Universal Banking in India

Universal Banking is a multi-purpose and multi-functional financial supermarket (a

company offering a wide range of financial services e.g. stock, insurance and
real-estate brokerage) providing both banking and financial services through a
single window.

Definition of Universal Banking: As per the World Bank, "In Universal Banking,
large banks operate extensive network of branches, provide many different
services, hold several claims on firms(including equity and debt) and participate
directly in the Corporate Governance of firms that rely on the banks for funding
or as insurance underwriters".

In a nutshell, a Universal Banking is a superstore for financial products under

one roof. Corporate can get loans and avail of other handy services, while can
deposit and borrow. It includes not only services related to savings and loans but
also investments.

However in practice the term 'universal banking' refers to those banks that offer
a wide range of financial services, beyond the commercial banking functions like
Mutual Funds, Merchant Banking, Factoring, Credit Cards, Retail loans, Housing
Finance, Auto loans, Investment banking, Insurance etc. This is most common in
European countries.

For example, in Germany commercial banks accept time deposits, lend money,
underwrite corporate stocks, and act as investment advisors to large corporations.
In Germany, there has never been any separation between commercial banks and
investment banks, as there is in the United States.

THE CONCEPT OF UNIVERSAL BANKING

The entry of banks into the realm of financial services was followed very soon
after the introduction of liberalization in the economy. Since the early 1990s
structural changes of profound magnitude have been witnessed in global banking
systems. Large scale mergers, amalgamations and acquisitions between the banks and
financial institutions resulted in the growth in size and competitive strengths of
the merged entities. Thus, emerged new financial conglomerates that could maximize
economies of scale and scope by building the production of financial services
organization called Universal Banking.

By the mid-1990s, all the restrictions on project financing were removed and banks
were allowed to undertake several in-house activities. Reforms in the insurance
sector in the late 1990s, and opening up of this field to private and foreign
players also resulted in permitting banks to undertake the sale of insurance
products. At present, only an 'arm's length relationship between a bank and an
insurance entity has been allowed by the regulatory authority, i.e. IRDA
(Insurance Regulatory and Development Authority).

The phenomenon of Universal Banking as a distinct concept, as different from

Narrow Banking came to the forefront in the Indian context with the Narsimham
Committee (1998) and later the Khan Committee (1998) reports recommending
consolidation of the banking industry through mergers and integration of financial
activities.

UNIVERSAL BANKING � PROS AND CONS

The solution of Universal Banking was having many factors to deal with, which can
be further analyzed by the pros and cons.

Advantages of Universal Banking

* Economies of Scale. The main advantage of Universal Banking is that it

results in greater economic efficiency in the form of lower cost, higher output
and better products. Many Committees and reports by Reserve Bank of India are in
favour of Universal banking as it enables banks to explit economies of scale and
scope.
* Profitable Diversions. By diversifying the activities, the bank can use its
existing expertise in one type of financial service in providing other types. So,
it entails less cost in performing all the functions by one entity instead of
separate bodies.
* Resource Utilization. A bank possesses the information on the risk
characteristics of the clients, which can be used to pursue other activities with
the same clients. A data collection about the market trends, risk and returns
associated with portfolios of Mutual Funds, diversifiable and non diversifiable
risk analysis, etc, is useful for other clients and information seekers.
Automatically, a bank will get the benefit of being involved in the researching
* Easy Marketing on the Foundation of a Brand Name. A bank's existing branches
can act as shops of selling for selling financial products like Insurance, Mutual
Funds without spending much efforts on marketing, as the branch will act here as a
parent company or source. In this way, a bank can reach the client even in the
remotest area without having to take resource to an agent.
* One-stop shopping. The idea of 'one-stop shopping' saves a lot of
transaction costs and increases the speed of economic activities. It is beneficial
for the bank as well as its customers.
* Investor Friendly Activities. Another manifestation of Universal Banking is
bank holding stakes in a form : a bank's equity holding in a borrower firm, acts
as a signal for other investor on to the health of the firm since the lending bank
is in a better position to monitor the firm's activities.

Disadvantages of Universal Banking

* Grey Area of Universal Bank. The path of universal banking for DFIs is
strewn with obstacles. The biggest one is overcoming the differences in regulatory
requirement for a bank and DFI. Unlike banks, DFIs are not required to keep a
portion of their deposits as cash reserves.
* No Expertise in Long term lending. In the case of traditional project
finance, an area where DFIs tread carefully, becoming a bank may not make a big
difference to a DFI. Project finance and Infrastructure finance are generally
long- gestation projects and would require DFIs to borrow long- term. Therefore,
the transformation into a bank may not be of great assistance in lending long-
term.
* NPA Problem Remained Intact. The most serious problem that the DFIs have had
to encounter is bad loans or Non-Performing Assets (NPAs). For the DFIs and
Universal Banking or installation of cutting-edge-technology in operations are
unlikely to improve the situation concerning NPAs.

