18 January, 2014

Financial Sector Reforms – The Road Ahead

BFSI & CM Study Group : Think Tank Competition

Dynamos Team - Financial Sector Reforms

CA Kinner Mehta – Group Leader (Debt & Capital Markets)

CA Resham Wadhwa - Participant (Banking Sector)

CA Laxmikant Gupta - Participant (Alternative Assets)

CA Rachana Kothari Doshi - Participant (Cash and Currency)

Banking Sector acts as a funnel for financial sector

Banks act as custodians of Money

Banks are important part of systemic structure of economy of the country

Banks leads to supply of money by multiplier effect

Failure in the banking system especially asset liability management could lead to large scale implications impacting financial system, Hence, our first focus area is banking

Critical areas for Reforms - Regulations

This is on fact that while other businesses operate with their own funds,

banks are highly leveraged institutions that operate with public money and hence, require to be closely regulated and supervised.

Banking operations cannot be carried out without a license. This restricts the free play of competitive forces and hence, makes it all the more imperative to have a sound regulatory framework, particularly for protection of customers.

The primary justification for financial regulation by authorities is to prevent systemic risk, avoid financial crises & protect depositors’ interest (learnings from international scams)

Banking Sector Reforms – What Next?

The objective of the reforms is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy

1. Bringing down the cost of banking services

(Reducing NPA), strengthening the credit delivery mechanism, (banking correspondent, new licenses, priority sector) and enhancing the financial outreach to hitherto critical areas of economy (infrastructure and real estate )

Agriculture ( 11.8% )

Industry ( 43.4%)

Transport Operators(2.3%)

Personal Loans &Professional Services( 11.5% )Trade ( 5.20% )

Others ( 20.9%)

Nationalised Banks

Agriculture ( 9.3% )

Industry ( 28.3%)

Transport Operators(4.6%)

Personal Loans &Professional Services (19.8% )

Trade ( 10.3% )

Others ( 27.6%)

Private Banks

JOURNEY OF NPAs OF PUBLIC SECTOR BANKS - 2004 TO 2013 ( figures are in billion )

Nationalised Banks

AMOUNT % of Share AMOUNT % of Share

2004 167.05 48% 71.36 47% 238.41

2005 163.81 51% 70.17 47% 233.98

2006 151.24 54% 72.5 55% 223.74

2007 157.79 61% 71.75 57% 229.54

2008 163.85 67% 89.02 58% 252.87

2009 157.21 60% 84.47 47% 241.68

2010 199.06 56% 109.4 50% 308.46

2011 257.21 60% 155.67 55% 412.88

2012 322.9 48% 239.11 52% 562.01

2013 404.86 42% 264.42 44% 669.28

Nationalised Banks

AMOUNT % of Share AMOUNT % of Share

2004 178.95 51% 78.03 51% 256.98

2005 153.46 48% 76.24 51% 229.7

2006 122.53 43% 58.19 44% 180.72

2007 96.68 38% 51.93 41% 148.61

2008 77.93 32% 62.22 41% 140.15

2009 101.4 39% 92.5 52% 193.9

2010 152.77 43% 106.46 49% 259.23

2011 169.47 39% 125.67 45% 295.14

2012 343.13 51% 217.59 48% 560.72

2013 553.59 58% 334.94 56% 888.53

YEAR

PRIORITY SECTOR TOTAL NPA OF

PRIORITY

SECTOR

SBI Group

YEAR

NON - PRIORITY SECTOR TOTAL NPA OF

NON PRIORITY

SECTOR

SBI Group

Banking Sector Reforms – What Next?

2. Addressing the need to reach unbanked and underbanking areas through Financial Inclusion (FI) ; it is believed that about 40% Indians still lack access to even the simplest kind of formal financial services

Financial Inclusion can be attained through product innovation, use of technology for lowering cost of transaction and expanding coverage through banking correspondents

Mobile banking, effective leverage of Information and Communications Technology (ICT) solutions and use of smart cards, biometric handheld devices, mobile, ATMs, etc. can aid cost reduction.

