Universal banking in India


By

Nityanand Deva
Sr. Lecturer
Fairfield Institute of Management and Technology
Kapashera, Delhi
 


Ever since the financial sector reforms were introduced in early 90's the banking sector saw the emergence of new generation of private sector banks. These banks gained at most popularity as they have technology edge and better business models when compared to public sector banks and the most important thing is they are able to attract more volumes simply because they meet their customers' requirements under one roof. If the newer players can do that then why can't the bigger players like the Financial Institutions (FIs) try their hands on it? Here comes the concept of universal banking, its Emergence, merits and related issues. The present paper focuses on understanding the concept of universal banking in India and attempts to explain the regulatory role, regulatory requirements, key duration and maturity distinction and lastly the optimal transition path. The paper also gives an overview of the international experience and argues in favor of developing a strong domestic financial system in order to compete in the global market.

JEL classification:

Universal Banking is a multi-purpose and multi-functional financial supermarket (a company offering a wide range of financial services e.g. stock, insurance and real-estate brokerage) providing both banking and financial services through a single window. Definition of Universal Banking: As per the World Bank, "In Universal Banking, large banks operate extensive network of branches, provide many different services, hold several claims on firms(including equity and debt) and participate directly in the Corporate Governance of firms that rely on the banks for funding or as insurance underwriters". However in practice the term 'universal banking' refers to those banks that offer a wide range of financial services, beyond the commercial banking functions like Mutual Funds, Merchant Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans, Investment banking, Insurance etc. This is most common in European countries.

For example, in Germany commercial banks accept time deposits, lend money, underwrite corporate stocks, and act as investment advisors to large corporations. In Germany, there has never been any separation between commercial banks and investment banks, as there is in the United States. Universal banks are huge banks providing all type of financial services. After 1990 when Mr. Manmohan singh who was the Finance Minister, he stated a new wave called Liberalization, privitation and Globalization, the demand for universal banking increased overnight. Now mergers and acquisitions were norm of the day which provided scope for financial services. The phenomenon of Universal Banking as a distinct concept, as different from Narrow Banking came to the forefront in the Indian context with the Narsimham Committee (1998) and later the Khan Committee (1998) reports recommending consolidation of the banking industry through mergers and integration of financial activities.

UNIVERSAL BANKING PROS AND CONS

The solution of Universal Banking was having many factors to deal with, which can be further analyzed by the pros and cons.

Advantages of Universal Banking

1) Economies of Scale.
The main advantage of Universal Banking is that it results in greater economic efficiency in the form of lower cost, higher output and better products. Many Committees and reports by Reserve Bank of India are in favour of Universal banking as it enables banks to use economies of scale and scope.

2) Profitable Diversions. By diversifying the activities, the bank can use its existing expertise in one type of financial service in providing other types. So, it entails less cost in performing all the functions by one entity instead of separate bodies.

3) Resource Utilization. A bank possesses the information on the risk characteristics of the clients, which can be used to pursue other activities with the same clients. A data collection about the market trends, risk and returns associated with portfolios of Mutual Funds, diversifiable and non diversifiable risk analysis, etc, is useful for other clients and information seekers. Automatically, a bank will get the benefit of being involved in the researching

4) Easy Marketing on the Foundation of a Brand Name. A bank's existing branches can act as shops of selling for selling financial products like Insurance, Mutual Funds without spending much efforts on marketing, as the branch will act here as a parent company or source. In this way, a bank can reach the client even in the remotest area without having to take resource to an agent.

5) One-stop shopping. The idea of 'one-stop shopping' saves a lot of transaction costs and increases the speed of economic activities. It is beneficial for the bank as well as its customers.

Disadvantages of Universal Banking

1) Grey Area of Universal Bank.
The path of universal banking for DFIs is strewn with obstacles. The biggest one is overcoming the differences in regulatory requirement for a bank and DFI. Unlike banks, DFIs are not required to keep a portion of their deposits as cash reserves.

2) No Expertise in Long term lending. In the case of traditional project finance, an area where DFIs tread carefully, becoming a bank may not make a big difference to a DFI. Project finance and Infrastructure finance are generally long- gestation projects and would require DFIs to borrow long- term. Therefore, the transformation into a bank may not be of great assistance in lending long-term.

3) NPA Problem Remained Intact. The most serious problem that the DFIs have had to encounter is bad loans or Non-Performing Assets (NPAs). For the DFIs and Universal Banking or installation of cutting-edge-technology in operations are unlikely to improve the situation concerning NPAs.