UNIVERSAL BANKING IN INDIA

In India Development financial institutions (DFIs) and refinancing institutions

(RFIs) were meeting specific sect oral needs and also providing long-term
resources at concessional terms, while the commercial banks in general, by and
large, confined themselves to the core banking functions of accepting deposits and
providing working capital finance to industry, trade and agriculture. Consequent
to the liberalisation and deregulation of financial sector, there has been
blurring of distinction between the commercial banking and investment banking.

Reserve Bank of India constituted on December 8, 1997, a Working Group under the
Chairmanship of Shri S.H. Khan to bring about greater clarity in the respective
roles of banks and financial institutions for greater harmonization of facilities
and obligations . Also report of the Committee on Banking Sector Reforms or
Narasimham Committee (NC) has major bearing on the issues considered by the Khan
Working Group.

The issue of universal banking resurfaced in Year 2000, when ICICI gave a
presentation to RBI to discuss the time frame and possible options for
transforming itself into an universal bank. Reserve Bank of India also spelt out
to Parliamentary Standing Committee on Finance, its proposed policy for universal
banking, including a case-by-case approach towards allowing domestic financial
institutions to become universal banks.

Now RBI has asked FIs, which are interested to convert itself into a universal
bank, to submit their plans for transition to a universal bank for consideration
and further discussions. FIs need to formulate a road map for the transition path
and strategy for smooth conversion into a universal bank over a specified time
frame. The plan should specifically provide for full compliance with prudential
norms as applicable to banks over the proposed period.

SALIENT OPERATIONAL AND REGULATORY ISSUES OF RBI TO BE ADDRESSED BY THE FIs FOR
CONVERSION INTO A UNIVERSAL BANK

a) Reserve requirements. Compliance with the cash reserve ratio and statutory
liquidity ratio requirements (under Section 42 of RBI Act, 1934, and Section 24
of the Banking Regulation Act, 1949, respectively) would be mandatory for an FI
after its conversion into a universal bank.

b) Permissible activities. Any activity of an FI currently undertaken but not

permissible for a bank under Section 6(1) of the B. R. Act, 1949, may have to be
stopped or divested after its conversion into a universal bank..

c) Disposal of non-banking assets. Any immovable property, howsoever acquired by

an FI, would, after its conversion into a universal bank, be required to be
disposed of within the maximum period of 7 years from the date of acquisition, in
terms of Section 9 of the B. R. Act.

d) Composition of the Board. Changing the composition of the Board of Directors

might become necessary for some of the FIs after their conversion into a universal
bank, to ensure compliance with the provisions of Section 10(A) of the B. R. Act,
which requires at least 51% of the total number of directors to have special
knowledge and experience.

e) Prohibition on floating charge of assets. The floating charge, if created by an

FI, over its assets, would require, after its conversion into a universal bank,
ratification by the Reserve Bank of India under Section 14(A) of the B. R. Act,
since a banking company is not allowed to create a floating charge on the
undertaking or any property of the company unless duly certified by RBI as
required under the Section.
f) Nature of subsidiaries. If any of the existing subsidiaries of an FI is engaged
in an activity not permitted under Section 6(1) of the B R Act , then on
conversion of the FI into a universal bank, delinking of such subsidiary /
activity from the operations of the universal bank would become necessary since
Section 19 of the Act permits a bank to have subsidiaries only for one or more
of the activities permitted under Section 6(1) of B. R. Act.

g) Restriction on investments. An FI with equity investment in companies in excess

of 30 per cent of the paid up share capital of that company or 30 per cent of its
own paid-up share capital and reserves, whichever is less, on its conversion into
a universal bank, would need to divest such excess holdings to secure compliance
with the provisions of Section 19(2) of the B. R. Act, which prohibits a bank from
holding shares in a company in excess of these limits.

h) Connected lending . Section 20 of the B. R. Act prohibits grant of loans and

advances by a bank on security of its own shares or grant of loans or advances on
behalf of any of its directors or to any firm in which its director/manager or
employee or guarantor is interested. The compliance with these provisions would
be mandatory after conversion of an FI to a universal bank.

i) Licensing. An FI converting into a universal bank would be required to obtain a

banking licence from RBI under Section 22 of the B. R. Act, for carrying on
banking business in India, after complying with the applicable conditions.

