementation of Basel II norms by March 2007 and opening up of sector in 2009, 95 per cent of the respondents view that this is the right time for the consolidation in the financial sector. 94 per cent respondents also fully supported government point of view of creating of -7 banks as big as the State Bank of India. ?92 per cent of Public sector bank’s respondents voiced that they do not have sufficient autonomy to offer attractive incentive packages to their employee to ensure their commitment levels. Out of these, 82 per cent of respondents expressed that to improve their productivity levels it is essential to offer competitive compensation packages at all levels. ?58 per cent of respondents expressed that Indian Banking Sector is prepared to achieve the Basel II milestone by 31st March 2007 whereas the remaining voiced that the deadline should get extended. 3 per cent respondents also highlighted that presently there are sufficient instruments in the market to meet the increased capital requirements of Indian Banks “Indian Banking System: The Current State and Road Ahead” 4 The Indian Banking System: The Current State and Road Ahead Annual Survey Introduction India’s banking sector is growing at a fast pace. India has become one of the most preferred banking destinations in the world. The reasons are numerous: the economy is growing at a rate of 8%, Bank credit is growing at 30% per annum and there is an ever-expanding middle class of between 250 and 300 million people (larger than the opulation of the US) in need of financial services. All this enables double-digit returns on most asset classes which is not so in a majority of other countries. Foreign banks in India achieving a return on assets (ROA) of 3%, their keen interest in expanding their businesses is understandable – even more so when compared with the measly 1% average ROA for the Top 1000 banks in the world. Indian markets provide growth opportunities, which are unlikely to be matched by the mature banking markets around the world. Some of the high growth potential areas to e looked at are: the market for consumer finance stands at about 2%-3% of GDP, compared with 25% in some European markets, the real estate market in India is growing at 30% annually and is projected to touch $ 50 billion by 2008, the retail credit is expected to cross Rs 5,70,000 crore by 2010 from the current level of Rs 1,89,000 crore in 2004-05 and huge SME sector which contributes significantly to India’s GDP. “Indian Banking System: The Current State and Road Ahead” 5 Indian Banking Sector: Strengths and Weaknesses Let’s have a look at what our respondents have to say about present state of Indian’s anking systems – some of its strengths that we are proud of and some weaknesses that need to be worked upon . Some of the major strengths of the Indian banking industry, which helps mark its place on the global banking scene as highlighted by our survey respondents were Regulatory Systems (84. 21%), Economic Growth Rate (63. 15%), Technological Advancement (52. 63%), Risk Assessment Systems (47%) and Credit Quality (42. 1%) Major Strength Areas * Regulatory Systems (84. 21%) Economic Growth Rate (63. 15%) Technological Advancement (52. 63%) Risk Assessment Systems (47%) Credit Quality (42. 1%) Areas To Be Geared Up

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For Future Growth * Diversification of markets beyond big cities (84. 2%) HR Systems (63. 15%) Size of banks (52. 63%) High Transaction Costs (47. 3%) Banking Infrastructure (42%) Labour Inflexibilities (42%) Turnaround success strategies “Indian Banking System: The Current State and Road Ahead” 6 Indian Banking Sector Strategies To Be Adopted For Creating World Class Banking System Consolidation Strict Corporate Governance Norms Regional Expansion (Both within India as well as Outside) Higher FDI limits FTA with countries where India has comparative advantage in banking sector Some of the areas that need to be geared up for future rowth, identified by the survey respondents were Diversification of markets beyond big cities (84. 2%), HR Systems (63. 15%), Size of banks (52. 63%), High Transaction Costs (47. 3%), Banking Infrastructure (42%) and Labour Inflexibilities (42%). Availability and reach of quality products is confined to just big cities. Thus it is essential now to expand the gamut of banking services both within India as well as outside. Size of the banks is also a critical element in the chase for avenues for growth as it facilitates banks to attain new capabilities, technologies and roducts at lower operating costs. Banking in India has to travel a long way to achieve global competitiveness, but surely it is on its way. But the key questions at this hour how will India go about it, what structures need to be created and when will it happen? To find out what we need to do to be there, we asked our respondents to rank the various Global strategies which if adopted would accentuate India’s pace towards it (On a scale of 1 to 5 with 5 being the Most important Global “Indian Banking System: The Current State and Road Ahead” 7 Trend).

