Indian Banking: Key Developments

1969

Government acquires ownership in major banks

Almost all banking operations in manual mode
Some banks had Unit record Machines of IBM for IBR

19701980

& Pay roll

Unprecedented expansion in geographical coverage,
staff, business & transaction volumes and directed
lending to agriculture, SSI & SB sector
Manual systems struggle to handle exponential rise
in transaction volumes - Outsourcing of data processing to service bureau
begins
Back office systems only in Multinational (MNC)

1981-

banks' offices
Regulator (read RBI) led IT introduction in Banks

1990

Product level automation on standalone PCs at

branches (ALPMs)
In-house EDP infrastructure with UNIX boxes, batch
processing in COBOL for MIS.
Mainframes in corporate office

1991-1995

Expansion slows down

Banking sector reforms resulting in progressive deregulation of banking, introduction of prudential
banking norms entry of new private sector banks
Total Branch Automation (TBA) in Govt. owned and
old private banks begins
New private banks are set up with CBS/TBA from the

1996-2000

start
New delivery channels like ATM, Phone banking and
Internet banking and convenience of any branch
banking and auto sweep products introduced by
new private and MNC banks
1

 Retail banking in focus, proliferation of credit cards

Communication

infrastructure

improves

and

becomes cheap. IDRBT sets up VSAT network for

Banks
Govt. owned banks feel the heat and attempt to
respond

using

implementation

intermediary
surges

ahead

technology,
under

fiat

TBA
from

Central Vigilance
Commission (CVC), Y2K threat consumes last two
2000-2003

years
Alternate delivery channels find wide consumer
acceptance
IT Bill passed lending legal validity to electronic
transactions
Govt. owned banks and old private banks start
implementing

CBSs,

but

initial

attempts

face

problems
Banks enter insurance business launch debit cards

Current Scenario of Indian Banking Industry:

The banking industry in India is in a midst of transformation, thanks to
the economic liberalization of the country, which has changed business
environment in the country. During the pre-liberalization period, the
industry was merely focusing on deposit mobilization and branch
expansion. But with liberalization, it found many of its advances under
the non-performing assets (NPA) list. More importantly, the sector has
become very competitive with the entry of many foreign and private
sector banks. The face of banking is changing rapidly. There is no doubt
that banking sector reforms have improved the profitability, productivity
and efficiency of banks, but in the days ahead banks will have to prepare
themselves to face new challenges.

 For the first quarter ended June 2004, the banking sector recorded a
bottom line growth of 18% to Rs 4852.50 crore. Higher net interest
income and lower provisioning were the main reasons for the profit
growth during the quarter. However, the above results were achieved
despite higher operating expenses and a lower rise in non-interest
income.
Among banks, public sector banks outperformed private sector banks
by registering a 20% rise in the net profit compared to an 11% growth
reported by private sector banks. This was mainly due to a higher rise
in other income (OI) and a lower increase in operating expenses by
public sector banks compared to a fall in OI and higher operating
expenses by private sector banks. However, at the net interest level,
private sector banks outperformed public sector banks by registering
a growth of 36% compared to a 14% rise reported by public sector
banks.

The net interest income of the overall banking sector during the
quarter rose 17% to Rs 11962.53 crore, mainly due to low cost of
funds. The interest earned rose 4% to Rs 29747.88 crore, contributed
mainly by interest income from core operations (i.e., lending). The
interest expenses decreased by 4% to Rs 17785.35 crore. The interest
spread of most banks witnessed an increase over the corresponding
previous quarter, as the decline of yield on lending was lower than the
cost of funds. In the falling interest rate scenario, the rate on deposits
for most banks fell faster than advances. Thus, interest expenses
came down faster to protect profit.
The sound economic growth, soft interest rate regime, upward
migration of incomes and wider distribution to cover a larger
proportion of the population are expected to increase the demand for
retail loans in a significant manner. The retail credit as a percentage of
GDP in India is only around 5% as compared to levels of 30 - 50% in
other Asian economies and, therefore, offers significant growth
opportunities. Also, favorable demographic profile like 69% of the
3

population estimated to be under 35 years and an increase in upper

middle/high income households are to be the main drivers for retail
credit. In the medium term, stronger demand for credit from the
corporate sector is also expected consequent to the resurgence of this
sector. Earlier, banks were seeing lower credit off take from corporate
because of weak business sentiments and lower credit requirement
due to improved operational efficiency.
Also, most banks are aggressively augmenting their fee incomes and
have embarked upon cross selling of products. They are also focusing
on fuller utilization of their IT investments such as ATMs by entering
into sharing arrangement with other banks to earn extra OI. Many
banks are hopeful of effecting significant NPA recoveries due to the
Securitization Act.

CURRENT RATES

S.No

Rates/Reserve
Ratios

Bank Rate

Repo Rate

Reverse Repo Rate

Cash Reserve
Ratio(CRR)
Statutory Liquidity
Ratio(SLR)

4
5

%
9.00
%
8.00
%
7.00
%
4.00
%
22.00
%

MARKET SHARE OF VARIOUS BANKS

Segment
Banks
Insurance Companies
Non-banking Financial Institutions
Mutual Funds
Provident and Pension Funds
Total

Market Share of Financial Assets

(Percentage)
63
19
8
6
4
100

Market Share of Total Banking

Institution

Assets

(2013)

(Percentage)
Public Sector Banks
Private Sector Banks
Foreign Banks
Regional Rural Banks
Rural and Urban Co-operative Banks
Local Area Banks
Total

67.2
18.7
6.5
2.7
3.4
1.5
100.0

RECENT TRENDS
I

Universal Banking

Universal banking refers to Financial Institution offering all types of

financial services under one roof. Thus, for example, besides borrowing
and lending for the long term, the Development Financial Institutions will
be able to borrow/lend for the short-term as well.
Impact on FDI:
Two key aspects of the business are affected. The institution can have
access to cheap retail deposits and the breadth of its advances increase
to include short-term working capital loans to corporate. The Institution
has greater operational flexibility. Also they can now effectively compete
with the commercial banks.
Indian Scenario:
In India the five FDIs that are frontrunners in the race to convert to
Universal Bank are:
1 Industrial Credit and Investment Corporation of India (ICICI)
2 Industrial Development Bank of India (IDBI)
3 Export Import Bank (EXIM Bank)
4 Industrial Finance Corporation of India (IFCI)
5 Industrial Investment Bank of India (IIBI)
ICICI is already a virtual bank with subsidiaries like ICICI Bank engaged in
banking business. Thus with clearing of legal hurdles it just has to work
out the modalities to formally call itself a universal bank.

Similarly other FDIs are charting out aggressive plans to stay ahead in
this race.
Also recently Bank of Baroda, a commercial bank has indicated its
intention to convert to a Universal Bank.

RBI Norms:

The norms stipulated by RBI treat FDIs at par with the existing
commercial banks. Thus all Universal banks have to maintain the CRR
and the SLR requirement on the same lines as the commercial banks.
Also they have to fulfill the priority sector lending norms applicable to the
commercial banks. These are the major hurdles as perceived by the
institutions, as it is very difficult to fulfill such norms without hurting the
bottom-line
Effect on the Banking Sector:
However, with large Term lenders converting into Commercial banks, the
existing players in the industry are likely to face stiff competition; lower
bottom line ultimately leading to a shakeout in the industry with only the
operationally efficient banks will stay into the business, irrespective to
the size.

Mergers & Acquisition

The Indian Banking Sector is more overcrowded than ever. There are 96
commercial banks reporting to the RBI. Ever since the RBI opened up the
sector to private players, there have been nine new entrants. All of them
are growing at a scorching pace and redefining the rules of the business.
However they are dwarfed by many large public and old private sector
banks with a large network of branches spread over a diverse
geographical area. Thus they are unable to make a significant dent in the
7

market share of the old players. Also it is impossible to exponentially

increase the number of branches. The only route available for these
banks is to grow inorganically via the M & A route. Hence the new banks
are under a tremendous pressure to acquire older banks and thus
increase their business.
Currently most of the institutionally promoted banks have already
gobbled smaller banks. ICICI Bank has acquired ITC Classic, Anagram
Finance and Bank of Madura within a period of two years. HDFC Bank has
merged Times Bank with itself. UTI bank had almost completed its
merger with Global Trust Bank before it ran into rough weather. Also
Nationalized Banks like Bank of Punjab, Vyasa Bank are wooing IDBI Bank
for a merger. Among foreign banks, Standard & Chartered Bank has
acquired ANZ Grind lays Banks Asian and Middle East operations
The above happenings clearly indicate that the M & A scenario in the
Indian banking sector are far from over. Strong banks will continue to
takeover weak and inefficient banks to increase their size.

