1

CHAPTER 1: Introduction
Banks have played a critical role in the economic development of some developed countries such as Japan and Germany and most of the emerging economies including India. Banks today are important not just from the point of view of economic growth, but also financial stability. In emerging economies, banks are special for three important reasons. First, they take a leading role in developing other financial intermediaries and markets. Second, due to the absence of welldeveloped equity and bond markets, the corporate sector depends heavily on banks to meet its financing needs. Finally, in emerging markets such as India, banks cater to the needs of a vast number of savers from the household sector, which prefer assured income and liquidity and safety of funds, because of their inadequate capacity to manage financial risks. Forms of banking have changed over the years and evolved with the needs of the economy. The transformation of the banking system has been brought about by deregulation, technological innovation and globalization. While banks have been expanding into areas which were traditionally out of bounds for them, non-bank intermediaries have begun to perform many of the functions of banks. Banks thus compete not only among themselves, but also with nonbank financial intermediaries, and over the years, this competition has only grown in intensity. Globally, this has forced the banks to introduce innovative products, seek newer sources of income and diversify into non-traditional activities.

Definition of banks
In India, the definition of the business of banking has been given in the Banking Regulation Act, (BR Act), 1949. According to Section 5(c) of the BR Act, 'a banking company is a company which transacts the business of banking in India.' Further, Section 5(b) of the BR Act defines banking as, 'accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdraw able, by cheque, draft, and order or otherwise.' This definition points to the three primary activities of a commercial bank which distinguish it from the other financial institutions. These are: (i) maintaining deposit

2 accounts including current accounts, (ii) issue and pay cheques, and (iii) collect cheques for the bank's customers.

Evolution of Commercial Banks in India

The commercial banking industry in India started in 1786 with the establishment of the Bank of Bengal in Calcutta. The Indian Government at the time established three Presidency banks, viz., the Bank of Bengal (established in 1809), the Bank of Bombay (established in 1840) and the Bank of Madras (established in 1843). In 1921, the three Presidency banks were amalgamated to form the Imperial Bank of India, which took up the role of a commercial bank, a bankers' bank and a banker to the Government. The Imperial Bank of India was established with mainly European shareholders. It was only with the establishment of Reserve Bank of India (RBI) as the central bank of the country in 1935, that the quasi-central banking role of the Imperial Bank of India came to an end. In 1860, the concept of limited liability was introduced in Indian banking, resulting in the establishment of joint-stock banks. In 1865, the Allahabad Bank was established with purely Indian shareholders. Punjab National Bank came into being in 1895. Between 1906 and 1913, other banks like Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. After independence, the Government of India started taking steps to encourage the spread of banking in India. In order to serve the economy in general and the rural sector in particular, the All India Rural Credit Survey Committee recommended the creation of a state-partnered and state-sponsored bank taking over the Imperial Bank of India and integrating with it, the former state-owned and state-associate banks. Accordingly, State Bank of India (SBI) was constituted in 1955. Subsequently in 1959, the State Bank of India (subsidiary bank) Act was passed, enabling the SBI to take over eight former state-associate banks as its subsidiaries. To better align the banking system to the needs of planning and economic policy, it was considered necessary to have social control over banks. In 1969, 14 of the major private sector banks were nationalized. This was an important milestone in the history of Indian banking. This was followed by the nationalization of another six private banks in

3 1980. With the nationalization of these banks, the major segment of the banking sector came under the control of the Government. The nationalization of banks imparted major impetus to branch expansion in un-banked rural and semi-urban areas, which in turn resulted in huge deposit mobilization, thereby giving boost to the overall savings rate of the economy. It also resulted in scaling up of lending to agriculture and its allied sectors. However, this arrangement also saw some weaknesses like reduced bank profitability, weak capital bases, and banks getting burdened with large non-performing assets. To create a strong and competitive banking system, a number of reform measures were initiated in early 1990s. The thrust of the reforms was on increasing operational efficiency, strengthening supervision over banks, creating competitive conditions and developing technological and institutional infrastructure. These measures led to the improvement in the financial health, soundness and efficiency of the banking system. One important feature of the reforms of the 1990s was that the entry of new private sector banks was permitted. Following this decision, new banks such as ICICI Bank, HDFC Bank, IDBI Bank and UTI Bank were set up. Commercial banks in India have traditionally focused on meeting the short-term financial needs of industry, trade and agriculture. However, given the increasing sophistication and diversification of the Indian economy, the range of services extended by commercial banks has increased significantly, leading to an overlap with the functions performed by other financial institutions. Further, the share of long-term financing (in total bank financing) to meet capital goods and projectfinancing needs of industry has also increased over the years.

Functions of Commercial Banks

The main functions of a commercial bank can be segregated into three main areas: (i) Payment System (ii) Financial Intermediation (iii) Financial Services. Main functions of a commercial bank

(i) Payment System Banks are at the core of the payments system in an economy. A payment refers to the means by which financial transactions are settled. A fundamental method by which banks help in settling the financial transaction process is by issuing and paying cheques issued on behalf of customers. Further, in modern banking, the payments system also involves electronic banking, wire transfers, settlement of credit card transactions, etc. In all such transactions, banks play a critical role. (ii) Financial Intermediation The second principal function of a bank is to take different types of deposits from customers and then lend these funds to borrowers, in other words, financial Intermediation. In financial terms, bank deposits represent the banks' liabilities, while loans disbursed, and investments made by banks are their assets. Bank deposits serve the useful purpose of addressing the needs of depositors, who want to ensure liquidity, safety as well as returns in the form of interest. On the other hand, bank loans and investments made by banks play an important function in channeling funds into profitable as well as socially productive uses. (iii) Financial Services In addition to acting as financial intermediaries, banks today are increasingly involved with offering customers a wide variety of financial services including investment banking, insurance-related services, government-related business, foreign exchange businesses, wealth management services, etc. Income from providing such services improves a bank's profitability.

Competitive Landscape of Banks in India

Banks face competition from a wide range of financial intermediaries in the public and private sectors in the areas of financial intermediation and financial services (although the payments system is exclusively for banks). Such intermediaries form a diverse group in terms of size and nature of their activities, and play an important role in the financial system by not only competing with banks, but also

5 complementing them in providing a wide range of financial services. Some of these intermediaries include: Term-lending institutions Non-banking financial companies Insurance companies Mutual funds (i) Term-Lending Institutions Term lending institutions exist at both state and all-India levels. They provide term loans (i.e., loans with medium to long-term maturities) to various industries, service and infrastructure sectors for setting up new projects and for the expansion of existing facilities and thereby competes with banks. At the all-India level, these institutions are typically specialized, catering to the needs of specific sectors, which make them competitors to banks in those areas. These include the Export Import Bank of India (EXIM Bank), Small Industries Development Bank of India (SIDBI), Tourism Finance Corporation of India Limited (TFCI), and Power Finance Corporation Limited (PFCL). At the state level, various State Financial Corporations (SFCs) have been set up to finance and promote small and medium-sized enterprises. There are also State Industrial Development Corporations (SIDCs), which provide finance primarily to medium-sized and large-sized enterprises. In addition to SFCs and SIDCs, the North Eastern Development Financial Institution Ltd. (NEDFI) has been set up to cater specifically to the needs of the north-eastern states. (ii) Non-Banking Finance Companies (NBFCs) India has many thousands of non-banking financial companies, predominantly from the private sector. NBFCs are required to register with RBI in terms of the Reserve Bank of India (Amendment) Act, 1997. The principal activities of NBFCs include equipment-leasing, hire purchase, loan and investment and asset finance. NBFCs have been competing with and complementing the services of commercial banks for a long time. All NBFCs together currently account for around nine percent of assets of the total financial system.

6 Housing-finance companies form a distinct sub-group of the NBFCs. As a result of some recent government incentives for investing in the housing sector, these companies' business has grown substantially. Housing Development Finance Corporation Limited (HDFC), which is in the private sector and the Governmentcontrolled Housing and Urban Development Corporation Limited (HUDCO) are the two premier housing-finance companies. These companies are major players in the mortgage business, and provide stiff competition to commercial banks in the disbursal of housing loans. (iii) Insurance Companies Insurance/reinsurance companies such as Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GICI), and others provide substantial longterm financial assistance to the industrial and housing sectors and to that extent, are competitors of banks. LIC is the biggest player in this area. (iv) Mutual Funds Mutual funds offer competition to banks in the area of fund mobilization, in that they offer alternate routes of investment to households. Most mutual funds are standalone asset management companies. In addition, a number of banks, both in the private and public sectors have sponsored asset management companies to undertake mutual fund business. Banks have thus entered the asset management business, sometimes on their own and other times in joint venture with others.

CHAPTER 2: Objective
To describe the term bank and Commercial Banking Explain nature and scope of Commercial Banking Enumerate its advantages Describe how suspension of banking activities will affect trade, commerce and industry. Make a comprehensive study of NPAs with respect to ICICI Bank. To Study different activities carried out by Commercial Banks.

Chapter 3: Research Methodology

RESEARCH METHODOLOGY
Research is a process through which, attempt to achieve systematically and with the support of data the answer to a question, the resolution of a problem, or a greater understanding of a phenomenon. This process, which is frequently called research methodology, has eight distinct characteristics: 1. Research originates with a question, problem or process. 2. Research requires a clear articulation of a goal. 3. Research follows a specific plan of procedure. 4. Research usually divides the principal problem into more manageable sub problems. 5. Research is guided by the specific research problem, question, or hypothesis. 6. Research accepts certain critical assumptions. 7. Research requires the collection and interpretation of data in attempting to resolve the problem that initiated the research. 8. Research is, by its nature, cyclical; or more exactly, helical.

Collection and Sources of data:

Market research requires two kinds of data, i.e., primary data and secondary data. Being a firm in the financial industry data gathering here involved usage of both primary and secondary data.