The results of the Mode score being accorded by the Public, Private & Foreign banks are presented below: 0 1 2 3 4 5 Consolidation Strict Corporate Governance Norms Regional Expansion (Both w ithin India as well as Outside) Higher FDI limits FTA’s Global Strategies for Indian Banking System (Overall Mode score of all banks) As evident from graph above, consolidation emerged to be the most significant measure required to create world class banking system followed by Strict Corporate Governance Norms, Regional Expansion, Higher FDI limits and FTA’s. India’s Steps towards Global Competitiveness

Of the many Asia Pacific countries, China, Taiwan, South Korea and India will continue to influence the development of the Asian markets. China and India are one of the fastest “Indian Banking System: The Current State and Road Ahead” 8 growing economies in the world as evident from the graphs below. Real GDP Growth Rate 10. 5 8. 3 7. 5 5. 6 5. 5 5. 3 5. 1 4. 5 4 0 2 4 6 8 10 12 C hina I ndia Singap ore Hong Kong Malaysi a I ndo nesi a K ore a T hailand T aiwan % Source: Morgan Stanley Research Loan Growth 27. 6 13. 4 9. 9 8. 1 7. 7 6. 4 6. 4 5. 1 0 5 10 15 20 25 30 I ndia C hina Malaysi a Hong Kong K ore a T aiwan

T hailand Singap ore % Source: Morgan Stanley Research These above-mentioned countries, though at different stages of development, have the potential to become major growth markets for traditional banking, investment banking, insurance, and securities products. As a result, leading international and regional banks are interested to establish their presence in these countries. “Indian Banking System: The Current State and Road Ahead” 9 How do we compare with these economies and with some other economies in terms of banking systems? Does our banking systems have the necessary systems in place?

This is what we have tried to analyse in this section. The Indian banking sector has scored over its counterparts not only in developing but even in developed world such as Japan, Singapore and Australia on significant parameters. According to Moody’s Investors Services data, Indian lenders have posted highest ROE of 20. 38% (system average of three years), closely followed by Indonesia at 20. 19% and New Zealand 18. 83%. Japan, the biggest economy in Asia posted negative returns of 6. 42%, implying that the banks there made losses. Banks of Phillippines and

Australia have posted an ROE of just 4. 40% and 11. 44% respectively. We asked our respondents to rate India on certain essential banking parameters (Regulatory Systems, Risk Assessment Systems, Technological Systems and Credit Quality) in comparison with other countries i. e China, Japan, Sinagapore, Russia, UK and USA. “Indian Banking System: The Current State and Road Ahead” 10 14. 3 7. 1 78. 6 14. 29 71. 43 14. 29 29. 41 35. 29 17. 65 17. 65 5. 89 58. 82 52. 94 11. 76 17. 65 47. 06 17. 65 17. 65 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% China Japan Singapore Russia UK USA

Regulatory Systems of India vis a vis other countries Better At Par Below Par Regulatory systems of Indian banks were rated better than China and Russia; at par with Japan and Singapore but less advanced than UK and USA. 21. 42 78. 57 14. 29 64. 29 21. 43 50 14. 29 35. 71 21. 43 78. 57 64. 29 14. 29 21. 43 64. 29 14. 29 21. 43 0% 20% 40% 60% 80% 100% China Japan Singapore Russia UK USA Risk Assessment Systems of India vis a vis other countries Better At Par Below Par Risk management framework is a key strength for sustainable growth of banks. How have we performed in this area? Indian Banking System: The Current State and Road Ahead” 11 Respondents rated India’s Risk management systems more advanced than China and Russia; at par with Japan, and less advanced than Singapore, UK and USA. This shows we need to work out this but we are not too far. It is with this confidence we are going ahead with the challenge of implementing Basel II by April 2007. 83% of our respondents highlighted that Basel II implementation would take us a step ahead in global competitiveness. 23 23 54 42. 9 42. 9 14. 29 64. 29 14. 29 21. 43 21. 43 35. 71 42. 86 71. 43 7. 14 21. 43 78. 57 21. 43 0% 20% 40% 0% 80% 100% China Japan Singapore Russia UK USA Technological Systems of India vis a vis other countries Better At Par Below Par Technology has given birth to a new era in banking. Technology can be the key differentiator between two banks and a major factor to attain competitive edge. Though slow in the beginning, Indian banks seem to have paced up in adoption of advanced technology, as is evident from our survey results. Technological systems of Indian banks have rated more advanced than China and Russia; at par with Japan, but less advanced than Singapore, UK and USA. Indian Banking System: The Current State and Road Ahead” 12 21. 43 78. 57 28. 57 14. 28 57. 14 28. 57 50 21. 43 14. 29 14. 29 71. 43 57. 14 42. 86 64. 29 35. 71 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% China Japan Singapore Russia UK USA Credit Quality of India vis a vis other countries Bette r At Par Below Par While enhancement of credit is an important function of the Banks, it is equally imperative to keep a check on the quality of credit to ensure good health of the banking system and effective functioning of market for distressed assets. One of the key fundamentals of Indian banking sector –