Multiple Delivery Channels

Today the technology driven banks are finding various means to reduce
costs and reach out to as many customers as possible spread over a
diverse area. This has led to using multiple channels of delivery of their
products.
1 ATM (Automatic Teller Machine):
An ATM is basically a machine that can deliver cash to the customers on
demand after authentication. However, nowadays we have ATMs that are
used to vend different FMCG products also. An ATM does the basic
function of a banks branch, i.e., delivering money on demand. Hence
setting of newer branches is not required thereby significantly lowering
infrastructure costs.
8

Cost reduction is however possible only when these machines are used.
In India, the average cash withdrawal per ATM per day has fallen from
100 last year to 70 this year. Though the number of ATMs has increased
since last year, it is not in sync with the number of cards issued. Also,
there are many dormant cardholders who do not use the ATMs and prefer
the teller counters. Inspire of these odds, Indian banks are increasing the
number of ATMs at a feverish pace. These machines also hold the keys to
future operational efficiency.

2 Net Banking:
Net banking means carrying out banking transactions via the Internet.
Thus the need for a branch is completely eliminated by technology. Also
this helps in serving the customer better and tailoring products better
suited for the customer
A customer can view his account details, transaction history, order
drafts, electronically make payments, transfer funds, check his account
position and electronically communicate with the bank through the
Internet for which he may have wanted to visit the bank branch.
Net banking helps a bank spread its reach to the entire world at a
fraction of the cost.
3 Phone Banking:
This means carrying out of banking transaction through the telephone. A
customer can call up the banks helpline or phone banking number to
conduct transactions like transfer of funds, making payments, checking
of account balance, ordering cheques, etc,. This also eliminates the
customer of the need to visit the banks branch.
9

4 Mobile Banking:
Banks can now help a customer conduct certain transactions through the
Mobile Phone with the help of technologies like WAP, SMS, etc,. This
helps a bank to combine the Internet and telephone and leverage it to
cut costs and at the same time provide its customer the convenience.
Thus it can be seen that tech savvy banks are tapping all the above
alternative channels to cut costs improve customer satisfaction.

I VRS (Voluntary Retirement Scheme):

VRS or the Golden Handshake is picking up very fast in the recent times
due to the serious attention of the government towards overstaffing in
the banks, especially among the public sector banks. The government
had also cleared a uniform VRS framework for the sector giving the
banks a seven months time frame to cut flab. The scheme was open till
31st march, 2001.
Though many banks had announced different VRS schemes it involved an
outflow of huge sums of money. This could have had an adverse impact
on the Capital Adequacy Ratio (CAR). Hence the RBI allowed the banks to
write off the VRS expenses over a period of 5 years.
SERVICES:
DOMESTIC TREASURY
SBI VISHWA YATRA FOREIGN TRAVEL CARD
BROKING SERVICES
REVISED SERVICE CHARGES
ATM SERVICES
INTERNET BANKING
E-PAY
E-RAIL
RBIEFT
SAFE DEPOSIT LOCKER
GIFT CHEQUES
MICR CODES
FOREIGN INWARD REMITTANCES

10

ATM SERVICES
STATE BANK NETWORKED ATM SERVICES
State Bank offers you the convenience of over 8000 ATMs in India, the
largest network in the country and continuing to expand fast! This means
that you can transact free of cost at the ATMs of State Bank Group (This
includes the ATMs of State Bank of India as well as the Associate Banks
namely, State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State
Bank of Indore, State Bank of Mysore, State Bank of Patiala, State Bank
of Saurashtra, and State Bank of Travancore) and wholly owned
subsidiary viz. SBI Commercial and International Bank Ltd., using the
State Bank ATM-cum-Debit (Cash Plus) card.
KINDS OF CARDS ACCEPTED AT STATE BANK ATMs
Besides State Bank ATM-Cum-Debit Card and State Bank International
ATM-Cum-Debit Cards following cards are also accepted at State Bank
ATMs: 1) State Bank Credit Card
2) ATM Cards issued by Banks under bilateral sharing viz. Andhra Bank,
Axis Bank, Bank of India, The Bank of Rajasthan Ltd., Canara Bank,
Corporation Bank, Dena Bank, HDFC Bank, Indian Bank, Induslnd Bank,
Punjab National Bank, UCO Bank and Union Bank of India.
3) Cards issued by banks (other than banks under bilateral sharing)
displaying Maestro, Master Card, Cirrus, VISA and VISA Electron logos
4) All Debit/ Credit Cards issued by any bank outside India displaying
Maestro, Master Card, Cirrus, VISA and VISA Electron logos
Note: If you are a cardholder of bank other than State Bank Group, kindly
contact your Bank for the charges recoverable for usage of State Bank
ATMs.
STATE BANK INTERNATIONAL ATM-CUM-DEBIT CARD

Eligibility:
All Saving Bank and Current Account holders having accounts with
networked branches and are:
18 years of age & above
Account type: Sole or Joint with Either or Survivor / Anyone or
Survivor
NRE account holders are also eligible but NRO account holders are not.

Benefits:

Convenience to the customers traveling overseas

can be used as Domestic ATM-cum-Debit Card
Available at a nominal joining fee of Rs. 200/ Daily limit of US $ 1000 or equivalent at the ATM and US $ 1000 or
equivalent
11

At Point of Sale (POS) terminal for debit transaction

Purchase Protection*up to Rs. 5000/- and Personal Accident cover*up
to Rs.
2, 00,000/ Charges for usage abroad: Rs. 150+ Service Tax per cash withdrawal
Rs. 15 +
Service Tax per enquiry.
State Bank ATM-cum-Debit (State Bank Cash plus) Card:
Indias largest bank is proud to offer you unparalleled convenience viz.
State Bank
ATM-cum-Debit (Cash Plus) card. With this card, there is no need to carry
cash in your wallet. You can now withdraw cash and make purchases
anytime you wish to with your ATM-cum-Debit Card. Get an ATM-cumDebit card with which you can transact for FREE at any of over 8000
ATMs of State Bank Group within our country.
SBI GOLD INTERNATIONAL DEBIT CARDS

E-PAY
Bill Payment at Online SBI (e-Pay) will let you to pay your Telephone,
Mobile, Electricity, Insurance and Credit Card bills electronically over our
Online SBI website
E-RAIL

Book your Railways Ticket Online.

The facility has been launched wef Ist September 2003 in association
with IRCTC.
The scheme facilitates Booking of Railways Ticket Online.
The salient features of the scheme are as under:
All Internet banking customers can use the facility.
on giving payment option as SBI, the user will be redirected to
onlinesbi.com.
After logging on to the site you will be displayed payment amount, TID
No. and
Railway reference no.
. The ticket can be delivered or collected by the customer.
the user can collect the ticket personally at New Delhi reservation
counter.
The Payment amount will include ticket fare including reservation
charges,
12

Courier charges and Bank Service fee of Rs 10/. The Bank service fee has
been
Waived unto 31st July 2006.
SAFE DEPOSIT LOCKER
For the safety of your valuables we offer our customers safe deposit
vault or locker
Facilities at a large number of our branches. There is a nominal annual
charge, which depends on the size of the locker and the centre in which
the branch is located.