Secondary Data: - The source of data for the Research Project is mainly
secondary data which was collected from the websites, documents, which were in printed forms like annuareports, pamphlets, reference books based on Financial Management

Chapter 4: Banking Structure in India

Banking Regulator The Reserve Bank of India (RBI) is the central banking and monetary authority of India, and also acts as the regulator and supervisor of commercial banks . Scheduled Banks in India Scheduled banks comprise scheduled commercial banks and scheduled cooperative banks. Scheduled commercial banks form the bedrock of the Indian financial system, currently accounting for more than three-fourths of all financial institutions' assets. SCBs are present throughout India, and their branches, having grown more than four-fold in the last 40 years now number more than 80,500 across the country SCBs in India

Scheduled Banking Structure in India

Public Sector Banks: Public sector banks are those in which the majority stake is held by the Government of India (GoI). Public sector banks together make up the largest category in the Indian banking system. There are currently 27 public sector banks in India. They include the SBI and its 6 associate banks (such as State Bank of Indore, State Bank of Bikaner and Jaipur etc), 19 nationalized banks (such as Allahabad Bank, Canara Bank etc) and IDBI Bank Ltd Public sector banks have taken the lead role in branch expansion, particularly in the rural areas. It can also be seen that: Public sector banks account for bulk of the branches in India (88 percent in 2009). In the rural areas, the presence of the public sector banks is overwhelming; in 2009, 96 percent of the rural bank branches belonged to the public sector. The private sector banks and foreign banks have limited presence in the rural areas

10

Regional Rural Banks: Regional Rural Banks (RRBs) were established during 1976-1987 with a view to develop the rural economy. Each RRB is owned jointly by the Central Government, concerned State Government and a sponsoring public sector commercial bank. RRBs provide credit to small farmers, artisans, small entrepreneurs and agricultural laborers. Over the years, the Government has introduced a number of measures of improve viability and profitability of RRBs, one of them being the amalgamation of the RRBs of the same sponsored bank within a State. This process of consolidation has resulted in a steep decline in the total number of RRBs to 86 as on March 31, 2009, as compared to 196 at the end of March 2005. Private Sector Banks In this type of banks, the majority of share capital is held by private individuals and corporate. Not all private sector banks were nationalized in 1969, and 1980. The private banks which were not nationalized are collectively known as the old private sector banks and include banks such as The Jammu and Kashmir Bank Ltd., Lord Krishna Bank Ltd etc.5 Entry of private sector banks was however prohibited during the post-nationalization period. In July 1993, as part of the banking reform process and as a measure to induce competition in the banking sector, RBI permitted the private sector to enter into the banking system. This resulted in the creation of a new set of private sector banks, which are collectively known as the new private sector banks. As at end March, 2009 there were 7 new private sector banks and 15 old private sector banks operating in India. Foreign Banks Foreign banks have their registered and head offices in a foreign country but operate their branches in India. The RBI permits these banks to operate either through branches; or through wholly-owned subsidiaries. The primary activity of most foreign banks in India has been in the corporate segment. However, some of the larger foreign banks have also made consumer financing a significant part of their portfolios. These banks offer products such as automobile finance, home loans, credit cards, household consumer finance etc. Foreign banks in India are required to

11 adhere to all banking regulations, including priority-sector lending norms as applicable to domestic banks.8 In addition to the entry of the new private banks in the mid- 90s, the increased presence of foreign banks in India has also contributed to boosting competition in the banking sector. Co-operative Banks Co-operative banks cater to the financing needs of agriculture, retail trade, small industry and self-employed businessmen in urban, semi-urban and rural areas of India. A distinctive feature of the co-operative credit structure in India is its heterogeneity. The structure differs across urban and rural areas, across states and loan maturities. Urban areas are served by urban cooperative banks (UCBs), whose operations are either limited to one state or stretch across states. The rural cooperative banks comprise State co-operative banks, district central cooperative banks, SCARDBs and PCARDBs. The co-operative banking sector is the oldest segment of the Indian banking system. The network of UCBs in India consisted of 1721 banks as at end-March 2009, while the number of rural co-operative banks was 1119 as at end-March 2008.10 Owing to their widespread geographical penetration, cooperative banks have the potential to become an important instrument for large-scale financial inclusion, provided they are financially strengthened.11 The RBI and the National Agriculture and Rural Development Bank (NABARD) have taken a number of measures in recent years to improve financial soundness of co-operative banks. Role of Reserve Bank of India vis--vis Commercial Banks The Reserve Bank of India (RBI) is the central bank of the country. It was established on April 1, 1935 under the Reserve Bank of India Act, 1934, which provides the statutory basis for its functioning. When the RBI was established, it took over the functions of currency issue from the Government of India and the power of credit control from the then Imperial Bank of India. As the central bank of the country, the RBI performs a wide range of functions; particularly, it: Acts as the currency authority Controls money supply and credit

12 Manages foreign exchange Serves as a banker to the government Builds up and strengthens the country's financial infrastructure Acts as the banker of banks Supervises banks As regards the commercial banks, the RBI's role mainly relates to the last two points stated above. RBI as Bankers' Bank As the bankers' bank, RBI holds a part of the cash reserves of banks,; lends the banks funds for short periods, and provides them with centralized clearing and cheap and quick remittance facilities. Banks are supposed to meet their shortfalls of cash from sources other than RBI and approach RBI only as a matter of last resort, because RBI as the central bank is supposed to function as only the 'lender of last resort'. To ensure liquidity and solvency of individual commercial banks and of the banking system as a whole, the RBI has stipulated that banks maintain a Cash Reserve Ratio (CRR). The CRR refers to the share of liquid cash that banks have to maintain with RBI of their net demand and time liabilities (NDTL).13 CRR is one of the key instruments of controlling money supply. By increasing CRR, the RBI can reduce the funds available with the banks for lending and thereby tighten liquidity in the system; conversely reducing the CRR increases the funds available with the banks and thereby raises liquidity in the financial system. RBI as supervisor To ensure a sound banking system in the country, the RBI exercises powers of supervision, regulation and control over commercial banks. The bank's regulatory functions relating to banks cover their establishment (i.e. licensing), branch expansion, liquidity of their assets, management and methods of working, amalgamation, reconstruction and liquidation. RBI controls the commercial banks through periodic inspection of banks and follow-up action and by calling for returns

13 and other information from them, besides holding periodic meetings with the top management of the banks. While RBI is directly involved with commercial banks in carrying out these two roles, the commercial banks help RBI indirectly to carry out some of its other roles as well. For example, commercial banks are required by law to invest a prescribed minimum percentage of their respective net demand and time liabilities (NDTL) in prescribed securities, which are mostly government securities.14 This helps the RBI to perform its role as the banker to the Government, under which the RBI conducts the Government's market borrowing program.

CHAPTER 5: Bank Deposit Accounts

14 As stated earlier, financial intermediation by commercial banks has played a key role in India in supporting the economic growth process. An efficient financial intermediation process, as is well known, has two components: effective mobilization of savings and their allocation to the most productive uses. In this chapter, we will discuss one part of the financial intermediation by banks: mobilization of savings. When banks mobilize savings, they do it in the form of deposits, which are the money accepted by banks from customers to be held under stipulated terms and conditions. Deposits are thus an instrument of savings. Since the first episode of bank nationalization in 1969, banks have been at the core of the financial intermediation process in India. They have mobilized a sizeable share of savings of the household sector, the major surplus sector of the economy. This in turn has raised the financial savings of the household sector and hence the overall savings rate. Notwithstanding the liberalization of the financial sector and increased competition from various other saving instruments, bank deposits continue to be the dominant instrument of savings in India.

Introduction to Bank Deposits

One of the most important functions of any commercial bank is to accept deposits from the public, basically for the purpose of lending. Deposits from the public are the principal sources of funds for banks. Safety of deposits At the time of depositing money with the bank, a depositor would want to be certain that his/ her money is safe with the bank and at the same time, wants to earn a reasonable return. The safety of depositors' funds, therefore, forms a key area of the regulatory framework for banking. In India, this aspect is taken care of in the Banking Regulation Act, 1949 (BR Act). The RBI is empowered to issue directives/advices on several aspects regarding the conduct of deposit accounts from time to time. Further, the establishment of the Deposit Insurance Corporation in 1962 (against the backdrop of failure of banks) offered protection to bank depositors, particularly small-account holders.

15 Deregulation of interest rates The process of deregulation of interest rates started in April 1992. Until then, all interest rates were regulated; that is, they were fixed by the RBI. In other words, banks had no freedom to fix interest rates on their deposits. With liberalization in the financial system, nearly all the interest rates have now been deregulated. Now, banks have the freedom to fix their own deposit rates with only a very few exceptions. The RBI prescribes interest rates only in respect of savings deposits and NRI deposits, leaving others for individual banks to determine. Deposit policy The Board of Directors of a bank, along with its top management, formulates policies relating to the types of deposit the bank should have, rates of interest payable on each type, special deposit schemes to be introduced, types of customers to be targeted by the bank, etc. Of course, depending on the changing economic environment, the policy of a bank towards deposit mobilization undergoes changes.

Types of Deposit Accounts

The bank deposits can also be classified into (i) demand deposits and (b) time deposits. (i) Demand deposits are defined as deposits payable on demand through cheque or otherwise. Demand deposits serve as a medium of exchange, for their ownership can be transferred from one person to another through cheques and clearing arrangements provided by banks. They have no fixed term to maturity. (ii) Time deposits are defined as those deposits which are not payable on demand and on which cheques cannot be drawn. They have a fixed term to maturity. A certificate of deposit (CD), for example-: A Certificate of Deposit (CD) is a negotiable money market instrument and is issued in Dematerialized form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are currently governed by various directives issued by the RBI, as amended from time to time.

16

CDs can be issued by (i) scheduled commercial banks (SCBs) excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by the RBI to raise short-term resources within the umbrella limit fixed by RBI. Deposit amounts for CDs are a minimum of Rs.1 lakh, and multiples thereof. Demand and time deposits are two broad categories of deposits. Note that these are only categories of deposits; there are no deposit accounts available in the banks by the names demand deposits' or 'time deposits'. Different deposit accounts offered by a bank, depending on their characteristics, fall into one of these two categories. There are several deposit accounts offered by banks in India; but they can be classified into three main categories: Current account Savings bank account Term deposit account Current account deposits fall entirely under the demand-deposit category and term deposit account falls entirely under time deposit. Savings bank accounts have both demand-deposit and time-deposit components. In other words, some parts of savings deposits are considered demand deposits and the rest as time deposits. We provide below the broad terms and conditions governing the conduct of current, savings and term-deposit accounts.

