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INDIAN FINACIAL SYSTEM – CHALLENGES AND ISSUES

AUTHOR : PROF. B.C. Thimmaiah – Professor ( Assistant ) – Moskovskaya Shkoloo
Upraveleniya Scolkovo , Novaya Ulitsa , 100, SCOLKOVO , MOSCOW OBLAST ,
RUSSIA ,143025

The Indian financial system comprises basically three broad groups. They are
(i) Banking sector; (ii) Broader financial sector; and (iii) Capital market. The banking
sector comprises 27 Public sector banks, 30 Private sector banks, 33 Foreign banks, 196
RRBs and 3111 co-operative banks. The broader financial sector comprises term lending
institutions, investment institutions and state level institutions, and non-banking Finance
Companies. The capital market comprises primary and secondary markets.

Of the total assets of financial sector as on 31 st March 2003, assets owned by

banking sector account for 75.1 percent (Rs 23, 47,337 Cr) and broader financial
institutions 24.9 percent. This composition indicate that in the Indian financial system, the
banking sector occupies a very important place and as such, issues and challenges of
Indian financial system means, more or less the issues and challenges of Indian banking
sector.

The Indian financial system, very specifically the Indian banking sector is
undergoing a metamorphosis. The changes taking place is unprecedented. After the
Financial Structure Reforms, the financial activities are getting more and more globalised.
The globalisation has made Indian institutions to be in conformity with international
standards. The government as well as the RBI felt that to keep in pace with the global
development, we have to change, and change faster, taking into consideration the
problems, issues and challenges.

When permission was given to Indian and foreign private sector banks to enter the
Indian banking sector, a silent revolution took place. The new private sector banks
resorted to aggressive marketing. They started with better technology and customer
orientation modelled on the lines of the most successful foreign banks operating at that
time.
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The impact of the entry of private sector banks resulted in public sector banks to
shake their traditional attitude and not only to survive but also to prove that they are
strong enough to withstand the onslaught of private sector foreign and domestic
banks. They geared themselves to successfully compete with the new entrants into the
banking sector. The deregulation of interest rates, reduction in SLR and CRR ratio,
reduction of NPA, entering into foreign capital markets for capital; maintenance of capital
adequacy ratio etc. gave lot of strength to the public sector banks and today we see
vibrant banking system functioning in the country. The episode of Global Trust Bank is a
very rare event. The method adopted for tackling GTB fiasco has strengthened the
confidence of people in Indian banking sector. The implementation of some of the
recommendations of Sri Narasimham committee has yielded very good results without
much problem to the economy or to the people.

Change is the order of the day. So also change is imperative. Competition is

something with which we have to live. The globalisation of banking/financial activities
has resulted in need for continuous study and evaluation of activity so that the necessary
changes could be brought in to avoid needless problems and also to be on par with global
players in the financial sector.

The Indian banking sector is facing number of challenges and has number of
issues which are to be considered this juncture. The GATS further expose Indian financial
system to face number of challenges and issues since level playing is expected in
financial system as per the agreement.

The challenges which Indian financial system encounters could be listed as under.
1. consolidation of the activities through mergers and acquisitions
2. globalisation of operations
3. universal banking
4. development of new technologies.

The consolidation could take place through strategy alliance and partnership. This results
in achieving economy of scale in operations, increasing the capital base significantly and
enjoy a large network of technology which will reduce the cost, customer retention as
well as offering better services to customers. The impact of consolidation will be
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reduction in operating cost and increasing the margin of returns. The outsourcing of
sources and technology will automatically take place in ensuring efficiency in operations.

However, consolidation poses certain problems, particularly in the Indian context.

The banks were nationalized in 1969 only because the then banks did not respond to the
needs of the society particularly the rural population and urban poor. Because of the
nationalization and opening up of branches, the banking institutions penetrated rural areas
and are serving the society involving directly and indirectly in almost all economic
activities. What will happen when once banks consolidate and become big? If they really
want to enjoy higher market return, the priorities of their services could get shifted and
society may suffer. No doubt, all types of assurances are given by existing banks that
present status is going to be continued, how far it is believable? Consolidation and
globalisation could result in local people sacrificing the benefit which accrued to them all
these years. How their requirement are going to be satisfied which generate very low
return is the issue before us. This challenge i.e. even after becoming big satisfactorily and
effectively meeting the requirements of the poorer segment of the society. On
consolidation, banks may become big and chances are there that they may misuse their
dominant position.