Credit Quality too has been rated fairly well in comparison with other countries. Majority of respondents quoted credit quality of Indian banks better in comparison with China, Japan and Russia; at par with Singapore but below par with UK and USA. As a percentage of GDP, the Net NPA of Indian banks stands mere to just 1. 4% as on March 2006 as compared with 3. 1% in 2004-05. As a percentage of GDP, gross NPA in India is just 1. 9 % compared with 6. 7% in China as on March 2005. It is evident that India fares well on these critical arameters. But are the existing International banks happy “Indian Banking System: The Current State and Road Ahead” 13 doing business here? Well, our foreign bank respondents seem to be happy here and wish to expand further. 75 per cent of the foreign bank’s respondents rated their working experience in India as “extremely good”. Given India’s potential over the next decade and beyond, all the foreign banks respondents stated that they have formulated strategies for future expansion in India. Future Global Expansion Strategy of India

In order to gain further access to the global trade, the government is expanding the Free Trade Agreements (FTA’s) with many countries (like Singapore, Thailand, and other ASEAN members). 55 per cent of the respondents highlighted that the FTA’s signed by India till now have helped enhance global trade and thus been of help to banks in their global expansion strategy. After the Comprehensive Economic Co-Operation Agreement (CECA) with Singapore, the government is now planning a similar deal with the 25-member European

Union. The EU is also likely to ask India to liberalise its financial sector on the lines of the India-Singapore CECA. The CECA with Singapore may have been appreciated but a similar deal with EU may not be as advantageous for Indian banks as evident from our survey results. EU banks are considered as one of the most globally competitive and successful banks. In consideration of this fact, 85 per cent of domestic banks respondents also emphasized that “Indian Banking System: The Current State and Road Ahead” 14 India should not give full domestic status to EU based anks under the proposed India-EU CECA. New Business Opportunities With the interest income coming under pressure, banks are urgently looking for expanding fee-based income activities. Banks are increasingly getting attracted towards activities such as marketing mutual funds and insurance policies, offering credit cards to suit different categories of customers and services such as wealth management and equity trading. These are indeed proving to be more profitable for banks than plain vanilla lending and borrowing. 69 per cent of respondents stated that 20 – 30 % proportion of their total