3. Meeting the challenges in fixing the fault lines in the system,

Consolidation

Reducing government influence in operations

DEPOSITS & CREDITS OF BANKS FOR LAST TWO YEARS (figures in Billion )

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

Rural semi urban metro

Year 2012

Year 2013

0

5000

10000

15000

20000

25000

30000

35000

40000

Rural semi urban metro

Year 2012

Year 2013

Deposits Advances

Recommendations

We recommend stringent framework of rules and procedures for regulating banking sector

Strengthening the regulatory and supervisory framework in following areas:

(i) Capital requirements through BASEL Framework

(ii) Liquidity Management

(iii) Structural Changes like setting up Financial Holding Companies

(iv) Revamping Financial Legislation

CHALLENGES – The Road Ahead Revamping financial legislation

Currently in the financial sector, we have about 60 Acts and multiple rules

and regulations. The incremental changes made to these Acts over a period have made the laws ambiguous and complex. Government has taken an initiative by setting up Reforms Commission which seeks to rewrite and streamline the financial sector laws, rules and regulations to bring them in harmony with India’s fast growing financial sector.

Debt Markets – Need for Development

Challenges in meeting the specific needs of the economy – Infrastructure Financing

Banks, traditionally, have been the major source of infrastructure financing and their exposure to infrastructure is already high at 17 per cent. Infrastructure projects involving long term funding plans have, however, severe implications for the asset liability management at banks

The targeted annual spend on infrastructure during 2007-12 is about USD 500 bn which is doubled in the next five year plan (USD 1 trillion during 2013-18). Shortfall in infrastructure financing, would cost nearly 4% of GDP every year !!

Reform in Debt Markets Well developed corporate bond market can help protect domestic

banking system (Experiences of Asian Crises and Development of bond markets in Asia)

Wide developed debt capital raising mechanism can create alternative pools for resource funding and reduce the pressure on government deficits (municipal bonds and state government bodies through structured pool mechanism to support urban infrastructure projects)

Financial stability can be attained by developing market infrastructure to promote healthy financial system (eg pension funds and insurance companies to invest in market oriented debt securities across investment grade)

Promote well developed financial system so that investors have wider choice and scope for better returns with risk management strategies (Credit Default Swaps, Interest Rate Futures, Structured Pools etc)

Recommendations

Provide tax breaks for investing in debt instruments like corporate bonds and infrastructure bonds at two stages – at the time of investment and at the stage of returns (concessional regime)

Develop infrastructure by electronic trading system and robust market making system to enhance liquidity in the markets

Increase depth of markets by allowing Market Makers (Primary Dealers) in debt market access to cheaper funding from Banks at repo rates or money market benchmark rates

Adequate capitalization of Debenture Trustees and additional powers to protect debenture holders interest

Remove tax anomalies for Pass Through Certificates

Allow development of derivatives trading in debt market for FIIs by simplifying rules and making enabling provisions

Widen penetration by holding investor camps and education awareness through a rigourous online and off line media campaign funded through investor education fund managed by SEBI and Company Law Board

Reforms in Capital Market Segment - Addressing the Aam Aadmi

Empowering investors through research – undertaken by CA professionals

Proper utilization of Investor Protection Fund as follows:

SEBI : BFSICM Group organize effective training programs across the country

Exchanges : Online Training Programs with voice over in local languages

Mutual Funds : Booklets and investor awareness programs

Other Financial Services Segment : Reforms

Venture Funds:

Disclosure Norms :

Fund Launches : AUM, Corpus, Competition etc

Performance : IRR, NAV etc : (Investor based or security based ?)

Chinese Wall for secondary market operations

Tax Pass Through Status for AIF registered

Tax arbitrage goes in favour of MF

Investment Advisors Regulation should exempt Co-Investor arrangement

Stock Exchange and Commodity Exchanges:

Factors including “x” factor must work in selecting promoters : Fit & Proper Criteria

Way Forward : New Initiatives

Monsoon Derivatives : Useful for Agricultural Societies, Manufacturing sector dependent upon agri raw material

Sentiment Index Derivatives :

Event Trigger based rather than Direction based

Superior to buying Out Of Money Call / Put

Corporate Reforms :

Independent Directors : Adequate Coverages

World over – what gets deposited in Banks? - Cash

- Cheques

In India –

first currency notes introduced include Bank of Hindostan (1770–1832), the General Bank of Bengal and Bihar (1773–75, established by Warren Hastings), and the Bengal Bank (1784–91); mass production started from mid 1940s..