Current Deposits
A current account is a form of demand-deposit, as the banker is obliged to repay these liabilities on demand from the customer. Withdrawals from current accounts are allowed any number of times depending upon the balance in the account or up to a particular agreed amount. Current deposits are non-interest bearing. Among the three broad categories of depositscurrent account deposit, savings accounts

17 deposit and term deposits--current account deposits account for the smallest fraction. A current account is basically a running and actively operated account with very little restriction on the number and amount of drawings. The primary objective of a current account is to provide convenient operation facility to the customer, via continuous liquidity. On account of the high cost of maintaining such accounts, banks do not pay any interest on such deposits. In addition, many banks insist on customers maintaining minimum balances to offset the transaction costs involved. If minimum balances are not maintained, these banks charge the customers a certain amount. Current accounts can be opened by rich individuals/ partnership firms/ private and limited companies/ Hindu Undivided Families (HUFs)/ societies/ trusts, etc.

Savings Bank Deposits

Savings deposits are a form of demand deposits, which is subject to restrictions on the number of withdrawals as well as on the amounts of withdrawals during any specified period. Further, minimum balances may be prescribed in order to offset the cost of maintaining and servicing such deposits. Savings deposits are deposits that accrue interest at a fixed rate set by RBI (3.5 percent as of January 2010). Savings bank accounts are used by a large segment of small depositors as they can put their regular incomes into these accounts, withdraw the money on demand and also earn interest on the balance left in the account. The flexibility provided by such a product means that savings bank accounts cannot be opened by big trading or business firms. Similarly, institutions such as government departments and bodies, local authorities, etc. cannot open savings bank accounts.

18 Term Deposits A "Term deposit" is a deposit received by the Bank for a fixed period, after which it can be withdrawn. Term deposits include deposits such as Fixed Deposits / Reinvestment deposits/ Recurring Deposits etc. The term deposits account for the largest share and have remained within the range of 61% to 67 % of total deposits in the recent years. Interest is paid on term-deposits, either on maturity or at stipulated intervals depending upon the deposit scheme under which the money is placed. Also, a customer can earn interest on a term-deposit for a minimum period of 7 days. Interest rates on term-deposits are usually higher than on savings deposits. Term deposits include: Fixed deposits on which a fixed rate of interest is paid at fixed, regular intervals; Re-investment deposits, under which the interest is compounded quarterly and paid on maturity, along with the principal amount of the deposit. Some banks have introduced flexi" deposits under which, the amount in savings deposit accounts beyond a fixed limit is automatically converted into term-deposits. Recurring deposits, under which a fixed amount is deposited at regular intervals for a fixed term and the repayment of principal and accumulated interest is made at the end of the term. These deposits are usually targeted at persons who are salaried or receive other regular income. A Recurring Deposit can usually be opened for any period from 6 months to 120 months.

Strategies of mobilizing deposits

To maximize their profits, commercial banks always attempt to mobilize savings at the lowest cost possible. While mobilizing deposits, banks have to comply with various directives issued by the RBI, the Indian Bank Association (IBA), Government of India and other statutory authorities/agencies. At the same time, since banks operate in a very competitive environment, they have to reach out to a wide spectrum of customers and also offer deposit products that lead to higher customer satisfaction.

19 Banks devise various strategies to expand the customer base and reducing the cost of raising deposits. This is done by identifying target markets, designing the products as per the requirements for customers, taking measures for marketing and promoting the deposit products. It is essential not only to expand the customer base but also to retain it. This is done by providing counseling, after-sales information and also through prompt handling of customer complaints. While the strategies for mobilizing bank deposits vary from bank to bank, common features generally observed are as follows: Staff members posted at branches are adequately trained to offer efficient and courteous service to the customers and to educate them about their rights and obligations. A bank often offers personalized banking relationship for its high-value customers by appointing Customer Relationship Managers (CRMs). Senior citizens/pensioners have become an important category of customers to be targeted by a bank. Products are developed by banks to meet the specific requirements of this group. While banks endeavour to provide services to the satisfaction of customers, they put in place an expeditious mechanism to redress the complaints of the customers.

Common Guidelines of Opening and Operating Deposit Accounts

To open and operate a bank account, the following guidelines need to be followed. Due Diligence Process: A bank before opening any deposit account has to carry out due diligence as required under "Know Your Customer" (KYC) guidelines issued by RBI and or such other norms or procedures adopted by the bank.16 The 'due diligence' process, while opening a deposit account, involves the bank having adequate knowledge of the person's identity, occupation, sources of income, and location. Obtaining an introduction of the prospective depositor from a person acceptable to the bank, obtaining recent photographs of people opening/ operating

20 the account are part of the due diligence process. For customers providing proof of identification and address, there is no need for personal introduction to the bank for opening of a new savings bank account. To promote financial inclusion in rural areas / tribal areas, KYC norms have been relaxed for below the poverty line (BPL) families. Minimum Balance: For deposit products like a savings bank account or a current account, banks normally stipulate certain minimum balances to be maintained as part of terms and conditions governing operation of such accounts. But for people below the poverty line, banks encourage the opening of 'No-frills Accounts', typically a special savings bank account where no minimum balance requirement is required. For a savings bank account, the bank may also place restrictions on number of transactions, cash withdrawals, etc., during a given period. Transparency: Failure to maintain minimum balance in the accounts, where applicable, will attract levy of charges as specified by the bank from time to time. Similarly, the bank may specify charges for issue of cheques books, additional statement of accounts, duplicate passbook, folio charges, etc. All such details regarding terms and conditions for operation of the accounts and schedule of charges for various services provided should be communicated to the prospective depositor while opening the account for the sake of transparency. Eligibility: A savings bank account can be opened by eligible person(s) and certain Organizations/agencies, as advised by the RBI from time to time. But current accounts can be opened by individuals, partnership firms, private and public limited companies, Hindu Undivided Families (HUFs), specified associates, society trusts, etc. Eligibility criteria for a savings account and a current account are largely similar, but there are important differences too. While both the accounts can be opened by individuals, the savings account cannot be opened by a firm. Term Deposit Accounts can be opened by all categories of account holders. Requirement of PAN: In addition to the due diligence requirements, under KYC norms, banks are required by law to obtain a Permanent Account Number (PAN)

21 from the prospective account holder or alternate declarations as specified under the Income Tax Act. Operation of Joint Account: Deposit accounts can be opened by an individual in his own name or by more than one individual in their own names (known as a 'joint account'). A joint account can be operated by a single individual or by more than one individual jointly. The mandate for who can operate the account can be modified with the consent of all account holders. Joint accounts opened by minors with their parents or guardians can be only operated by the latter. Accountholders of a joint account can give mandates on the operation of the account, and the disposal of balances in the event of the demise of one or more of the holders. Banks classify these mandates as 'Either or Survivor', and 'Anyone or Survivor(s)', etc. Power of Attorney: At the request of the depositor, the bank can register mandate/power of attorney given by him authorizing another person to operate the account on his behalf. Closure/renewal of deposits: Term-deposit account holders at the time of placing their deposits can give instructions with regard to closure of deposit account or renewal of deposit for further period on the date of maturity. In absence of such mandate, the bank will usually seek instructions from the depositor(s) as to the renewal of the deposit or otherwise by sending intimation before say, 15 days of the maturity date of the term deposit. If no mandate is given or received by the bank before the date of maturity of term deposit, the bank will be at liberty to roll over the deposit on due date. Nomination: A depositor is permitted to officially authorize someone, who would receive the money of his account when the depositor passes away. This is called the nomination process. Nomination facility is available on all deposit accounts opened by individuals. Nomination is also available to a sole proprietary concern account. Nomination can be made in favor of one individual only. Nomination so made can be

22 cancelled or changed by the account holder/s any time. Nomination can be made in favor of a minor too.

Deposit Related Services

As per the RBI guidelines, banks are required to provide some services to the depositors and to recognize the rights of depositors. The ultimate objective of the banking industry should be to provide a customer different services they are rightfully entitled to receive without demand. We take a quick look at some such services provided by banks in India. Customer Information Customer information collected from the customers should not be used for crossselling of services or products by the bank, its subsidiaries and affiliates. If the bank proposes to use such information, it should be strictly with the 'express consent' of the account-holder. Banks are not expected to disclose details/particulars of the customer's account to a third person or party without the expressed or implied consent from the customer. However, there are some exceptions, such as disclosure of information under compulsion of law or where there is a duty to public for the bank to disclose. Interest Payments Savings bank accounts: Interest is paid on savings bank deposit account at the rate specified by RBI from time to time. In case of savings bank accounts, till recently, banks paid interest on the minimum balance between the 11th and the last day of calculate interest on savings bank deposit by considering daily product, which would benefit the holders of savings bank accounts. Term deposits: Term-deposit interest rates are decided by individual banks within these general guidelines. In terms of RBI directives, interest is calculated at month. With effect from April 1, 2010, banks have been advised to

23 quarterly intervals on term deposits and paid at the rate decided by the bank depending upon the period of deposits. The interest on term deposits is calculated by the bank in accordance with the formulae and conventions advised by Indian Bank Association.17 Also, a customer can earn interest on a term deposit for a minimum period of 7 days, as stated earlier. Tax deducted at source (TDS): The bank has statutory obligation to deduct tax at source if the total interest paid/payable on all term deposits held by a person exceeds the amount specified under the Income Tax Act and rules there under. The Bank will issue a tax deduction certificate (TDS Certificate) for the amount of tax deducted. The depositor, if entitled to exemption from TDS, can submit a declaration to the bank in the prescribed format at the beginning of every financial year. Premature Withdrawal of Term Deposit The bank on request from the depositor, at its discretion, may allow withdrawal of term deposit before completion of the period of the deposit agreed upon at the time of placing the deposit. Banks usually charge a penalty for premature withdrawal of deposits. The bank shall declare their penal interest rates policy for premature withdrawal of term deposit, if any, at the time of opening of the account. Premature Renewal of Term Deposit In case the depositor desires to renew the deposit by seeking premature closure of an existing term deposit account, the bank will permit the renewal at the applicable rate on the date of renewal, provided the deposit is renewed for a period longer than the balance period of the original deposit. While prematurely closing a deposit for the purpose of renewal, interest on the deposit for the period it has remained with the bank will be paid at the rate applicable to the period for which the deposit remained with the bank and not at the contracted rate. Advances against Deposits The Bank may consider requests of the depositor(s) for loan/overdraft facility against term deposits duly discharged by the depositor(s) on execution of necessary