RiskManagementSystemsinBanks
Introduction
Banksintheprocessoffinancialintermediationareconfrontedwithvariouskindsoffinancial
andnonfinancialrisksviz.,credit,interestrate,foreignexchangerate,liquidity,equityprice,
commodity price, legal, regulatory, reputational, operational, etc. These risks are highly
interdependentandeventsthataffectoneareaofriskcanhaveramificationsforarangeofother
risk categories. Thus, top management of banks should attach considerable importance to
improve the ability to identify, measure, monitor and control the overall level of risks
undertaken.
Thebroadparametersofriskmanagementfunctionshouldencompass:
i) organisationalstructure;
ii) comprehensiveriskmeasurementapproach;
iii) riskmanagementpoliciesapprovedbytheBoardwhichshouldbeconsistentwiththe
broader business strategies, capital strength, management expertise and overall
13

willingnesstoassumerisk;
iv) guidelinesandotherparametersusedtogovernrisktakingincludingdetailedstructure
ofprudentiallimits;
v) strongMISforreporting,monitoringandcontrollingrisks;
vi) welllaidoutprocedures,effectivecontrolandcomprehensiveriskreportingframework;
vii) separateriskmanagementframeworkindependentofoperationalDepartmentsandwith
cleardelineationoflevelsofresponsibilityformanagementofrisk;and
viii)periodicalreviewandevaluation.
2.RiskManagementStructure
2.1Amajorissueinestablishinganappropriateriskmanagementorganisationstructureischoosing
between a centralised and decentralised structure. The global trend is towards centralising risk
management with integrated treasury management function to benefit from information on
aggregateexposure,naturalnettingofexposures,economiesofscaleandeasierreportingtotop
management.Theprimaryresponsibilityofunderstandingtherisksrunbythebankandensuring
thattherisksareappropriatelymanagedshouldclearlybevestedwiththeBoardofDirectors.The
Boardshouldsetrisklimitsbyassessingthebanksriskandriskbearingcapacity.Atorganisational
level,overallriskmanagementshouldbeassignedtoanindependentRiskManagementCommittee
orExecutiveCommitteeofthetopExecutivesthatreportsdirectlytotheBoardofDirectors.The
purposeofthistoplevelcommitteeistoempoweronegroupwithfullresponsibilityofevaluating
overallrisksfacedbythebankanddeterminingthelevelofriskswhichwillbeinthebestinterestof
thebank.Atthesametime,theCommitteeshouldholdthelinemanagementmoreaccountablefor
therisksundertheircontrol,andtheperformanceofthebankinthatarea.ThefunctionsofRisk
ManagementCommitteeshouldessentiallybetoidentify,monitorandmeasuretheriskprofileof
thebank.TheCommitteeshouldalsodeveloppoliciesandprocedures,verifythemodelsthatare
used for pricing complex products, review the risk models as development takes place in the
markets and also identify new risks. The risk policies should clearly spell out the quantitative
prudentiallimitsonvarioussegmentsofbanksoperations.Internationally,thetrendistowards
assigningrisklimitsintermsofportfoliostandardsorCreditatRisk(creditrisk)andEarningsat
RiskandValueatRisk(marketrisk).TheCommitteeshoulddesignstressscenariostomeasurethe
impactofunusual

14

marketconditionsandmonitorvariancebetweentheactualvolatilityofportfoliovalueandthat
predictedbytheriskmeasures.TheCommitteeshouldalsomonitorcomplianceofvariousrisk
parametersbyoperatingDepartments.
2.2 Aprerequisiteforestablishmentofaneffectiveriskmanagementsystemistheexistenceofa
robustMIS,consistentinquality.TheexistingMIS,however,requiressubstantialupgradation
andstrengtheningofthedatacollectionmachinerytoensuretheintegrityandreliabilityofdata.
2.3 Theriskmanagementisacomplexfunctionanditrequiresspecialisedskillsandexpertise.
Bankshavebeenmovingtowardstheuseofsophisticatedmodelsformeasuringandmanaging
risks.Largebanksandthoseoperatingininternationalmarketsshoulddevelopinternalrisk
managementmodelstobeabletocompeteeffectivelywiththeircompetitors.Asthedomestic
marketintegrateswiththeinternationalmarkets,thebanksshouldhavenecessaryexpertiseand
skillinmanagingvarioustypesofrisksinascientificmanner.Atamoresophisticatedlevel,the
corestaffatHeadOfficesshouldbetrainedinriskmodellingandanalyticaltools.Itshould,
therefore,betheendeavourofallbankstoupgradetheskillsofstaff.
2.4 Giventhediversityofbalancesheetprofile,itisdifficulttoadoptauniformframeworkfor
management of risks in India. The design of risk management functions should be bank
specific,dictatedbythesize,complexityoffunctions,theleveloftechnicalexpertiseandthe
qualityofMIS.Theproposedguidelinesonlyprovidebroadparametersandeachbankmay
evolvetheirownsystemscompatibletotheirriskmanagementarchitectureandexpertise.
2.5 Internationally,acommitteeapproachtoriskmanagementisbeingadopted.WhiletheAsset
LiabilityManagementCommittee(ALCO)dealwithdifferenttypesofmarketrisk,theCredit
PolicyCommittee(CPC)overseesthecredit/counterpartyriskandcountryrisk.Thus,market
andcreditrisksaremanagedinaparalleltwotrackapproachinbanks.Bankscouldalsosetup
a single Committee for integrated management of credit and market risks. Generally, the
policiesandproceduresformarketriskarearticulatedintheALMpoliciesandcreditriskis
addressedinLoanPoliciesandProcedures.
2.6 Currently,whilemarketvariablesareheldconstantforquantifyingcreditrisk,creditvariables
areheldconstantinestimatingmarketrisk.Theeconomiccrisesinsomeofthecountrieshave
revealedastrongcorrelationbetweenunhedgedmarketriskandcreditrisk.Forexexposures,
assumedbycorporateswhohavenonaturalhedges,willincreasethecreditriskwhichbanks
runvisvistheir counterparties.Thevolatilityinthe pricesofcollateralalsosignificantly
affectsthequalityoftheloanbook.Thus,thereisaneedforintegrationoftheactivitiesofboth
theALCOandtheCPCandconsultationprocessshouldbeestablishedtoevaluatetheimpactof
marketandcreditrisksonthefinancialstrengthofbanks.Banksmayalsoconsiderintegrating
marketriskelementsintotheircreditriskassessmentprocess.
3.CreditRisk
3.1General
3.1.1
Lendinginvolvesanumberofrisks.Inadditiontotherisksrelatedtocreditworthinessof
thecounterparty,thebanksarealsoexposedtointerestrate,forexandcountryrisks.
3.1.2
Creditriskordefaultriskinvolvesinabilityorunwillingnessofacustomerorcounterpartyto
meetcommitmentsinrelationtolending,trading,hedging,settlementandotherfinancial

15

transactions.TheCreditRiskisgenerallymadeupoftransactionriskordefaultriskandportfolio
risk.Theportfolioriskinturncomprisesintrinsicandconcentrationrisk.Thecreditriskofabanks
portfoliodependsonbothexternalandinternalfactors.Theexternalfactorsarethestateofthe
economy,wideswingsincommodity/equityprices,foreignexchangeratesandinterestrates,trade
restrictions,economicsanctions,Governmentpolicies,etc.Theinternalfactorsaredeficienciesin
loanpolicies/administration,absenceofprudentialcreditconcentrationlimits,inadequatelydefined
lendinglimitsforLoanOfficers/CreditCommittees,deficienciesinappraisalofborrowersfinancial
position,excessivedependenceoncollateralsandinadequateriskpricing,absenceofloanreview
mechanismandpostsanctionsurveillance,etc.

3.1.3
Anothervariantofcreditriskiscounterpartyrisk.Thecounterpartyriskarisesfromnon
performance of the trading partners. The nonperformance may arise from counterpartys
refusal/inabilitytoperformduetoadversepricemovementsorfromexternalconstraintsthat
werenotanticipatedbytheprincipal.Thecounterpartyriskisgenerallyviewedasatransient
financialriskassociatedwithtradingratherthanstandardcreditrisk.
3.1.4
Themanagementofcreditriskshouldreceivethetopmanagementsattentionandthe
processshouldencompass:
a) Measurementofriskthroughcreditrating/scoring;
b) Quantifyingtheriskthroughestimatingexpectedloanlossesi.e.theamountofloanlosses
that bank would experience over a chosen time horizon (through tracking portfolio
behaviourover5ormoreyears)andunexpectedloanlossesi.e.theamountbywhichactual
losses exceed the expected loss (through standard deviation of losses or the difference
betweenexpectedloanlossesandsomeselectedtargetcreditlossquantile);
c) Riskpricingonascientificbasis;and
d) ControllingtheriskthrougheffectiveLoanReviewMechanismandportfoliomanagement.
3.1.5ThecreditriskmanagementprocessshouldbearticulatedinthebanksLoanPolicy,duly
approvedbytheBoard.Eachbankshouldconstituteahighlevel CreditPolicyCommittee,
alsocalledCreditRiskManagementCommitteeorCreditControlCommitteeetc.todealwith
issuesrelatingtocreditpolicyandproceduresandtoanalyse,manageandcontrolcreditriskon
abankwidebasis.TheCommitteeshouldbeheadedbytheChairman/CEO/ED,andshould
compriseheadsofCreditDepartment,Treasury,CreditRiskManagementDepartment(CRMD)
and the Chief Economist. The Committee should, inter alia, formulate clear policies on
standards for presentation of credit proposals, financial covenants, rating standards and
benchmarks,delegationofcreditapprovingpowers,prudentiallimitsonlargecreditexposures,
asset concentrations, standards for loan collateral, portfolio management, loan review
mechanism,riskconcentrations,riskmonitoringandevaluation,pricingofloans,provisioning,
regulatory/legal compliance, etc. Concurrently, each bank should also set up Credit Risk
ManagementDepartment(CRMD),independentoftheCreditAdministrationDepartment.The
CRMDshouldenforceandmonitorcomplianceoftheriskparametersandprudentiallimitsset
bytheCPC.TheCRMDshouldalsolaydownriskassessmentsystems,monitorqualityofloan
portfolio, identify problems and correct deficiencies, develop MIS and undertake loan
review/audit. Large banks may consider separate set up for loan review/audit. The CRMD
shouldalsobemadeaccountableforprotectingthequalityoftheentireloanportfolio.The
Departmentshouldundertakeportfolioevaluationsandconductcomprehensivestudiesonthe
environmenttotesttheresilienceoftheloanportfolio.
16