History of Universal banking in India

Universal banking involves a mix of commercial deposit and loan businesses and investment banking. Universal banking took off in the 19th century, and conditions became more difficult in the 2oth century. This is because there have been exogenous political shocks and macro-economic instability during the 20th century. The wider institutional context is important for universal banking, and this includes central bank support. The context has been less favorable in the 20th century. Globalization has also had an impact on the banking industry.

In India Development financial institutions (DFIs) and refinancing institutions (RFIs) were meeting specific sectoral needs and also providing long-term resources at concessional terms, while the commercial banks in general, by and large, confined themselves to the core banking functions of accepting deposits and providing working capital finance to industry, trade and agriculture. Consequent to the liberalization and deregulation of financial sector, there has been blurring of distinction between the commercial banking and investment banking.

Reserve Bank of India constituted on December 8, 1997, a Working Group under the Chairmanship of Shri S.H. Khan to bring about greater clarity in the respective roles of banks and financial institutions for greater harmonization of facilities and obligations. Also report of the Committee on Banking Sector Reforms or Narasimham Committee (NC) has major bearing on the issues considered by the Khan Working Group.

The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to RBI to discuss the time frame and possible options for transforming itself into an universal bank. Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance, its proposed policy for universal banking, including a case-by-case approach towards allowing domestic financial institutions to become universal banks.

Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit their plans for transition to a universal bank for consideration and further discussions. FIs need to formulate a road map for the transition path and strategy for smooth conversion into a universal bank over a specified time frame. The plan should specifically provide for full compliance with prudential norms as applicable to banks over the proposed period. So, saddled with obligations to fund long gestation projects, the DFIs have been burdened with serious mismatches between their assets and liabilities of the balance sheet. In this context, the Narsimham Committee II had suggested DFIs should convert into banks or Non-Banking Finance Companies. Converting of these DFIs into Universal Banks will grant them ready access to cheap retail deposits and increase the coverage of the advances to include short term working capital loans to corporate with greater operational flexibility. At that time DFIs were in the need to acquire a lot of mass in their volume of operations to solve the problem of total asset base and net worth. So, the emergence of Universal Banking was the solution for the problem of banking sector.

Now banks like ICICI bank have expressed their desire to change into a universal bank. That's why they want to merge ICICI with ICICI bank. The Narsimham Committee II suggested that DFIs should convert ultimately into either commercial banks or non-bank finance companies. The Khan Working Group held the view that DFIs should be allowed to become banks at the earliest. The RBI released a 'Discussion Paper' (DP) in January 1999 for wider public debate. The feedback indicated that while the universal banking is desirable from the point of view of efficiency of resource use, there is need for caution in moving towards such a system. Major areas requiring attention are the status of financial sector reforms, the state of preparedness of the concerned institutions, the evolution of the regulatory regime and above all a viable transition path for institutions which are desirous of moving in the direction of universal banking.

SALIENT OPERATIONAL AND REGULATORY ISSUES OF RBI TO BE ADDRESSED BY THE FIs FOR CONVERSION INTO A UNIVERSAL BANK

a) Reserve requirements. Compliance with the cash reserve ratio and statutory liquidity ratio requirements (under Section 42 of   RBI Act, 1934, and Section 24 of the Banking Regulation Act, 1949, respectively) would be mandatory for an FI after its conversion into a universal bank.

b) Permissible activities. Any activity of an FI currently undertaken but not permissible for a bank under Section 6(1) of the B. R. Act, 1949, may have to be stopped or divested after its conversion into a universal bank..

c) Disposal of non-banking assets. Any immovable property, howsoever acquired by an FI, would, after its conversion into a universal bank, be required to be disposed of within the maximum period of 7 years from the date of acquisition, in terms of   Section 9 of the B. R. Act.

d) Composition of the Board. Changing the composition of the Board of Directors might become necessary for some of the FIs after their conversion into a universal bank, to ensure compliance with the provisions of Section 10(A) of the B. R. Act, which requires at least 51% of the total number of directors to have special knowledge and experience.

e) Prohibition on floating charge of assets. The floating charge, if created by an FI, over its assets, would require, after its conversion into a universal bank, ratification by the Reserve Bank of India under Section 14(A) of the B. R. Act, since a banking company is not allowed to create a floating charge on the undertaking or any property of the company unless duly certified by RBI as required under the Section.

f) Nature of subsidiaries. If any of the existing subsidiaries of an FI is engaged in an activity not permitted under Section 6(1) of the B R Act, then on conversion of the FI into a universal bank, delinking of such subsidiary / activity from the operations of the universal bank would become necessary since Section 19 of the Act permits a bank to have subsidiaries only for one or more of the activities permitted under Section 6(1) of B. R. Act.