24 security documents. The bank may also consider giving an advance against a deposit standing in the name of minor. However, a suitable declaration stating that the loan is for the benefit of the minor is to be furnished by the depositor-applicant. Settlement of Dues in Deceased Deposit Account a) If the depositor has registered nomination with the bank; the balance outstanding in the account of the deceased depositor will be transferred/ paid to the nominee after the bank is satisfied about the identity of the nominee, etc. b) The above procedure will be followed even in respect of a joint account where nomination is registered with the bank. c) In case of joint deposit accounts where joint account holders do not give any mandate for disposal, when one of the joint account holders dies, the bank is required to make payment jointly to the legal heirs of the deceased person and the surviving depositor(s). In these cases, delays may ensue in the production of legal papers by the heirs of the deceased. However, if the joint account holders had given mandate for disposal of the balance in the account in the forms such as 'either or survivor', 'former/latter or survivor', 'anyone of survivors or survivor'; etc., the payment will be made as per the mandate. In such cases, there is no delay in production of legal papers by the heirs of the deceased. d) In the absence of nomination, the bank will pay the amount outstanding to all legal heirs against joint application and on receipt of the necessary documents, including court order. Stop Payment Facility The Bank will accept 'stop payment' instructions from the depositors in respect of cheques issued by them. Charges, as specified, will be recovered. Dormant Accounts Accounts which are not operated for a considerable period of time (usually 12/24 months for savings bank accounts and 6/12 months for current accounts), will be transferred to a separate dormant/inoperative account status in the interest of the

25 depositor as well as the bank. The depositor will be informed if there are charges that the bank would levy on dormant/inoperative accounts. Such accounts can be used again on an activation request to the bank. Safe Deposit Lockers This facility is not offered through all bank branches and wherever the facility is offered, allotment of safe deposit vault will be subject to availability and compliance with other terms and conditions attached to the service. Safe deposit lockers may be hired by an individual (not a minor) singly or jointly with another individual(s), HUFs, firms, limited companies, associates, societies, trusts etc. Nomination facility is available to individual(s) holding the lockers singly or jointly. In the absence of nomination or mandate for disposal of contents of lockers, with a view to avoid hardship to common persons, the bank will release the contents of locker to the legal heirs against indemnity on the lines as applicable to deposit accounts. Redress of Complaints and Grievances Depositors having any complaint/grievance with regard to services rendered by the bank have a right to approach the authorities designated by the bank for handling customer complaints/ grievances. In case the depositor does not get a response from the bank within one month after the bank receives his representation /complaint or he is not satisfied with the response received from the bank, he has a right to approach the Banking Ombudsman appointed by RBI Deposit Services Offered to Non-Resident Indians Banks actively seek banking business from Non-Resident Indians (NRIs) by offering different types of deposit accounts (and related services) in accordance with RBI guidelines, including: Non-resident ordinary account; Non-resident (external) Rupee account; and Foreign currency nonresident account (Banks)

Definition of Non-Resident Indian (NRI)

26 As per the Foreign Exchange Management Act (FEMA), 1999, an NRI means: Non-Resident Indian National (i.e. Non-resident Indian holding Indian passport), and Persons of Indian Origin (i.e., Non-residents holding foreign passports) Non-resident Indian Nationals include (i) Indian citizens who proceed abroad for employment or for any business or vocation in circumstances indicating an indefinite period of stay outside India; (ii) Indian citizens working abroad on assignments with foreign governments, international/multinational agencies such as the United Nations, the International Monetary Fund, the World Bank etc. (iii) Officials of Central and State Governments and Public Sector Undertakings (PSUs) deputed abroad on assignments with foreign governments, multilateral agencies or Indian diplomatic missions abroad. PIO (Persons of Indian Origin) is defined as a citizen of any country other than Bangladesh or Pakistan, if a. he has at any time held an Indian passport; or b. he or either of his parents or any of his grandparents was a citizen of India; or c. the person is a spouse of an Indian citizen or a person referred to in sub-clause (a) or (b). In general, NRI is thus a person of Indian nationality or origin, who is resident abroad for business or employment or vocation, or with the intension of seeking employment or vocation and the period of stay abroad is uncertain Non Resident Ordinary Accounts (NRO) These are Rupee accounts and can be opened by any person resident outside India. Typically, when a resident becomes non-resident, his domestic Rupee account gets converted into an NRO account. In other words, it is basically a domestic account of an NRI which help him get credits which accrue in India, such as rent from property

27 or income from other investments. New accounts can be opened by sending fresh remittances from abroad. NRO accounts can be opened only as savings account, current account, recurring deposits and term-deposit accounts. Regulations on interest rates, tenors etc. are similar to those of domestic accounts. While the principal of NRO deposits is non-repatriable, current income such as interest earnings on NRO deposits are repatriable. Further, NRI/PIO may remit an amount, not exceeding US$1million per financial year, for permissible transactions from these accounts. Non-Resident (External) Rupee Accounts The Non-Resident (External) Rupee Account NR (E) RA scheme, also known as the NRE scheme, was introduced in 1970. This is a rupee account. Any NRI can open an NRE account with funds remitted to India through a bank abroad. An NRE rupee account may be opened as current, savings, and recurring or term deposit account. Since this account is maintained in Rupees, the depositor is exposed to exchange risk. This is a repatriable account (for both interest and principal) and transfer from/to another NRE account or FCNR (B) account (see below) is also permitted. Local payments can also be freely made from NRE accounts. NRIs / PIOs have the option to credit the current income to their NRE accounts, provided income tax has been deducted / provided for. Interest rates on NRE accounts are determined by the RBI, for both savings and term deposits. Foreign Currency Non Resident Account (Banks) The Foreign Currency Non-Resident Account (Banks) or FCNR(B) accounts scheme was introduced with effect from May 15, 1993 to replace the then prevailing FCNR(A) scheme introduced in 1975. These are foreign currency accounts, which can be opened by NRIs in only designated currencies: Pound Sterling, US Dollar, Canadian Dollar, Australian Dollar, EURO and Japanese Yen.

28 Repatriation of principal amount and interest is permitted. These deposits can be opened only in the form of term deposits. Deposits are in foreign currency and are repaid in the currency of issue. Hence, there is no exchange risk for the account holder. Transfer of funds from existing NRE accounts to FCNR (B) accounts and viceversa, of the same account holder, is permissible without the prior approval of RBI. A bank should obtain the prior approval of its Board of Directors for the interest rates that it will offer on deposits of various maturities, within the ceiling prescribed by RBI. Deposit Insurance Deposit insurance helps sustain public confidence in the banking system through the protection of depositors, especially small depositors, against loss of deposit to a significant extent. In India, bank deposits are covered under the insurance scheme offered by Deposit Insurance and Credit Guarantee Corporation of India (DICGC), which was established with funding from the Reserve Bank of India. The scheme is subject to certain limits and conditions. DICGC is a wholly-owned subsidiary of the RBI. Banks insured by the DICGC All commercial banks including branches of foreign banks functioning in India, local area banks and regional rural banks are insured by the DICGC. Further, all State, Central and Primary cooperative banks functioning in States/Union Territories which have amended the local Cooperative Societies Act empowering RBI suitably are insured by the DICGC. Primary cooperative societies are not insured by the DICGC.

Features of the scheme

29 When is DICGC liable to pay? In the event of a bank failure, DICGC protects bank deposits that are payable in India. DICGC is liable to pay if (a) a bank goes into liquidation or (b) if a bank is amalgamated/ merged with another bank. Methods of protecting depositors' interest There are two methods of protecting depositors' interest when an insured bank fails: (i) By transferring business of the failed bank to another sound bank (in case of merger or amalgamation) and (ii) where the DICGC pays insurance proceeds to depositors (insurance pay-out method). Types of deposit covered by DICGC The DICGC insures all deposits such as savings, fixed, current, recurring, etc. except the following types of deposits: Deposits of foreign Governments; Deposits of Central/State Governments; Inter-bank deposits; Deposits of the State Land Development Banks with the State co-operative bank; Any amount due on account of any deposit received outside India; Any amount, which has been specifically exempted by the corporation with the previous approval of RBI. Maximum deposit amount insured by the DICGC Each depositor in a bank is insured up to a maximum of Rs100, 000 for both principal and interest amount held by him in the same capacity and same right. For example, if an individual had a deposit with principal amount of Rs.90, 000 plus accrued interest of Rs.7, 000, the total amount insured by the DICGC would be Rs.97, 000. If, however, the principal amount were Rs. 99,000 and accrued interest of Rs 6,000, the total amount insured by the DICGC would be Rs 1 lakh. The deposits kept in different branches of a bank are aggregated for the purpose of insurance cover and a maximum amount up to Rs 1 lakh is paid. Also, all funds held in the same type of ownership at the same bank are added together before deposit insurance is determined. If the funds are in different types of ownership (say as

30 individual, partner of firm, director of company, etc.) or are deposited into separate banks they would then be separately insured. Also, note that where a depositor is the sole proprietor and holds deposits in the name of the proprietary concern as well as in his individual capacity, the two deposits are to be aggregated and the insurance cover is available up to rupees one lakh maximum. Cost of deposit insurance Deposit insurance premium is borne entirely by the insured bank. Banks are required to pay the insurance premium for the eligible amount to the DICGC on a semi-annual basis. The cost of the insurance premium cannot be passed on to the customer. Premium charged and claims paid by DICGC The premium rates charged by DICGC were raised to Re 0.10 per deposit of Rs.100 with effect from April 1, 2005. While the premiums received by DICGC during the years 2006- 07, 2007-08 and 2008-09 were Rs.2321 crores, Rs.2844 crores and Rs.3453 crores respectively, the net claims paid by DICGC during these three years were Rs.323 crores, Rs.180 crores and Rs.909 crores respectively. Withdrawal of insurance cover The deposit insurance scheme is compulsory and no bank can withdraw from it. The DICGC, on the other hand, can withdraw the deposit insurance cover for a bank if it fails to pay the premium for three consecutive half year periods. In the event of the DICGC withdrawing its cover from any bank for default in the payment of premium, the public will be notified through the newspapers.