3.2InstrumentsofCreditRiskManagement
CreditRiskManagementencompassesahostofmanagementtechniques,whichhelpthebanks
inmitigatingtheadverseimpactsofcreditrisk.
3.2.1CreditApprovingAuthority
Eachbankshouldhaveacarefullyformulatedschemeofdelegationofpowers.Thebanksshould
also evolve multitier credit approving system where the loan proposals are approved by an
ApprovalGridoraCommittee.Thecreditfacilitiesaboveaspecifiedlimitmaybeapprovedby
theGridorCommittee,comprisingatleast3or4officersandinvariablyoneofficershould
represent the CRMD, who has no volume and profit targets. Banks can also consider credit
approvingcommitteesatvariousoperatinglevelsi.e.largebranches(whereconsiderednecessary),
RegionalOffices,ZonalOffices,HeadOffices,etc.Bankscouldconsiderdelegatingpowersfor
sanction of higher limits to the Approval Grid or the Committee for better rated / quality
customers.Thespiritofthecreditapprovingsystemmaybethatnocreditproposalsshouldbe
approvedorrecommendedtohigherauthorities,ifmajoritymembersoftheApprovalGridor
Committeedonotagreeonthecreditworthinessoftheborrower.Incaseofdisagreement,the
specificviewsofthedissentingmember/sshouldberecorded.

The banks should also evolve suitable framework for reporting and evaluating the
qualityofcreditdecisionstakenbyvariousfunctionalgroups.Thequalityofcreditdecisions
shouldbeevaluatedwithinareasonabletime,say36months,throughawelldefinedLoan
ReviewMechanism.
3.2.2PrudentialLimits
Inordertolimitthemagnitudeofcreditrisk,prudentiallimitsshouldbelaiddownonvarious
aspectsofcredit:
a) stipulatebenchmarkcurrent/debtequityandprofitabilityratios,debtservicecoverageratio
orotherratios,withflexibilityfordeviations.Theconditionssubjecttowhichdeviations
arepermittedandtheauthoritythereforshouldalsobeclearlyspeltoutintheLoanPolicy;
b) single/groupborrowerlimits,whichmaybelowerthanthelimitsprescribedbyReserve
Banktoprovideafilteringmechanism;
c) substantialexposurelimiti.e.sumtotalofexposuresassumedinrespectofthosesingle
borrowersenjoyingcreditfacilitiesinexcessofathresholdlimit,say10%or15%of
capitalfunds.Thesubstantialexposurelimitmaybefixedat 600%or800% ofcapital
funds,dependinguponthedegreeofconcentrationriskthebankisexposed;
d) maximumexposurelimitstoindustry,sector,etc.shouldbesetup.Theremustalsobe
systemsinplacetoevaluatetheexposuresatreasonableintervalsandthelimitsshouldbe
adjusted especially when a particular sector or industry faces slowdown or other
sector/industry specific problems. The exposure limits to sensitive sectors, such as,
advancesagainstequityshares,realestate,etc.,whicharesubjecttoahighdegreeofasset
pricevolatilityandtospecificindustries,whicharesubjecttofrequentbusinesscycles,
maynecessarilyberestricted.Similarly,highriskindustries,asperceivedbythebank,

17

shouldalsobeplacedunderlowerportfoliolimit.Anyexcessexposureshouldbefully
backedbyadequatecollateralsorstrategicconsiderations;and
e) banksmayconsidermaturityprofileoftheloanbook,keepinginviewthemarketrisks
inherentinthebalancesheet,riskevaluationcapability,liquidity,etc.
3.2.3RiskRating
Banksshouldhaveacomprehensiveriskscoring/ratingsystemthatservesasasinglepoint
indicatorofdiverseriskfactorsofacounterpartyandfortakingcreditdecisionsinaconsistent
manner.Tofacilitatethis,asubstantialdegreeofstandardisationisrequiredinratingsacross
borrowers.Theriskratingsystemshouldbedesignedtorevealtheoverallriskoflending,
critical input for setting pricing and nonprice terms of loans as also present meaningful
informationforreviewandmanagementofloanportfolio.Theriskrating,inshort,should
reflecttheunderlyingcreditriskoftheloanbook.Theratingexerciseshouldalsofacilitatethe
creditgrantingauthoritiessomecomfortinitsknowledgeofloanqualityatanymomentof
time.
Theriskratingsystemshouldbedrawnupinastructuredmanner,incorporating,inter
alia,financialanalysis,projectionsandsensitivity,industrialandmanagementrisks.Thebanks
may use any number of financial ratios and operational parameters and collaterals as also
qualitative aspects of management and industry characteristics that have bearings on the
creditworthinessofborrowers.Bankscanalsoweightheratiosonthebasisoftheyearsto
which they represent for giving importance to near term developments. Within the rating
framework,bankscanalsoprescribecertainlevelofstandardsorcriticalparameters,beyond
whichnoproposalsshouldbeentertained.Banksmayalsoconsiderseparateratingframework
forlargecorporate/smallborrowers,traders,etc.thatexhibitvaryingnatureanddegreeofrisk.
Forexexposuresassumedbycorporateswhohavenonaturalhedgeshavesignificantlyaltered
theriskprofileofbanks.Banksshould,therefore,factortheunhedgedmarketriskexposuresof
borrowersalsointheratingframework.Theoverallscoreforriskistobeplacedonanumerical
scalerangingbetween16,18,etc.onthebasisofcreditquality.Foreachnumericalcategory,
a quantitative definition of the borrower, the loans underlying quality, and an analytic
representationoftheunderlyingfinancialsoftheborrowershouldbepresented.Further,asa
prudentriskmanagementpolicy,eachbankshouldprescribetheminimumratingbelowwhich
noexposureswouldbeundertaken.Anyflexibilityintheminimumstandardsandconditionsfor
relaxationandauthoritythereforshouldbeclearlyarticulatedintheLoanPolicy.
Thecreditriskassessmentexerciseshouldberepeatedbiannually(orevenatshorter
intervalsforlowqualitycustomers)andshouldbedelinkedinvariablyfromtheregularrenewal
exercise.Theupdatingofthecreditratingsshouldbeundertakennormallyatquarterlyintervals
oratleastathalfyearlyintervals,inordertogaugethequalityoftheportfolioatperiodic
intervals.Variationsintheratingsofborrowersovertimeindicatechangesincreditqualityand
expectedloanlossesfromthecreditportfolio.Thus,iftheratingsystemistobemeaningful,the
credit qualityreportsshouldsignalchangesin expectedloanlosses.Inorder toensurethe
consistencyandaccuracyofinternalratings,theresponsibilityforsettingorconfirmingsuch
ratings should vest with the Loan Review function and examined by an independent Loan
ReviewGroup.Thebanksshouldundertakecomprehensivestudyonmigration(upwardlower
tohigheranddownwardhighertolower)ofborrowersintheratingstoaddaccuracyin
expectedloanlosscalculations.

