A STUDY OF NON PERFORMING ASSETS WITH SPECIAL REFERENCE TOICICI BANK DISSERTATION 2009

Submitted in the partial fulfillment of the requirement For the award of POST GRADUATE DIPLOMA IN MANAGEMENT

SUBMITTED BY:

SWAROOP DHARIWAL ROLL NO.-7108UNDER THE GUIDENCE OF PROF. B.D. ARORA

DEPARTMENT OF MANAGEMENT

INSTITUTE OF MANAGEMENT EDUCATION SAHIBABAD

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Certificate This is to certify that the Dissertation entitled (A STYDY OF NON PERFORMING ASSETS WITH SPECIAL REFERENCE TO ICICI BANK) and submitted by SWAROOP DHARIWAL having roll no7108 for the partial fulfillment of the requirements of the PGDM BATCH 200709, IME, embodies the bonafide work done by him under our supervision.

……………………………. …............... Signature of the guide

…… ……… Signature of the dean

Place…………………. Date………………….

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ACKNOWLEDGEMENT With profound veneration, first of all we recline ourselves before ALMIGHTY without whose blessings ourselves is cipher. It is my pleasure to be indebted to various people, who directly or indirectly contributed in the development of this work and who influenced my thinking, behavior, and acts during the course of study. As a student specializing in finance, I came to know about the ground realities in topics like Non Performing Assets with special reference to ICICI BANK. For this I am indebted to Mr. B.D. ARORA, Faculty, IME who took personal interest in my project and bore the associated headaches My attitude carries the imprint of Mr. GURPREET SINGH SACHDEVA, Faculty, IME. I am thankful to him for his support, cooperation, and motivation provided to me during the study. It would be unfair if I do not mention the name of Dr.D.P.Goyal, Director, IME who gave me valuable tips to complete this project and Mr. H.P. Gupta, vice chairman, for his inspiring presence and blessings. Lastly, I would like to thank the almighty and my parents for their moral support and my colleagues with whom I shared my day-to-day experience and received lots off suggestions that improved my work quality. Signature ----------------------Name: SWAROOP DHARIWAL

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ABSTRACT A strong banking sector is important for flourishing economy. The failure of the banking sector may have an adverse impact on other sectors. Non-performing assets are one of the major concerns for banks in India. NPAs reflect the performance of banks. A high level of NPAs suggests high probability of a large number of credit defaults that affect the profitability and net-worth of banks and also erodes the value of the asset. The NPA growth involves the necessity of provisions, which reduces the over all profits and shareholders value. The issue of Non Performing Assets has been discussed at length for financial system all over the world. The problem of NPAs is not only affecting the banks but also the whole economy. In fact high level of NPAs in Indian banks is nothing but a reflection of the state of health of the industry and trade. This report deals with understanding the concept of NPAs, its magnitude and major causes for an account becoming non-performing, projection with special reference to ICICI bank.

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CONTENTS i) ii) ACKNOWLEDGEMENT………………………………………3 ABSTRACT……………………………………………………… 4

CHAPTER 1: INTRODUCTION ………………………………………….7 i) ii) Background Need of the study

CHAPTER II: RESEARCH METHODOLOGY .………………………..............11 CHAPTER III: DESCRIPTIVE WORK …..........................................................14

i) ii) iii) iv) v) vi)

History of Banking in India Transformation of Indian Banking System Non Performing Assets: Definition, Causes, Problem Trends of Non Performing Assets About ICICI Bank Impact of Financial Crisis on ICICI Bank

CHAPTER IV: DATA ANALYSIS AND INTERPRETATION. ………………56

i)

Financial of ICICI Bank Comparison Among Various Bank Basel Report Framework And India

ii) iii)

CHAPTER V: SUGGESTIONS AND CONCLUSION …………………..88 BIBLIOGRAPHY

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LIST OF FIGURE S.NO 1 2 3 4 5 6 7 8 9 10 11 12 13 14 CONTENT GNNP,NNPA and credit growth over the years Operating expenses/total assets ratio Credit growth over the years Gross NPA in banking system Current shareholding of CIBIL Gross NPA level for various banks Deposits growth over 5 years Unsecured loan as % of total loan Composition of loan book of ICICI bank Gross NPA as % of total advances Cost income ratio Real state exposure of various bank Loan loss coverage ratio Provision coverage for various bank PAGE NO 38 41 43 45 46 47 66 67 68 68 69 69 70 70LIST OF TABLES S.NO 1 2 3 4 5 6 7 8 9 10 11 12 13 14 CONTENT Gross NPA\ advances ratio Return on assets- India v/s other countries Gross NPA and gross advances Tier capital Net NPA of ICICI bank Profit & loss a/c of ICICI bank Balance sheet of ICICI bank Q2FY09 assets Q2FY09 liabilities Loan growth of various bank Deposit growth Amount of tier 1 capital (sep 30, 08) Amount of tier 2 capital (sep 30, 08) Capital adequacy ratio PAGE NO 41 42 44 60 61 62 63 65 65 66 66 85 85 87

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Chapter1. Introduction The crucial role of bank economists in transforming the banking system in India. Economists have to be more ‘mainstreamed’ within the operational structure of commercial banks. Apart from the traditional functioning of macro-scanning, the inter linkages between treasuries, dealing rooms and trading rooms of banks need to be viewed not only with the day-to-day needs of operational necessity, but also with analytical content and policy foresight. Banking sector reforms in India has progressed promptly on aspects like interest rate deregulation, reduction in statutory reserve requirements, prudential norms for interest rates, asset classification, income recognition and provisioning. But it could not match the pace with which it was expected to do. The accomplishment of these norms at the execution stages without restructuring the banking sector as such is creating havoc. During pre-nationalization period and after independence, the banking sector remained in private hands Large industries who had their control in the management of the banks were utilizing major portion of financial resources of the banking system and as a result low priority was accorded to priority sectors. Government of India nationalized the banks to make them as an instrument of economic and social change and the mandate given to the banks was to expand their networks in rural areas and to give loans to priority sectors such as small scale industries, self-employed groups, agriculture and schemes involving women. To a certain extent the banking sector has achieved this mandate. Lead Bank Scheme enabled the banking system to expand its network in a planned way and make available banking series to the large number of population and touch every strata of society by extending credit to their productive endeavours. This is evident from the fact that population per office of commercial bank has come down from 66,000 in the year 1969 to 11,000 in 2004. Similarly, share of advances of public sector banks to priority sector increased form 14.6% in 1969 to 44% of the net bank credit. The number of deposit

8 accounts of the banking system increased from over 3 crores in 1969 to over 30 crores. Borrowed accounts increased from 2.50 lakhs to over 2.68 crores. Without a sound and effective banking system in India it cannot have a healthy economy. The banking system of India should not only be hassle free but it should be able to meet new challenges posed by the technology and any other external and internal factors. For the past three decades India's banking system has several outstanding achievements to its credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system has reached even to the remote corners of the country. This is one of the main reasons of India's growth process. Financial sector reform in India has progressed rapidly on aspects like interest rate deregulation, reduction in reserve requirements, barriers to entry, prudential norms and risk-based supervision. But progress on the structural-institutional aspects has been much slower and is a cause for concern. The sheltering of weak institutions while liberalizing operational rules of the game is making implementation of operational changes difficult and ineffective. Changes required to tackle the NPA problem would have to span the entire gamut of judiciary, polity and the bureaucracy to be truly effective. In liberalizing economy banking and financial sector get high priority. Indian banking sector of having a serious problem due non performing. The financial reforms have helped largely to clean NPA was around Rs. 52,000 crores in the year 2004. The earning capacity and profitability of the bank are highly affected due to this Non Performing Asset means an asset or account of borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or guidelines relating to asset classification issued by The Reserve Bank of India. The level of NPA act as an indicator showing the bankers credit risks and efficiency of allocation of resource.

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Background Granting of credit for economic activities is the prime duty of banking. Apart from raising resources through fresh deposits, borrowings and recycling of funds received back from borrowers constitute a major part of funding credit dispensation activity. Lending is generally encouraged because it has the effect of funds being transferred from the system to productive purposes, which results into economic growth. However lending also carries a risk called credit risk, which arises from the failure of borrower. Non-recovery of loans along with interest forms a major hurdle in the process of credit cycle. Thus, these loan losses affect the banks profitability on a large scale. Though complete elimination of such losses is not possible, but banks can always aim to keep the losses at . at a low level. Non-performing Asset (NPA) has emerged since over a decade as an alarming threat to the banking industry in our country sending distressing signals on the sustainability and endurability of the affected banks. The positive results of the chain of measures affected under banking reforms by the Government of India and RBI in terms of the two Narasimhan Committee Reports in this contemporary period have been neutralized by the ill effects of this surging threat. Despite various correctional steps administered to solve and end this problem, concrete results are eluding. It is a sweeping and all pervasive virus confronted universally on banking and financial institutions.

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NEED OF THE STUDY This report explores an empirical approach to the analysis of Non-Performing Assets (NPAs) with special reference of ICICI bank in India. The NPAs are considered as an important parameter to judge the performance and financial health of banks. The level of NPAs is one of the drivers of financial stability and growth of the banking sector. This report aims to find the fundamental factors which impact NPAs of banks. A model consisting of two types of factors, viz., macroeconomic factors and bank-specific parameters, is developed and the behavior of NPAs of the three categories of banks is observed. The empirical analysis assesses how macroeconomic factors and bank-specific parameters affect NPAs of a particular category of banks. The macroeconomic factors of the model included are GDP growth rate and excise duty, and the bank-specific parameters are Credit Deposit Ratio (CDR), loan exposure to priority sector, Capital Adequacy Ratio (CAR), and liquidity risk. The results show that movement in NPAs over the years can be explained well by the factors considered in the model for the public and private sector banks. The other important results derived from the analysis include the finding that banks' exposure to priority sector lending reduces NPAs.

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Chapter 2 RESEARCH METHODOLOGY  To test a hypothesis of a casual relationship between variables. Research methodology is a way to systematically solve the research problem . it may be understood as a science of studying how research is done scientifically. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them. Research methodology has many dimensions and research methods do constitute a part of the research methodology. The scope of research methodology is wider than that of research methods. Thus, when we talk of research methodology we not only talk of the research methods but also consider the logic behind the methods we use in the context of our research study and explain why we are using a particular method or technique and why we are not using others so that research results are capable of being evaluated either by the researcher himself or by others. Why a research study has been undertaken, what data have been collected and what particular method has been adopted, why particular technique of analyzing data has been used and a host of similar other question are usually answered when we talk of research methodology concerning a research problem or study.

To determine the frequency with which something occurs or with which it is associated with something else. To portray accurately the characteristics of a particular individual, situation or a group. To gain familiarity with a phenomenon or to achieve new insights into it. The purpose of research is to discover answers to the questions through the application of scientific procedures. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet. Though each research study has its own specific purpose, we may think of research objectives as falling into a number of following broad categories:

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Research is often described as active; diligent and systematic process of inquiry aimed at discovering, interpreting and revising facts. This intellectual investigation produces a greater understanding of events, behaviors or theories and makes practical application through laws and theories. In other words we can say, the purpose of research is to discover answers to the questions through the application of scientific procedures. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet. Research methodology is a way to systematically solve the research problem. It may be understood as a science of studying how research is done scientifically. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them.

OBJECTIVE The main objective of the research is to understand the concept of non performing assets. What is the definition of non performing assets. Why they are increasing? What are the causes of NPA’s? How we can control this thing? Through this project we can also analyse the banking industry. What type of challenges this industry is facing. I also include Basel committee report in my project which tells about the risk management in the banks. I choose ICICI BANK for my study of NPA. It is the leading private sector bank. They control NPA in very good manner. That why it is interesting to know how they able to do this one, To carry out my project I have used the descriptive research. Descriptive research includes surveys and fact-finding enquiries of different kinds. The major purpose of descriptive research is description of the state of affairs, as it exists at present. The main characteristic of this method is that the researcher has no control over the variables; he can only report what has happened or what is happening. It is also called

13 as ex post facto research. Most ex post facto research projects are used for descriptive studies in which researcher seeks to measure such items as, for example, frequency of shopping, preferences of people, or similar data. Descriptive research also includes attempts by the researcher to discover causes even when they cannot control the variables. The methods of research utilized in descriptive research are survey methods of all kinds.

WHY DESCRIPTIVE RESEARCH? In this case descriptive study was most suitable because it helped in giving focus to the preferences, knowledge, beliefs & satisfaction of a group of people in a given population and characteristics of the successful and unsuccessful companies. Moreover it helped in determining the relationships between two or more variables.DATA SOURCE To carry out the project work I have consulted the various secondary sources of data such as Magazines, Journals and websites.

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Chapter 3. Descriptive work The transformation of the Indian banking sector The financial sector reforms in the country were initiated in the beginning of the 1990s.The reforms have brought about a sea change in the profile of the banking sector. Our implementation of the reforms process has had several unique features. Our financial sector reforms were undertaken early in the reform cycle. Notably, the reforms process was not driven by any banking crisis, nor was it the outcome of any external support package. Besides, the design of the reforms was crafted through domestic expertise, taking on board the international experiences in this respect. The reforms were carefully sequenced with respect to the instruments to be used and the objectives to be achieved. Thus, prudential norms and supervisory strengthening were introduced early in the reform cycle, followed by interest-rate deregulation and a gradual lowering of statutory preemptions. The more complex aspects of legal and accounting measures were ushered in subsequently when the basic tenets of the reforms were already in place. The public sector banks continue to be a dominant part of the banking system. As on March 31, 2008, the PSBs accounted for 69.9 per cent of the aggregate assets and 72.7 per cent of the aggregate advances of the Scheduled commercial banking system. A unique feature of the reform of the public sector banks was the process of their financial restructuring. The banks were recapitalised by the government to meet prudential norms through recapitalisation bonds. The mechanism of hiving off bad loans to a separate government asset management company was not considered appropriate in view of the moral hazard. The subsequent divestment of equity and offer to private shareholders was undertaken through a public offer and not by sale to strategic investors. Consequently, all the public sector banks, which issued shares to private shareholders, have been listed on the exchanges and are subject to the same disclosure and market discipline standards as other listed entities. To address the problem of distressed assets, a mechanism has been

15 developed to allow sale of these assets to Asset Reconstruction Companies which operate as independent commercial entities. As regard the prudential regulatory framework for the banking system, we have come a long way from the administered interest rate regime to deregulated interest rates, from the system of Health Codes for an eight-fold, judgmental loan classification to the prudential asset classification based on objective criteria, from the concept of simple statutory minimum capital and capital-deposit ratio to the risk-sensitive capital adequacy norms – initially under Basel I framework and now under the Basel II regime. There is much greater focus now on improving the corporate governance set up through “fit and proper” criteria, on encouraging integrated risk management systems in the banks and on promoting market discipline through more transparent disclosure standards. The policy endeavor has all along been to benchmark our regulatory norms with the international best practices, of course, keeping in view the domestic imperatives and the country context. The consultative approach of the RBI in formulating the prudential regulations has been the hallmark of the current regulatory regime which enables taking account of a wide diversity of views on the issues at hand. The implementation of reforms has had an all round salutary impact on the financial health of the banking system, as evidenced by the significant improvements in a number of prudential parameters. Let me briefly highlight the improvements in a few salient financial indicators of the banking system. The average capital adequacy ratio for the scheduled commercial banks, which was around two per cent in 1997, had increased to 13.08 per cent as on March 31, 2008. The improvement in the capital adequacy ratio has come about despite significant growth in the aggregate asset of the banking system. This level of capital ratio in the Indian banking system compares quite well with the banking system in many other countries – though the capital adequacy of some of the banks in the developed countries has remained under considerable strain in the recent past in the aftermath of the sub-prime crisis. In regard to the asset quality also, the gross NPAs of the scheduled commercial banks, which were as high as 15.7 per cent at end-March 1997, declined significantly to 2.4 per cent as at end-March 2008. The net NPAs of these banks during the same period declined from 8.1 per cent to 1.08 per cent. These figures too compare favourably with the

