New Challenges

The first phase of financial sector reforms has laid the base for a sound and viable banking system even though we have to travel still some distance. What the is the emerging banking horizon? What are the new challenges and new opportunities? Going by the experiences of commercial banks in other countries, the following trends as I have indicated elsewhere may dominate the future course of banking development in India :

• greater specialisation by banks in different niches of the market such as retail, agriculture, export, small-scale and corporate sector;

• greater reliance on non-fund business such as advisory and consultancy services, guarantee and custody services;

• greater overlap in product coverage between commercial banks and non-bank financial intermediaries; and

• greater financial disintermediation with large companies accessing securitised debt domestically and from financial markets abroad.

• All of these will require the banks to prepare a corporate plan over the next five years taking into accounts its own strengths and the markets in which it is looking to operate. Banks should not expect customers to walk in. They should seek customers. That will be the important change in the new scenario.

In the environment of tomorrow, banks will have to learn to operate in a more deregulated interest rate environment and a diversified competitive market place. Both these will require banks to manage risk better.

Interest rate regime in India has undergone a rapid transformation in the last five years or more. The structure of interest rates, which was extremely complex, has now been rationalised to fixing only three as far as banking system is concerned. Besides a maximum deposit rate for one year maturity, the prescriptions include a lending rate for loans upto Rs.25,000, another lending rate for loans between Rs.25,000 and Rs.2,00,000. The money market rates have been completely freed as have the rates at which corporate entities can borrow from the capital market. Perhaps, the most striking transformation has been in the Government securities market where the Central Government borrows both in terms of dated securities and treasury bills through the auction system.

Banks need to equip themselves to operate in such a deregulated interest rate environment. This will imply that they should be able to fix the rates on deposits and loans depending on the overall liquidity conditions and demand factors. Obviously, in such situations, certain market leaders always emerge. Banks, over the last few years, have evolved a set of criteria for determining the rate charged on the individual borrowers. They have also understood recently that this does not give them unlimited freedom to fix the rate. Pressures of competition and the intensity of demand will determine what the appropriate level is. These lessons will have to be modified and improved upon as interest rate structure becomes more flexible. The deregulation of interest rates will also lead to innovations of various types and corporates and others have already started experimenting with floating rate issues.

With abundant liquidity, the interest rates have clearly shown a downward decline. This is reflected in Treasury Bills of all maturities and dated securities. The CP rate as well as PLR have come down substantially. The lending rates are at the lowest level since 1988.

The management of the investment portfolio of the commercial banks will also require greater attention, since the prices of the securities will be affected with changes in interest rates. Therefore the maturity pattern of the investment portfolio, and the distribution according to instruments are matters which must receive the attention of technical experts in the banks. It is quite conceivable to have a situation in which the investment portfolio will consist not only of Government and quasi-Government paper, but also other instruments including securitised loans. All this will demand a proper attention on existing and expected levels of interest rates.

Banks will begin to function increasingly under competitive pressures. These may emanate from within the banking system as well as from non-banking institutions. A greater overlap in product coverage between commercial banks and non-bank intermediaries will occur. Thus, both on the liability and asset sides, banks will face increasing competition. Banks should be willing to offer products to savers which are competitive in terms of both price and service. On the lending side, apart from the competition from other intermediaries, corporates seeking funds directly from the market will also have an impact on the asset distribution of banks. This is already happening in our country. Apart from the very large funds that corporates have been able to raise from the domestic capital market, with the lower interest abroad, big Indian corporates have also begun to raise funds from the international markets. Some of the corporates have used the funds so raised to retire high cost domestic commercial bank credit. This type of disintermediation is not uncommon. Banks will have to take note of these developments. Lending is an important function of commercial banks and will remain the most profitable form of utilising funds. They cannot let an important asset of theirs to go down. Competition will compel banks to keep the interest spread to the minimum and in this context bank can earn enough for themselves only by reducing the proportion of non-performing assets.

Banks will also have to pay attention to market segmentation, and greater specialisation in different niches of the markets. It is important to note that `bigness' is not synonymous with success. Small and medium sized banks can also effectively compete if appropriate niche strategies are adopted.

In the context of these changes, risk management is emerging as an important area which needs a great deal of attention. Originally banks concentrated on asset management treating themselves purely as deposit takers. Funds supply was regarded as a factor beyond their control. Asset management was governed by the basic principle that liquidity and profitability are opposing considerations. Risks and return were two inversely related variables which influenced the composition of assets. Effort was to distribute the assets in such a way that for a given level of liquidity the return was of the maximum. This approach is being substituted by a more comprehensive approach of asset liability management which has been described as 'a continuous process of planning, organising and controlling asset and liability volumes, maturities, rates and yields'. The objective is to avoid the mis-match of asset liability characteristics and liability is no longer treated as given. The liability structure can also be modified in tune with the asset structure that is desired. Banking is much more of a risky business today than it was a decade ago. The kinds of risks and the frequency of occurrence of such risks have increased dramatically. Both liabilities and assets are subject to interest rate risks. The asset quality of loans can be influenced by factors which go beyond the control of the lenders. It is in this context that provisioning for loan losses and need for adequate capital become important. In terms of asset liability management, portfolio managers look at the variable and fixed components both under assets and liabilities. Asset-liability management is not a static concept. The most important element in the process of asset-liability management is to build into the analysis of possible future behaviour of variables such as interest rates. Thus, the asset liability management is a process and it must be practiced in an on-going manner. Managements must regularly forecast assumptions and develop contingencies to accommodate changes expected.

Given these challenges, banks will need to chalk out a plan of action. In this context, two tasks appear important. One is technology upgradation and the other is organisational improvement.

The impact of technology on banking has been spectacular in the industrially advanced countries. Against the background of growing volume of transactions and the need to meet customer needs expeditiously, technology upgradation has become indispensable. To strengthen internal control, to improve accuracy of records and to facilitate provision of new products and services, banks will have to rely increasingly on computer based technologies. Apart from improving the functioning of banks at various levels, technology has a key role to play in developing a payments system network through which funds can be transmitted quickly and efficiently. I hope the VSAT Satellite based network will come into operation soon. Much groundwork has already been done by RBI and banks.

The second phase of reforms will have also to focus on the organisational effectiveness of banks for which the initiatives will have to come from banks themselves. I find many banks have already taken the initiative to seek the advice of in-house as well as external experts to look into these issues. The areas which need improvement are known. In depth corporate planning combined with organisational restructuring are a necessary prerequisite to achieve desired results in terms of productivity and profitability. A properly designed management system that improves productivity and drives the behaviour of employees in delivering quality service must be clearly spelt out. There must be a vision and mission to which employees can relate. To achieve all these goals public sector banks need to be given greater autonomy with respect to recruitment and promotion of personnel and in general management of staff and in determining the organisational structure. Greater accountability has to go with greater autonomy. RBI and Government are actively looking into these issues.