18

3.2.4RiskPricing
Riskreturn pricing is a fundamental tenet of risk management. In a riskreturn setting,
borrowerswithweakfinancialpositionandhenceplacedinhighcreditriskcategoryshouldbe
pricedhigh.Thus,banksshouldevolvescientificsystemstopricethecreditrisk,whichshould
haveabearingontheexpectedprobabilityofdefault.Thepricingofloansnormallyshouldbe
linkedtoriskratingorcreditquality.Theprobabilityofdefaultcouldbederivedfromthepast
behaviouroftheloanportfolio,whichisthefunctionofloanlossprovision/chargeoffsforthe
last five years or so. Banks should build historical database on the portfolio quality and
provisioning/chargeofftoequipthemselvestopricetherisk.Butvalueofcollateral,market
forces,perceivedvalueofaccounts,futurebusinesspotential,portfolio/industryexposureand
strategicreasonsmayalsoplayimportantroleinpricing.Flexibilityshouldalsobemadefor
revisingtheprice(riskpremia)duetochangesinrating/valueofcollateralsovertime.Large
sized banks across the world have already put in place Risk Adjusted Return on Capital
(RAROC) framework for pricing ofloans, whichcalls for dataonportfolio behaviour and
allocationofcapitalcommensuratewithcreditriskinherentinloanproposals.UnderRAROC
framework,lenderbeginsbycharginganinterestmarkuptocovertheexpectedlossexpected
defaultrateoftheratingcategoryoftheborrower.Thelenderthenallocatesenoughcapitalto
theprospective loantocover some amountofunexpectedloss variabilityofdefaultrates.
Generally,internationalbanksallocateenoughcapitalsothattheexpectedloanlossreserveor
provisionplusallocatedcapitalcovers99%oftheloanlossoutcomes.
Thereis,however,aneedforcomparingthepricesquotedbycompetitorsforborrowers
perchedonthesamerating/quality.Thus,anyattemptatpricecuttingformarketsharewould
resultinmispricingofriskandAdverseSelection.
3.2.5PortfolioManagement
TheexistingframeworkoftrackingtheNonPerformingLoansaroundthebalancesheetdate
doesnotsignalthequalityoftheentireLoanBook.Banksshouldevolvepropersystemsfor
identificationofcreditweaknesseswellinadvance.Mostofinternationalbankshaveadopted
variousportfoliomanagementtechniquesforgaugingassetquality.TheCRMD,setupatHead
Office should be assigned the responsibility of periodic monitoring of the portfolio. The
portfolio quality could be evaluated by tracking the migration (upward or downward) of
borrowers from one rating scale to another. This process would be meaningful only if the
borrowerwise ratings are updated at quarterly / halfyearly intervals. Data on movements
withingradingcategoriesprovideausefulinsightintothenatureandcompositionofloanbook.
Thebankscouldalsoconsiderthefollowingmeasurestomaintaintheportfolioquality:
1) stipulatequantitativeceilingonaggregateexposureinspecifiedratingcategories,i.e.certain
percentageoftotaladvancesshouldbeintheratingcategoryof1to2or1to3,2to4or4to
5,etc.;
2) evaluatetheratingwisedistributionofborrowersinvariousindustry,businesssegments,
etc.;
3) exposuretooneindustry/sectorshouldbeevaluatedonthebasisofoverallratingdistributionof
borrowers in the sector/group. In this context, banks should weigh the pros and cons of
specialisationandconcentrationbyindustrygroup.Incaseswhereportfolioexposuretoa

19

singleindustryisbadlyperforming,thebanksmayincreasethequalitystandardsforthat
specificindustry;
4) targetratingwisevolumeofloans,probabledefaultsandprovisioningrequirementsasa
prudentplanningexercise.Foranydeviation/sfromtheexpectedparameters,anexercisefor
restructuringoftheportfolioshouldimmediatelybeundertakenandifnecessary,theentry
levelcriteriacouldbeenhancedtoinsulatetheportfoliofromfurtherdeterioration;
5) undertakerapidportfolioreviews,stresstestsandscenarioanalysiswhenexternalenvironment
undergoesrapidchanges(e.g.volatilityintheforexmarket,economicsanctions,changesinthe
fiscal/monetary policies, general slowdown of the economy, market risk events, extreme
liquidityconditions,etc.).Thestresstestswouldrevealundetectedareasofpotentialcreditrisk
exposureandlinkagesbetweendifferentcategoriesofrisk.Inadversecircumstances,theremay
besubstantialcorrelationofvariousrisks,especiallycreditandmarketrisks.Stresstestingcan
rangefromrelativelysimplealterationsinassumptionsaboutoneormorefinancial,structuralor
economicvariablestotheuseofhighlysophisticatedmodels.Theoutputofsuchportfoliowide
stresstestsshouldbereviewedbytheBoardandsuitablechangesmaybemadeinprudential
risklimitsforprotectingthequality.Stresstestscouldalsoincludecontingencyplans,detailing
managementresponsestostressfulsituations.
6) introduce discriminatory time schedules for renewal of borrower limits. Lower rated
borrowerswhosefinancialsshowsignsofproblemsshouldbesubjectedtorenewalcontrol
twice/thriceanyear.
Banksshouldevolvesuitableframeworkformonitoringthemarketrisksespeciallyforexrisk
exposure of corporates who have no natural hedges on a regular basis. Banks should also
appointPortfolioManagerstowatchtheloanportfoliosdegreeofconcentrationsandexposure
to counterparties. For comprehensiveevaluationof customer exposure, banksmay consider
appointing Relationship Managers to ensure that overall exposure to a single borrower is
monitored,capturedandcontrolled.TheRelationshipManagershavetoworkincoordination
withtheTreasuryandForexDepartments.TheRelationshipManagersmayservicemainlyhigh
valueloanssothatasubstantialshareoftheloanportfolio,whichcanaltertheriskprofile,
wouldbeunderconstantsurveillance.Further,transactionswithaffiliatedcompanies/groups
needtobeaggregatedandmaintainedclosetorealtime.Thebanksshouldalsoputinplace
formalisedsystemsforidentificationofaccountsshowingpronouncedcreditweaknesseswellin
advance and also prepare internal guidelines for such an exercise and set time frame for
decidingcoursesofaction.
Manyoftheinternationalbankshaveadoptedcreditriskmodelsforevaluationofcredit
portfolio.Thecreditriskmodelsofferbanksframeworkforexaminingcreditriskexposures,across
geographical locations and product lines in a timely manner, centralising data and analysing
marginal and absolute contributions to risk. The models also provide estimates of credit risk
(unexpectedloss)whichreflectindividualportfoliocomposition.TheAltmansZScoreforecasts
theprobabilityofacompanyenteringbankruptcywithina12monthperiod.Themodelcombines
fivefinancialratiosusingreportedaccountinginformationandequityvaluestoproduceanobjective
measure of borrowers financial health. J. P. Morgan has developed a portfolio model
CreditMetricsforevaluatingcreditrisk.Themodelbasicallyfocusonestimatingthevolatilityin
the value of assets causedbyvariations in the quality of assets. The volatility is computedby
tracking the probability that the borrower might migrate from one rating category to another
(downgradeorupgrade).Thus,thevalueofloanscanchangeovertime,reflectingmigrationofthe
borrowerstoadifferentriskratinggrade.Themodelcanbeusedforpromotingtransparencyin
creditrisk,establishingbenchmarkforcreditrisk

20

measurementandestimatingeconomiccapitalforcreditriskunderRAROCframework.Credit
Suissedevelopedastatisticalmethodformeasuringandaccountingforcreditriskwhichis
knownas CreditRisk+. Themodelisbasedonactuarialcalculationofexpecteddefaultrates
andunexpectedlossesfromdefault.
ThebanksmayevaluatetheutilityofthesemodelswithsuitablemodificationstoIndian
environment for finetuning the credit risk management. The success of credit risk models
impingesontimeseriesdataonhistoricalloanlossratesandothermodelvariables,spanning
multiple credit cycles. Banks may, therefore, endeavour building adequate database for
switchingovertocreditriskmodellingafteraspecifiedperiodoftime.
3.2.6LoanReviewMechanism(LRM)
LRMisaneffectivetoolforconstantlyevaluatingthequalityofloanbookandtobringabout
qualitativeimprovementsincreditadministration.Banksshould,therefore,putinplaceproper
Loan Review Mechanismfor large value accounts with responsibilities assigned in various
areassuchas,evaluatingtheeffectivenessofloanadministration,maintainingtheintegrityof
creditgradingprocess,assessingtheloanlossprovision,portfolioquality,etc.Thecomplexity
andscopeofLRMnormallyvarybasedonbankssize,typeofoperationsandmanagement
practices.ItmaybeindependentoftheCRMDorevenseparateDepartmentinlargebanks.
ThemainobjectivesofLRMcouldbe:
toidentifypromptlyloanswhichdevelopcreditweaknessesandinitiatetimelycorrective
action;
toevaluateportfolioqualityandisolatepotentialproblemareas;
toprovideinformationfordeterminingadequacyofloanlossprovision;
toassesstheadequacyofandadherenceto,loanpoliciesandprocedures,andtomonitor
compliancewithrelevantlawsandregulations;and
to provide top management with information on credit administration, including credit
sanctionprocess,riskevaluationandpostsanctionfollowup.
AccurateandtimelycreditgradingisoneofthebasiccomponentsofaneffectiveLRM.Credit
gradinginvolvesassessmentofcreditquality,identificationofproblemloans,andassignment
ofriskratings.AproperCreditGradingSystemshouldsupportevaluatingtheportfolioquality
and establishing loanloss provisions. Given the importanceandsubjective nature ofcredit
rating,thecreditratingsawardedbyCreditAdministrationDepartmentshouldbesubjectedto
reviewbyLoanReviewOfficerswhoareindependentofloanadministration.
3.2.7BanksshouldformulateLoanReviewPolicyanditshouldbereviewedannuallybythe
Board.ThePolicyshould,interalia,address:

QualificationandIndependence

TheLoanReviewOfficersshouldhavesoundknowledgeincreditappraisal,lendingpractices
andloanpoliciesofthebank.Theyshouldalsobewellversedintherelevantlaws/regulations
thataffectlendingactivities.TheindependenceofLoanReviewOfficersshouldbeensuredand
thefindingsofthereviewsshouldalsobereporteddirectlytotheBoardorCommitteeofthe
Board.

21

FrequencyandScopeofReviews

TheLoanReviewsaredesignedtoprovidefeedbackoneffectivenessofcreditsanctionandto
identify incipient deterioration in portfolio quality. Reviews of high value loans should be
undertakenusuallywithinthreemonthsofsanction/renewalormorefrequentlywhenfactors
indicateapotentialfordeteriorationinthecreditquality.Thescopeofthereviewshouldcover
allloansaboveacutofflimit.Inaddition,banksshouldalsotargetotheraccountsthatpresent
elevatedriskcharacteristics.Atleast3040%oftheportfolioshouldbesubjectedtoLRMina
yeartoprovidereasonableassurancethatallthemajorcreditrisksembeddedinthebalance
sheethavebeentracked.

DepthofReviews

Theloanreviewsshouldfocuson:
Approvalprocess;
Accuracyandtimelinessofcreditratingsassignedbyloanofficers;
Adherencetointernalpoliciesandprocedures,andapplicablelaws/regulations;
Compliancewithloancovenants;
Postsanctionfollowup;
Sufficiencyofloandocumentation;
Portfolioquality;and
Recommendationsforimprovingportfolioquality
3.2.8
ThefindingsofReviewsshouldbediscussedwithlineManagersandthecorrective
actionsshouldbeelicitedforalldeficiencies.Deficienciesthatremainunresolvedshouldbe
reportedtotopmanagement.
3.2.9
The Risk Management Group of the Basle Committee on Banking Supervision has
releasedaconsultativepaperonPrinciplesfortheManagementofCreditRisk.ThePaperdeals
withvariousaspectsrelatingtocreditriskmanagement.ThePaperisenclosedforinformation
ofbanks.
4.CreditRiskandInvestmentBanking
4.1Significantmagnitudeofcreditrisk,inadditiontomarketrisk,isinherentininvestment
banking.Theproposalsforinvestmentsshouldalsobesubjectedtothesamedegreeofcredit
riskanalysis,asanyloanproposals.Theproposalsshouldbesubjectedtodetailedappraisaland
ratingframeworkthatfactorsinfinancialandnonfinancialparametersofissuers,sensitivityto
externaldevelopments,etc.Themaximumexposuretoacustomershouldbebankwideand
includeallexposuresassumedbytheCreditandTreasuryDepartments.Thecoupononnon
sovereignpapersshouldbecommensuratewiththeirriskprofile.Thebanksshouldexercisedue
caution, particularly in investment proposals, which are not rated and should ensure
comprehensiveriskevaluation.ThereshouldbegreaterinteractionbetweenCreditandTreasury
Departments and the portfolio analysis should also cover the total exposures, including
investments.Theratingmigrationoftheissuersandtheconsequentdiminutionintheportfolio
qualityshouldalsobetrackedatperiodicintervals.

22

4.2 As a matter of prudence, banks should stipulate entry level minimum ratings/quality
standards,industry,maturity,duration,issuerwise,etc.limitsininvestmentproposalsaswellto
mitigatetheadverseimpactsofconcentrationandtheriskofilliquidity.
5.CreditRiskinOffbalanceSheetExposure
5.1 Banksshouldevolveadequateframeworkfor managingtheir exposure inoffbalance sheet
products like forex forward contracts, swaps, options, etc. as a part of overall credit to
individualcustomerrelationshipandsubjecttothesamecreditappraisal,limitsandmonitoring
procedures.Banksshouldclassifytheiroffbalancesheetexposuresintothreebroadcategories
fullrisk(creditsubstitutes)standbylettersofcredit,moneyguarantees,etc,mediumrisk(not
directcreditsubstitutes,whichdonotsupportexistingfinancialobligations)bidbonds,letters
ofcredit,indemnitiesandwarrantiesand lowrisk reverserepos,currencyswaps,options,
futures,etc.
5.2 Thetradingcreditexposuretocounterpartiescanbemeasuredonstatic(constantpercentageof
the notional principal over the life of the transaction) and on a dynamic basis. The total
exposurestothecounterpartiesonadynamicbasisshouldbethesumtotalof:
1) thecurrentreplacementcost(unrealisedlosstothecounterparty);and
2) thepotentialincreaseinreplacementcost(estimatedwiththehelpofVaRorothermethods
tocapturefuturevolatilitiesinthevalueoftheoutstandingcontracts/obligations).
Thecurrentandpotentialcreditexposuresmaybemeasuredonadailybasistoevaluatethe
impactofpotentialchangesinmarketconditionsonthevalueofcounterpartypositions.The
potentialexposuresalsomaybequantifiedbysubjectingthepositiontomarketmovements
involving normal andabnormal movementsininterestrates,foreignexchange rates,equity
prices,liquidityconditions,etc.
6.InterbankExposureandCountryRisk
6.1Asuitableframeworkshouldbeevolvedtoprovideacentralisedoverviewontheaggregate
exposureonotherbanks.Bankwiseexposurelimitscouldbesetonthebasisofassessmentof
financial performance, operating efficiency, management quality, past experience, etc. Like
corporateclients,banksshouldalsoberatedandplacedinrangeof15,18,asthecasemaybe,
on thebasis oftheir creditquality.Thelimitssoarrivedatshouldbeallocated tovarious
operatingcentresandfollowedupandhalfyearly/annualreviewsundertakenatasinglepoint.
Regardingexposureonoverseasbanks,bankscanusethecountryratingsofinternationalrating
agenciesandclassifythecountriesintolowrisk,moderateriskandhighrisk.Banksshould
endeavourfordevelopinganinternalmatrixthatreckonsthecounterpartyandcountryrisks.
Themaximumexposureshouldbesubjectedtoadherenceofcountryandbankexposurelimits
alreadyinplace.Whiletheexposureshouldatleastbemonitoredonaweeklybasistillthe
banks are equipped to monitor exposures on a real time basis, all exposures to problem
countriesshouldbeevaluatedonarealtimebasis.
7.MarketRisk
7.1Traditionally,creditriskmanagementwastheprimarychallengeforbanks.Withprogressive
deregulation,marketriskarisingfromadversechangesinmarketvariables,suchasinterestrate,
23