CHAPTER 6: Basics of Bank Lending

31

Banks extend credit to different categories of borrowers for a wide variety of purposes. For many borrowers, bank credit is the easiest to access at reasonable interest rates. Bank credit is provided to households, retail traders, small and medium enterprises (SMEs), corporate, the Government undertakings etc. in the economy. Retail banking loans are accessed by consumers of goods and services for financing the purchase of consumer durables, housing or even for day-to-day consumption. In contrast, the need for capital investment, and day-to-day operations of private corporate and the Government undertakings are met through wholesale lending. Loans for capital expenditure are usually extended with medium and long-term maturities, while day-to-day finance requirements are provided through short-term credit (working capital loans). Meeting the financing needs of the agriculture sector is also an important role that Indian banks play.

Principles of Lending and Loan policy

Principles of lending To lend, banks depend largely on deposits from the public. Banks act as custodian of public deposits. Since the depositors require safety and security of their deposits, want to withdraw deposits whenever they need and also adequate return, bank lending must necessarily be based on principles that reflect these concerns of the depositors. These principles include: safety, liquidity, profitability, and risk diversion. Safety Banks need to ensure that advances are safe and money lent out by them will come back. Since the repayment of loans depends on the borrowers' capacity to pay, the banker must be satisfied before lending that the business for which money is sought is a sound one. In addition, bankers many times insist on security against the loan, which they fall back on if things go wrong for the business. The security must be adequate, readily marketable and free of encumbrances. Liquidity

32 To maintain liquidity, banks have to ensure that money lent out by them is not locked up for long time by designing the loan maturity period appropriately. Further, money must come back as per the repayment schedule. If loans become excessively illiquid, it may not be possible for bankers to meet their obligations vis-vis depositors. Profitability To remain viable, a bank must earn adequate profit on its investment. This calls for adequate margin between deposit rates and lending rates. In this respect, appropriate fixing of interest rates on both advances and deposits is critical. Unless interest rates are competitively fixed and margins are adequate, banks may lose customers to their competitors and become unprofitable. Risk diversification To mitigate risk, banks should lend to a diversified customer base. Diversification should be in terms of geographic location, nature of business etc. If, for example, all the borrowers of a bank are concentrated in one region and that region gets affected by a natural disaster, the bank's profitability can be seriously affected.

Loan Policy
Based on the general principles of lending stated above, the Credit Policy Committee (CPC) of individual banks prepares the basic credit policy of the Bank, which has to be approved by the Bank's Board of Directors. The loan policy outlines lending guidelines and establishes operating procedures in all aspects of credit management including standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, portfolio management, loan review mechanism, risk monitoring and evaluation, pricing of loans, provisioning for bad debts, regulatory/ legal compliance etc. The lending guidelines reflect the specific bank's lending strategy (both at the macro level and individual borrower level) and have to be in conformity with RBI guidelines. The loan policy typically lays down lending guidelines in the following areas:

33 Level of credit-deposit ratio Targeted portfolio mix Hurdle ratings Loan pricing Collateral security Credit Deposit (CD) Ratio A bank can lend out only a certain proportion of its deposits, since some part of deposits have to be statutorily maintained as Cash Reserve Ratio (CRR) deposits, and an additional part has to be used for making investment in prescribed securities (Statutory Liquidity Ratio or SLR requirement).It may be noted that these are minimum requirements. Banks have the option of having more cash reserves than CRR requirement and invest more in SLR securities than they are required to. Further, banks also have the option to invest in non-SLR securities. Therefore, the CPC has to lay down the quantum of credit that can be granted by the bank as a percentage of deposits available. Currently, the average CD ratio of the entire banking industry is around 70 percent, though it differs across banks. It is rarely observed that banks lend out of their borrowings. Targeted Portfolio Mix The CPC aims at a targeted portfolio mix keeping in view both risk and return. Toward this end, it lays down guidelines on choosing the preferred areas of lending (such as sunrise sectors and profitable sectors) as well as the sectors to avoid.25 Banks typically monitor all major sectors of the economy. They target a portfolio mix in the light of forecasts for growth and profitability for each sector. If a bank perceives economic weakness in a sector, it would restrict new exposures to that segment and similarly, growing and profitable sectors of the economy prompt banks to increase new exposures to those sectors. This entails active portfolio management. Further, the bank also has to decide which sectors to avoid. For example, the CPC of a bank may be of the view that the bank is already overextended in a particular industry and no more loans should be provided in that sector. It may also like to avoid certain kinds of loans keeping in mind general credit discipline, say loans for speculative purposes, unsecured loans, etc.

34

Hurdle ratings There are a number of diverse risk factors associated with borrowers. Banks should have a comprehensive risk rating system that serves as a single point indicator of diverse risk factors of a borrower. This helps taking credit decisions in a consistent manner. To facilitate this, a substantial degree of standardization is required in ratings across borrowers. The risk rating system should be so designed as to reveal the overall risk of lending. For new borrowers, a bank usually lays down guidelines regarding minimum rating to be achieved by the borrower to become eligible for the loan. This is also known as the 'hurdle rating' criterion to be achieved by a new borrower. Pricing of loans Risk-return trade-off is a fundamental aspect of risk management. Borrowers with weak financial position and, hence, placed in higher risk category are provided credit facilities at a higher price (that is, at higher interest). The higher the credit risk of a borrower the higher would be his cost of borrowing. To price credit risks, banks devise appropriate systems, which usually allow flexibility for revising the price (risk premium) due to changes in rating. In other words, if the risk rating of a borrower deteriorates, his cost of borrowing should rise and vice versa. At the macro level, loan pricing for a bank is dependent upon a number of its cost factors such as cost of raising resources, cost of administration and overheads, cost of reserve assets like CRR and SLR, cost of maintaining capital, percentage of bad debt, etc. Loan pricing is also dependent upon competition. Collateral security As part of a prudent lending policy, banks usually advance loans against some security. The loan policy provides guidelines for this. In the case of term loans and working capital assets, banks take as 'primary security' the property or goods against which loans are granted. In addition to this, banks often ask for additional security or 'collateral security' in the form of both physical and financial assets to further bind the borrower. This reduces the risk for the bank. Sometimes, loans are

35 extended as 'clean loans' for which only personal guarantee of the borrower is taken.

Compliance with RBI guidelines

The credit policy of a bank should be conformant with RBI guidelines; some of the important guidelines of the RBI relating to bank credit are discussed below. Directed credit stipulations The RBI lays down guidelines regarding minimum advances to be made for priority sector advances, export credit finance, etc. These guidelines need to be kept in mind while formulating credit policies for the Bank. Capital adequacy If a bank creates assets-loans or investment-they are required to be backed up by bank capital; the amount of capital they have to be backed up by depends on the risk of individual assets that the bank acquires. The riskier the asset, the larger would be the capital it has to be backed up by. This is so, because bank capital provides a cushion against unexpected losses of banks and riskier assets would require larger amounts of capital to act as cushion. The Basel Committee for Bank Supervision (BCBS) has prescribed a set of norms for the capital requirement for the banks for all countries to follow. These norms ensure that capital should be adequate to absorb unexpected losses.28 In addition, all countries, including India, establish their own guidelines for risk based capital framework known as Capital Adequacy Norms. These norms have to be at least as stringent as the norms set by the Basel committee. A key norm of the Basel committee is the Capital Adequacy Ratio (CAR), also known as Capital Risk Weighted Assets Ratio, is a simple measure of the soundness of a bank. The ratio is the capital with the bank as a percentage of its risk-weighted assets. Given the level of capital available with an individual bank, this ratio determines the maximum extent to which the bank can lend.

36 The Basel committee specifies a CAR of at least 8% for banks. This means that the capital funds of a bank must be at least 8 percent of the bank's risk weighted assets. In India, the RBI has specified a minimum of 9%, which is more stringent than the international norm. In fact, the actual ratio of all scheduled commercial banks (SCBs) in India stood at 13.2% in March 2009. The RBI also provides guidelines about how much risk weights banks should assign to different classes of assets (such as loans). The riskier the asset class, the higher would be the risk weight. Thus, the real estate assets, for example, are given very high risk weights. This regulatory requirement that each individual bank has to maintain a minimum level of capital, which is commensurate with the risk profile of the bank's assets, plays a critical role in the safety and soundness of individual banks and the banking system. Credit Exposure Limits As a prudential measure aimed at better risk management and avoidance of concentration of credit risks, the Reserve Bank has fixed limits on bank exposure to the capital market as well as to individual and group borrowers with reference to a bank's capital. Limits on inter-bank exposures have also been placed. Banks are further encouraged to place internal caps on their sectoral exposures, their exposure to commercial real estate and to unsecured exposures. These exposures are closely monitored by the Reserve Bank. Prudential norms on banks' exposures to NBFCs and to related entities are also in place. Table 4.1 gives a summary of the RBI's guidelines on exposure norms for commercial banks in India. Lending Rates Banks are free to determine their own lending rates on all kinds of advances except a few such as export finance; interest rates on these exceptional categories of advances are regulated by the RBI. It may be noted that the Section 21A of the BR Act provides that the rate of interest charged by a bank shall not be reopened by any court on the ground that the rate of interest charged is excessive.