16 international trends and have been driven by the improvements in loan loss provisioning by the banks as also by the improved recovery climate enabled by the legislative environment. What is noteworthy is that the NPA ratios have recorded remarkable improvements despite progressive tightening of the asset classification norms by the RBI over the years. The reform measures have also resulted in an improvement in the profitability of banks. The Return on Assets (RoA) of scheduled commercial banks increased from 0.4 per cent in the year 1991-92 to 0.99 per cent in 2007-08. The Indian banks would appear well placed in this regard too vis-à-vis the broad range of RoA for the international banks. The banking sector reforms also emphasized the need to improve productivity of the banks through appropriate rationalisation measures so as to reduce the operating cost and improve the profitability. A variety of initiatives were taken by the banks, including adoption of modern technology, which has resulted in improved productivity. The Business per Employee (BPE), as a measure of productivity, for the public sector banks has registered considerable improvement. The BPE for the public sector banks, which was Rs. 95 lakh in 1998-99, almost doubled to Rs. 188 lakh in 2002 and more than redoubled to Rs. 496 lakh in 2007. It needs to be noted that the turnaround in the financial performance of the public sector banks, pursuant to the banking sector reforms, has resulted in the market valuation of government holdings in these banks far exceeding the initial recapitalisation cost – which is something unique to the Indian banking system. Thus, the recapitalisation of banks by the government has not been merely a “holding out” operation by the majority owner of the banks. The Indian experience has shown that a strong, pragmatic and nondiscriminatory regulatory framework coupled with the market discipline effected through the listing of the equity shares and operational autonomy provided to the banks, can have a significant positive impact on the functioning of the public sector banks. The Task Ahead Let me now turn to some of the areas where the public sector banks face certain challenges and hence, need to work further to achieve the desired results, particularly in

17 regard to fuller leveraging of the available technology for rendering better banking services to the public at large. Awareness of electronic payment products As is well known, the financial sector has witnessed a quantum jump in the availability of technological solutions for delivery of financial services, and the RBI too has launched several payment system products for improving the efficiency of the payment system. It is, however, the general perception that the awareness of these products in the system has remained rather limited. This lack of awareness is not confined to only to the members of public at large. It is not uncommon to find that even the branch staff, having direct interface with the banking customers, is not aware of these products and services offered by the bank. This has, therefore, resulted in the continued reliance of the members of public on the traditional methods for availing of various banking services and the benefits of technology have not fully percolated to the level of the customers. I would, therefore, like to urge upon you to take appropriate measures to increase the awareness of the electronic payment products – not only among the clientele of the banks but also among the banks’ own staff so that the members of public can be properly guided and efficient and hassle-free customer service is rendered to them. National Electronic Fund Transfer As we are aware, the NEFT was launched by the RBI in November 2005 as a more secure, nationwide retail electronic payment system to facilitate funds transfer by the bank customers, between the networked bank branches in the country. It has, however, been observed that the public sector banks are not the most active users of this product and the majority of NEFT outward transactions are originated by a few new-generation private sector banks and foreign banks. For instance, in June 2008, while these banks, as a segment, accounted for a little over 43 per cent each of the aggregate volume of outward and inward NEFT transactions, the share of public sector banks in total outward NEFT transactions was rather low at a little over 12 per cent, of which half the volume was the contribution of the State Bank of India. The RBI has been pursuing the matter with the PSBs for increasing their participation in the NEFT system in terms of the number of NEFT-enabled branches and the number of NEFT transactions originated by them. I would like to urge upon the bankers present here to initiate appropriate measures

18 to stimulate greater usage of this payment medium and thereby, improve their share in this regard. In order to popularise the e-payments in the country, the RBI, on its part, has waived the service charges to be levied on the member banks, till March 31, 2009, in respect of the RTGS and NEFT transactions. The RBI also provides, free of charge, intraday liquidity to the banks for the RTGS transactions. The service charges to be levied by banks from their customers for RTGS & NEFT have, however, been deregulated and left to discretion of the individual bank. It has been our experience that while some of the banks have rationalised their service charges and a few have made it even cost-free to the customers, there are also certain banks that have fixed multiples slabs or unreasonably high service charges, at times linked to the amount of the transaction, for providing these services to their customers – even though the RBI provides these services to the banks free of charge. We would therefore, like to take this opportunity to impress upon such banks the need to have proper appreciation of the underlying policy intent of the RBI in waiving the charges for these services, and to adopt a pragmatic approach in determining their own service charges for providing these electronic payment products to their customers. ATM Networks As many of us might know, the National Financial Switch (NFS) network started its operations on August 27, 2004 and is owned and operated by Institute for Development and Research in Banking Technology (IDRBT), Hyderabad. NFS is one of the several shared ATM networks which interconnect the banks’ ATM switches together and thus, enable inter-operability of the ATM cards issued by any bank across the entire network. While there are a few other ATM networks also functioning in the country, the NFS has emerged to be the largest one, with a network of 28,773 ATMs of 31 banks, including 16 public sector banks. The primary objective of any ATM network, like the NFS, is to make the ATM deployment more economical and viable for banks by pooling their respective ATM resources. The main advantage of an ATM network is that it obviates the need for having bank-specific multiple ATM installations in the same geographical area, thereby reducing the entailed costs for the banks but without compromising on the reach of the banks to their customers. From the customers’ perspective, the ATM card of any bank can

19 be used in any ATM – which enables more convenient and wider ATM access to the bank customers of varied banks in different geographical areas. As regards the charges for use of the ATMs connected through any of the ATM networks in the country, while the balance enquiry by the customers is free of any charges, the cash withdrawal from such ATMs, which currently attracts a nominal charge, would also become cost free for the customers from April 1, 2009,. Thus, the networking of the ATMs across the country, by leveraging the technology, is indeed a very customerfriendly development. At end-June 2008, the number of ATMs in the country stood at 36,314 of which the number of ATMs deployed by the PSBs, new-private-sector, old-private-sector and foreign banks was 22,525, 10,552, 2,189 and 1048 ATMs, respectively. At the system level, the banks had planned the installation of another 10,560 ATMs during 2008-09. During the quarter ended June 2008, the daily average number of hits on the ATMs of the PSBs aggregated 31,31,431, with the daily average amount of transactions at Rs. 759.81 crore as against the corresponding figure of 14,91,399 and over Rs. 385 crore for the (old and new) private sector banks, of which the new private sector banks accounted for a loin’s share at 12,84, 071 hits and around Rs. 329 crore in the value of daily transactions. Credit Cards There has been phenomenal increase in the number of credit cards issued by the banks in India during the last few years and a majority of the PSBs has been in the credit card business since long. The number of credit cards outstanding at the end of June 2008 was 27.02 million as against 24.39 million in June 2007. Of these, the number of credit cards issued by public sector banks was 3.8 million, of which 3.09 million cards were issued by the SBI Cards – a joint venture of GE Money and SBI. The usage of credit cards has also recorded an increase of 10.73 per cent during the year this period, which is mainly at the Point of Sale (POS) terminals. In June 2008, the number of transactions by credit cards at POS terminals was 20.6 million as against 17.2 million transactions in June 2007, reflecting an increase of almost 20 per cent during the year. The amount involved in these transactions recorded a growth of 25.6 per cent during the year ended June 2008 with the aggregate value of such transactions at Rs. 5261.63 crore. While the increasing usage of

20 the credit cards is a welcome development in as much as it reduces reliance on currency for settlement of transactions, it also entails certain additional elements of operational risk and can be a potential source of customer complaints. The RBI, based on the complaints received from the credit card holders, had undertaken a study of the credit card operations of the banks. The RBI has since advised the banks in July 2008, the recommendations emerging from the study, for implementation. These recommendations are fairly wide ranging and encompass several issues in the areas of card issuance, card statements, interest and other chares on the cards, using the services of direct selling / marketing agents, redressal of customers’ grievances, reporting of default information of the card holder to the CIBIL, etc. We would urge the banks to put in place necessary mechanism to ensure meticulous compliance with these instructions of the RBI so as to minimise, if not eliminate, the risks and customer complaints in the area of credit card operations. Satellite banking We might be aware, having regard to much greater reliability of a satellite-based communication link for interconnecting the branches of the banks, particularly in the hilly areas and difficult terrain where terrestrial communication link is difficult to provide, the RBI had constituted a Technical Group to examine the proposal for providing satellite connectivity to the bank branches in such areas. The objective is to enable greater penetration of the electronic payment products in the hinterland areas also, by facilitating the integration of the rural and remote branches with the core banking solution platform of the banks and help them providing efficient banking services to their customers. Under the proposal, the RBI would be bearing a part of the leased rentals for the satellite connectivity, provided the banks use it for connecting their branches in the North Eastern States and in the under-banked districts in the rest of the country. Thus, the RBI would be providing an incentive to the banks for adopting the satellite communication technology for networking their branches in the remote areas.

21 Challenges facing Banking industry in India The banking industry in India is undergoing a major transformation due to changes in economic conditions and continuous deregulation. These multiple changes happening one after other has a ripple effect on a bank (Refer fig. 2.1) trying to graduate from completely regulated sellers market to completed deregulated customers market.

· Deregulation: This continuous deregulation has made the Banking market extremely competitive with greater autonomy, operational flexibility, and decontrolled interest rate and liberalized norms for foreign exchange. The deregulation of the industry coupled with decontrol in interest rates has led to entry of a number of players in the banking industry. At the same time reduced corporate credit off take thanks to sluggish economy has resulted in large number of competitors battling for the same pie. · New rules: As a result, the market place has been redefined with new rules of the game. Banks are transforming to universal banking, adding new channels with lucrative pricing and freebees to offer. Natural fall out of this has led to a series of innovative product offerings catering to various customer segments, specifically retail credit.

22 · Efficiency: This in turn has made it necessary to look for efficiencies in the business. Banks need to access low cost funds and simultaneously improve the efficiency. The banks are facing pricing pressure, squeeze on spread and have to give thrust on retail assets · Diffused Customer loyalty: This will definitely impact Customer preferences, as they are bound to react to the value added offerings. Customers have become demanding and the loyalties are diffused. There are multiple choices, the wallet share is reduced per bank with demand on flexibility and customization. Given the relatively low switching costs; customer retention calls for customized service and hassle free, flawless service delivery. · Misaligned mindset: These changes are creating challenges, as employees are made to adapt to changing conditions. There is resistance to change from employees and the Seller market mindset is yet to be changed coupled with Fear of uncertainty and Control orientation. Acceptance of technology is slowly creeping in but the utilization is not maximised. · Competency Gap: Placing the right skill at the right place will determine success. The competency gap needs to be addressed simultaneously otherwise there will be missed opportunities. The focus of people will be on doing work but not providing solutions, on escalating problems rather than solving them and on disposing customers instead of using the opportunity to cross sell. Strategic options with banks to cope with the challenges Leading players in the industry have embarked on a series of strategic and tactical initiatives to sustain leadership. The major initiatives include: · Investing in state of the art technology as the back bone of to ensure reliable service delivery · Leveraging the branch network and sales structure to mobilize low cost current and savings deposits · Making aggressive forays in the retail advances segment of home and personal loans

23 · Implementing organization wide initiatives involving people, process and technology to reduce the fixed costs and the cost per transaction · Focusing on fee based income to compensate for squeezed spread, (e.g. CMS, trade services) · Innovating Products to capture customer ‘mind share’ to begin with and later the wallet share · Improving the asset quality as per Basel II norms

NON PERFORMING ASSETS (NPA) Action for enforcement of security interest can be initiated only if the secured asset is classified as Nonperforming asset. Non performing asset means an asset or account of borrower, which has been classified by bank or financial institution as sub –standard , doubtful or loss asset, in accordance with the direction or guidelines relating to assets classification issued by RBI . An amount due under any credit facility is treated as “past due “when it is not been paid within 30 days from the due date. Due to the improvement in the payment and settlement system, recovery climate, up gradation of technology in the banking system etc, it was decided to dispense with “past due “concept, with effect from March 31, 2001. Accordingly as from that date, a Non performing asset shell be an advance where i. Interest and/or instalment of principal remain overdue for a period of more than 180 days in respect of a term loan, ii. The account remains ‘out of order ‘for a period of more than 180 days, in respect of an overdraft/cash credit (OD/CC) iii. The bill remains overdue for a period of more than 180 days in case of bill purchased or discounted. iv. Interest and/or principal remains overdue for two harvest season but for a period not exceeding two half years in case of an advance granted for agricultural purpose, and v. Any amount to be received remains overdue for a period of more than 180 days in respect of other accounts

24 With a view to moving towards international best practices and to ensure greater transparency, it has been decided to adopt ’90 days overdue ‘norms for identification of NPA s, from the year ending March 31, 2004, a non performing asset shell be a loan or an advance where; i. Interest and/or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan, ii. The account remains ‘out of order ‘for a period of more than 90 days ,in respect of an overdraft/cash credit (OD/CC) iii. The bill remains overdue for a period of more than 90 days in case of bill purchased or discounted. iv. Interest and/or principal remains overdue for two harvest season but for a period not exceeding two half years in case of an advance granted for agricultural purpose, and v. Any amount to be received remains overdue for a period of more than 90 days in respect of other accounts Out of order An account should be treated as out of order if the outstanding balance remains continuously in excess of sanctioned limit /drawing power. in case where the out standing balance in the principal operating account is less than the sanctioned amount /drawing power, but there are no credits continuously for six months as on the date of balance sheet or credit are not enough to cover the interest debited during the same period ,these account should be treated as ‘out of order’. Overdue Any amount due to the bank under any credit facility is ‘overdue’ if it is not paid on due date fixed by the bank. FACTORS FOR RISE IN NPAs The banking sector has been facing the serious problems of the rising NPAs. But the problem of NPAs is more in public sector banks when compared to private sector banks and foreign banks. A strong banking sector is important for a flourishing economy. The

25 failure of the banking sector may have an adverse impact on other sectors. The Indian banking system, which was operating in a closed economy, now faces the challenges of an open economy. On one hand a protected environment ensured that banks never needed to develop sophisticated treasury operations and Asset Liability Management skills. On the other hand a combination of directed lending and social banking relegated profitability and competitiveness to the background. The net result was unsustainable NPAs and consequently a higher effective cost of banking services. The problem India Faces is not lack of strict prudential norms but i. The legal impediments and time consuming nature of asset disposal proposal. ii. Postponement of problem in order to show higher earnings. iii. Manipulation of debtors using political influence.