foreignexchangerate,equitypriceandcommoditypricehasbecomerelativelymoreimportant.
Evenasmallchangeinmarketvariablescausessubstantialchangesinincomeandeconomic
valueofbanks.Marketrisktakestheformof:
1) LiquidityRisk
2) InterestRateRisk
3) ForeignExchangeRate(Forex)Risk
4) CommodityPriceRiskand
5) EquityPriceRisk
8.MarketRiskManagement
8.1 Managementofmarketriskshouldbethemajorconcernoftopmanagementofbanks.The
Boardsshouldclearlyarticulatemarketriskmanagementpolicies,procedures,prudentialrisk
limits,reviewmechanismsandreportingandauditingsystems.Thepoliciesshouldaddressthe
banksexposureonaconsolidatedbasisandclearlyarticulatetheriskmeasurementsystems
thatcaptureallmaterialsourcesofmarketriskandassesstheeffectsonthebank.Theoperating
prudentiallimitsandtheaccountabilityofthelinemanagementshouldalsobeclearlydefined.
TheAssetLiabilityManagementCommittee(ALCO)shouldfunctionasthetopoperational
unitformanagingthebalancesheetwithintheperformance/riskparameterslaiddownbythe
Board.ThebanksshouldalsosetupanindependentMiddleOfficetotrackthemagnitudeof
marketriskonarealtimebasis.TheMiddleOfficeshouldcompriseofexpertsinmarketrisk
management, economists, statisticians and general bankers and may be functionally placed
directly under the ALCO. The Middle Office should also be separated from Treasury
DepartmentandshouldnotbeinvolvedinthedaytodaymanagementofTreasury.TheMiddle
Officeshouldapprisethetopmanagement/ALCO/Treasuryaboutadherencetoprudential/
riskparametersandalsoaggregatethetotalmarketriskexposuresassumedbythebankatany
pointoftime.
8.2 LiquidityRisk
8.2.1
Liquidity Planning is an important facet of risk management framework in banks.
Liquidityistheabilitytoefficientlyaccommodatedepositandotherliabilitydecreases,aswell
as,fundloanportfoliogrowthandthepossiblefundingofoffbalancesheetclaims.Abankhas
adequate liquidity when sufficient funds can be raised, either by increasing liabilities or
convertingassets,promptlyandatareasonablecost.Itencompassesthepotentialsaleofliquid
assets and borrowings from money, capital and forex markets. Thus, liquidity should be
consideredasadefencemechanismfromlossesonfiresaleofassets.
8.2.2
The liquidity risk of banks arises from funding of longterm assets by shortterm
liabilities,therebymakingtheliabilitiessubjecttorolloverorrefinancingrisk.
8.2.3 Theliquidityriskinbanksmanifestindifferentdimensions:
i) Funding Risk need to replace net outflows due to unanticipated withdrawal/non
renewalofdeposits(wholesaleandretail);
ii) Time Risk need to compensate for nonreceipt of expected inflows of funds, i.e.
performingassetsturningintononperformingassets;and
24

iii) Call Risk due to crystallisation of contingent liabilities and unable to undertake
profitablebusinessopportunitieswhendesirable.
8.2.4
The first step towards liquidity management is to put in place an effective liquidity
managementpolicy,which,interalia,shouldspelloutthefundingstrategies,liquidityplanning
underalternativescenarios,prudentiallimits,liquidityreporting/reviewing,etc.
8.2.5
Liquiditymeasurementisquiteadifficulttaskandcanbemeasuredthroughstockorcash
flowapproaches.Thekeyratios,adoptedacrossthebankingsystemare:
i) LoanstoTotalAssets
ii) LoanstoCoreDeposits
iii) Large Liabilities (minus) Temporary Investments to Earning Assets (minus)
TemporaryInvestments,wherelargeliabilitiesrepresentwholesaledepositswhichare
marketsensitiveandtemporaryInvestmentsare thosematuringwithinoneyear and
thoseinvestmentswhichareheldinthetradingbookandarereadilysoldinthemarket;
iv) PurchasedFundstoTotalAssets,wherepurchasedfundsincludetheentireinterbank
andothermoneymarketborrowings,includingCertificateofDepositsandinstitutional
deposits;and
v) LoanLosses/NetLoans.
8.2.6
Whiletheliquidityratiosaretheidealindicatorofliquidityofbanksoperatingindeveloped
financialmarkets,theratiosdonotrevealtheintrinsicliquidityprofileofIndianbankswhichare
operatinggenerallyinanilliquidmarket.Experiencesshowthatassetscommonlyconsideredas
liquidlikeGovernmentsecurities,othermoneymarketinstruments,etc.havelimitedliquidityasthe
marketandplayersareunidirectional.Thus,analysisofliquidityinvolvestrackingofcashflow
mismatches.Formeasuringandmanagingnetfundingrequirements,theuseofmaturityladderand
calculationofcumulativesurplusordeficitoffundsatselectedmaturitydatesisrecommendedasa
standardtool.TheformatprescribedbyRBIinthisregardunderALMSystemshouldbeadopted
formeasuringcashflowmismatchesatdifferenttimebands.Thecashflowsshouldbeplacedin
differenttimebandsbasedonfuturebehaviourofassets,liabilitiesandoffbalancesheetitems.In
otherwords,banksshouldhavetoanalysethebehaviouralmaturityprofileofvariouscomponentsof
on/offbalancesheetitemsonthebasisofassumptionsandtrendanalysissupportedbytimeseries
analysis.Banksshouldalsoundertakevarianceanalysis,atleast,onceinsixmonthstovalidatethe
assumptions. The assumptions should be finetuned over a period which facilitate near reality
predictionsaboutfuturebehaviourofon/offbalancesheetitems.Apartfromtheabovecashflows,
banksshouldalsotracktheimpactofprepayments ofloans,premature closure ofdepositsand
exerciseofoptionsbuiltincertaininstrumentswhichofferput/calloptionsafterspecifiedtimes.
Thus,cashoutflowscanberankedbythedateonwhichliabilitiesfalldue,theearliestdatea
liabilityholdercouldexerciseanearlyrepaymentoptionortheearliestdatecontingenciescouldbe
crystallised.

8.2.7
Thedifferencebetweencashinflowsandoutflowsineachtimeperiod,theexcessor
deficitoffunds,becomesastartingpointforameasureofabanksfutureliquiditysurplusor
deficit,ataseriesofpointsoftime.Thebanksshouldalsoconsiderputtinginplacecertain
prudentiallimitstoavoidliquiditycrisis:

25

1. Caponinterbankborrowings,especiallycallborrowings;

26

2. Purchasedfundsvisvisliquidassets;
3. CoredepositsvisvisCoreAssetsi.e.CashReserveRatio,LiquidityReserveRatioand
Loans;
4. Durationofliabilitiesandinvestmentportfolio;
5. MaximumCumulativeOutflows.Banksshouldfixcumulativemismatchesacrossalltime
bands;
6. Commitment Ratio track the total commitments given to corporates/banks and other
financialinstitutionstolimittheoffbalancesheetexposure;
7. SwappedFundsRatio,i.e.extentofIndianRupeesraisedoutofforeigncurrencysources.
8.2.8
Banksshouldalsoevolveasystemformonitoringhighvaluedeposits(otherthaninter
bankdeposits)sayRs.1croreormoretotrackthevolatileliabilities.Furtherthecashflows
arisingoutofcontingentliabilitiesinnormalsituationandthescopeforanincreaseincash
flowsduringperiodsofstressshouldalsobeestimated.Itisquitepossiblethatmarketcrisiscan
triggersubstantialincreaseintheamountofdrawdownsfromcashcredit/overdraftaccounts,
contingentliabilitieslikelettersofcredit,etc.
8.2.9
Theliquidityprofileofthebankscouldbeanalysedonastaticbasis,whereintheassets
andliabilitiesandoffbalancesheetitemsarepeggedonaparticulardayandthebehavioural
patternandthesensitivityoftheseitemstochangesinmarketinterestratesandenvironmentare
dulyaccountedfor.Thebankscanalsoestimatetheliquidityprofileonadynamicwayby
givingdueimportanceto:
1) Seasonalpatternofdeposits/loans;
2) Potentialliquidityneedsformeetingnewloandemands,unavailedcreditlimits,loanpolicy,
potentialdepositlosses,investmentobligations,statutoryobligations,etc.
8.2.10AlternativeScenarios
Theliquidityprofileofbanksdependsonthemarketconditions,whichinfluencethecashflow
behaviour.Thus,banksshouldevaluateliquidityprofileunderdifferentconditions,viz.normal
situation,bankspecificcrisisandmarketcrisisscenario.Thebanksshouldestablishbenchmark
fornormalsituation,cashflowprofileofon/offbalancesheetitemsandmanagesnetfunding
requirements.
8.2.11
Estimatingliquidityunderbankspecificcrisisshouldprovideaworstcasebenchmark.
Itshouldbeassumedthatthepurchasedfundscouldnotbeeasilyrolledover;someofthecore
deposits could be prematurely closed; a substantial share of assets have turned into non
performingandthusbecometotallyilliquid.Thesedevelopmentswouldleadtoratingdown
gradesandhighcostofliquidity.Thebanksshouldevolvecontingencyplanstoovercomesuch
situations.
8.2.12
Themarketcrisisscenarioanalysescasesofextremetighteningofliquidityconditions
arisingoutofmonetarypolicystanceofReserveBank,generalperceptionaboutriskprofileof
thebankingsystem,severemarketdisruptions,failureofoneormoreofmajorplayersinthe
market,financialcrisis,contagion,etc.Underthisscenario,therolloverofhighvaluecustomer
depositsandpurchasedfundscouldextremelybedifficultbesidesflightofvolatiledeposits/
liabilities. The banks could also sell their investment with huge discounts, entailing severe
capitalloss.