j) Branch network An FI, after its conversion into a bank, would also be required
to comply with extant branch licensing policy of RBI under which the new banks
are required to allot at least 25 per cent of their total number of branches in
semi-urban and rural areas.

k) Assets in India. An FI after its conversion into a universal bank, will be

required to ensure that at the close of business on the last Friday of every
quarter, its total assets held in India are not less than 75 per cent of its total
demand and time liabilities in India, as required of a bank under Section 25 of
the B R Act.

l) Format of annual reports. After converting into a universal bank, an FI will be

required to publish its annual balance sheet and profit and loss account in the
forms set out in the Third Schedule to the B R Act, as prescribed for a banking
company under Section 29 and Section 30 of the B. R. Act.

m) Managerial remuneration of the Chief Executive Officers. On conversion into a

universal bank, the appointment and remuneration of the existing Chief Executive
Officers may have to be reviewed with the approval of RBI in terms of the
provisions of Section 35 B of the B. R. Act. The Section stipulates fixation of
remuneration of the Chairman and Managing Director of a bank by Reserve Bank of
India taking into account the profitability, net NPAs and other financial
parameters. Under the Section, prior approval of RBI would also be required for
appointment of Chairman and Managing Director.

n) Deposit insurance . An FI, on conversion into a universal bank, would also be

required to comply with the requirement of compulsory deposit insurance from DICGC
up to a maximum of Rs.1 lakh per account, as applicable to the banks.

o) Authorized Dealer's License. Some of the FIs at present hold restricted AD

licence from RBI, Exchange Control Department to enable them to undertake
transactions necessary for or incidental to their prescribed functions. On
conversion into a universal bank, the new bank would normally be eligible for
full-fledged authorised dealer licence and would also attract the full rigour of
the Exchange Control Regulations applicable to the banks at present, including
prohibition on raising resources through external commercial borrowings.

p) Priority sector lending. On conversion of an FI to a universal bank, the

obligation for lending to "priority sector" up to a prescribed percentage of their
'net bank credit' would also become applicable to it.

q) Prudential norms. After conversion of an FI in to a bank, the extant prudential

norms of RBI for the all-India financial institutions would no longer be
applicable but the norms as applicable to banks would be attracted and will need
to be fully complied with.

(This list of regulatory and operational issues is only illustrative and not
exhaustive).

THE FUTURE TREND OF UNIVERSAL BANKING IN DIFFERENT COUNTRIES

Universal banks have long played a leading role in Germany, Switzerland, and other
Continental European countries. The principal Financial institutions in these
countries typically are universal banks offering the entire array of banking
services. Continental European banks are engaged in deposit, real estate and other
forms of lending, foreign exchange trading, as well as underwriting, securities
trading, and portfolio management. In the Anglo-Saxon countries and in Japan, by
contrast, commercial and investment banking tend to be separated. In recent years,
though, most of these countries have lowered the barriers between commercial and
investment banking, but they have refrained from adopting the Continental European
system of universal banking. In the United States, in particular, the resistance
to softening the separation of banking activities, as enshrined in the Glass-
Steagall Act, continues to be stiff.

In Germany and Switzerland the importance of universal banking has grown since the
end of World War II. Will this trend continue so that universal banks could
completely overwhelm the specialized institutions in the future? Are the
specialized banks doomed to disappear? This question cannot be answered with a
simple "yes" or "no". The German and Swiss experiences suggest that three factors
will determine future growth of universal banking.

First, universal banks no doubt will continue to play an important role. They
possess a number of advantages over specialized institutions. In particular, they
are able to exploit economies of scale and scope in banking. These economies are
especially important for banks operating on a global scale and catering to
customers with a need for highly sophisticated financial services. As we saw in
the preceding section, universal banks may also suffer from various shortcomings.
However, in an increasingly competitive environment, these defects will likely
carry far less weight than in the past.

Second, although universal banks have expanded their sphere of influence, the
smaller specialized institutions have not disappeared. In both Germany and
Switzerland, they are successfully coexisting and competing with the big banks. In
Switzerland, for example, the specialized institutions are firmly entrenched in
such areas as real estate lending, securities trading, and portfolio management.
The continued strong performance of many specialized institutions suggests that
universal banks do not enjoy a comparative advantage in all areas of banking.

Third, universality of banking may be achieved in various ways. No single type of

universal banking system exists. The German and Swiss universal banking systems
differ substantially in this regard. In Germany, universality has been
strengthened without significantly increasing the market shares of the big banks.
Instead, the smaller institutions have acquired universality through cooperation.
It remains to be seen whether the cooperative approach will survive in an
environment of highly competitive and globalized banking.