Macro Perspective Behind NPAs A lot of practical problems have been found in Indian banks, especially in public sector banks. For Example, the government of India had given a massive wavier of Rs. 15,000 Crs. under the Prime Minister ship of Mr. V.P. Singh, for rural debt during 1989-90. This was not a unique incident in India and left a negative impression on the payer of the loan. Poverty elevation programs like IRDP, RREP, SUME, SEPUP, JRY, PMRY etc., failed on various grounds in meeting their objectives. The huge amounts of loan granted under these schemes were totally unrecoverable by banks due to political manipulation, misuse of funds and non-reliability of target audience of these sections. Loans given by banks are their assets and as the repayments of several of the loans were poor, the qualities of these assets were steadily deteriorating. Credit allocation became 'Lon Melas', loan proposal evaluations were slack and as a result repayments were very poor. There are several reasons for an account becoming NPA. * Internal factors * External factors EXTERNAL FACTORS Ineffective recovery tribunal

26 The Govt. has set of numbers of recovery tribunals, which works for recovery of loans and advances. Due to their negligence and ineffectiveness in their work the bank suffers the consequence of non-recover, their by reducing their profitability and liquidity. Willful Defaults There are borrowers who are able to payback loans but are intentionally withdrawing it. These groups of people should be identified and proper measures should be taken in order to get back the money extended to them as advances and loans. Natural calamities This is the measure factor, which is creating alarming rise in NPAs of the PSBs. every now and then India is hit by major natural calamities thus making the borrowers unable to pay back there loans. Thus the bank has to make large amount of provisions in order to compensate those loans, hence end up the fiscal with a reduced profit. Mainly ours framers depends on rain fall for cropping. Due to irregularities of rain fall the framers are not to achieve the production level thus they are not repaying the loans. Industrial sickness Improper project handling , ineffective management , lack of adequate resources , lack of advance technology , day to day changing govt. Policies give birth to industrial sickness. Hence the banks that finance those industries ultimately end up with a low recovery of their loans reducing their profit and liquidity. Lack of demand Entrepreneurs in India could not foresee their product demand and starts production which ultimately piles up their product thus making them unable to pay back the money they borrow to operate these activities. The banks recover the amount by selling of their assets, which covers a minimum label. Thus the banks record the non recovered part as NPAs and has to make provision for it. Change on Govt. policies With every new govt. banking sector gets new policies for its operation. Thus it has to cope with the changing principles and policies for the regulation of the rising of NPAs. The fallout of handloom sector is continuing as most of the weavers Co-operative societies have become defunct largely due to withdrawal of state patronage. The

27 rehabilitation plan worked out by the Central govt to revive the handloom sector has not yet been implemented. So the over dues due to the handloom sectors are becoming NPAs. Apart from these factors there may be others external factors which can cause of NPA’s, these factors are: 1. Sluggish legal system - Long legal tangles Changes that had taken place in labour laws Lack of sincere effort. 2. Scarcity of raw material, power and other resources. 3. Industrial recession. 4. Shortage of raw material, raw material\input price escalation, power shortage, industrial recession, excess capacity, natural calamities like floods, accidents. 5. Failures, non payment\ over dues in other countries, recession in other countries, externalization problems, adverse exchange rates etc. 6. Government policies like excise duty changes, Import duty changes etc., INTERNAL FACTORS Defective Lending process There are three cardinal principles of bank lending that have been followed by the commercial banks since long. i. Principles of safety ii. Principle of liquidity iii. Principles of profitability i. Principles of safety By safety it means that the borrower is in a position to repay the loan both principal and interest. The repayment of loan depends upon the borrowers: a. Capacity to pay b. Willingness to pay Capacity to pay depends upon: 1. Tangible assets 2. Success in business Willingness to pay depends on: 1. Character 2. Honest 3. Reputation of borrower

28 The banker should, there fore take utmost care in ensuring that the enterprise or business for which a loan is sought is a sound one and the borrower is capable of carrying it out successfully .he should be a person of integrity and good character. Inappropriate technology Due to inappropriate technology and management information system, market driven decisions on real time basis can not be taken. Proper MIS and financial accounting system is not implemented in the banks, which leads to poor credit collection, thus NPA. All the branches of the bank should be computerized. Improper swot analysis The improper strength, weakness, opportunity and threat analysis is another reason for rise in NPAs. While providing unsecured advances the banks depend more on the honesty, integrity, and financial soundness and credit worthiness of the borrower. 1. Banks should consider the borrowers own capital investment. 2. It should collect credit information of the borrowers from a. From bankers b. Enquiry from market/segment of trade, industry, business. c. From external credit rating agencies. · Analyse the balance sheet True picture of business will be revealed on analysis of profit/loss a/c and balance sheet. 3. Purpose of the loan When bankers give loan, he should analyse the purpose of the loan. To ensure safety and liquidity, banks should grant loan for productive purpose only. Bank should analyse the profitability, viability, long term acceptability of the project while financing. Poor credit appraisal system Poor credit appraisal is another factor for the rise in NPAs. Due to poor credit appraisal the bank gives advances to those who are not able to repay it back. They should use good credit appraisal to decrease the NPAs. Managerial deficiencies The banker should always select the borrower very carefully and should take tangible assets as security to safe guard its interests. When accepting securities banks should consider the 1. Marketability

29 2. Acceptability 3. Safety 4. Transferability. The banker should follow the principle of diversification of risk based on the famous maxim “do not keep all the eggs in one basket”; it means that the banker should not grant advances to a few big farms only or to concentrate them in few industries or in a few cities. If a new big customer meets misfortune or certain traders or industries affected adversely, the overall position of the bank will not be affected. Like OSCB suffered loss due to the OTM Cuttack, and Orissa hand loom industries. The biggest defaulters of OSCB are the OTM (117.77lakhs), and the handloom sector Orissa hand loom WCS ltd (2439.60lakhs). Absence of regular industrial visit The irregularities in spot visit also increases the NPAs. Absence of regularly visit of bank officials to the customer point decreases the collection of interest and principals on the loan. The NPAs due to wilful defaulters can be collected by regular visits. Re loaning process Non remittance of recoveries to higher financing agencies and re loaning of the same have already affected the smooth operation of the credit cycle. Due to re loaning to the defaulters and CCBs and PACs, the NPAs of OSCB is increasing day by day. Apart from these the other internal factors are: 1. Funds borrowed for a particular purpose but not use for the said purpose. 2. Project not completed in time. 3. Poor recovery of receivables. 4. Excess capacities created on non-economic costs. 5. In-ability of the corporate to raise capital through the issue of equity or other debt instrument from capital markets. 6. Business failures. 7. Diversion of funds for expansion\modernization\setting up new projects\ helping or promoting sister concerns. 8. Willful defaults, siphoning of funds, fraud, disputes, management disputes, misappropriation etc.,

30 9. Deficiencies on the part of the banks viz. in credit appraisal, monitoring and followups, delay in settlement of payments\ subsidiaries by government bodies etc., PROBLEMS DUE TO NPA 1. Owners do not receive a market return on there capital .in the worst case, if the banks fails, owners loose their assets. In modern times this may affect a broad pool of shareholders. 2. Depositors do not receive a market return on saving. In the worst case if the bank fails, depositors loose their assets or uninsured balance. 3. Banks redistribute losses to other borrowers by charging higher interest rates, lower deposit rates and higher lending rates repress saving and financial market, which hamper economic growth. 4. Non performing loans epitomise bad investment. They misallocate credit from good projects, which do not receive funding, to failed projects. Bad investment ends up in misallocation of capital, and by extension, labour and natural resources. 5. Non performing asset may spill over the banking system and contract the money stock, which may lead to economic contraction. This spill over effect can channelize through liquidity or bank insolvency: a) when many borrowers fail to pay interest, banks may experience liquidity shortage. This can jam payment across the country, b) illiquidity constraints bank in paying depositors .c) undercapitalised banks exceeds the banks capital base. What caused such high NPAs in the system until 1995? Some key reasons for huge NPAs until mid-1990s are as follows: Absence of competition: The entire banking sector was state-owned; there was complete absence of any kind of competition from the private sector. Lack of focus and control: The government-controlled operations of banks resulted in favoritisms in terms of lending, besides lack of focus on quality of lending. Managements of banks lacked any control on operations of their banks, while directors largely were influenced by the will of power-circles.

31 Collateral-based lending and a dormant legal recourse system: Collateral was considered king. Under the name of collateral, large sums of loans were disbursed, and in the absence of an active legal recovery system, loan repayment and quality considerations took a back seat. Corruption and bureaucracy: Political interference and lack of supervision increased corruption and redtapism in the banking system. This resulted in complete dilution of credit quality and control procedures. Inadequacy of capital and tools relating to asset quality monitoring: Banks suffered from shortage of capital funds to pursue any meaningful investments in quality control, loan monitoring, etc. This inadequacy of funds, together with the absence of independent management, led to low focus on asset quality tracking and taking corrective actions. The situation changed after 1993, when the Reserve Bank of India (RBI) with the government's support, came up with several decisions on managing Indian banks that had a salutary impact, and the future never looked so much in control henceforth. There was a significant decline in the non-performing assets (NPAs) of SCBs in 2003-04, despite adoption of 90 day delinquency norm from March 31, 2004. The gross NPAs of SCBs declined from 4.0 per cent of total assets in 2002-03 to 3.3 per cent in 2003-04. The corresponding decline in net NPAs was from 1.9 per cent to 1.2 per cent. Both gross NPAs and net NPAs declined in absolute terms. While the gross NPAs declined from Rs. 68,717 crore in 2002-03 to Rs. 64,787 crore in 2003-04, net NPAs declined from Rs. 32,670 crore to Rs. 24,617 crore in the same period. There was also a significant decline in the proportion of net NPAs to net advances from 4.4 per cent in 2002-03 to 2.9 per cent in 2003-04. The significant decline in the net NPAs by 24.7 per cent in 2003-04 as compared to 8.1 per cent in 2002- 03 was mainly on account of higher provisions (up to 40.0 per cent) for NPAs made by SCBs. The decline in NPAs in 2003-04 was witnessed across all bank groups. The decline in net NPAs as a proportion of total assets was quite significant in the case of new private sector banks, followed by PSBs. The ratio of net NPAs to net advances of SCBs declined from 4.4 per cent in 2002-03 to 2.9 per cent in 2003-04. Among the bank groups, old private sector banks had the highest ratio of net NPAs to net advances at 3.8 per cent followed by

32 PSBs (3.0 per cent) new private sector banks (2.4 per cent) and foreign banks (1.5 per cent) An analysis of NPAs by sectors reveals that in 2003-04, advances to non-priority sectors accounted for bulk of the outstanding NPAs in the case of PSBs (51.24 per cent of total) and for private sector banks (75.30 per cent of total). While the share of NPAs in agriculture sector and SSIs of PSBs declined in 2003-04, the share of other priority sectors increased. The share of loans to other priority sectors in priority sector lending also increased. Measures taken to reduce NPAs include reschedulement, restructuring at the bank level, corporate debt restructuring, and recovery through Lok Adalats, Civil Courts, and debt recovery tribunals and compromise settlements. The recovery management received a major fillip with the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 enabling banks to realise their dues without intervention of courts and tribunals. The Supreme Court in its judgment dated April 8, 2004, while upholding the constitutional validity of the Act, struck down section 17 (2) of the Act as unconstitutional and contrary to Article 14 of the Constitution of India. The Government amended the relevant provisions of the Act to address the concerns expressed by the Supreme Court regarding a fair deal to borrowers through an ordinance dated November 11, 2004. It is expected that the momentum in the recovery of NPAs will be resumed with the amendments to the Act. The revised guidelines for compromise settlement of chronic NPAs of PSBs were issued in January 2003 and were extended from time to time till July 31, 2004. The cases filed by SCBs in Lok Adalats for recovery of NPAs stood at 5.20 lakh involving an amount of Rs. 2,674 crore (prov.). The recoveries effected in 1.69 lakh cases amounted to Rs. 352 crore (prov.) as on September 30, 2004. The number of cases filed in debt recovery tribunals stood at 64, 941 as on June 30, 2004, involving an amount of Rs. 91,901 crore. Out of these, 29, 525 cases involving an amount of Rs. 27,869 crore have been adjudicated. The amount recovered was to Rs. 8,593 crore. Under the scheme of corporate debt restructuring introduced in 2001, the number of cases and value of assets restructured stood at 121 and Rs. 69,575 crore, respectively, as on December 31, 2004. Iron and steel, refinery, fertilisers and telecommunication sectors were the major

33 beneficiaries of the scheme. These sectors accounted for more than two-third of the values of assets restructured. Capital adequacy ratio The concept of minimum capital to risk weighted assets ratio (CRAR) has been developed to ensure that banks can absorb a reasonable level of losses. Application of minimum CRAR protects the interest of depositors and promotes stability and efficiency of the financial system. At the end of March 31, 2004, CRAR of PSBs stood at 13.2 per cent, an improvement of 0.6 percentage point from the previous year. There was also an improvement in the CRAR of old private sector banks from 12.8 per cent in 200203 to 13.7 per cent in 2003-04. The CRAR of new private sector banks and foreign banks registered a decline in 2003-04. For the SCBs as a whole the CRAR improved from 12.7 per cent in 2002-03 to 12.9 per cent in 2003-04. All the bank groups had CRAR above the minimum 9 per cent stipulated by the RBI. During the current year, there was further improvement in the CRAR of SCBs. The ratio in the first half of 2004-05 improved to 13.4 per cent as compared to 12.9 per cent at the end of 2003-04. Among the bank groups, a substantial improvement was witnessed in the case of new private sector banks from 10.2 per cent as at the end of 2003-04 to 13.5 percent in the first half of 2004-05. While PSBs and old private banks maintained the CRAR at almost the same level as in the previous year, the CRAR of foreign banks declined to 14.0 per cent in the first half of 2004-05 as compared to 15.0 per cent as at the end of 2003-04.

34

Source: Antique research

Graph: 1

The above picture is self-explanatory. Over the period of time, Indian commercial banks have shown tremendous improvement in terms of quality of credit. NPAs, both at gross and net levels, as a percentage of advances, have fallen consistently. The gross NPA/Advances ratio has fallen from 16% in FY97 to less than 2.5% in FY08. Banks displayed great control over credit quality, as even in times of falling IIP and GDP growth, they continued to show fewer NPAs. This is a very impressive indicator that highlights the fact that Indian banking has shown substantial improvement in terms of asset quality management even in adverse macro-economic conditions. FY99, FY01 and FY02 saw considerable fall in industrial production from the then existing levels. However, this did not lead to any increase in bank NPAs. On the contrary, banks improved NPA ratios considerably through the exercise of strong asset quality monitoring programmes. The current environment is again indicating a decline in GDP, and IIP growth rates as slowdown hits demand and consumption across all major sectors. However, we strongly believe that managements of top Indian banks have put 'NPA Management and Control' as one of their top priorities, and that even though there would be a jump in NPAs as a proportion of total assets, the banking sector has the ability to withstand this jump and still emerge as a strong performer in these extremely difficult times.

35 What changed the scenario of NPAs after 1995? Some of the key factors that contributed to the fall in NPAs in the Indian banking Introduction of competition: The RBI opened up gates for the private sector participation in the Indian banking industry. HDFC, the principal mortgage lender, got the first approval to start a private bank in the reform-driven era. HDFC Bank was given permission to carry on commercial banking operations. Many new private banks and foreign banks were allowed later, which brought in the much-required competition in the Indian banking industry. Guidelines on NPAs, income recognition, capital adequacy: One of the key reasons for such a drastic fall in system NPAs was the introduction of asset and capital quality guidelines. These norms, introduced on the basis of the Narasimhan Committee report in 1993, had a revolutionary impact on the way banks managed and controlled their asset book. Separation of control: Bank managements were given a free hand to run their businesses as the Ministry of Finance and the RBI moved away from controlling positions to supervising and regulating positions. This enabled boards of Indian banks to take uninfluenced calls as to lending and asset control. Improvement of the legal recourse mechanism: This is another significant step. Through Debt Recovery Tribunal (DRT), Lok Adalat mechanism for small loans, and One-Time Settlement (OTS) mechanism for stressed loans in 1999, the central bank ensured that there is a quick clean-up of sticky assets, so as to enable banks to start functioning with a clean slate. The legal recourse for amounts lent has been an important contributor to asset quality improvement. Capital infusion: Public banks were allowed to bring down the government holding to 51%, thereby enabling flow of fresh money for much-needed banks and also roping in investment interest from market participants. Board of directors now became more independent, and a mixed lot of individuals brought in experience from various segments of the financial world. Establishment of CIBIL: Credit Information Bureau of India Ltd was established in 2000. This institution started to maintain a database of borrowers and their credit history. This served as a very effective tool for loan sanctioning and asset quality maintenance.

36 Banks use the database to ensure credit does not fall in the hands of a borrower, with a bad credit record. Asset Reconstruction Company: ARCs were permitted to operate from 2002; these institutions helped the removal of bank's focus on bad assets by acquiring their bad loans, thereby strengthening their balance sheets. Corporate Debt Restructuring, SICA: The CDR mechanism, sick industries revival enactments enabled addressing issues of troubled borrowers through effective handholding and bank support. This prevented further slippage of asset quality. Exposure limits (sector-wise and borrower-wise): The RBI put in place strict exposure limits for banks with respect to sensitive sectors like real estate and capital markets. In addition, limits on amounts a bank can lend to a specific borrower, or a borrower group helped in non-concentration of funds as loans in a few hands, thereby diversifying the risk of default. Risk management tools: The RBI ensured that banks have effective risk measurement, management and control systems in place, so as to avoid credit shocks. Asset liability management (ALM), value at risk (VAR), control on off-balance sheet exposures, credit risk weightages, etc. are few concepts that enabled banks to effectively control NPAs. In this context of a highly improved, dynamic and competitive domestic banking environment, we expect that Indian banks will exercise adequate caution in terms of the quality of their loan-books. In addition, some of the steps (underlined) can be effectively used again by RBI and the government, if the condition of NPAs worsens. Have Indian banks achieved the best asset quality levels? In terms of global comparisons (table below), the performance of Indian banks over the years has surely been exemplary, and with regard to further scope for improvement, there are many countries where GNPA/advances ratio is much below levels at which Indian banks are currently positioned. This shows there is further scope for quality improvements for banks in India.