Fully printed Cheques were introduced in early 1700s, 1st personalised cheques find mention in 1881 – Negotiable Instruments Act.

From Bearer cheques to Endorsable cheques, we have come a long way to move to

MICR system of clearing and latest being CTS system ; However we lack serious reforms in our Cash currency – we are currently using Mahatma Gandhi series (replaced Ashoka Pillar Capital series) of Bank Notes which has replaced all other series – was introduced way back in 1996 with the embedded security features carried on from 1996..

Counterfeit Currency circulation statistics for some prominent economies...

* The US $ chart represents Value in Mn and not number of notes in Mn.

PROBLEMS CURRENTLY FACED BY INDIA :

Compressing GDP…

High inflation trajectory

High rate of interest and Depreciating currency

Reducing value of INR…

All of these can be addressed at one go – to some extent by addressing the issue of fake currencies..

These figures suggest a significant amount of resources spent by every country to control counterfeit currencies

However, a few countries have been able to control it and some have failed…

To put these numbers in perspective for India –

Particulars (in Rs Crs. For FY 2013)

GDP @ current prices 101,700 Value of counterfeits (including RBI and other seizures) 2,600

Impact on GDP 2.6%

Recommendations: Polymer Resin currency notes to replace Current Paper currency

these notes to contain Censor chips weaved in each currency note – chip to contain data of Mint at which it was produced, printed and originated

Each Mint should have different marker to identify and differentiate the currency notes – to make it extremely difficult to fake

currently 4 mints for coins – Mumbai( ), Calcutta ( ), Hyderabad(*) , Noida( .)}

{currently 4 mints for notes - Currency Note Press in Nashik, Bank Note Press in Dewas, Bharatiya Note Mudra Nigam (P) presses at Salboni and Mysore, Watermark Paper Manufacturing Mill in Hoshangabad

{currently different identification marks on each note - 20: vertical rectangle, 50: square, 100: triangle, 500: circle,

1,000: diamond)

Reduce the faking as it will be extremely difficult to make exact replica of data contained on chip due to different denominations and different permutation and combination of date of production, place of origination etc

Censor chip will enable trail of the currencies – at least should be introduced in higher denomination notes to trace the faking to its source..

CHALLENGES IN IMPLEMENTING THESE REFORMS:

Political will to enable reforms – RBI should prevail over the Ministries as currently it is taking care of the currency printing Mints as well..

Cost of production will be high – with technological advancements, cost of production can be brought down significantly just like it has happened with RFID and Bar codes technology..

Questions

Annexure : Data Slides and Back up Slides

Reform -History • Financial sector reforms were initiated in 1991-1992. The Narasimham

Committee Report (1991) recommended several reform measures such as

1. reduction of reserve requirements

2. de-regulation of interest rates

3. introduction of prudential norms

Second Narasimham Committee Report (1998 ) Which was focused on the :-

• strengthening of the banking system

• upgrading of technology

• human resource development

Present Major Reforms in the Banking Sector :-

• New Services and New Products - Some of the Banks have established subsidiaries in merchant banking, mutual funds, insurance, venture capital, etc which has led to diversified sources of income from them.

• New Generation Bank emerged : Banks such as ICICI Bank, HDFC Bank, UTI Bank have given a big challenge to the public sector banks leading to a greater degree of competition

• Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) • interest rates deregulated - Banks now enjoy freedom of fixing the lower and upper

limit of interest on deposits. Interest rates on the bank loans above Rs.2 lakhs are fully decontrolled. These measures have resulted in more freedom to commercial banks in interest rate regime.