The globalisation of financial services may result in a number of global banks

taking large stakes and control over banking entities in the country. They would bring
capital, technology and management skills. This may lead to competitive spirit in the
system and efficiency of banking sector could increase. Though this could usher in good
banking system, what could government do with the FDI funds. Already we have more
than $ 140 billion. The government should be in a position to use the funds effectively. At
present, there is a plan to establish the special purpose vehicle to be established by RBI.
The special purpose vehicle is expected to issue securities which are to be bought by RBI
paying in terms of dollars. The securities bought to be sold in the market and RBI getting
Indian Rupee from the market to be deployed for useful purposes. All these are in paper.
Will this method is going to be adopted? This is a big question. Government cannot adopt
the other method that is printing of currency notes for buying dollars. This method, if
followed may result in inflation. The allowing of FDI in banking sector should therefore
be look at this angle.
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The consolidation could also take place between public sector and private sector
banks or it could be between DFI and public/private sector banks. When this type of
consolidation takes place it again poses challenge to other banks either functioning
independently or with a smaller bank. There could be clash of perception about the basic
mission and objectives.

The speed of consolidation is reported to be slow and the model of universal

banking which was earlier being hotly pursued by the big banks is now considered as
flawed. The universal banking system was considered to be very good since all financial
activities such as regular banking activity, investment activity including insurance and
other activities to be undertaken by single entity was considered to be more profitable to
the banking institutions and at the same time very much convenient for the general public.
However, it has been reported that there are number of conflicts between commercial
banking and investment banking conducted by one entity. Further despite the theoretical
argument in support of cross selling of products such as insurance, there are few success
stories possibly because this requires team building and selling skills which all banks do
not have. This particular issue requires to be analyzed and loopholes system is to be
plugged to the make the system succeed because of its tremendous advantage.

The information technology revolution has brought in revolutionary change in the

Indian banking system. The system is adapting itself to the technology requirements and
there is proliferation of Automated Teller Machines (ATM), networking of these ATMs
and shared payment network based ATMs have become regular activity. Today we have
internet banking, electronic fund transfers, electronic clearance services etc. Though these
modern technologies have made banking activity more convenient and easy. They do
have number of problems particularly other than drawing of cash. The personal
relationship between the banker and customer has been completely eroded and in its place
today we have impersonal relationship which may ultimately result in developing
problem of confidence in periods of crisis.

The decade of 1990s is known as decade of FSRs. Many significant reforms have
been introduced into the forex. The FERA has been replaced by FEMA. The focus has
been shifted from foreign exchange control to foreign exchange management. The RBI
has taken several steps towards deregulation and liberalization in forex management. The
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government went in for converting fixed exchange rate regime to a fluctuating or floating
rate regime. Of course, first it introduced the system of LERMS and it’s a success result
in introduction of floating rates. In the last three years we are witnessing Indian Rupee
appreciating and it has resulted in exporters facing problem in getting adequate return on
their dollar values. The fluctuation when it is violent the RBI is directly participating in
whether buying or selling of dollars through the dealers. The question is how long the
RBI could be expected to play this role of bringing some semblance in the market. This is
one of the issue as well as the challenge which we are facing. This is in addition to the
bulging forex reserve.

It should be noted here that the current account convertibility has already been
implemented while the road map for capital account convertibility is in progress. There is
need to safe guard the interest of the country and prevent the misuse of liberalization
particularly if the country goes for capital account convertibility. At present the
government is aware of the anticipated problems of capital account convertibility and it is
going slow and at the same time is taking appropriate measures and in fact it has enacted
special Acts like prevention of money laundering Act.

Risk Based Supervision looks at how well a bank (supervised) identifies, measures,
controls and monitor risks. It not only tries to to identify systematic risks caused by the
economic environment in which bank operates but also management’s ability to deal with
them. In this regard the country has adopted Basel-2 report and it has given utmost
importance for identifying and management of risk. In the process of ensuring safety
there is every chance that the bankers may prefer the borrowers to be from the organized
sector where as people from unorganized sector who cannot offer the required securities
may be kept out of the purview of banking sector. This Risk Based Supervision may be
excellent from the point of view of managing efficiently the banking sector. However, the
sector may not fully satisfy the rural and poor segment of the society. This holds good
even in the case of technology. Hi-tech, Internet, E-banking definitely it is the order of the
day, but does the benefit of the modern technological advancements reach the lower rung
of the society since even today we have huge illiterate population in the country with
limited financial resources for making use of the facilities of banking sector.
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Taking into consideration of pattern of deployment of funds, it is reported that

during 2003-04, the banks have invested far more in government securities than what has
been disbursed as credit. As per the latest report of RBI, non-food credit of banks stood
at Rs. 55,125 cr while the investment in government securities stood at Rs. 97, 197 cr. It
means, that as against the stipulated investment of 25 percent of incremental assets in
GILTS, they have almost invested around 66 percent during the above period. The
investment in GILTS does not require an assessment of neither creditworthiness nor the
measurement and want of risk. This may be the reasons why this type of investment is
called lazy banking.