37 Table 1

Source: Antique research

Efficiency and return parameters - Room for betterment?

Source: Antique research

Graph 2

As can be observed from the above chart, Indian banks have kept their operating expenses under check. From around 3% levels during 1996 and 1997, operating expenses/assets ratio has come down to 1.8% levels by the end of FY2008. Though this is a good indicator reflecting the efficiency of Indian banks, it is still higher as compared with banks in other countries such as China, Malaysia, Korea and Thailand where the ratio is below 1.5%. In addition, one reason that might have contributed positively to Indian banks is the fact that over the past 3-4 years there has been a rapid increase in bank loans, and hence, the balance sheet size of banks. The higher base (as advances and total assets) might have helped in the ratio falling to low levels. Return on assets ratio comparison table above shows that most other banks earn better returns as compared with their Indian peers. Considering the fact that the loan quality is improving and expenses

38 are under control, Indian banks identified the need to improve the profitability. Focus on fee income that is less sensitive to interest rate fluctuations (unlike NIMs and treasury income) has been defined as one key area besides expenses control that Indian banks would strive for in the future to improve the return generated over assets. Providing various value-added financial services under one umbrella has also been aimed at to improve the bottom-line. Table 2

Source: Antique research

From the above paragraphs, it can be inferred that though Indian banking has shown tremendous improvement over the years in terms of asset quality and efficiency, the comparison with global peers in terms of these aspects and return on assets shows that there is still ample scope for improvement. Indian Banking - Internal dynamics - Changed circumstances In terms of the domestic scenario, as shown in the chart below, bank credit in FY08 has been\ growing at a slower pace than that observed over the past 4 years. The central bank tried to ensure that the economy does not get overheated by raising the 'repo rate' regularly. Rates were slashed from the period starting October 2008 to support liquidity in the domestic market that had become extremely scarce due to global credit crisis. The average 3-year credit growth steadily rose to 29% during 2005-08 from 14% levels observed between 1996 and 1999. Though the RBI's target credit growth is in the vicinity of 20% for FY09, yearly credit growth as of November 2008 remained at 26%, above the level targeted by the central bank.

39

Source: Antique research

Graph 3

In addition to the objective of slowing or moderating the pace of credit growth, the RBI had to control the sudden spike in domestic inflation that rose to levels not seen at least for more than a decade. Inflation shot up to above 12% during July 2008 due to a hike in fuel prices and increase in commodity and food prices. However, inflation started to cool off from mid-September 2008, as global crude and commodity prices crashed due to recession worries. Prices of primary articles, representing food and agriculture products, still remain firm, but the overall inflation has fallen to 9% levels in November 2008. The data indicates how inflation, indicated by the wholesale price index (WPI), shot up from around 4% levels in FY97 to 12% by 1HFY09. The impact of increasing inflation, rising interest rates (repo rate) and slowing credit growth on Indian banks was seen in increasing cost of funds, increasing pressure on the asset quality and squeezing of margins. The movement of BSE Bankex, the share-price index of banks, reflects the impact of all the above factors. An inverse correlation between Inflation and the Bankex movement is clearly observed until September 2008, when global credit crisis started to pull down prices of all bank stocks even when inflation cooled off significantly. Today, the situation is vastly different! Inflation has cooled off to 6% and high credit growth does not pose a threat to RBI anytime soon In short, the following aspects are key arguments for our positive view on Indian banks in the current environment: NPAs will rise to 5% at gross level as a percentage of advances, almost double from current levels. However, considering the regulatory and systemic changes that have happened after mid-1990s, Indian banks have become extremely conscious and strong in terms of managing and maintaining credit quality.

40 Credit growth has slowed as compared with previous years, but even assuming a slow GDP growth due to global recession, Indian banks have adequate demand from the system to cater to, and this will ensure decent growth in business. The bank credit is evenly diversified to all major sectors of the economy without undue reliance on any single segment or industry. In terms of credit quality, the return on assets, operating expenses and the scope for private sector credit growth, Indian banks have shown tremendous improvement over a period of time. However, considering global examples, there is enough room to improve further in each of the above parameters. Indian banks withstood the fall in economic growth observed during the periods of Asian economic crisis (FY98-99), and also the global slump seen during FY01-02. Even when global GDPs fell and domestic industrial production declined, NPAs were effectively controlled. The market share of advances and deposits is spread between many banks across public and private sector indicating ‘no concentration’ of NPA risks in one single bank. Table 3 Gross NPAs, Gross advances

Source: Antique research

Why it feels that markets’ expectation of a huge rise in NPAs from current levels may be unreasonable?Bad loans are not concentrated in any single segment. The chart below shows the distribution of gross NPAs of Indian banks as at the end of FY08. Non-concentration of low quality loans in any single borrowing segment will reduce the overall impact of the

41 economic slowdown, as segments like agriculture, among some others, would not add to the pain on account of their non-dependence on the current economic slowdown.

Source: Antique research

Graph 4

The corporate sector of India has improved its financial soundness over the past few years (industry segment borrows 40% of total loans). The debt-equity ratio of Indian companies has fallen to less than 0.5 levels from highs of 1.2 times observed during the mid-1990s. Also, the profitability of companies has substantially improved as is evident from the chart below, which shows the growth in shareholders’ equity (capital + reserves) of BSE-500 companies. These factors provide cushion to lenders on two fronts: one, borrower’s quality is good (improved), and the other, there are sufficient reserves with the borrower to tide over the slowdown pain for a while. Speedy legal/quasi-legal recourse in the form of Debt Recovery Tribunals, Lok Adalats, Corporate Debt Restructuring (CDR) mechanism and One-time Settlements have yielded positive results both in terms of time taken to recover the amount lent and also the success rate. Under the CDR mechanism, cases involving INR830bn have been resolved that comprises 165 corporate accounts. Only 31 cases referred to the CDR failed. Securitisation of sticky assets that was made easier for banks by the promulgation of SARFAESI Act (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002) also provides a great impetus to the recovery procedures adopted by banks. Balance sheets of banks would be much cleaner when they dispose of bad loans to a securitisation company. Loans totaling INR9.8bn and INR17.4bn have

42 been sold in FY07 and FY08, respectively, to ARCIL, the biggest asset securitisation company in India. The entry of ARCIL into the retail loan segment, a segment that is currently experiencing high default rates, will benefit Indian banks. CIBIL (Credit Information Bureau of India Ltd) was established in 2000, with SBI and HDFC holding 40% stakes each, and Dun & Bradstreet and TransUnion holding 10% each of the balance. The credit information bureau is a repository of information, which contains the credit history of commercial and consumer borrowers. Member banks/institutions exchange customer credit appraisal-related data, and thus accounts with a poor credit record are identified for proper action. Currently, most banks are members of CIBIL.

Source: Antique research

Graph 5

Besides the above factors, we believe that the RBI will be proactive in modifying the NPA-recognition norms, provisioning norms that will enable a wider window for banks to deal with the NPA issue. Even though these measures might ‘cover’ bad quality loans for a certain period of time, they support the idea to provide recovery time for borrowers to achieve financial health helping banks, at the same time, to provide less to such accounts in the form of NPAs.

43 All these reasons, together with certain other parameters that we have explained in the following paragraphs, make us believe that NPAs will not zoom up to such levels that could pose a threat to the solvency of any banks, or even profitability for that matter! NPAs will rise, but they will not go up to unreasonable levels. Given below is a chart depicting future GNPA levels that we have considered for banks covered in this report. NPAs will show the maximum impact in FY10, though problems in the real economy began to appear from the beginning of 2HFY09. This is due to the fact that NPA-recognition norms prescribe a 90-day period before assigning a mandatory 'non-performing' tag to the asset head.

Source: Antique research

Graph 6

44

ICICI GROUP In 1955, The Industrial Credit and Investment Corporation of India Limited (ICICI) incorporated at the initiative of the World Bank, the Government of India and representatives of Indian industry, with the objective of creating a development financial institution for providing medium-term and long-term project financing to Indian businesses. Mr.A.Ramaswami Mudaliar elected as the first Chairman of ICICI Limited. ICICI emerges as the major source of foreign currency loans to Indian industry. Besides funding from the World Bank and other multi-lateral agencies, ICICI was also among the first Indian companies to raise funds from international markets OVERVIEW ICICI Group offers a wide range of banking products and financial services to corporate and retail customers through a variety of delivery channels and through its specialised group companies, subsidiaries and affiliates in the areas of personal banking, investment banking, life and general insurance, venture capital and asset management. With a strong customer focus, the ICICI Group Companies have maintained and enhanced their leadership position in their respective sectors. ICICI Bank is India's second-largest bank with total assets of Rs. 3,997.95 billion (US$ 100 billion) at March 31, 2008 and profit after tax of Rs. 41.58 billion for the year ended March 31, 2008. ICICI Bank is second amongst all the companies listed on the Indian stock exchanges in terms of free float market capitalisation. The Bank has a network of about 1,308 branches and 3,950 ATMs in India and presence in 18 countries. ICICI Prudential Life Insurance Company is a 74:26 joint venture with Prudential plc (UK). It is the largest private sector life insurance company offering a comprehensive suite of life, health and pensions products. It is also the pioneer in launching innovative health care products like Diabetes Care and Cancer Care. The company operates on a multi-channel platform and has distribution strength of over 2, 90,000 financial advisors operating from 1956 branches spread across 1669 locations across the country. In addition to the agency force, it also has tie-ups with various banks, corporate agents and

45 brokers. In fiscal 2008, ICICI Prudential attained a market share of 12.7% with new business weighted premium growth of 68.3% to Rs. 66.84 billion and held assets of Rs. 285.78 billion at March 31, 2008. ICICI Lombard General Insurance Company, a joint venture with the Canada based Fairfax Financial Holdings, is the largest private sector general insurance company. It has a comprehensive product portfolio catering to all corporate and retail insurance needs and is present in over 200 locations across the country. ICICI Lombard General Insurance has achieved a market share of 29.8% among private sector general insurance companies and an overall market share of 11.9% during fiscal 2008. The gross return premium grew by 11.4% from Rs. 30.3 billion in fiscal 2007 to Rs. 33.45 billion in fiscal 2008. ICICI Securities Ltd is the largest equity house in the country providing end-to-end solutions (including web-based services) through the largest non-banking distribution channel so as to fulfill all the diverse needs of retail and corporate customers. ICICI Securities (I-Sec) has a dominant position in its core segments of its operations Corporate Finance including Equity Capital Markets Advisory Services, Institutional Equities, Retail and Financial Product Distribution. ICICI Securities Primary Dealership is the largest primary dealer in Government securities. In fiscal 2008, it achieved a profit after tax of Rs.1.40 billion. ICICI Prudential Asset Management is the second largest mutual fund with asset under management of Rs. 547.74 billion and a market share of 10.2% as on March 31, 2008. The Company manages a comprehensive range of mutual fund schemes and portfolio management services to meet the varying investment needs of its investors through 235 branches spread across the country. Incorporated in 1987, ICICI Venture is the oldest and the largest private equity firm in India. The funds under management of ICICI Venture have increased at a 5 year CAGR of 49% to Rs.95.50 billion as on March 31, 2008.

46 PRODUCTS ICICI Group has always been at the forefront of developing innovative financial products, which caters to various needs of people from all walks of life. Over the years, it has launched several financial products that offer financial support, security and more to not just individuals, but to big and small organisations too. Banking • • • • •

Personal Banking Global Private Clients Corporate Banking Business Banking NRI Banking

Insurance & Investment • • • • •

Life Insurance General Insurance Securities Mutual Fund Private Equity Practice

Overview of ICICI BANK ICICI Bank is India's second-largest bank with total assets of Rs. 3,849.70 billion (US$ 82 billion) at September 30, 2008 and profit after tax Rs. 17.42 billion for the half year ended September 30, 2008. The Bank has a network of about 1,400 branches and 4,530 ATMs in India and presence in 18 countries. ICICI Bank offers a wide range of banking products and financial services to corporate and retail customers through a variety of delivery channels and through its specialised subsidiaries and affiliates in the areas of investment banking, life and non-life insurance, venture capital and asset management. The Bank currently has subsidiaries in the United Kingdom, Russia and

47 Canada, branches in United States, Singapore, Bahrain, Hong Kong, Sri Lanka, Qatar and Dubai International Finance Centre and representative offices in United Arab Emirates, China, South Africa, Bangladesh, Thailand, Malaysia and Indonesia. Our UK subsidiary has established branches in Belgium and Germany. ICICI Bank's equity shares are listed in India on Bombay Stock Exchange and the National Stock Exchange of India Limited and its American Depositary Receipts (ADRs) are listed on the New York Stock Exchange (NYSE). Effect of Financial Crisis The major financial crisis of the 21st century involves esoteric instruments, unaware regulators, and nervous investors. Starting in the summer of 2007, the United States experienced a startling contraction in wealth, triggered by the sub prime crisis, thereby leading to increase in risk spreads, and decrease in credit market functioning. During boom years, mortgage brokers enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without credit checks. Higher default levels, particularly among less credit-worthy borrowers, magnified the impact of the crisis on the financial sector. The same financial crisis, which started last summer, is back with a vengeance. Paul Krugman describes the analogy between credit – lending between market players and the financial markets, and motor oil to car engines. The ability to raise cash on short notice, i.e. liquidity, is an essential lubricant for the markets and for the economy as a whole. The drying liquidity has closed shops of a large number of credit markets. Interest rates have been rising across the world, even rates at which banks lend to each other. The freezing up of the financial markets will ultimately lead to a severe reduction in the rate of lending, followed by slowed and drastically reduced business investments, leading to a recession, possibly a nasty one. A collapse of trust between market players has decreased the willingness of lending institutions to risk money. The major reason behind this lack of trust being the bursting of the housing bubble, which caused a lot of AAA labeled investments to turn out to be junk.

48 The IMF has warned the global economy of a spiraled mortgage crisis, starting in the United States, ultimately leading to the largest financial shock since the Great Depression. Since 1864, American Banking has been split into commercial banks and investment banks. But now that’s changing. Some of the biggest names on Wall Street, Bear Stearns, Lehman Brothers, and Merrill Lynch, have disappeared into thin air overnight. Goldman Sachs and Morgan Stanley are the only two giants left. Nervous investors have been sending markets plunging down. Even Morgan Stanley, one of the last two big independent investment banks on Wall Street, is struggling to survive at the exchange, though it insists that the company is still in solid shape. Markets all over the world are confronted by all-time low figures in the past couple of years or more, including those of Britain, Germany, and Asia. In India, IT companies, with nearly half of their revenues coming from banking and financial service segments, are close monitors of the financial crisis across the world. The IT giants which had Lehman Brothers and Merrill Lynch as their clients are TCS, Wipro, Satyam, and Infosys Technologies. HCL escaped the loss to a great extent because neither Lehman Brothers nor ML was its client. The government has a reason to worry because the ongoing financial crisis may have an adverse impact on the banks. Lehman Brothers and Merrill Lynch had invested a substantial amount in the stocks of Indian Banks, which in turn had invested the money in derivatives, leading to the exposure of even the derivates market to these investment bankers. The real estate sector is also affected due to the same factor. Lehman Brothers’ real estate partner had given Rs. 7.40 crores to Unitech Ltd., for its mixed use development project in Santa Cruz. Lehman had also signed a MoU with Peninsula Land Ltd, an Ashok Piramal real estate company, to fund the latter’s project amounting to Rs. 576 crores. DLF Assets, which holds an investment worth $200 million, is another major real estate organization whose valuations are affected by the Lehman Brothers dissolution. Britain has also witnessed the so called “bursting of the Brown bubble”, in the form of the highest personal debt per capita in the G7 combined with an unsustainable rise in housing prices. The longest period of expansion in the 21st century, which Britain

49 claimed to be undergoing, eventually revealed itself of being an illusion. The illusion of rising to prosperity has been maintained by borrowing to spend, often in the form of equity withdrawal from increasing expensive houses. The bubble ultimately burst, exposing Britain to the most serious financial crisis since the 1920s. This brings a lot of misery for home owners who are set to see the cost of mortgages soar following the deepening of the banking crisis and the Libor – the rate at which banks lend to each other. The impact of the crisis is more vividly observable in the emerging markets which are suffering from one of their biggest sell-offs. “Everyone has exposure to everything…either directly or indirectly”, JP Morgan analyst, Brian Johnson Economies with disproportionate offshore borrowings (like that of Australia) are adversely affected by the western financial crunch. Globalization has ensured that none of the economies of the world stay insulated from the present financial crisis in the developed economies. Analysis of the impact of the crisis on India can be on the basis of the following 3 criteria: 1. Availability of global liquidity 2. Demand for India investment and cost thereof 3. Decreased consumer demand affecting Indian exports The main source of Indian prosperity was Foreign Direct Investment (FDI). American and European companies were bringing in truck-loads of dollars and Euros to get a piece of the pie of Indian prosperity. Less inflow of foreign investment will result in the dilution of the element of GDP driven growth. Liquidity is a major driving force of the strong market performances we have seen in emerging markets. Markets such as those of India are especially dependent on global liquidity and international risk appetite. While interest rates in some countries are increasing, countries such as Brazil are decreasing interest rates. In general, rising interest rates tend to have a negative impact on global liquidity and subsequently equity prices as fund may move into bonds and other money markets.