Income is constituted by fee-based incomes. “Indian Banking System: The Current State and Road Ahead” 15 New Business Opportunities tapped by banks Derivatives Trading 36 . 8 % Wealth Management 21. 05 % Forex Management 68. 4% Bancassurance 7 3 . 6% Selling of Mutual Funds 73. 6% * Bancassurance and selling of mutual funds were recognized as the most tapped business opportunities by the bankers closely followed by Forex Management. Out of these selling of mutual funds was identified as the most profitable venture by 47 per cent of respondents. Today, India has 83000 HNWIs, a 19. % increase in number over 2004. This data clearly exemplifies the fact that the number of wealthy individuals in the country is growing at a rapid pace. However, presently, there are only a handful of entities which offer high-end private banking in India. Just about 21. 5 per cent of our survey respondents stated of having tapped this opportunity. This area has a huge potential for growth. Penetration of Banking Services “Indian Banking System: The Current State and Road Ahead” 16 The penetration of banking services to Indian households stands at a mere 35. 5%. According to the data released by he Census office, even relatively prosperous states like Maharashtra, Gujarat and Karnataka have less than half of their total households operating a bank account. Delhi was ranked 8th with only 51% of the population having access to banking facilities. Some of the efforts highlighted to increase this penetration level were: Tapping the Rural markets (87. 5 per cent respondents) It is time that Indian banks capitalize upon the untapped potential of the rural markets. Rural India is now being viewed more as an opportunity than as a challenge. 44 per cent of respondent banks erceived Rural markets as difficult but Profitable market whereas 43 per cent view it as Lucrative and Profitable Market. Improving macro indicators like better education, higher income levels and comfort with technology clearly indicates the rural India’s potential of massive economic upsurge. “Indian Banking System: The Current State and Road Ahead” 17 Perception about Rural markets by Banks High Cost Market & Difficult Market 1 3 % Lucrative and Pr ofitable 4 3 % Difficult yet Pr ofitable 4 4 % Opening more branches in Tier II and Tier III towns (62. 5 per cent respondents)

Fierce competition in the business of banks in metro cities has brought into sharp focus the untapped potential in the emerging markets of the Tier-II and Tier III cities across the country. In fact, analysts have forecasted that the next retail boom is waiting to happen in these smaller towns and cities, as the urban markets have now saturated. Many public sector banks are now enhancing their focus towards the Tier-II cities, as most of them have lost their considerable market share in the metros to their private sector and foreign counterparts.

Innovation and Customization: New Products and Services By 2015, market will become intensely customer – centric and dominated by global mega banks and densely populated by specialist financial services providers. Innovation in “Indian Banking System: The Current State and Road Ahead” 18 products, processes, relationships and business models will be the primary path to sustainable growth. Consumer today is open to ideas, demands flexiblity and is looking for innovation and new products. On an average an Indian bank sells 1. 4 products to every customer whereas in Spain it is 1. , in UK 2. 6, in Norway it is about 2. 7 and in France it is about 3. Indian banks acknowledged the need to expand their product portfolio as endorsed by 94 per cent of our survey respondent banks. 80 40 20 20 0 10 20 30 40 50 60 70 80 Delivery Channels Closed Customer Mindset Regulatory Support Know ledge and e fforts m ade by the ground level personnel % Hindrances faced during introduction of New Products * The respondents also highlighted a few hindrances faced by them in churning products in tandem with their counterparts in other countries. Effective delivery channels (80 per ent) was identified as one of the major hindrance being faced at the time of “Indian Banking System: The Current State and Road Ahead” 19 introducing new products or schemes followed by closed customer mindset (40 per cent). Regulatory support and Knowledge and efforts made by the ground level personnel were other factors earmarked by the respondents. Consumers Insight: Success Path for Bankers One of the biggest problems facing senior managers of banks today is attracting customers and attaining growth, often in an environment where products and prices among competitors are close substitutes. Traditional bases for ifferentiation, such as product features or cost, are becoming less tangible. So the management’s are forced to look for new ways to appear attractive to its target market and simultaneously retain the existing one. We asked our respondents to rank their business strategies that have helped them in increased customer acquisition and retention (On a scale of 1 to 8 with 8 being the Most important marketing strategy). The results of the Mode score being accorded by the Public, Private & Foreign banks are presented below: “Indian Banking System: The Current State and Road Ahead” 20

Strategies Suc c esful in Customer Ac qusition & Retention 0 1 2 3 4 5 6 7 8 Bank by Phone Additional Customer Service Counters Door Step Banking Market Campaigns Additional Sales force Advertisements Expansion of ATM Network Technological Upgradation Technology has moved from being just a business enabler to being a business driver. Be it customer service, reducing operational costs, achieving profitability, developing risk management systems, we turn to technology for providing necessary solution. Technological upgradation was clearly identified as one of the most successful strategy in