37

The concept of benchmark prime lending rate (BPLR) was however introduced in November 2003 for pricing of loans by commercial banks with the objective of enhancing transparency in the pricing of their loan products. Each bank must declare its benchmark prime lending rate (BPLR) as approved by its Board of Directors. A bank's BPLR is the interest rate to be charged to its best clients; that is, clients with the lowest credit risk. Each bank is also required to indicate the maximum spread over the BPLR for various credit exposures. However, BPLR lost its relevance over time as a meaningful reference rate, as the bulk of loans were advanced below BPLR. Further, this also impedes the smooth transmission of monetary signals by the RBI. The RBI therefore set up a Working Group on Benchmark Prime Lending Rate (BPLR) in June 2009 to go into the issues relating to the concept of BPLR and suggest measures to make credit pricing more transparent. Following the recommendations of the Group, the Reserve Bank has issued guidelines in February 2010. According to these guidelines, the 'Base Rate system' will replace the BPLR system with effect from July 01, 2010.All categories of loans should henceforth be priced only with reference to the Base Rate. Each bank will decide its own Base Rate. The actual lending rates charged to borrowers would be the Base Rate plus borrower-specific charges, which will include product specific operating costs, credit risk premium and tenor premium. Since transparency in the pricing of loans is a key objective, banks are required to exhibit the misinformation on their Base Rate at all branches and also on their websites. Changes in the Base Rate should also be conveyed to the general public from time to time through appropriate channels. Apart from transparency, banks should ensure that interest rates charged to customers in the above arrangement are non-discriminatory in nature. Guidelines on Fair Practices Code for Lenders RBI has been encouraging banks to introduce a fair practices code for bank loans. Loan application forms in respect of all categories of loans irrespective of the amount of loan sought by the borrower should be comprehensive. It should include

38 information about the fees/ charges, if any, payable for processing the loan, the amount of such fees refundable in the case of no acceptance of application, prepayment options and any other matter which affects the interest of the borrower, so that a meaningful comparison with the fees charged by other banks can be made and informed decision can be taken by the borrower. Further, the banks must inform 'all-in-cost' to the customer to enable him to compare the rates charged with other sources of finance. Regulations relating to providing loans The provisions of the Banking Regulation Act, 1949 (BR Act) govern the making of loans by banks in India. RBI issues directions covering the loan activities of banks. Some of the major guidelines of RBI, which are now in effect, are as follows: Advances against banks own shares: a bank cannot grant any loans and advances against the security of its own shares. Advances to bank's Directors: The BR Act lays down the restrictions on loans and advances to the directors and the firms in which they hold substantial interest. Restrictions on Holding Shares in Companies: In terms of Section 19(2) of the BR Act, banks should not hold shares in any company except as provided in sub-section (1) Whether as pledge, mortgagee or absolute owner, of an amount exceeding 30% Of the paid-up share capital of that company or 30% of its own paid-up share capital And reserves, whichever is less.

Basics of Loan Appraisal, Credit decision-making and Review

Credit approval authorities The Bank's Board of Directors also has to approve the delegation structure of the various credit approval authorities. Banks establish multi-tier credit approval

39 authorities for corporate banking activities, small enterprises, retail credit, agricultural credit, etc. Concurrently, each bank should set up a Credit Risk Management Department (CMRD), being independent of the CPC. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set up by the CPC. The usual structure for approving credit proposals is as follows: Credit approving authority: multi-tier credit approving system with a proper scheme of delegation of powers. In some banks, high valued credit proposals are cleared through a Credit Committee approach consisting of, say 3/ 4 officers. The Credit Committee should invariably have a representative from the CRMD, who has no volume or profit targets.

Credit appraisal and credit decision-making

When a loan proposal comes to the bank, the banker has to decide how much funds does the proposal really require for it to be a viable project and what are the credentials of those who are seeking the project. In checking the credentials of the potential borrowers, Credit Information Bureaus play an important role

Monitoring and Review of Loan Portfolio

It is not only important for banks to follow due processes at the time of sanctioning and disbursing loans, it is equally important to monitor the loan portfolio on a continuous basis. Banks need to constantly keep a check on the overall quality of the portfolio. They have to ensure that the borrower utilizes the funds for the purpose for which it is sanctioned and complies with the terms and conditions of sanction. Further, they monitor individual borrowed accounts and check to see whether borrowers in different industrial sectors are facing difficulty in making loan repayment. Information technology has become an important tool for efficient handling of the above functions including decision support systems and data bases.

40 Such a surveillance and monitoring approach helps to mitigate credit risk of the portfolio. Banks have set up Loan Review Departments or Credit Audit Departments in order to ensure compliance with extant sanction and post-sanction processes and procedures laid down by the Bank from time to time. This is especially applicable for the larger advances. The Loan Review Department helps a bank to improve the quality of the credit portfolio by detecting early warning signals, suggesting remedial measures and providing the top management with information on credit administration, including the credit sanction process, risk evaluation and postsanction follow up.

Types of Advances
Advances can be broadly classified into: fund-based lending and non-fund based lending. Fund based lending: This is a direct form of lending in which a loan with an actual cash outflow is given to the borrower by the Bank. In most cases, such a loan is backed by primary and/or collateral security. The loan can be to provide for financing capital goods and/or working capital requirements. Non-fund based lending: In this type of facility, the Bank makes no funds outlay. However, such arrangements may be converted to fund-based advances if the client fails to fulfill the terms of his contract with the counterparty. Such facilities are known as contingent liabilities of the bank. Facilities such as 'letters of credit' and 'guarantees' fall under the category of nonfund based credit.

Working Capital Finance

Working capital finance is utilized for operating purposes, resulting in creation of current assets (such as inventories and receivables). This is in contrast to term loans which are utilized for establishing or expanding a manufacturing unit by the acquisition of fixed assets.

41 Banks carry out a detailed analysis of borrowers' working capital requirements. Credit limits are established in accordance with the process approved by the board of directors. The limits on Working capital facilities are primarily secured by inventories and receivables (chargeable current assets). Working capital finance consists mainly of cash credit facilities, short term loan and bill discounting. Under the cash credit facility, a line of credit is provided up to a pre-established amount based on the borrower's projected level of sales inventories, receivables and cash deficits. Up to this pre-established amount, disbursements are made based on the actual level of inventories and receivables. Here the borrower is expected to buy inventory on payments and, thereafter, seek reimbursement from the Bank. In reality, this may not happen. The facility is generally given for a period of up to 12 months and is extended after a review of the credit limit. For clients facing difficulties, the review may be made after a shorter period. One problem faced by banks while extending cash credit facilities, is that customers can draw up to a maximum level or the approved credit limit, but may decide not to. Because of this, liquidity management becomes difficult for a bank in the case of cash credit facility. RBI has been trying to mitigate this problem by encouraging the Indian corporate sector to avail of working capital finance in two ways: a short-term loan component and a cash credit component. The loan component would be fully drawn, while the cash credit component would vary depending upon the borrower's requirements. According to RBI guidelines, in the case of borrowers enjoying working capital credit limits of Rs. 10 crores and above from the banking system, the loan component should normally be 80% and cash credit component 20 %. Banks, however, have the freedom to change the composition of working capital finance by increasing the cash credit component beyond 20% or reducing it below 20 %, as the case may be, if they so desire. Bill discounting facility involves the financing of short-term trade receivables through negotiable instruments. These negotiable instruments can then be discounted with other banks, if required, providing financing banks with liquidity

42

Project Finance
Project finance business consists mainly of extending medium-term and long-term rupee and foreign currency loans to the manufacturing and infrastructure sectors. Banks also provide financing by way of investment in marketable instruments such as fixed rate and floating rate debentures. Lending banks usually insist on having a first charge on the fixed assets of the borrower. During the recent years, the larger banks are increasingly becoming involved in financing large projects, including infrastructure projects. Given the large amounts of financing involved, banks need to have a strong framework for project appraisal. The adopted framework will need to emphasize proper identification of projects, optimal allocation and mitigation of risks. The project finance approval process entails a detailed evaluation of technical, commercial, financial and management factors and the project sponsor's financial strength and experience. As part of the appraisal process, a risk matrix is generated, which identifies each of the project risks, mitigating factors and risk allocation. Project finance extended by banks is generally fully secured and has full recourse to the borrower company. In most project finance cases, banks have a first lien on all the fixed assets and a second lien on all the current assets of the borrower company. In addition, guarantees may be taken from sponsors/ promoters of the company. Should the borrower company fail to repay on time, the lending bank can have full recourse to the sponsors/ promoters of the company. (Full recourse means that the lender can claim the entire unpaid amount from the sponsors / promoters of the company.) However, while financing very large projects, only partial recourse to the sponsors/ promoters may be available to the lending banks.

Loans to Small and Medium Enterprises

43 A substantial quantum of loans is granted by banks to small and medium enterprises (SMEs). While granting credit facilities to smaller units, banks often use a cluster-based approach, which encourages financing of small enterprises that have a homogeneous profile such as leather manufacturing units, chemical units, or even export oriented units. For assessing the credit risk of individual units, banks use the credit scoring models. As per RBI guidelines, banks should use simplified credit appraisal methods for assessment of bank finance for the smaller units. Further, banks have also been advised that they should not insist on collateral security for loans up to Rs.10 lakh for the micro enterprises. Small Industries Development Bank of India (SIDBI) also facilitates the flow of credit at reasonable interest rates to the SME sector. This is done by incentivising banks and State Finance Corporations to lend to SMEs by refinancing a specified percentage of incremental lending to SMEs, besides providing direct finance along with banks.

Rural and Agricultural Loans

The rural and agricultural loan portfolio of banks comprises loans to farmers, small and medium enterprises in rural areas, dealers and vendors linked to these entities and even corporates. For farmers, banks extend term loans for equipments used in farming, including tractors, pump sets, etc. Banks also extend crop loan facility to farmers. In agricultural financing, banks prefer an 'area based' approach; for example, by financing farmers in an adopted village. The regional rural banks (RRBs) have a special place in ensuring adequate credit flow to agriculture and the rural sector. The concept of 'Lead Bank Scheme (LBS)' was first mooted by the Gadgil Study Group, which submitted its report in October 1969. Pursuant to the recommendations of the Gadgil Study Group and those of the Nariman Committee, which suggested the adoption of 'area approach' in evolving credit plans and programmes for development of banking and the credit structure, the LBS was

44 introduced by the RBI in December, 1969. The scheme envisages allotment of districts to individual banks to enable them to assume leadership in bringing about banking developments in their respective districts. More recently, a High Level Committee was constituted by the RBI in November 2007, to review the LBS and improve its effectiveness, with a focus on financial inclusion and recent developments in the banking sector. The Committee has recommended several steps to further improve the working of LBS. The importance of the role of State Governments for supporting banks in increasing banking business in rural areas has been emphasized by the Committee.