• RBI Prudential Norms - It includes recognition of income sources. Classification of assets, provisions for bad debts, maintaining international standards in accounting practices, etc. It helped banks in reducing and restructuring Non-performing assets (NPAs).

• Capital to Risk Weighted Asset Ratio (CRAR) - all most all the banks in India has reached the Capital Adequacy Ratio (CAR) above the statutory level of 9%.

• Freedom :- If a bank satisfies the CAR then it gets freedom in opening new branches, upgrading the extension counters, closing down existing branches and they get liberal lending norms

• MPBF system was removed : (Maximum Permissible Bank Finance)

•

FUTURE – The Road Ahead • Customer Expectations - have been growing. Clients should get services from

the banks on a 24x7 -Broadly, these expectations are swift service with minimal response time, efficient service delivery, tailor-made and value-added products to suit specific needs, hassle-free procedures and minimum transaction costs, and pleasant and personalized service. Banks have to undertake a continuous process of monitoring customers’ perceptions of service quality, identifying the causes for service quality shortfalls and taking appropriate remedial action to improve quality.

Other Income - The future strategies of banks should be to earn more of ‘other income ‘and reduce dependence of interest income.

Service Sector - contributing around 50 per cent to the Gross Domestic Product, banks should explore the possibilities to tap this sector.

Staff Productivity - There is need to downsize staff to cut high cost of staff expenses

Marketing - In the coming years, the key word is marketing would be innovation. It would become impossible to survive and prosper unless organizational skills are effectively channalised towards innovating new ideas,

new products, and new strategies for winning over and retaining the customer. NPA - The level of Non-Performing Assets (NPA ) of public sector banks

remained high;

Reforms in Banking and Allied Sectors Shadow Banking System – Greater consistency in regulation

Another important regulatory challenge is ensuring “greater consistency in regulation of similar instruments and institutions performing similar activity" to prevent or contain regulatory arbitrage.

In the case of systemically important non-deposit taking NBFCs (NBFCs-ND-SI), a gradually calibrated regulatory framework in the form of capital requirements, exposure norms, liquidity management, asset liability management and reporting requirements has been extended, which has limited the space for regulatory arbitrage as also their capacity to leverage.

Given the increasing significance of the sector, the supervisory regime for the systemically important NBFCs will need to be strengthened further for a more robust assessment of the underlying risks.

Recommendations – Others Liquidity Management

There are concerns over growing reliance of banks on wholesale funding/ market borrowing to fund assets

During the crisis as the wholesale funding sources can dry up quickly. Banks, therefore, have to factor this in their liquidity management. Besides, there is an issue under Basel III about the extent to which SLR holdings can be taken into consideration for the purpose of calculating the liquidity ratios

Further, the major challenge for Indian banks in implementing the liquidity standards is to develop the capability to collect the relevant data accurately and granularly and also to formulate and predict the liquidity stress scenarios with reasonable accuracy and consistency.

SOME INTERESTING ANECDOTES FOR COUNTERFEITS : Faking is as old as currency itself – first of currencies faked was metal coins produced by

Roman kings in 1200s – the process was knowing as clipping where metal coins were plated with silver and gold to make them work in place of real silver and gold coins..!!!

The history of the rupees traces back to Ancient India in circa 6th century BC, ancient India was one of the earliest issuers of coins in the world along with the Chinese wen and Lydian staters.

The word rūpiya is alleged to be derived from a Dravidian word rūpa, which means "wrought silver, a coin of silver

Nations have used counterfeiting as a means of warfare. The idea is to overflow the enemy's economy with fake bank notes, so that the real value of the money plummets….!!!

Great Britain did this during the American Revolutionary War to reduce the value of the Continental Dollar. The counterfeiters for the British were known as "shovers," presumably for the ability to "shove" the fake currency into circulation

Operation Bernhard was the codename of a secret Nazi plan devised during the 2nd World War to destabilise the British economy by flooding the country with forged Bank of England £5, £10, £20, and £50 notes…

http://www.businesspundit.com/10-most-notorious-counterfeiting-operations-of-the-last-100-years/