Customer Acquisition and Retention followed by Expansion of ATM Network, Advertisements and additional sales force. Customer Retention and Customer Satisfaction are inexorably inter – linked. While consumers may be happy to make payments and interact with their bank through convenient – and cheaper – banking channels, they still expect high standards of service. A consistent service reflects the bank’s brand and image across all channels. “Indian Banking System: The Current State and Road Ahead” 21 93. 75 per cent of respondent banks informed that superior ervice pre and post banking has been one of the essential factors rated high by their customers. 75 per cent of respondent banks felt that Personal touch in the dealings has helped them in winning customers. Key Factors that convert a satisfied customer into a loyal customer Better service pre and post banking 93 . 7 5 % Being a leader in offering innovative products from time from time 37. 5% Offering Customized Products 37. 5% Ensuring Customer Security 37. 5% Personal Touch 75% * Some forthcoming Challenges before Indian Bankers Presently some of the top most concerns of the stakeholders of the banking industry i. . government, regulator and bankers are consolidation in the financial sector, improving HR systems of Public sector banks thereby improving their “Indian Banking System: The Current State and Road Ahead” 22 competitiveness and successful implementation of Basel II norms. Size and Efficiency: Is consolidation the answer? The RBI’s roadmap for the banking sector envisages greater access to foreign banks in India from April 2009. The increased competition, it is argued, would be tough on smaller banks. Besides, the Basel II capital adequacy framework, which kicks off from March 2007, is expected o increase the banks’ capital requirement. PSU banks short on capital can look to mergers instead of government capitalization. 95 per cent of the respondents also view that this is the right time for the consolidation in the financial sector. What is needed is a roadmap for managed consolidation. Voluntary mergers are certainly better than forced ones. Forced mergers are always a compromise and cannot lead to maximization of shareholders value. The government is planning to kick off consolidation in the sector by lining up a series of merger and acquisition proposals for the public sector banks, thus enabling reation of 6-7 banks as big as the State Bank of India. The idea behind the move is to create large players that can take on the competition when the sector is thrown open three years from now. 94 per cent respondents also fully supported this view of the government. The presence of 6 –7 large sized banks does not rule out the relevance of small/niche/regional banks in the market, as highlighted by 83 per cent of respondents. “Indian Banking System: The Current State and Road Ahead” 23 Small niche banks thrive even in the most competitive markets. The state-owned banks that have regional character an look for geographical diversification though inorganic growth. HR Excellence for PSB Banks In this market driven economy, a level playing field is required for PSU banks to compete with new private sector and foreign banks. 92 per cent of Public sector bank’s respondents voiced that they do not have sufficient autonomy to offer attractive incentive packages to their employee to ensure their commitment levels. Out of these, 82 per cent of respondents expressed that to improve their productivity levels it is essential to offer competitive compensation packages at all levels.

Skill development too is a critical challenge and PSB’s seem to be moving fast towards it as evident from survey results. 67 per cent of PSB’s quoted that sufficient skill development efforts are being made for their employees to gear them up to meet challenges of growing competition. Basel II: Some Last minute preparations 58 per cent of respondents expressed that Indian Banking Sector is prepared to achieve the Basel II “Indian Banking System: The Current State and Road Ahead” 24 milestone by 31st March 2007 whereas the remaining oiced that the deadline should get extended. 83 per cent respondents highlighted that presently there are sufficient instruments in the market to meet the increased capital requirements of Indian Banks. Most of the banks are preferring to raise their capital through upper Tier II and hybrid Tier I route as an equity issue will dilute the ROE (return on equity). However, some of the banks expressed that in another one-year’s time, banks should be permitted to issue preference shares. 58 per cent of respondents also expressed the need of regulatory support in successful implementation of these orms. Some of such areas identified by them are guidelines on consolidation of banking sector, greater capital flexibility, support for the establishment of PD, LGD etc, necessary amendment to the banking regulation act. * Results are not mutually exclusive Source ?Newspapers ?Business Standard ?Economic Times ?Websites ?The Banker ?Asian Banker “Indian Banking System: The Current State and Road Ahead” 25 ?Reports ?BCG Study ?India & China: New Tigers of Asia Part II, Morgan Stanley ?World Wealth Report 2006 “Indian Banking System: The Current State and Road Ahead” 26

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