Directed Lending
The RBI requires banks to deploy a certain minimum amount of their credit in certain identified sectors of the economy. This is called directed lending. Such directed lending comprises priority sector lending and export credit. A. Priority sector lending The objective of priority sector lending program is to ensure that adequate credit flows into some of the vulnerable sectors of the economy, which may not be attractive for the banks from the point of view of profitability. These sectors include agriculture, small scale enterprises, retail trade, etc. Small housing loans, loans to individuals for pursuing education, loans to weaker sections of the society etc also qualify as priority sector loans. To ensure banks channelize a part of their credit to these sectors, the RBI has set guidelines defining targets for lending to priority sector as whole and in certain cases, sub-targets for lending to individual priority B. Export Credit As part of directed lending, RBI requires banks to make loans to exporters at concessional rates of interest. Export credit is provided for pre-shipment and postshipment requirements of exporter borrowers in rupees and foreign currencies. At the end of any fiscal year, 12.0% of a bank's credit is required to be in the form of export credit. This requirement is in addition to the priority sector lending

45 requirement but credits extended to exporters that are small scale industries or small businesses may also meet part of the priority sector lending requirement. Retail Loan Banks, today, offer a range of retail asset products, including home loans, automobile loans, personal loans (for marriage, medical expenses etc), credit cards, consumer loans (such as TV sets, personal computers etc) and, loans against time deposits and loans against shares. Banks also may fund dealers who sell automobiles, two wheelers, consumer durables and commercial vehicles. The share of retail credit in total loans and advances was 21.3% at end- March 2009. Customers for retail loans are typically middle and high-income, salaried or selfemployed individuals, and, in some cases, proprietorship and partnership firms. Except for personal loans and credit through credit cards, banks stipulate that (a) a certain percentage of the cost of the asset (such as a home or a TV set) sought to be financed by the loan, to be borne by the borrower and (b) that the loans are secured by the asset financed. Many banks have implemented a credit-scoring program, which is an automated credit approval system that assigns a credit score to each applicant based on certain attributes like income, educational background and age. The credit score then forms the basis of loan evaluation. External agencies such as field investigation agencies and credit processing agencies may be used to facilitate a comprehensive due diligence process including visits to offices and homes in the case of loans to individual borrowers. Before disbursements are made, the credit officer checks a centralized delinquent database and reviews the borrower's profile. In making credit decisions, banks draw upon reports from agencies such as the Credit Information Bureau (India) Limited (CIBIL). Some private sector banks use direct marketing associates as well as their own branch network and employees for marketing retail credit products. However, credit approval authority lies only with the bank's credit officers. Two important categories of retail loans--home finance and personal loansare discussed below.

46 Home Finance: Banks extend home finance loans, either directly or through home finance subsidiaries. Such long term housing loans are provided to individuals and corporations and also given as construction finance to builders. The loans are secured by a mortgage of the property financed. These loans are extended for maturities generally ranging from five to fifteen years and a large proportion of these loans are at floating rates of interest. This reduces the interest rate risk that banks assume, since a bank's sources of finance are generally of shorter maturity. However, fixed rate loans may also be provided; usually with banks keeping a higher margin over benchmark rates in order to compensate for higher interest rate risk. Equated monthly installments are fixed for repayment of loans depending upon the income and age of the borrower(s). Personal Loans: These are often unsecured loans provided to customers who use these funds for various purposes such as higher education, medical expenses, social events and holidays. Sometimes collateral security in the form of physical and financial assets may be available for securing the personal loan. Portfolio of personal loans also includes micro-banking loans, which are relatively small value loans extended to lower income customers in urban and rural areas.

International Loans Extended by Banks

Indian corporates raise foreign currency loans from banks based in India as well as abroad as per guidelines issued by RBI/ Government of India. Banks raise funds abroad for on-lending to Indian corporates. Further, banks based in India have an access to deposits placed by Non Resident Indians (NRIs) in the form of FCNR (B) deposits, which can be used by banks in India for on-lending to Indian customers.

Management of Non Performing Assets

An asset of a bank (such as a loan given by the bank) turns into a non-performing asset (NPA) when it ceases to generate regular income such as interest etc for the bank. In other words, when a bank which lends a loan does not get back its principal and interest on time, the loan is said to have turned into an NPA. While NPAs are a natural fall-out of undertaking banking business and hence cannot be completely avoided, high levels of NPAs can severely erode the bank's profits, its capital and

47 ultimately its ability to lend further funds to potential borrowers. Similarly, at the macro level, a high level of nonperforming assets means choking off credit to potential borrowers, thus lowering capital formation and economic activity. So the challenge is to keep the growth of NPAs under control. Clearly, it is important to have a robust appraisal of loans, which can reduce the chances of loan turning into an NPA. Also, once a loan starts facing difficulties, it is important for the bank to take remedial action.

Classification of non-performing Assets

Banks have to classify their assets as performing and non-performing in accordance with RBI's guidelines. Under these guidelines, an asset is classified as nonperforming if any amount of interest or principal installments remains overdue for more than 90 days, in respect of term loans. In respect of overdraft or cash credit, an asset is classified as non-performing if the account remains out of order for a period of 90 days and in respect of bills purchased and discounted account, if the bill remains overdue for a period of more than 90 days. All assets do not perform uniformly. In some cases, assets perform very well and the recovery of principal and interest happen on time, while in other cases, there may be delays in recovery or no recovery at all because of one reason or the other. Similarly, an asset may exhibit good quality performance at one point of time and poor performance at some other point of time. According to the RBI guidelines, banks must classify their assets on an on-going basis into the following four categories: Standard assets: Standard assets service their interest and principal installments on time; although they occasionally default up to a period of 90 days. Standard assets are also called performing assets. They yield regular interest to the banks and return the due principal on time and thereby help the banks earn profit and recycle the repaid part of the loans for further lending. The other three categories (sub-standard assets, doubtful assets and loss assets) are NPAs and are discussed below.

48 Sub-standard assets: Sub-standard assets are those assets which have remained NPAs (that is, if any amount of interest or principal installments remains overdue for more than 90 days) for a period up to 12 months. Doubtful assets: An asset becomes doubtful if it remains a sub-standard asset for a period of 12 months and recovery of bank dues is of doubtful. Loss assets: Loss assets comprise assets where a loss has been identified by the bank or the RBI. These are generally considered uncollectible. Their realizable value is so low that their continuance as bankable assets is not warranted.

49

Chapter 7. Study Of Non Performing assets With respect to ICICI Bank

About ICICI Bank 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 Ram swami 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 specialized 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 capitalization. The Bank has a network of about 1,308 branches and 3,950 ATMs in India and presence in 18 countries.

50 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 and44 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

51 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.

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 too big and small organizations 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

52 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 & through its specialized subsidiaries and affiliates in the area of investment banking, life and non-life insurance, venture capital and asset management. The Bank currently has subsidiaries in the United Kingdom, Russia and 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 subprime 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

53

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 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 thats 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.

54

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 latters 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 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.

55

Everyone has exposure to everythingeither 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. 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: Reduced capacity of

expansion leading to supply side pressure Increased interest rates to affect corporate profitability Increased demand for domestic liquidity will put interest rates under pressure

56 Consumer demand will face a slow-down in developed economies leading to a reduced demand for Indian goods and services, thus affecting Indian exports. Export oriented units will be worst hit, thus impacting employment .Widening of the trade gap due to reduced exports, leading to pressure on the rupee. Exchange rate Impact on Financial Markets: Equity market will continue to remain in bearish mood 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 countrys 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 Banks 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 $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 Banks 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

57

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. 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

58

overseas assets dropped because investors are shunning all except the safest securities.

Financial of ICICI Bank

Performance Review Quarter ended September 30, 2010 18.8% year-on-year increase in profit after tax to Rs 1,236 crore (US$ 275 million) for the quarter ended September 30, 2010 (Q2-2011) from Rs 1,040 crore (US$ 231 million) for the quarter ended September 30, 2009 (Q2-2010) Consolidated profit after tax increased by 21.8% to Rs 1,395 crore (US$ 310 million) in Q2-2011 from Rs 1,145 crore (US$ 255 million) in Q2-2010 Current and savings account (CASA) ratio increased to 44.0% at September 30, 2010 from 36.9% at September 30, 2009. Net non-performing asset ratio declined to 1.37% at September 30, 2010 from 2.19% at September 30, 2009. Strong capital adequacy ratio of 20.2% and Tier-1 capital adequacy of 13.8%. 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, 2010. During the quarter, the Bank received approval of Reserve Bank of India (RBI) for merger of Bank of Rajasthan. The merger was effective from the close of business of August 12, 2010. The financials for Q2-2011 include the financials for erstwhile Bank of Rajasthan (e-BoR) for the period August 13, 2010 to September 30, 2010 (49 days). At the merger date, e- BoR had total assets of Rs 15,596 crore (US$ 3.5 billion), advances of Rs 6,528 crore (US$ 1.5 billion) and deposits of Rs 13,483 crore (US$ 3.0 billion) including CASA deposits of Rs 4,680 crore (US$ 1.0 billion).

Profit & loss account

59

Profit after tax increased 18.8% to Rs 1,236 crore (US$ 275 million) for Q2-2011 from Rs 1,040 crore (US$ 231 million) for Q2-2010. Net interest income increased 8.3% to Rs 2,204 crore (US$ 490 million) in Q22011 from Rs 2,036 crore (US$ 453 million) in Q2-2010. Fee income increased 14.6% to Rs 1,590 crore (US$ 354 million) in Q2- 2011 from Rs 1,387 crore (US$ 309 million) in Q2-2010. Operating expenses (including direct marketing agency expenses) increased 11.3% to Rs 1,535 crore (US$ 342 million) in Q2-2011 from Rs 1,379 crore (US$ 307 million) in Q2-2010, primarily due to the impact of new branches opened and increase in the number of employees. Provisions decreased 40.2% to Rs 641 crore (US$ 143 million) in Q2- 2011 from Rs 1,071 crore (US$ 238 million) in Q2 2010.

Balance sheet
The Bank continues to leverage its branch network to enhance its deposit franchise and create an integrated distribution network for both asset and liability products. At September 30, 2010, the Bank had 2,501 branches, the largest branch network among private sector banks in the country. CASA deposits increased by 34.5% to Rs 98,105 crore (US$ 21.8 billion) at September 30, 2010 from Rs 72,930 crore (US$ 16.2 billion) at September 30, 2009 and the CASA ratio increased to 44.0% at September 30, 2010 from 36.9% at September 30, 2009. Total deposits of the Bank increased by 11.0% to Rs 223,094 crore (US$ 49.6 billion) at September 30, 2010 from Rs 200,913 crore (US$ 44.7 billion) at June 30, 2010 Advances increased by 5.3% to Rs 194,201 crore (US$ 43.2 billion) at September 30, 2010 from Rs 184,378 crore (US$ 41.0 billion) at June 30, 2010.