g) Restriction on investments. An FI with equity investment in companies in excess of 30 per cent of the paid up share capital of that company or 30 per cent of its own paid-up share capital and reserves, whichever is less, on its conversion into a universal bank, would need to divest such excess holdings to secure compliance with the provisions of Section 19(2) of the B. R. Act, which prohibits a bank from holding shares in a company in excess of these limits.

h) Connected lending. Section 20 of the B. R. Act prohibits grant of loans and advances by a bank on security of its own shares or grant of loans or advances on behalf of any of its directors or to any firm in which its director/manager or employee or guarantor is interested.   The compliance with these provisions would be mandatory after conversion of an FI to a universal bank.

i) Licensing. An FI converting into a universal bank would be required to obtain a banking license from RBI under Section 22 of the B. R. Act, for carrying on banking business in India, after complying with the applicable conditions.

j) Branch network An FI, after its conversion into a bank, would also be required to comply with extant branch licensing policy of RBI   under which the new banks are required to allot at least 25 per cent of their total number of branches in semi-urban and rural areas.

k) Assets in India. An FI after its conversion into a universal bank, will be required to ensure that at the close of business on the last Friday of every quarter, its total assets held in India are not less than 75 per cent of its total demand and time liabilities in India, as required of a bank under Section 25 of the B R Act.

l) Format of annual reports. After converting into a universal bank, an FI will be required to publish its annual balance sheet and profit and loss account in the forms set out in the Third Schedule to the B R Act, as prescribed for a banking company under Section 29 and Section 30 of the B. R. Act.

m) Managerial remuneration of the Chief Executive Officers. On conversion into a universal bank, the appointment and remuneration of the existing Chief Executive Officers may have to be reviewed with the approval of RBI in terms of the provisions of Section 35 B of the B. R. Act. The Section stipulates fixation of remuneration of the Chairman and Managing Director of a bank by Reserve Bank of India taking into account the profitability, net NPAs and other financial parameters. Under the Section, prior approval of RBI would also be required for appointment of Chairman and Managing Director.

n) Deposit Insurance. An FI, on conversion into a universal bank, would also be required to comply with the requirement of compulsory deposit insurance from DICGC up to a maximum of Rs.1 lakh per account, as applicable to the banks.

o) Authorized Dealer's License. Some of the FIs at present hold restricted AD license from RBI, Exchange Control Department to enable them to undertake transactions necessary for or incidental to their prescribed functions. On conversion into a universal bank, the new bank would normally be eligible for full-fledged authorized dealer license and would also attract the full rigor of the Exchange Control Regulations applicable to the banks at present, including prohibition on raising resources through external commercial borrowings.

p) Priority sector lending. On conversion of an FI to a universal bank, the obligation for lending to "priority sector" up to a prescribed percentage of their 'net bank credit' would also become applicable to it.

q) Prudential norms. After conversion of an FI in to a bank, the extant prudential norms of RBI for the all-India financial institutions would no longer be applicable but the norms as applicable to banks would be attracted and will need to be fully complied with.

(This list of regulatory and operational issues is only illustrative and not exhaustive).

Regulatory burden:

One of the major problems associated with universal banking is the issue of regulation. Financial Institutions in India are governed by separate Acts and banks are regulated and governed by RBI and Banking Regulation Act 7. Financial Institutions in India have commercial banks as their subsidiaries, but due to the separation of regulation, the Financial Institutions cannot have direct access to the resource base of its subsidiary bank. Without any doubt, the regulatory burden for all participants in the entire financial system should be equalized in order to ensure that no participant might end up having a disadvantage relative to any other.

Reverences

http://www.indianmba.com/Occasional_Papers/OP157/op157.html

http://www.faqs.org/abstracts/Economics/Universal-banking-in-historical-perspective-Universal-banking.ht ml

http://www.economist.com/node/12274054?source=hptextfeature&story_id=12274054

http://www.mbaknol.com/business-finance/universal-banking-in-india/

http://www.banknetindia.com/banking/ubfeature.htm

http://www.banknetindia.com/banking/ub1.htm

http://www.usc.es/~economet/reviews/eers511.pdf

http://www.authorsden.com/visit/viewArticle.asp?id=8673
 


Nityanand Deva
Sr. Lecturer
Fairfield Institute of Management and Technology
Kapashera, Delhi
 

Source: E-mail January 11, 2012

          

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