50 Indian companies which had access to foreign funds for financing their import and export will be worst hit Foreign funds will be available at huge premiums and will be limited only to the blue-chip companies, thus leading to: o Reduced capacity of expansion leading to supply – side pressure o Increased interest rates to affect corporate profitability o Increased demand for domestic liquidity will put interest rates under pressure Consumer demand will face a slow-down in developed economies leading to a reduced demand for Indian goods and services, thus affecting Indian exports o Export oriented units will be worst hit, thus impacting employment o Widening of the trade gap due to reduced exports, leading to pressure on the rupee exchange rate Impact on Financial Markets: o Equity market will continue to remain in bearish mood o Demand for domestic liquidity will push interest rates high and as a result will lead to rupee depreciation and depleted currency reserves “Every happy family is alike, but every unhappy family is unhappy in their own way.” – Leo Tolstoy. While each financial crisis is undoubtedly distinct, there are also striking similarities between them in growth patterns, debt accumulation, and in current account deficits.

Impact on ICICI bank The move by Lehman Brothers Holdings, the fourth-largest investment bank to file for bankruptcy in the US, will impact the country’s largest private bank ICICI Bank partly. The bank will have to take a hit of $28 million on account of the additional provisioning that ICICI Bank’s UK subsidiary will have to make. During this quarter, ICICI Bank pared its credit default swap (CDS) exposures to overseas corporate from $650 million to

51 $80 million. Some of the larger state-owned banks are also likely to take small hits because of mark-to-market provisioning on their overseas investments. ICICI Bank will also have to make additional provisioning on its investments in corporate bonds and on CDS exposures of Indian corporates. However, officials in the Mumbai-based bank said that the provisioning requirement for these investments is not substantial. For the first quarter of FY09, ICICI Bank had reported a net profit of Rs 728 crore. ICICI Bank’s UK subsidiary had investments of euro 57 million (around $80 million) in senior bonds of Lehman Brothers. It has already made a provision of close to $12 million against investment in these bonds. Assuming a recovery of 50% of these investments, the additional provision required would be about $28 million. The bank has already made a provision of $188 million in its international books at the end of March 2007-08. According to a research report by broking house Edelweiss, the UK subsidiary would have to book mark-to-market losses of $200 million. The report said that the subsidiary had $600 million investments in mortgage-backed securities and another $500 million investment in corporate bonds. However, bank officials said that it was too early to comment on the mark-to-market on corporate bonds as things could change if the Fed cuts rates. ICICI Bank and its subsidiaries had consolidated total assets of Rs 484,643 crore as on June 30, while ICICI Bank UK had total assets of around $8.7 billion. At the end of the last quarter, the bank had on its books CDS papers of overseas clients in the range of close to $650 million. Subsequently, the bank was able to pare this to $80 million. The bank also has close to $1.5 billion of CDS of Indian papers. It is likely to take a small hit on these investments. Some of the other Indian banks such as State Bank of India would also have to take a mark-to-market hit on its investments. SBI officials said that it was too early to quantify the amount. ICICI Bank Ltd., India's second- largest bank, reported $264 million of costs to write down the value of overseas investments, the biggest loss disclosed by an Indian bank since the collapse of the U.S. subprime-loan market. The bank set aside $90 million through December and $70 million will be earmarked in fourth-quarter earnings. The rest will be set off against the bank's net worth.

52 So far, 45 of the world's biggest banks and securities firms have written down or lost $181 billion related to investments tied to rising defaults on U.S. home loans or to people with poor credit histories. The company has the largest holdings of overseas investments among the nation's major banks and has been expanding internationally to counter slowing demand for credit in India. The value of the subprime-related investments in its $2 billion of overseas assets dropped because investors are shunning all except the safest securities

53

Chapter 4 Data Analysis and Interpretation Financial of ICICI bank Performance Review – Quarter ended September 30, 2008 • Profit after tax of Rs. 1,014 crore; 39% increase over first quarter • 42% year-on-year increase in core operating profit • 12% year-on-year reduction in costs due to cost rationalization measures • Capital adequacy of 14.01% • CASA ratio increased to 30% from 25% a year ago The Board of Directors of ICICI Bank Limited (NYSE: IBN) at its meeting held at Mumbai today, approved the audited accounts of the Bank for the quarter ended September 30, 2008 (Q2-2009).Highlights • The profit after tax for Q2-2009 was Rs. 1,014 crore (US$ 216 million) compared to the profit after tax of Rs. 1,003 crore (US$ 214 million) for the quarter ended September 30, 2007 (Q2-2008). • The profit after tax for Q2-2009 represents an increase of 39% over the profit after tax of Rs. 728 crore (US$ 155 million) in the quarter ended June 30, 2008 (Q1-2009). • Core operating profit (operating profit excluding treasury) increased 42% to Rs. 2,437 crore (US$ 519 million) for Q2-2009 from Rs. 1,712 crore (US$ 365 million) for Q22008. • Net interest income increased 20% to Rs. 2,148 crore (US$ 457 million) for Q2-2009 from Rs. 1,786 crore (US$ 380 million) for Q2- 2008. • Fee income increased 26% to Rs. 1,876 crore (US$ 399 million) for Q2-2009 from Rs. 1,486 crore (US$ 316 million) for Q2-2008. • Operating expenses1 decreased 12% to Rs. 1,688 crore (US$ 359 million) for Q2-2009 from Rs. 1,926 crore (US$ 410 million) for Q2- 2008 due to the Bank’s focus on efficiency improvement and cost rationalization. The cost/average asset ratio for Q2-2009

54 was 1.7% compared to 2.1% for Q2-2008, and the cost/income ratio for Q2- 2009 was 42.5% compared to 50.5% for Q2-2008. Operating review Deposit growth The Bank has adopted a conscious strategy of focusing on current and savings account deposits and reducing its wholesale term deposit base. Current and savings account deposits increased 16% to Rs. 66,914 crore (US$ 14.2 billion) at September 30, 2008 from Rs. 57,827 crore (US$ 12.3 billion) at September 30, 2007. Current and savings account (CASA) deposits constituted 30% of total deposits at September 30, 2008 compared to 25% at September 30, 2007. Total deposits declined marginally on a yearon-year basis due to the reduction in term deposits pursuant to the strategy adopted by the Bank. The Bank has significantly expanded its branch network to expand its reach and further enhance its deposit franchise. At October 22, 2008, the Bank had 1,400 branches and 4,530 ATMs. Credit growth Consolidated advances of the Bank and its banking subsidiaries and ICICI Home Finance Company increased 16% to Rs. 264,665 crore (US$ 56.4 billion) at September 30, 2008 from Rs. 227,583 crore (US$ 48.5 billion) at September 30, 2007.

International operations ICICI Bank’s international business continued to focus on: • Building a retail deposit base which gives the Bank access to low cost deposits on a sustainable basis. • Being the preferred financier and adviser for overseas expansion of Indian corporate and strengthening the global syndication network. • Being the preferred bank for non-resident Indians: The Bank’s remittance volumes increased by 38.2% in Q2-2009 to about Rs. 11,946 crore (US$ 2.5 billion) compared to Q2-2008.

55 ICICI Bank Canada’s profit after tax for the six months ended September 30, 2008 (H12009) was CAD 22 million. ICICI Bank Canada’s capital position continued to be strong with a capital adequacy ratio of 15.4% at September 30, 2008. ICICI Bank Canada’s deposit base increased by over CAD 1.0 billion during the quarter to CAD 4.85 billion at September 30, 2008, of which 86% was term deposits. ICICI Bank UK’s profit before mark to market impact and provision on investments was US$ 43 million for H1-2009. After the required provisioning charge in respect of its investment portfolio (including the mark-to-market impact of credit spread widening during the period), ICICI Bank UK reported a net loss of US$ 35 million. ICICI Bank UK’s capital position continued to be strong with a capital adequacy ratio of 18.4% at September 30, 2008. ICICI Bank UK’s deposit base was US$ 4.9 billion at September 30, 2008, of which 39% was term deposits. At September 30, 2008, ICICI Bank UK had zero net non-performing assets. The Bank and its subsidiaries have entirely exited their non-India linked credit derivatives portfolio at no incremental loss over and above the provisions already held.

Capital adequacy The Bank’s capital adequacy at September 30, 2008 as per Reserve Bank of India’s revised guidelines on Basel II norms was 14.01% and Tier-1 capital adequacy was 11.03%, well above RBI’s requirement of total capital adequacy of 9.0% and Tier-1 capital adequacy of 6.0%. Table 4 (Rs in billion)

MAR 31, 2008 JUNE 30, 2008 SEP 30. 2008 TOTAL CAPITAL 13.97% 13.42% 14.01% - TIER 1 11.76% 11.29% 11.03% - TIER 2 2.20% 2.13% 2.98% * * Pursuant to clarification received from RBI, Upper Tier II capital bonds of US$ 750 mn issued in January 2007 are included in Tier-II capital.

Asset quality

56 At September 30, 2008, the Bank’s net non-performing asset ratio was 1.8% on an unconsolidated basis. The consolidated net NPA ratio of the Bank and its subsidiaries was 1.6%. The specific provisions for nonperforming assets (excluding the impact of farm loan waiver) were Rs. 868 crore (US$ 185 million) in Q2-2009 compared to Rs. 878 crore (US$ 187 million) in Q1-2009. Table 5 GROSS NPAs Less: cumulative w/offs and provision NET NPAs 30.36 NET NPA ratio 1.41% SEP 30,2007 66.89 36.53 MAR 31, 2008 83.50 47.86 JUNE 30, 2008 92.82 51.80 (Rs in billion)

SEP 30. 2008 102.71 59.72

35.64 1.49%

41.02 1.74%

42.99 1.83%

Consolidated net NPA ratio of the Bank and its subsidiaries at 1.6% Gross retail NPLs of Rs. 69.57 bn and net retail NPLs of Rs. 26.77 bn at September 30, 2008 Unsecured products constitute 57% of net retail NPLs Performance highlights of insurance subsidiaries ICICI Prudential Life Insurance Company (ICICI Life) increased its overall market share in retail new business weighted received premiums from 12.7% in the year ended March 31, 2008 (FY2008) to 13.7% during April- August 2008. New business weighted received premium increased by 22% in H1-2009 to Rs. 2,650 crore (US$ 564 million). While ICICI Life’s results reduced the consolidated profit after tax of ICICI Bank by Rs. 466 crore (US$ 99 million) in H1-2009, ICICI Life’s unaudited New Business Profit (NBP)2 in H1-2009 was Rs. 522 crore (US$ 111 million). Assets held increased to Rs. 30,107 crore (US$ 6.4 billion) at September 30, 2008. ICICI Lombard General Insurance Company (ICICI General) increased its overall market share from 11.9% in FY2008 to 12.5% during April-August 2008. ICICI General’s premiums increased 12.2% on a year-on-year basis to Rs. 1,925 crore (US$ 410 million) in H1-2009.

57

Other subsidiaries PROFIT AFTER TAX ICICI Securities Ltd. ICICI Securities PD ICICI Venture ICICI AMC ICICI Home Finance H-1 2008 0.37 0.99 0.27 0.53 0.29 H-1 2009 0.24 0.21 1.39 0.44 0.39

(Rs in billion)

Summary Profit and Loss Statement Table 6 (Rs in crore)Summary Balance Sheet Table 7 (Rs in crore)

58

Source: Company website

Balance sheet for Q2 FY09 Assets Table 8 (Rs in billion)

Source: Company website

Liabilities Table 9 (Rs in billion)

59

Source: Company website

Comparison Comparison of banks on various parameters I analysed the above banks on various parameters to find out how they are placed in terms of business growth, efficiency and the comfort they provide in terms of their current financial standing and business exposures. The growth-related variables indicate the last 5-year CAGR banks achieved in advances and deposits. It also carries a ranking of these banks in terms of their latest CASA ratio. Axis Bank emerges as an out-performer in this category. On efficiency-related parameters, the cost/income ratio, quality of advances and the extent of loan loss-loss provision coverage have been reviewed, and banks have been accordingly ranked. PNB leads the pack with high scores in each variable. In the next segment, certain comfort-related yardsticks have been compared. Capitalraising by banks to bolster future growth, real estate exposure and overseas dependence for the business have been compared. Although PNB did not raise any fresh capital and ranks last on that metric, it ranks as the best bank with lower real estate and foreign exposure, which is critical during a global economic slowdown. Also, we analysed banks that generate the maximum core interest income as a proportion of total income. ICICI Bank and Axis Bank have greater proportions of their income coming from 'other income' and these segments might have greater tendency to show slower growth in the current scenario. A detailed analysis of the above parameters is presented in the ensuing paragraphs.

60

Growth metric - Loan growth comparison The chart below shows that the last 5 years loan growth achieved by India's major banks. HDFC Bank showed consistent growth over the last 3 years (even though it shows a slight falling trend in the 5-year chart). Axis Bank achieved a high compounded annual growth during this period, followed by ICICI Bank. Table 10 Loan growth CAGR (from FY04 to FY08) AXIS BANK 59% BOB 32% BOI 25% HDFC 37% ICICI 38% PNB 26% SBI 27%Growth metric - Deposit comparison In terms of the deposit growth (CAGR) achieved by these banks during the last 5 years, Axis Bank and ICICI Bank retain top two slots as seen in loan growth. ICICI Bank registered a deposit growth of just 6% in FY08. This was in sharp contrast to the 40% growth the bank achieved in the 4 years before FY08. PSU banks, on the other hand, grew at a much slower pace. AXIS BANK 43% BOB 20% BOI 20% HDFC 35% Table 11 ICICI 38% PNB 17% SBI 14% Deposits growth CAGR (from FY04 to FY08)

61

Source: Antique research

Graph 7

Loan book analysis - Unsecured loans and NPAs Unsecured loans primarily include personal loans and credit card exposures, priority sector lending in rural areas, education loans, credits to SMEs (small and medium entrepreneurs) up to Rs 5 lakh, etc. Exposure of Indian banks towards unsecured loans rose consistently over the years. As shown in the chart below, HDFC Bank has the highest, with around 30% of its total loans exposed to such loans.

Source: Company website

Graph 8

Though there is no direct correlation between loan losses and unsecured loan exposure, in an economic slowdown scenario, such exposure will carry a greater stress, and hence, a higher probability of default. Banks need to be extremely vigilant in terms of monitoring these loans regularly, so that losses in the form of NPAs do not increase unreasonably and dent the quality of the loan book. However, a review of the gross NPA ratio, i.e., GNPA as a percentage of advances indicates that HDFC Bank and other banks have ensured that the NPA increase is

62 proportionate to that of the loan growth. In fact, PSU banks have shown tremendous improvement in terms of loan quality, as the GNPA ratio for these banks fell from average 8-9% levels to less than 3% levels in the last 5 years. Only ICICI Bank has shown deterioration of its loan quality as reflected in its increasing GNPA ratio. The main reason for this increase is that the bank has substantial exposure to the retail segment, including huge exposure to the real estate segment at almost 36% of total loans that includes close to 30% exposure in the form of housing loans. The retail segment constitutes close to 75% of ICICI Bank's NPAs. Composition of loan book: Sept 30, 2008

Graph 9 Total loan book: Rs. 2,220 bn H1-2009 1 Small ticket personal loans Total retail loan book: Rs. 1,225 bn Total retail disbursements (including ICICI Housing Finance Company): Rs. 170.00 bn in

Source: Antique research

Graph 10

Efficiency comparison - Cost / Income ratios of banks

63 In terms of control over costs, the below table explains cost/income ratios of these banks over the last 5 years. At the end of FY08, all banks have a similar cost/income ratio averaging between 48- 50%. However, Bank of India has substantially lower cost-toincome ratio of 42%.