Capital adequacy

60 The Banks capital adequacy at September 30, 2010 as per Reserve Bank of Indias guidelines on Basel II norms was 20.2% and Tier-1 capital adequacy was 13.8%, well above RBIs requirement of total capital adequacy of 9.0% and Tier-1 capital adequacy of 6.0%.

Asset quality
Net non-performing assets decreased by 30.0% to Rs 3,192 crore (US$ 710 million) at September 30, 2010 from Rs 4,558 crore (US$ 1,014 million) at September 30, 2009. The Banks net non-performing asset ratio decreased to 1.37% at September 30, 2010 from 2.19% at September 30, 2009. The Banks provisioning coverage ratio computed in accordance with the RBI guidelines at September 30, 2010 was 69.0% compared to 51.7% at September 30, 2009.

Consolidated profits
Consolidated profit after tax of the Bank increased by 21.8% to Rs 1,395 crore (US$ 310 million) in Q2-2011 from 1,145 crore (US$ 255 million) in Q2-2010.

Insurance subsidiaries
ICICI Life maintained its position as the largest private sector life insurer based on retail new business weighted received premium during the six months ended September 30, 2010 (H1-2011). ICICI Lifes new business annualised premium equivalent (APE) increased by 10.9% to Rs 1,344 crore (US$ 299 million) in Q2-2011 from Rs 1,212 crore (US$ 270 million) in Q2- 2010. ICICI Lifes renewal premium in Q2-2011 was Rs 2,264 crore (US$ 504 million). ICICI Lifes unaudited new business profit (NBP) increased by 9.0% to Rs 254 crore (US$ 57 million) in Q2-2011 from Rs 233 crore (US$ 52 million) in Q2-2010. Assets held increased 30.7% to Rs 65,484 crore (US$ 14.6 billion) at September 30, 2010 from Rs 50,093 crore (US$ 11.1 billion) at September 30, 2009. For Q2-2011, ICICI Prudential Life Insurance Company (ICICI Life) reported a profit after tax of Rs 15 crore (US$ 3 million), before accounting for a surplus of Rs 254 crore (US$ 57 million) in the non-participating policyholders funds, which would be transferred at the end of the financial year based on the appointed actuarys

61 recommendation. If this surplus were transferred in Q2-2011, the profit after tax of ICICI Life for the quarter would have been Rs 269 crore (US$ 60 million) and the Banks consolidated profit after tax for Q2-2011 would have been Rs 1,583 crore (US$ 352 million). ICICI Lombard General Insurance Company (ICICI General) maintained its leadership in the private sector during H1-2011. ICICI Generals premium income in Q2-2011 increased by 36.2% to Rs 1,091 crore (US$ 243 million) from Rs 801 crore (US$ 178 million) in Q2-2010. ICICI Generals profit after tax was Rs 104 crore (US$ 23 million) in Q2-2011 compared to Rs 51 crore (US$ 11 million) in Q2-2010.

Summary Profit and Loss Statement (as per unconsolidated Indian GAAP accounts) In Crores

62

FY Net Interest income Non Interest Income -Fee Income -Lease and Other income Less: O.E Expenses on DMAs Lease Depreciation Core OP Treasury Income -Provisions PBT Less: Tax PAT 2010 8,114 6,297 5,650 6,47

Q1 2010 1,985 1,376 1,319 57

Q2 2010 2,036 1,527 1,387 140

H1 2010 4,021 2,903 2,706 197

Q1 2011 1,991 1,576 1,413 163

Q2 2011 2,204 1,722 1,590 132

H1 2011 4,195 3,298 3,003 295

5,593 125 142 8,551 1,181 4,387 5,345 1,320 4,025

1,467 27 52 1,815 714 1,324 1,205 327 878

1,358 21 46 2,138 297 1,071 1,364 324 1,040

2,825 48 98 3,953 1,011 2,395 2,569 651 1,918

1,425 36 22 2,084 104 798 1,390 364 1,026

1,500 35 35 2,356 (144) 641 1,571 335 1,236

2,925 71 57 4,440 (40) 1,439 2,961 699 2,262

Summary Balance sheet March31, 2010 Assets Cash & bank balances Advances Investments Fixed & 38,874
181,206 120,893 22,427

Sept 2009 29,267

190,860 119,965 26,282

30, Sept 2010 34,848

194,201 136,275 24,674

30,

63

other assets Total Liabilities Net worth -Equity capital -Reserves Deposits CASA ratio Borrowings Other liabilities Total

363,400 51,618 1,115

366,374 51,258 1,114

389,998 53,975 1,151

50,503 202,017 41.7% 94,264 15,501

363,400

50,144 197,832 36.9% 100,123 17,161

366,374

52,824 223,094 44.0% 97,010 15,919

389,998

Borrowings include preference shares amounting to Rs 350 crore

Chapter 8: 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 Banks financial condition to adverse movements in interest rates. Banks have an appetite for this risk and use it to earn

64 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 banks 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-at- risk (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 is held in the trading book of the bank and (iii) Foreign Currency Risk.

Strategic Risk
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 organizations 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

65 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, and codes of conduct and standards of good practice. It is also called integrity risk since a banks 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 counterparty 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 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

66 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

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

67

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: 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. These are

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 counterparty banks during which Bank Herstatt was liquidated by German regulators, i.e. before the dollar payments could be affected.

68
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 categorized 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

69
Undisclosed reserves, asset revaluation reserves, general provisions & loanloss 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 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.

70 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, one- tailed 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

71

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

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 standardized 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.

72

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 criticized for its `one size fits all prescription. In addition, it lacked proper recognition of credit risk mitigants such as credit derivatives, securitization, 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

73 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

Three alternate approaches for measurement of credit risk have been proposed. These are: Standardized Internal Ratings Based (IRB) Foundation Internal Ratings Based (IRB) Advanced The standardized approach is similar to the current accord in that banks are required to slot their credit exposures into supervisory categories based on

74

observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardized 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 standardized 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 recognized 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. Loss given default (LGD), which measures the proportion of the exposure that will be lost if a default occurs.

75 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 Standardized 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 Comprehensive assessment of risks; Monitoring and reporting; and Internal control review.

76

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.

PILLAR 3:

77

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 banks risk profile and level of capitalizationthereby 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 harmonize these disclosures with International Financial Reporting Standards (IFRS) Board Standards (International Accounting Standards 30 & 32).

ICICI BANK
BASEL II PILLAR 3 DISCLOSURES (STANDALONE) for the six months ended September 30, 2010 CAPITAL STRUCTURE

78 a. Amount of Tier-1 capital (September 30, 2010) Rupees in Billion TIER- 1 Capital Element Paid-up Share Capital/Common Stock Reserves Innovative Tier-1 Capital Instruments Gross Tier-1 Capital Deductions Investments in instruments eligible for regulatory capital of financial subsidiaries/associates Intangible assets other than goodwill 17.27 Securitization exposures including credit 13.57 enhancements Net Tier-1 Capital 425.90 Amount 12.72 472.82 28.89 514.43 57.69

b. Amount of Tier-2 Capital (September 30, 2010) 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 Investments in instruments eligible for regulatory capital of financial Amount 14.58 78.26 93.31 186.15 57.69

79 subsidiaries/associate Securitization exposure including credit 13.57 enhancement Net-Tier 2 capital 114.89

Capital Adequacy Rupees in Billion Risk Area Credit Risk Market Risk Operational Risk Total Capital Requirement at 9% Total capital funds of the bank Total risk weighted assets Capital adequacy ratio Amount 310.61 18.35 18.51 347.47 540.79 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 FY09 as against Q2-FY10. 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.

80 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 sectors solvency is based on two broad parameters including net non performing assets and capital adequacy ratio. 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 2009-10 from Rs 15,462.84 crore in the same period of FY08. Karur Vysya Bank recorded maximum rise of 275.36 per cent in net NPAs in Q2-FY10 with Rs. 50.03 crore as against Rs 13.33 crore in Q2- 07. 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 2009-10, 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 FY10, there were 11 public sector banks out of the total 16 banks that registered decline in CAR from the previous year.

81 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 banks capital expressed as a percentage of its risk weighted credit exposures. The ratio determines the capacity of the bank to meet the time liabilities and other risk such as credit risk and operational risk.

In the simplest formulation, a banks capital is the cushion for potential losses, which protect the banks 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 2008-09. 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 2008-09 compared to 13.2% of the eight banks of the State Bank group, 12.1% of the 20 nationalized banks and 13.1% of the 28 foreign banks. The private sector banks not only have the highest CRAR in 2008-09, they have also witnessed the sharpest rise up by 2.2 percentage points to 14.3% last year from

82

12.1% in 2006-07. Foreign banks rose 1.1 percentage points and SBI group saw rise of 0.9 percentage point. The nationalized banks, in contrast, have witnessed a 0.4 percentage points fall in CRAR last year over 2008-09.

Axis bank registered the maximum decline in CAR from 17.59 per cent in Q2 FY10 to 12.2 per cent in Q2 FY09. 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. However, Federal Bank had the maximum rise in CAR up to 20.81 per cent in Q2 FY 2009-10 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 FY09 to 12.34 per cent in same quarter of the last fiscal.

83

CHAPTER 9: Conclusion
Banking sectors are very transparently exhibiting their financial positions after the entry of I.T, industry in the banking field. In the past decade the world has witnessed an intense consolidation of the international banking, which is often associated with the concept of globalization. Indian banking sector introduces modern service by innovative product and services to its customers. Banking industry in India has to adopt strategies, which are adopted by the developed countries in the past, present and future. So the recent trends in banking industry in India lead to the development of our nation.

84

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

85 outweighed positives such as increasing forex reserves and a manageable inflation rate. 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.

BIBLIOGRAPHY WEBSITES VISITED

www.invetopedia.com www.nseindia.com www.rbi.org.in www.banknetindia.com

JOURNALS REFERRED

86

Journals of reserve Bank of India Economic Survey