This investment of banks in GILTS is considered to the alright in an environment

wherein interest rates are dropping or declining. However, if interest rates starting
increasing, it will lead to severe loss of revenue to the banks. Can banks follow this lazy
investment pattern. In the context of market becoming more turbulent owing to a
continuous change in the interest rates strategic resilience is expected to help the banks.
Resilience is a strategy of constant morphing that enables banks to be on a forever
conforming themselves with emerging opportunities and underlying trends.

After liberalization the Indian financial system has been undergoing a number of
changes. These changes have facilitated Indian companies to raise capital from other
countries. Indian firms had raised $ 1.1 billion till 2003 August as cheaper foreign loans
and a raising rupee helped cut borrowing costs at home. The forex reserve to increased to
$ 130 billion.

Recently Government of India has tightened the norms for External Commercial
Borrowings. It allows borrowing of more than $ 50 million of equipment imports and
infrastructure projects. Now no banks, financial institutions or NBFCs are allowed to
access ECB or provide guarantees for such loans. In addition hedging is compulsory for
forex exposure of loans under automatic route and AAA-rated companies alone will able
to raise the funds from ECB route. The reason for this restriction is to protect domestic
banking and financial institutions. This is considered as a hurdle in achieving full capital
accounts convertibility. In this era of globalisation, ECB restrictions are not desirable and
it may be detrimental to the Indian corporate.
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Among the many issues which require bestowing immediate attention include
revamping Indian rural financial system. The rural financial system has challenging task
of facing the drastic changes taking place in the banking sector. The co-operative banks
and the regional rural banks need to be modeled on commercial banks and the technology
has to be introduced for enlarging their functions and their services. At present these
banks have a weak structural base and their strengthening requires immediate attention.
Co-operative banks even today can play a vital role in rural areas because of their
position, perception and experience.

The universal banking system may result in winding up of specialized financial

institutions like State Finance Corporations over a period of time. At present these
institutions are offering financial assistance at state level to small and medium scale
industries keeping apart a portion of the funds specifically for the weaker section of the
society. The universalisation of banking activity may not offer any preferential treatment
to the weaker sections and this may affect their chance of coming to the main stream
through their improved economic status.

There are number of other issues which may result in the form of challenges to the
banking sector. They include

1. Asset Liability Management as an effective means of assessing the funds management

of a bank. This provides valuable insights to price products (both Assets & Liabilities)
of banks.

2. Banc assurance is part of the on-going process of FSR. Banks are allowed to
participate in the insurance business. Several banks have already entered into different
types of arrangement with different insurance companies. The problem in this case
could be the foreign companies because of their financial strength and also increased
participation in the form of FDI may monopolies the market and Indian Institutions
like LIC and GIC may find it very difficult to compete with joint ventures. This may
affect even the redemption of funds to insured or assured.
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3. Micro-financing through Self Help Groups may assume greater importance because of
the implementation of more and more technology. From inanimate approach, the SHG
may help the poorer population to have their owes heard by bigger banking
institutions. The desirability and commercial viability of micro-finance is now well
established. The success of the linkage form of delivering this type of credit is also
widely accepted. The experience of Indian banks in practicing this mode of credit
delivery, impact of this method on the economic well-being of the recipients, lessons
learnt by the banks etc. are required to be empirically studied by not only banks but
also the government agencies.

4. The Indian banking system is witnessing structural changes and requires new
competencies and capabilities on on-going basis. This requires the personal to have
adequate knowledge and skill. On of the problems which are witnessed at present is
top banking experts quitting the jobs and entering the foreign banks. So far it has not
created any impact on the performance of Indian banking system because of the
excellent system of training and development of skill among all the levels of
personnel working in the Indian financial system.

5. The corporate governance in banking sector has been given highest importance and
transparency in all activities is expected. Managing of financial system is considered
to be a specialized job with commitment to uphold the trust of the people. It is
considered that banking system functions efficiently and contributes to the
development of individual and the society only when the system functions as real
trustee of the peoples wealth.

The financial structure reforms have contributed immensely for the development of
Indian banking system and it is hoped that in the years to come Indian banks will play a
vital role not only in India but also in other developed countries because of the inherent
strength and excellent structure and system which we have ably supported by the Central
Bank and the Government.