Source: Antique research

Graph 11

Source: Antique research

Source: Antique research

Graph 12

64 A not-so-encouraging sign in terms of NPA management of Indian banks is the fact that the loan loss coverage ratio for banks as a group has reduced over the last 2 years. From 60% levels, the coverage ratio has fallen to around 55%.

Source: Antique research

Graph 13

In terms of provision coverage for specific banks, Axis Bank has a low coverage ratio in the private bank group at around 50%, and the SBI has a ratio of 42%, the lowest in PSU banks in the comparison chart below.

Source: Antique research

Graph 14

65

Basel Report Framework and India Various risks in bank Liquidity Risk Market Liquidity Risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price. Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations. For banks, funding liquidity risk is more crucial. Interest Rate Risk Interest Rate Risk (IRR) is the exposure of a Bank’s financial condition to adverse movements in interest rates. Banks have an appetite for this risk and use it to earn returns. IRR manifests itself in four different ways: re-pricing, yield curve, basis and embedded options. Pricing Risk Pricing Risk is the risk to the bank’s financial condition resulting from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities and currencies. Pricing Risk is usually measured as the potential gain/loss in a position/portfolio that is associated with a price movement of a given probability over a specified time horizon. This measure is typically known as value-atrisk (VAR). Foreign Currency Risk Foreign Currency Risk is pricing risk associated with foreign currency. Market Risk The term Market Risk applies to (i) that part of IRR which affects the price of interest rate instruments, (ii) Pricing Risk for all other assets/portfolio that are held in the trading book of the bank and (iii) Foreign Currency Risk. Strategic Risk

66 Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organization’s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation. Reputation Risk Reputation risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss, or a decline in customer base. Transaction Risk Transaction risk is the risk arising from fraud, both internal & external, failed business processes and the inability to maintain business continuity and manage information. Compliance Risk Compliance risk is the risk of legal or regulatory sanctions, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, codes of conduct and standards of good practice. It is also called integrity risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing. Operational Risk The term Operational Risk includes both compliance risk and transaction risk but excludes strategic risk and reputation risk. Credit Risk Credit Risk is most simply defined as the potential of a bank borrower or counter-party to fail to meet its obligations in accordance with agreed terms. For most banks, loans are the largest and most obvious source of credit risk. Banking Regulation and Supervision The Need for Regulation Banking is one of the most heavily regulated businesses since it is a very highly leveraged (high debt-equity ratio or low capital-assets ratio) industry. In fact, it is an irony that banks, which constantly judge their borrowers on debt-equity ratio, have themselves a debt-equity ratio far too adverse than their borrowers! In simple words, they

67 earn by taking risk on their creditors’ money rather than shareholders’ money. And since it is not their money (shareholders’ stake) on the block, their appetite for risk needs to be controlled.

Goals and Tools for Bank Regulation and Supervision The main goal of all regulators is the stability of the banking system. However, regulators cannot be concerned solely with the safety of the banking system, for if that was the only purpose, it would impose a narrow banking system, in which checkable deposits are fully backed by absolutely safe assets – in the extreme, currency. Coexistent with this primary concern is the need to ensure that the financial system operates efficiently. As we have seen, banks need to take risks to be in business despite a probability of failure. In fact, Alan Greenspan puts it very succinctly, `providing institutions with the flexibility that may lead to failure is as important as permitting them the opportunity to succeed’. The twin supervisory or regulatory goals of stability and efficiency of the financial system often seem to pull in opposite directions and there is much debate raging on the nature and extent of the trade-off between the two. Though very interesting, it is outside the scope of this report to elaborate upon. Instead, let us take a look at the list of some tools that regulators employ: • Restrictions on bank activities and banking-commerce links: To avoid conflicts of interest that may arise when banks engage in diverse activities such as securities underwriting, insurance underwriting, and real estate investment. • Restrictions on domestic and foreign bank entry: The assumption here is that effective screening of bank entry can promote stability. • Capital Adequacy: Capital serves as a buffer against losses and hence also against failure. Capital adequacy is deemed to control risk appetite of the bank by aligning the incentives of bank owners with depositors and other creditors.

68 • Deposit Insurance: Deposit insurance schemes are to prevent widespread bank runs and to protect small depositors but can create moral hazard (which means in simple terms the propensity of both firms and individuals to take more risks when insured). • Information disclosure & private sector monitoring: Includes certified audits and/or ratings from international rating agencies. Involves directing banks to produce accurate, comprehensive and consolidated information on the full range of their activities and risk management procedures. • Government Ownership: The assumption here is that governments have adequate information and incentives to promote socially desirable investments and in extreme cases can transfer the depositors’ loss to tax payers! Government ownership can, at times, promote financing of politically attractive projects and not the economically efficient ones. • Mandated liquidity reserves: To control credit expansion and to ensure that banks have a reasonable amount of liquid assets to meet their liabilities. • Loan classification, provisioning standards & diversification guidelines: These are controls to manage credit risk. `Unfortunately, however, there is no evidence that any universal set of best practices is appropriate for promoting well-functioning banks; that successful practices in the United States, for example, will succeed in countries with different institutional settings; or that detailed regulations and supervisory practices should be combined to produce an extensive checklist of best practices in which more checks are better than fewer. There is no broad cross-country evidence on which of the many different regulations and supervisory practices employed around the world work best, if at all, to promote bank development and stability.’ The Basel I Accord Basel Committee on Banking Supervision (BCBS) On 26th June 1974, a number of banks had released Deutschmarks to Bank Herstatt in Frankfurt in exchange for dollar payments that were to be delivered in New York. Due to differences in time zones, there was a lag in dollar payments to counter-party banks during which Bank Herstatt was liquidated by German regulators, i.e. before the dollar payments could be affected.

69 The Herstatt accident prompted the G-10 countries (the G-10 is today 13 countries: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States) to form, towards the end of 1974, the Basel Committee on Banking Supervision (BCBS), under the auspices of the Bank for International Settlements (BIS), comprising of Central Bank Governors from the participating countries. BCBS has been instrumental in standardizing bank regulations across jurisdictions with special emphasis on defining the roles of regulators in cross-jurisdictional situations. The committee meets four times a year. It has around 30 technical working groups and task forces that meet regularly.

1988 Basel Accord In 1988, the Basel Committee published a set of minimal capital requirements for banks, known as the 1988 Basel Accord. These were enforced by law in the G-10 countries in 1992, with Japanese banks permitted an extended transition period. The 1988 Basel Accord focused primarily on credit risk. Bank assets were classified into five risk buckets i.e. grouped under five categories according to credit risk carrying risk weights of zero, ten, twenty, fifty and one hundred per cent. Assets were to be classified into one of these risk buckets based on the parameters of counter-party (sovereign, banks, public sector enterprises or others), collateral (e.g. mortgages of residential property) and maturity. Generally, government debt was categorised at zero per cent, bank debt at twenty per cent, and other debt at one hundred per cent. 100%. OBS exposures such as performance guarantees and letters of credit were brought into the calculation of risk weighted assets using the mechanism of variable credit conversion factor. Banks were required to hold capital equal to 8% of the risk weighted value of assets. Since 1988, this framework has been progressively introduced not only in member countries but also in almost all other countries having active international banks. The 1988 accord can be summarized in the following equation: Total Capital = 0.08 x Risk Weighted Assets (RWA) The accord provided a detailed definition of capital. Tier 1 or core capital, which includes equity and disclosed reserves, and Tier 2 or supplementary capital, which could include

70 undisclosed reserves, asset revaluation reserves, general provisions & loan–loss reserves, hybrid (debt/equity) capital instruments and subordinated debt.

Value at Risk (VAR) VAR is a method of assessing risk that uses standard statistical techniques and provides users with a summary measure of market risk. For instance, a bank might say that the daily VAR of its trading portfolio is rupees 20 million at the 99 per cent confidence level. In simple words, there is only one chance in 100, under normal market conditions, for a loss greater than rupees 20 million to occur. This single number summarizes the bank's exposure to market risk as well as the probability (one per cent, in this case) of it being exceeded. Shareholders and managers can then decide whether they feel comfortable at this level of risk. If not, the process that led to the computation of VAR can be used to decide where to trim risk. Now the definition; `VAR summarizes the predicted maximum loss (or worst loss) over a target horizon within a given confidence interval’. Target horizon means the period till which the portfolio is held. Ideally, the holding period should correspond to the longest period needed for an orderly (as opposed to a `fire sale’) portfolio liquidation. Without going into the related math, it should be mentioned here that there exist three methods of computing VAR, viz. Delta-Normal, Historical Simulation and Monte Carlo Simulation, the last one being the most computation intensive and predictably the most sophisticated one. In a lighter vein, a definition of VAR that was found at the gloriamundi.org web site said, `A number invented by purveyors of panaceas for pecuniary peril intended to mislead senior management and regulators into false confidence that market risk is adequately understood and controlled.’ 1996 Amendment to include Market Risk In 1996, BCBS published an amendment to the 1988 Basel Accord to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. This amendment was brought into effect in 1998.

71 Salient Features • Allows banks to use proprietary in-house models for measuring market risks. • Banks using proprietary models must compute VAR daily, using a 99th percentile, onetailed confidence interval with a time horizon of ten trading days using a historical observation period of at least one year. • The capital charge for a bank that uses a proprietary model will be the higher of the previous day's VAR and three times the average of the daily VAR of the preceding sixty business days. • Use of `back-testing’ (ex-post comparisons between model results and actual performance) to arrive at the `plus factor’ that is added to the multiplication factor of three. • Allows banks to issue short-term subordinated debt subject to a lock-in clause (Tier 3 capital) to meet a part of their market risks. • Alternate standardized approach using the `building block’ approach where general market risk and specific security risk are calculated separately and added up. • Banks to segregate trading book and mark to market all portfolio/position in the trading book. • Applicable to both trading activities of banks and non-banking securities firms. Evolution of Basel Committee Initiatives

The Basel I Accord and the 1996 Amendment thereto have evolved into Basel II, as depicted in the figure above.

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The New Accord (Basel II) Close on the heels of the 1996 amendment to the Basel I accord, in June 1999 BCBS issued a proposal for a New Capital Adequacy Framework to replace the 1988 Accord. The proposed capital framework consists of three pillars: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. The accord has been finalized recently on 11th May 2004 and the final draft is expected by the end of June 2004. For banks adopting advanced approaches for measuring credit and operational risk the deadline has been shifted to 2008, whereas for those opting for basic approaches it is retained at 2006.The Need for Basel II The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad brush structure) for measuring credit risk. For example, all corporations carry the same risk weight of 100 per cent. It also gave rise to a significant gap between the regulatory measurement of the risk of a given transaction and its actual economic risk. The most troubling side effect of the gap between regulatory and actual economic risk has been the distortion of financial decision-making, including large amounts of regulatory arbitrage, or investments made on the basis of regulatory constraints rather than genuine economic opportunities. The strict rule based approach of the 1988 accord has also been criticised for its `one size fits all’ prescription. In addition, it lacked proper

73 recognition of credit risk mitigants such as credit derivatives, securitisation, and collaterals. The recent cases of frauds, acts of terrorism, hacking, have brought into focus the operational risk that the banks and financial institutions are exposed to. The proposed new accord (Basel II) is claimed by BCBS to be `an improved capital adequacy framework intended to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities’. It also seeks to provide a `level playing field’ for international competition and attempts to ensure that its implementation maintains the aggregate regulatory capital requirements as obtaining under the current accord. The new framework deliberately includes incentives for using more advanced and sophisticated approaches for risk measurement and attempts to align the regulatory capital with internal risk measurements of banks subject to supervisory review and market disclosure.

PILLAR I: Minimum Capital Requirements There is a need to look at proposed changes in the measurement of credit risk and operational risk.

Credit Risk

74 Three alternate approaches for measurement of credit risk have been proposed. These are: • Standardised • Internal Ratings Based (IRB) Foundation • Internal Ratings Based (IRB) Advanced The standardised approach is similar to the current accord in that banks are required to slot their credit exposures into supervisory categories based on observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current accord. The risk weights for sovereign, inter-bank, and corporate exposures are differentiated based on external credit assessments. An important innovation of the standardised approach is the requirement that loans considered `past due’ be risk weighted at 150 per cent unless, a threshold amount of specific provisions has already been set aside by the bank against that loan. Credit risk mitigants (collaterals, guarantees, and credit derivatives) can be used by banks under this approach for capital reduction based on the market risk of the collateral instrument or the threshold external credit rating of recognised guarantors. Reduced risk weights for retail exposures, small and medium size enterprises (SME) category and residential mortgages have been proposed. The approach draws a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. The IRB approach uses banks’ internal assessments of key risk drivers as primary inputs to the capital calculation. The risk weights and resultant capital charges are determined through the combination of quantitative inputs provided by banks and formulae specified by the Committee. The IRB calculation of risk weighted assets for exposures to sovereigns, banks, or corporate entities relies on the following four parameters:

Probability of default (PD), which measures the likelihood that the borrower will default over a given time horizon.

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Loss given default (LGD), which measures the proportion of the exposure that will be lost if a default occurs. Exposure at default (EAD), which for loan commitment measures the amount of the facility that is likely to be drawn in the event of a default.

Maturity (M), which measures the remaining economic maturity of the exposure.

Operational Risk Within the Basel II framework, operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events. Operational risk identification and measurement is still in an evolutionary stage as compared to the maturity that market and credit risk measurements have achieved. As in credit risk, three alternate approaches are prescribed: • Basic Indicator • Standardised • Advanced Measurement (AMA)PILLAR 2: Supervisory Review Process Pillar 2 introduces two critical risk management concepts: the use of economic capital, and the enhancement of corporate governance, encapsulated in the following four principles: • Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

The key elements of this rigorous process are: • Board and senior management attention; • Sound capital assessment;

76 • Comprehensive assessment of risks; • Monitoring and reporting; and • Internal control review. • Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

This could be achieved through: • On-site examinations or inspections; • Off-site review; • Discussions with bank management; • Review of work done by external auditors; and • Periodic reporting. • Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. • Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. Prescriptions under Pillar 2 seek to address the residual risks not adequately covered under Pillar 1, such as concentration risk, interest rate risk in banking book, business risk and strategic risk. `Stress testing’ is recommended to capture event risk. Pillar 2 also seeks to ensure that internal risk management process in the banks is robust enough. The combination of Pillar 1 and Pillar 2 attempt to align regulatory capital with economic capital.

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PILLAR 3: Market Discipline The focus of Pillar 3 on market discipline is designed to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). With this, the Basel Committee seeks to enable market participants to assess key information about a bank’s risk profile and level of capitalization—thereby encouraging market discipline through increased disclosure. Public disclosure assumes greater importance in helping banks and supervisors to manage risk and improve stability under the new provisions which place reliance on internal methodologies providing banks with greater discretion in determining their capital needs. There has been some confusion on the extent, medium, confidentiality and materiality of such disclosures. It has been agreed that such disclosures will depend on the legal authority and accounting standards existing in each country. Efforts are in progress to harmonise these disclosures with International Financial Reporting Standards’ (IFRS’) Board Standards (International Accounting Standards 30 & 32).

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ICICI BANK BASEL II – PILLAR 3 DISCLOSURES (STANDALONE) for the six months ended September 30, 2008 CAPITAL STRUCTURE a. Amount of Tier-1 capital (September 30, 2008) Table Rupees in billion 12TIER-1 capital element Paid-up share capital/common stock Reserves Innovative Tier-1 capital instruments Gross Tier-1 capital:Amount 12.72 472.82 28.89 514.43Deductions Investment in instruments eligible for 57.69 regulatory capital of financial subsidiaries/associates Intangible assets other than goodwill 17.27 Securitisation exposures including 13.57 credit enhancements Net Tier-1 capital 425.90 b. Amount of Tier-2 capital (September 30, 2008) Table Rupees in billion Tier-2 capital elements General provisions & loss reserves Upper Tier-2 instruments Lower Tier-2 capital instruments Gross Tier-2 capital Deductions Amount 14.58 78.26 93.31 186.15 13

Investments in instruments eligible 57.69 for regulatory capital of financial subsidiaries/associates Securitisation exposure including 13.57 credit enhancement Net Tier-2 capital CAPITAL ADEQUACY 114.89

79 Table 14 in billion Rupees Amount 310.61 18.35Risk area Credit risk Market risk Operational risk Total capital requirement at 9% Total capital funds of the Bank Total risk weighted assets Capital adequacy ratio18.51 347.47 540.79 3,860.87 14.01%24% rise in Banks NPAs in 2nd QR and Capital Adequacy Ratio declines by 2% Points If NPAs and CAR reported by the commercial banks are an indication of the financial strength, the second quarter results of the Indian banking sector do not portray a healthy picture. This is because the net non-performing assets have risen by an average 24 per cent while capital adequacy ratio reduced by 2 percentage points in Q2 of current fiscal as compared to the corresponding period of previous year, according to the ASSOCHAM Eco Pulse (AEP) Study. The ASSOCHAM Study titled “Solvency Analysis of the Indian Banking Sector”, reveals that on an average 24 per cent rise in net non performing assets (NPAs) have been registered by 25 public sector and commercial banks during the second quarter of the FY’09 as against Q2-FY’08. However, the average capital adequacy ratio (CAR) of the banks slipped to 12.68 per cent in Q2-FY ‘09 from 13.41 per cent in the previous year. The analysis of the Indian banking sector was based on the quarterly results posted by 25 Indian banks on Bombay Stock Exchange (BSE) from 20th - 29th October 2008. For a macro analysis, the total 25 banks included an aggregation of 15 public sector banks (PSBs) and 10 private sector banks. The AEP analysis of the Indian banking sector’s solvency is based on two broad parameters including net non performing assets and capital adequacy ratio.

80 “Although the Indian banking sector has remained insulated from the global financial crisis, the emerging trends as found in the AEP do not give positive signals”, says the ASSOCHAM spokesman. As per the AEP, the aggregate net non-performing assets (NPA) of 25 banks increased by 24.36 per cent to Rs 17,522.82 crore in second quarter of 2008-09 from Rs 15,462.84 crore in the same period of FY’08. Karur Vysya Bank recorded maximum rise of 275.36 per cent in net NPAs in Q2-FY’09 with Rs. 50.03 crore as against Rs 13.33 crore in Q207. It was followed by HDFC bank with an increase by 139 per cent, Vijaya Bank (132 per cent), State Bank of Hyderabad (81.42 per cent) and IDBI (57 per cent). On the contrast, seven major PSBs recorded a significant decrease in net NPAs, including Central Bank of India (-87.39 per cent), Oriental bank of Commerce (-82.18 per cent), Union Bank of India (-73.38 per cent), Dena Bank (-17.24 per cent), Bank of India (-14.80 crore), Bank of Maharashtra (-7.75 crore) and Indian Bank (-1.54 per cent) have shown improvement in net NPA levels. Whereas, among the private sector banks only South Indian Bank registered an improvement in net NPAs by -29.82 per cent. In terms of capital adequacy ratio, out of the 25 banks posting their results for the quarter ending September 2008-09, it was found that 16 banks witnessed a fall in their CAR from the previous fiscal, but they still managed to remain above the prescribed limit of nine per cent posed by the Basel II accord. The AEP study also revealed that in Q2 FY’09, there were 11 public sector banks out of the total 16 banks that registered decline in CAR from the previous year. A close looks at their capital adequacy ratio — an indicator to their capital strength — can be handy to drive this point home. All of our banks have capital adequacy ratio (CAR), also called capital to risk weighted assets ratio (CRAR) in conformation with the Basel II accord. CRAR is the measure of the amount of a bank’s capital expressed as a percentage of its risk weighted credit exposures. The ratio determines the capacity of the bank to meet the

81 time liabilities and other risk such as credit risk and operational risk. In the simplest formulation, a bank’s capital is the cushion for potential losses, which protect the bank’s depositors or other lenders. Banking regulators in most countries define and monitor CRAR to protect depositors, thereby maintaining confidence in the banking system. An ET survey of 79 commercial banks finds that all of them have more than 8% CRAR in 2007-08, the minimum that the Basel II accord demands. The average CRAR for the sample banks was estimated at 13%. What is significant is that the CRAR has increased steadily in recent years — it has gone up 0.7 percentage point last year to 13% from 12.3% in 2006-07. The private sector banks seem to have done better than their public sector or foreign counterparts in terms of CRAR. The average CRAR of 23 private sector banks was estimated at 14.3% in 2007-08 compared to 13.2% of the eight banks of the State Bank group, 12.1% of the 20 nationalised banks and 13.1% of the 28 foreign banks. The private sector banks not only have the highest CRAR in 2007-08, they have also witnessed the sharpest rise — up by 2.2 percentage points to 14.3% last year from 12.1% in 2006-07. Foreign banks rose 1.1 percentage point and SBI group saw rise of 0.9 percentage point. The nationalised banks, in contrast, have witnessed a 0.4 percentage spoints fall in CRAR last year over 2006-07. Axis bank registered the maximum decline in CAR from 17.59 per cent in Q2 FY’08 to 12.2 per cent in Q2 FY’09. It was followed by HDFC bank from 14.9 per cent to 11.4 per cent, Bank of Maharashtra from 13.6 per cent to 10.78 per cent and ICICI bank recorded a decline from 16.79 per cent to 14.01 per cent respectively. In the second quarter of current financial year, the Central Bank of India registered a 9.85 per cent CAR from the previous 12.38 per cent. It was the only bank whose CAR dipped just around the thresh hold limit of 9 per cent CAR posed by the Basel II.

82 However, Federal Bank had the maximum rise in CAR upto 20.81 per cent in Q2 FY 2008-09 from 13.08 per cent a year earlier. South Indian Bank at the second position registered a mere increase from 14.36 per cent to 14.44 per cent in the second quarter of current financial year. Other banks which registered a significant rise in CAR include Yes Bank, whose ratio rose to 14.28 per cent over 13.02 per cent in previous year, City Union Bank from 12.85 per cent to 13.24 per cent, Karnataka Bank from 13.03 per cent in the second quarter of the previous fiscal to 13.21 per cent in the current fiscal and Dena Bank registered an increase in the ratio from 11.47 per cent in Q2 FY’09 to 12.34 per cent in same quarter of the last fiscal.

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Chapter 5 Conclusion and Suggestions The issue of Non-Performing Assets (NPAs) in the financial sector has been an area of concern for all economies and reduction in NPAs has become synonymous with functional efficiency of financial intermediaries. Although NPAs are a balance sheet issue of individual banks and financial institutions, it has wider macroeconomic implications. It is important that, if resolution strategies for recovery of dues from NPAs are not put in place quickly and efficiently, these assets would deteriorate in value over time and only scrap value would be realized at the end. It should, however, be kept in mind that NPAs are an integral part of the business financial sector and the players are in as they are in the business of taking risk and their earnings reflect the risk they take. They operate in an environment, where there would be defaults as well as deterioration in portfolio value, as market movements can never be predicted with certainty. It is in this context, that countries have adopted regulatory measures and the guiding structure has been provided by the Basel guidelines. There are various reasons for assets turning non-performing and there can be alternative resolution strategies. Identification of the reasons and timely action are the key to improved profitability of financial sector intermediaries. In this context, the details of the CAMEL model that RBI introduced for evaluating performance of banks and the need for this arose from the systemic generation of large volume of NPAs. CAMEL covers capital adequacy, asset quality, management quality, earnings ability and liquidity. Indian economy and NPAs Undoubtedly the world economy has slowed down, recession is at its peak, globally stock markets have tumbled and business itself is getting hard to do. The Indian economy has been much affected due to high fiscal deficit, poor infrastructure facilities, sticky legal system, cutting of exposures to emerging markets by FIIs, etc. Further, international rating agencies like, Standard & Poor have lowered India's credit rating to sub-investment grade. Such negative aspects have often outweighed positives such as increasing forex reserves and a manageable inflation rate.

84 Under such a situation, it goes without saying that banks are no exception and are bound to face the heat of a global downturn. One would be surprised to know that the banks and financial institutions in India hold non-performing assets worth Rs. 1,10,000 crores. Bankers have realized that unless the level of NPAs is reduced drastically, they will find it difficult to survive. Global Developments and NPAs The core banking business is of mobilizing the deposits and utilizing it for lending to industry. Lending business is generally encouraged because it has the effect of funds being transferred from the system to productive purposes which results into economic growth. However lending also carries credit risk, which arises from the failure of borrower to fulfill its contractual obligations either during the course of a transaction or on a future obligation. A question that arises is how much risk can a bank afford to take ? Recent happenings in the business world - Enron, WorldCom, Xerox, Global Crossing do not give much confidence to banks. In case after case, these giant corporates became bankrupt and failed to provide investors with clearer and more complete information thereby introducing a degree of risk that many investors could neither anticipate nor welcome. The history of financial institutions also reveals the fact that the biggest banking failures were due to credit risk. Due to this, banks are restricting their lending operations to secured avenues only with adequate collateral on which to fall back upon in a situation of default. Performance in terms of profitability is a benchmark for any business enterprise including the banking industry. However, increasing NPAs have a direct impact on banks profitability as legally banks are not allowed to book income on such accounts and at the same time banks are forced to make provision on such assets as per the Reserve Bank of India (RBI) guidelines. Reserve Bank of India (RBI) has issued guidelines on provisioning requirement with respect to bank advances. In terms of these guidelines, bank advances are mainly classified into:

85 Standard Assets: Such an asset is not a non-performing asset. In other words, it carries not more than normal risk attached to the business. Sub-standard Assets: Which has remained NPA for a period less than or equal to 12 months. Doubtful Assets: This has remained in the sub-standard category for a period of 12 months .Loss Assets: Here loss is identified by the banks concerned or by internal auditors or by external auditors or by Reserve Bank India (RBI) inspection. In terms of RBI guidelines, as and when an asset becomes a NPA, such advances would be first classified as a sub-standard one for a period that should not exceed 12 months and subsequently as doubtful assets. It should be noted that the above classification is only for the purpose of computing the amount of provision that should be made with respect to bank advances and certainly not for the purpose of presentation of advances in the banks balance sheet. Provision Standard Assets – general provision of a minimum of 0.25% Substandard Assets – 10% on total outstanding balance, 10 % on unsecured exposures identified as sub-standard & 100% for unsecured “doubtful” assets. Doubtful Assets – 100% to the extent advance not covered by realizable value of security. In case of secured portion, provision may be made in the range of 20% to 100% depending on the period of asset remaining sub-standard Loss Assets – 100% of the outstanding

Management of NPA During initial sage the percentage of NPA was higher. This was due to show ineffective recovery of bank credit, lacuna in credit recovery system, inadequate legal provision etc. Various steps have been taken by the government to recover and reduce NPAs. Some of them are. • Formation of the Credit Information Bureau (India) Limited (CIBIL)

86 • Release of Wilful Defaulter’s List. RBI also releases a list of borrowers with aggregate outstanding of Rs.1 crore and above against whom banks have filed suits for recovery of their funds • • Reporting of Frauds to RBI Norms of Lender’s Liability – framing of Fair Practices Code with regard to lender’s liability to be followed by banks, which indirectly prevents accounts turning into NPAs on account of bank’s own failure • • Risk assessment and Risk management RBI has advised banks to examine all cases of wilful default of Rs.1 crore and above and file suits in such cases. Board of Directors are required to review NPA accounts of Rs.1 crore and above with special reference to fixing of staff accountability. • • Reporting quick mortality cases Special mention accounts for early identification of bad debts. Loans and advances overdue for less than one and two quarters would come under this category. However, these accounts do not need provisioning NPA MANAGEMENT - RESOLUTION • • • • • • • • • • Compromise Settlement Schemes Restructuring / Reschedulement Lok Adalat Corporate Debt Restructuring Cell Debt Recovery Tribunal (DRT) Proceedings under the Code of Civil Procedure Board for Industrial & Financial Reconstruction (BIFR)/ AAIFR National Company Law Tribunal (NCLT) Sale of NPA to other banks Sale of NPA to ARC/ SC under Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (SRFAESI)

87 • Liquidation

The description of these points are as below 1. Restructuring and Rehabilitation a. Banks are free to design and implement their own policies for restructuring/ rehabilitation of the NPA accounts b. Reschedulement of payment of interest and principal after considering the Debt service coverage ratio, contribution of the promoter and availability of security 2. Corporate Debt Restructuring a. The objective of CDR is to ensure a timely and transparent mechanism for restructuring of the debts of viable corporate entities affected by internal and external factors, outside the purview of BIFR, DRT or other legal proceedings b. The legal basis for the mechanism is provided by the Inter-Creditor Agreement (ICA). All participants in the CDR mechanism must enter the ICA with necessary enforcement and penal clauses. c. The scheme applies to accounts having multiple banking/ syndication/ consortium accounts with outstanding exposure of Rs.10 crores and above. d. The CDR system is applicable to standard and sub-standard accounts with potential cases of NPAs getting a priority. e. Packages given to borrowers are modified time & again f. Drawback of CDR – Reaching of consensus amongst the creditors delays the process DRT Act a. The banks and FIs can enforce their securities by initiating recovery proceeding under the Recovery if Debts due to Banks and FI act, 1993 (DRT Act) by filing an application for recovery of dues before the Debt Recovery Tribunal constituted under the Act.

88 b. On adjudication, a recovery certificate is issued and the sale is carried out by an auctioneer or a receiver. c. DRT has powers to grant injunctions against the disposal, transfer or creation of third party interest by debtors in the properties charged to creditor and to pass attachment orders in respect of charged properties d. In case of non-realization of the decreed amount by way of sale of the charged properties, the personal properties if the guarantors can also be attached and sold. e. However, realization is usually time-consuming f. Steps have been taken to create additional benches 3. Proceeding under Code of Civil Procedure a. For claims below Rs.10 lacs, the banks and FIs can initiate proceedings under the Code of Civil Procedure of 1908, as amended, in a Civil court. b. The courts are empowered to pass injunction orders restraining the debtor through itself or through its directors, representatives, etc from disposing of, parting with or dealing in any manner with the subject property. c. Courts are also empowered to pass attachment and sales orders for subject property before judgment, in case necessary. d. The sale of subject property is normally carried out by way of open public auction subject to confirmation of the court. e. The foreclosure proceedings, where the DRT Act is not applicable, can be initiated under the Transfer of Property Act of 1882 by filing a mortgage suit where the procedure is same as laid down under the CPC. 6. BIFR AND AAIFR a. BIFR has been given the power to consider revival and rehabilitation of companies under the Sick Industrial Companies (Special Provisions) Act of 1985 (SICA), which has been repealed by passing of the Sick Industrial Companies (Special Provisions) Repeal Bill of 2001.

89 b. The board of Directors shall make a reference to BIFR within sixty days from the date of finalization of the duly audited accounts for the financial year at the end of which the company becomes sick c. The company making reference to BIFR to prepare a scheme for its revival and rehabilitation and submit the same to BIFR the procedure is same as laid down under the CPC. d. The shelter of BIFR misused by defaulting and dishonest borrowers e. It is a time consuming process 4. SALE OF NPA TO OTHER BANKS a. A NPA is eligible for sale to other banks only if it has remained a NPA for at least two years in the books of the selling bank b. The NPA must be held by the purchasing bank at least for a period of 15 months before it is sold to other banks but not to bank, which originally sold the NPA. c. The NPA may be classified as standard in the books of the purchasing bank for a period of 90 days from date of purchase and thereafter it would depend on the record of recovery with reference to cash flows estimated while purchasing d. The bank may purchase/ sell NPA only on without recourse basis e. If the sale is conducted below the net book value, the short fall should be debited to P&L account and if it is higher, the excess provision will be utilized to meet the loss on account of sale of other NPA. 5. SARFESI Act 2002 a. SARFESI provides for enforcement of security interests in movable (tangible or intangible assets including accounts receivable) and immovable property without the intervention of the court b. The bank and FI may call upon the borrower by way of a written legal notice to discharge in full his liabilities within 60 days from the date of notice,

90 failing which the bank would be entitled to exercise all or any of the rights set out under the Act. c. Another option available under the Act is to takeover the management of the secured assets d. Any person aggrieved by the measures taken by the bank can proffer an appeal to DRT within 45 days after depositing 75% of the amount claimed in the notice. e. Chapter II of SARFESI provides for setting up of reconstruction and securitization companies for acquisition of financial assets from its owner, whether by raising funds by such company from qualified institutional buyers by issue of security receipts representing undivided interest in such assets or otherwise. f. The ARC can takeover the management of the business of the borrower, sale or lease of a part or whole of the business of the borrower and rescheduling of payments, enforcement of security interest, settlement of dues payable by the borrower or take possession of secured assets g. Additionally, ARCs can act as agents for recovering dues, as manager and receiver. h. Drawback – differentiation between first charge holders and the second charge holders Second Amendment & SARFESI a. The second amendment and SARFESI are a leap forward but requirement exists to make the laws predictable, transparent and affordable enforcement by efficient mechanisms outside of insolvency b. No definite time frame has been provided for various stages during the liquidation proceedings c. Need is felt for more creative and commercial approach to corporate entities in financial distress and attempts to revive rather than applying conservative approach of liquidation

91 d. Tribunals have largely failed to serve the purpose for which they were set up. NCLT would be over-burdened with workload. Change in eligibility criteria for making a reference would itself generate a greater workload. e. The second amendment stops short of providing a comprehensive bankruptcy code to deal with corporate bankruptcy. f. Does not introduce the required roadmap of the bankruptcy proceeding viz: • • • • • • • • • Application for initiating Appointments & empowerment of trustee Operational and functional independence Accountability to court Monitoring and time bound restructuring Mechanism to sell off Number of time bound attempts for restructuring Decision to pursue insolvency and winding up Strategies for realization and distribution

g. Need for new laws & procedures to handle bankruptcy proceedings in consultation with RBI

Perceived Impact Adapting to Basel II will be more demanding for some institutions than for others, based on factors including current risk management practices, business size, geographical spread, risk types, specific business, portfolio, and market conditions Impact on various entities in financial markets Apart from banks and regulators, who are directly affected by Basel II, customers, rating agencies, capital markets and other financial companies (outside the scope of Basel II) will also be affected. Banks will have to implement an enterprise-wide risk management framework, which will entail establishing relevant processes and gathering, integrating and analysing large amount of data. Using quantitative methods to manage risk - and to deploy capital based on risks - requires high quality and high frequency data.

92 Customers will find that they have to cope with increased demands for timely information from banks that are on IRB approaches. Risk-based pricing of credit products will become the norm as banks begin differentiating customers as per their risk profiles. Riskier borrowers are likely to find their borrowing costs going up and/or credit lines tightened up. Rating agencies may face more competition as the market for them will expand and deepen, which will be a driver for them to be more transparent in their rating process. Good quality rated corporates will prefer capital markets to banks for their funding. Securitisation and credit derivatives will increasingly be used as credit risk hedging tools. Basel II is also likely to impact financial institutions that do not have to comply with it. Non-banking corporations such as credit card companies, leasing companies, auto manufacturers and financiers, or retailers’ financing arms may not have to fulfill the potentially extensive disclosure requirements prescribed by Basel II nor make investments in managing operational risk, which will put them at a competitive advantage vis-à-vis banks. Impact on emerging markets and smaller banks In an attempt to assess the impact of Pillar 1 requirements of capital adequacy, BCBS did undertake a few quantitative impact surveys (QIS), the last of which is referred to as QIS3. The results indicated that, in general, banks’ required capital will decrease with respect to credit risks and increase with respect to operational risks. However, in Asia and other emerging markets, several factors may raise the required capital even for credit risks, as real estate continues to be widely used as collateral for business loans, and the standardised approach, which is the most likely approach for many banks, places a 150 per cent risk weight on non-performing loans. Basel II will increase the level of capital that is required for banking institutions in the emerging markets, mainly owing to the new operational risk charge, which will be higher if the basic indicator approach is used. By application of differential risk weights on the basis of sovereign rating as a benchmark, the capital inflows in emerging markets could be seriously affected as most of the borrowers in such markets will be categorised under the speculative grade. Smaller banks would find the investments on Basel II compliance too big for their existing budgets.

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Implications for India The official position of the Reserve Bank of India (RBI), as emphasized in its response to CP3 of BCBS, is as follows, `In its (Basel II) attempt to strive for more accurate measure of risks in banks, the simplicity of the present Capital Accord is proposed to be replaced, with a highly complex methodology which needs the support of highly sophisticated MIS / data processing capabilities. The complexity and sophistication essential for banks for implementing the new capital accord restricts its universal application in the emerging markets.’ RBI had also suggested that a common definition of `internationally active banks’ be provided by BCBS. Even the United States of America is not adopting the new accord for all of its banks. But, in the same response, RBI has also affirmed that it is `fully committed to implement the best international practices’. The response from the Indian banking industry is equally positive. `Indian Banks are not averse to making the investment of the effort to embrace global practices,’ asserts V. Leeladhar, chairman, Indian Banks’ Association (IBA) and chairman and managing director, Union Bank of India. H.N. Sinor, chief executive officer, IBA, adds `Basel II is a reality that no progressive country can afford to ignore. It provides an opportunity for global integration and ushering in international best practices.’ Viewed against these brave words from the major Indian banks, the Indian regulator RBI, appears to be more cautious and pragmatic, holding a view that `Banks in emerging markets would, therefore, face serious implementation challenges due to lack of adequate technical skills, under development of financial markets, structural rigidities and less robust legal systems. Besides banks, supervisors would be required to invest considerable resources in upgrading technology systems, and human resources to meet the minimum standards.’ Having successfully implemented the 1988 Basel Accord, the Indian banking industry is poised to implement the 1996 Amendment for inclusion of market risk in capital adequacy calculations this year. Sinor expects Indian banks to eventually embrace Basel II, albeit slowly and ‘without making noises’. Supporting the phased approach taken by RBI with respect to Basel II, Sinor feels that `the new accord provides incentives to banks for improving their credit portfolio through risk management’. Leeladhar expresses

94 confidence that `in any event, banks will reap the benefits of improved systems and efficiency in the long term’. nitially, banks in India will have to adopt the standardised approach (possibly the simplified one) for credit risk, and the basic indicator approach for operational risk calculations. RBI had done a selective impact study last year using these approaches on data sourced from seven major banks. The results of both the RBI study and the QIS-3, suggest an increase of one to two per cent on account of credit risk and eleven per cent on account of operational risk, in the minimum capital requirements, moving from Basel I to Basel II. Kapoor provides the roadmap, saying `Most (Indian) banks are likely to start with simpler, elementary approaches, just adequate to ensure compliance to Basel II norms and gradually adopt more sophisticated approaches. The continued regulatory challenge will be to migrate to Basel II in a non-disruptive manner. Competitive compulsions will ensure that banks make the necessary investments in the appropriate technology and qualified, experience professionals to adopt advanced approaches.’ `The new accord will reward those banks that use a more sophisticated IRB approach to measure and manage risk.’ Counters Niall S.K. Booker, chief executive officer, HSBC India and chairman of the IBA Committee on Basel II, `There is the possibility that in international markets access may be easier and costs less for banks adopting a more sophisticated approach….however in a market like India it seems likely that the large domestic players will continue to play a very significant role regardless of the model used.’ Meanwhile, Leeladhar is hopeful that banks will ultimately adopt the IRB approach for credit risk. The additional capital charge on account of operational risk is considered `harsh’ by bankers and software suppliers unanimously. But all of them agree that it will benefit banks in the long term by making them sensitive to operational risk. Sinor hopes that the operational risk charge will eventually be calibrated down as the implementation progresses. It is generally agreed the implementation of Basel II is likely to provide momentum for mergers and acquisitions in the Indian banking industry. Shenoy thinks that `The higher disclosure requirements in the banking sector might lead to a growing tendency towards structural changes in the form of mergers and acquisitions.’ Kapoor provides another

95 reason, saying `as more and more banks move towards the advanced approaches, the gap between the strong and weak banks will increase further, making the weaker banks potential takeover targets’ Here are a few excerpts, which describe RBI’s current approach: • `We are now not debating whether to go forward with Basel II but how to implement Basel II. In fact, understanding Basel II concepts is one step away from agreeing to it in principle. Implementing Basel II is another long step away from understanding it’. • `RBI’s approach to the institution of prudential norms has been one of gradual convergence with international standards and best practices with suitable country specific adaptations. Our aim has been to reach global best standards in a deliberately phased manner through a consultative process evolved within the country. RBI had in April 2003 itself accepted in principle to adopt the new capital accord’. • `RBI has announced, in its Annual Policy statement in May 2004 that banks in India should examine in depth the options available under Basel II and draw a road-map by end December 2004 for migration to Basel II and review the progress made thereof at quarterly intervals’. • `At a minimum all banks in India, to begin with, will adopt Standardized Approach for credit risk and Basic Indicator Approach for operational risk. After adequate skills are developed, both in banks and at supervisory levels, some banks may be allowed to migrate to IRB Approach’. • `India has three established rating agencies in which leading international credit rating agencies are stakeholders. However, the level of rating penetration is not very significant as, so far, ratings are restricted to issues and not issuers. Encouraging ratings of issuers would be a challenge’. • `Basel II could actually imply that the minimum requirements could become procyclical. No doubt prudent risk management policies and Pillars II and III would help in overall stability. We feel that it would be preferable to have consistent prudential norms in good and bad times rather than calibrate prudential norms to counter pro-cyclicality’.

96 • `Banks adopting IRB Approach will be much more risk sensitive than the banks on Standardised Approach, (so) the banks on Standardised Approach could be inclined to assume exposures to high risk clients, which were not financed by IRB banks. Due to concentration of higher risks, Standardised Approach banks can become vulnerable at times of economic downturns’. • `Keeping in view the cost of compliance for both banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-disruptive manner. We would like to continue the process of interaction with other countries to learn from their experiences’.

Criticism of Basel 2 accord Before we set out to list the concerns that have been voiced against Basel II, we must acknowledge the fact that any attempt to regulate the complexity that current global financial infrastructure presents is far from easy. Trying to model such complexity involves what we would prefer to call `modeling risk’, which can be reduced by backtesting the model, but not eliminated entirely. Under this section only general arguments against Basel II have been discussed. The rest appears in the perceived impact section where Basel II prescriptions have different implications for different markets and entities. Pro-cyclicality In simple terms, pro-cyclicality means that banks governed by Basel II (capital tied to risks) will loosen credit in `good times’ (when risk perceptions are low) and restrict it when times are bad (when risks rise again). If most banks act in this fashion, having adopted the accord, they would accentuate the crisis in bad times, jeopardizing stability. Risk-based financial regulation is inherently pro-cyclic. The pro-cyclicality springs from the treatment of risk as an exogenous variable, whereas in reality, it is endogenous. The actions of a market participant based on a predictive model affects the market and if many participants are using the same model, their combined actions render the basic assumptions of the model on the heterogeneous nature of the market (normal distribution) false.

97 `Requiring banks to run their capital through a stress test to assess what impact worsening economic conditions will have on their loan portfolios, and requiring bank supervisors to evaluate those models independently, increases the safety of the bank. This is one of the measures that will help the banks to be less pro-cyclical because they will have taken into account the whole (business) cycle,’ Fearsome complexity The US Comptroller of Currency, John D. Hawke Jr., considers CP3 (Consultative Paper 3) published by Basel Committee as having `mind-numbing complexity’. `Can anyone reasonably assume that a mandate of the complexity of Basel II will be applied with equal forcefulness across such a broad spectrum of supervisory regimes,’ asks Hawke. The meek answer from BCBS is that the complexity of the new accord results from the complexity it seeks to address. `This (Basel II implementation) is a task of extreme complexity involving the intersection of computer science, mathematics and finance,’ says Dr. Ron Dembo, founding chairman of Algorithmics Inc., a Toronto- based company specializing in financial risk management software. Heavy Implementation Costs Data monitor estimates that financial institutions worldwide will spend close to US$ 4 billion over two years on upgrading databases and other systems in order to comply with Basel II. Aberdeen Group estimates that banks will spend US $3.2 billion in the next four years preparing for Basel II. `Asian banks are expected to spend between seven to ten per cent of their global IT and business operations budget on Basel II compliance for the next four to six years,’ observes BIS. While such estimates would be music to the ears of software suppliers and consulting firms, the moot question for banks are `what benefits will accrue from this investment?’ and `how long will the pay back period be?’ Credit Risk Concerns

98 Using the standardized approach, un-rated corporate borrowers attract less risk weight (100 per cent) than the lowest rated borrower (150 per cent) giving incentives to high-risk borrowers to remain un-rated. Another argument against Basel II is that it does not resort to full credit risk modeling--it fails to take into account portfolio effects of risk mitigation through diversification.

Concerns of National Supervisors The New Accord is criticized on the ground of being as much prescriptive as to be lacking in trust for national supervisors. Also, Pillar 2 requires national supervisors to give up arms-length supervision in favour of participative implementation. Supervisors also need to invest heavily in people and technology to perform their duties as envisaged in Basel II.

Suggestion After all these points, I just want to say that NPA is a big problem of banks. Due to this crisis the NPA are also increased. That’s why all the banks are facing problems and ICICI bank is top most in those banks, ICICI banks has a big exposure in that crisis as compare to other banks. So banks have to take care of those banks. My recommendations are: 1. Strengthening provision norms and loan classification standards based on forward looking criteria (like future cash flows) were implemented. 2. Through securitization they can reduce NPA 3. Speed of action- the speedy containment of systematic risk and the domestic credit crunch problem with the injection of large public fund for bank recapitalization are critical steps towards normalizing the financial system. 4. Strengthening legal system

99 5. Maintain required capital adequacy ratio as per basel 2 norms. That means now the provision for NPL will be more. This may look a conservative approach. But it should be implemented to reduce risk. 6. Modification in accounting system 7. Use the concept of credit derivative 8. Aligning of prudential norms with international standard.

Reports of SH. V. Leeladhar

Research paper of Prasanta K Reddy Indiabulls report Antique research Indian bank association report Businessstandard.com RESEARCH REPORTS. RBI.com Google.com ICICI.com Marketresearch.com Economic survey WEBSITES VISITED: Journal of Reserve Bank of India Marketing Research – NARESH MALHOTRA. JOURNALS REFERRED: Banking and law practices-S.L. GUPTA Macro economics – MISHRA and PURI BIBLIOGRAPHY BOOKS REFERRED:

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Checklist 1. 2. 3. 4. 5. Is the report properly hard bound/Spiral bound. Is the Cover page in proper format as given in Annexure A? Is the Title page (Inner cover page) in proper format? (a) Is the Certificate from the Supervisor in proper format? Yes / No Yes / No Yes / No Yes / No

(b) Has it been signed by the Supervisor? Yes / No Is the Abstract included in the report properly written within one Yes / No page? Have the keywords been specified properly? Yes / No Is the title of your report appropriate? The title should be adequately Yes / No descriptive, precise and must reflect scope of the actual work done.

6.

7. 8. 9.

Have you included the List of abbreviations / Acronyms? Uncommon Yes / No abbreviations / Acronyms should not be used in the title. Does the Report contain a summary of the literature survey? Does the Table of Contents include page numbers? (i). (ii). (iii). Are the Pages numbered properly? Are the Figures numbered properly? (Figure Numbers and Yes / No Yes / No Are the Tables numbered properly? (Table Numbers and Yes / No Yes / No

Figure Titles at the bottom of the figures) Table Titles at the top of the tables)

101 (iv). 10. 11. Are the Captions for the Figures and Tables proper? Yes / No Yes / No Yes / No Yes / No Yes / No

(v). Are the Appendices numbered properly? Is the conclusion of the Report based on discussion of the work? Are References or Bibliography given at the end of the Report? Have the References been cited properly inside the text of the Report? Is the citation of References in proper format?

12.

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Signature of the Student ---------------------------------------------------------

Date: _________________________ Name: ___________________________ Roll No.: ___________________________