8.2.13ContingencyPlan
BanksshouldprepareContingencyPlanstomeasuretheirabilitytowithstandbankspecificor
marketcrisisscenario.Theblueprintforassetsales,marketaccess,capacitytorestructurethe
maturityandcompositionofassetsandliabilitiesshouldbeclearlydocumentedandalternative
optionsoffundingintheeventofbanksfailuretoraiseliquidityfromexistingsource/scould
beclearlyarticulated.LiquidityfromtheReserveBank,arisingoutofitsrefinancewindowand
interim liquidity adjustment facility or as lender of last resort should not be reckoned for
contingencyplans.Availabilityofbackupliquiditysupportintheformofcommittedlinesof
credit,reciprocalarrangements,liquiditysupportfromotherexternalsources,liquidityofassets,
etc.shouldalsobeclearlyestablished.
9.InterestRateRisk(IRR)
9.1 ThemanagementofInterestRateRiskshouldbeoneofthecriticalcomponentsofmarketrisk
managementinbanks.Theregulatoryrestrictionsinthepasthadgreatlyreducedmanyofthe
risksinthebankingsystem.Deregulationofinterestrateshas,however,exposedthemtothe
adverseimpactsofinterestraterisk.TheNetInterestIncome(NII)orNetInterestMargin
(NIM)ofbanksisdependentonthemovementsofinterestrates.Anymismatchesinthecash
flows(fixedassetsorliabilities)orrepricingdates(floatingassetsorliabilities),exposebanks
NIIorNIMtovariations.Theearningofassetsandthecostofliabilitiesarenowcloselyrelated
tomarketinterestratevolatility.
9.2 InterestRateRisk(IRR)referstopotentialimpactonNIIorNIMorMarketValueofEquity
(MVE),causedbyunexpectedchangesinmarketinterestrates.InterestRateRiskcantake
differentforms:
9.3 TypesofInterestRateRisk
9.3.1GaporMismatchRisk:
Agapormismatchriskarisesfromholdingassetsandliabilitiesandoffbalancesheetitems
withdifferentprincipalamounts,maturitydatesorrepricingdates,therebycreatingexposureto
unexpectedchangesinthelevelofmarketinterestrates.
9.3.2

BasisRisk

Marketinterestratesofvariousinstrumentsseldomchangebythesamedegreeduringagiven
periodoftime.Theriskthattheinterestrateofdifferentassets,liabilitiesandoffbalancesheet
itemsmaychangeindifferentmagnitudeistermedasbasisrisk.Thedegreeofbasisriskis
fairlyhighinrespectofbanksthatcreatecompositeassetsoutofcompositeliabilities.The
Loan book in India is funded out of a composite liability portfolio and is exposed to a
considerable degree of basis risk. The basis risk is quite visible in volatile interest rate
scenarios.WhenthevariationinmarketinterestratecausestheNIItoexpand,thebankshave
experiencedfavourablebasisshiftsandiftheinterestratemovementcausestheNIItocontract,
thebasishasmovedagainstthebanks.
9.3.3EmbeddedOptionRisk

Significantchangesinmarketinterestratescreateanothersourceofrisktobanksprofitability
byencouragingprepaymentofcashcredit/demandloans/termloansandexerciseofcall/put
optionsonbonds/debenturesand/orprematurewithdrawaloftermdepositsbeforetheirstated
maturities. The embedded option risk is becoming a reality in India and is experienced in
volatilesituations.Thefasterandhigherthemagnitudeofchangesininterestrate,thegreater
will be the embedded option risk to the banks NII. Thus, banks should evolve scientific
techniquestoestimatetheprobableembeddedoptionsandadjusttheGapstatements(Liquidity
andInterestRateSensitivity)torealisticallyestimatetheriskprofilesintheirbalancesheet.
Banksshouldalsoendeavourforstipulatingappropriatepenaltiesbasedonopportunitycoststo
stemtheexerciseofoptions,whichisalwaystothedisadvantageofbanks.

9.3.4YieldCurveRisk
Inafloatinginterestratescenario,banksmaypricetheirassetsandliabilitiesbasedondifferent
benchmarks,i.e.TBsyields,fixeddepositrates,callmoneyrates,MIBOR,etc.Incasethe
banksusetwodifferentinstrumentsmaturingatdifferenttimehorizonforpricingtheirassets
and liabilities, any nonparallel movements in yield curves would affect the NII. The
movements in yield curve are rather frequent when the economy moves through business
cycles.Thus,banksshouldevaluatethemovementinyieldcurvesandtheimpactofthatonthe
portfoliovaluesandincome.
9.3.5PriceRisk
Priceriskoccurswhenassetsaresoldbeforetheirstatedmaturities.Inthefinancialmarket,
bondpricesandyieldsareinverselyrelated.Thepriceriskiscloselyassociatedwiththetrading
book,whichiscreatedformakingprofitoutofshorttermmovementsininterestrates.Banks
whichhaveanactivetradingbookshould,therefore,formulatepoliciestolimittheportfolio
size,holdingperiod,duration,defeasanceperiod,stoplosslimits,markingtomarket,etc.
9.3.6ReinvestmentRisk
Uncertaintywithregardtointerestrateatwhichthefuturecashflowscouldbereinvestedis
calledreinvestmentrisk.Anymismatchesincashflowswouldexposethebankstovariationsin
NIIasthemarketinterestratesmoveindifferentdirections.
9.3.7NetInterestPositionRisk
The size of nonpaying liabilities is one of the significant factors contributing towards
profitabilityofbanks.Whenbankshavemoreearningassetsthanpayingliabilities,interestrate
riskariseswhen the marketinterestrates adjustdownwards.Thus,banks withpositivenet
interestpositionswillexperienceareductioninNIIasthemarketinterestratedeclinesand
increaseswheninterestraterises.Thus,largefloatisanaturalhedgeagainstthevariationsin
interestrates.

9.4MeasuringInterestRateRisk

9.4.1
Beforeinterestrateriskcouldbemanaged,theyshouldbeidentifiedandquantified.
Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to
measurethedegreeofriskstowhichbanksareexposed.Itisalsoequallyimpossibletodevelop
effectiveriskmanagementstrategies/hedgingtechniqueswithoutbeingabletounderstandthe
correctriskpositionofbanks.TheIRRmeasurementsystemshouldaddressallmaterialsources
ofinterestrate riskincludinggapormismatch, basis, embedded option, yieldcurve, price,
reinvestmentandnetinterestpositionrisksexposures.TheIRRmeasurementsystemshould
also take into account the specific characteristics of each individual interest rate sensitive
positionandshouldcaptureindetailthefullrangeofpotentialmovementsininterestrates.
9.4.2
Therearedifferenttechniquesformeasurementofinterestraterisk,rangingfromthe
traditionalMaturityGapAnalysis(tomeasuretheinterestratesensitivityofearnings),Duration
(to measure interest rate sensitivity of capital), Simulation and Value at Risk. While these
methodshighlightdifferentfacetsofinterestraterisk,manybanksusethemincombination,or
usehybridmethodsthatcombinefeaturesofallthetechniques.
9.4.3
Generally, the approach towards measurement and hedging of IRR varies with the
segmentationofthebalancesheet.Inawellfunctioningriskmanagementsystem,banksbroadly
positiontheirbalancesheetintoTradingandInvestmentorBankingBooks.Whiletheassetsin
the trading book are held primarily for generating profit on shortterm differences in
prices/yields,thebankingbookcomprisesassetsandliabilities,whicharecontractedbasically
onaccountofrelationshiporforsteadyincomeandstatutoryobligationsandaregenerallyheld
tillmaturity.Thus,while theprice riskistheprime concernofbanksintradingbook,the
earningsoreconomicvaluechangesarethemainfocusofbankingbook.
9.5TradingBook
The top management of banks should lay down policies with regard to volume, maximum
maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for
classifyingsecuritiesinthetradingbook.Whilethesecuritiesheldinthetradingbookshould
ideallybemarkedtomarketonadailybasis,thepotentialpricerisktochangesinmarketrisk
factorsshouldbeestimatedthroughinternallydevelopedValueatRisk(VaR)models.TheVaR
methodisemployedtoassesspotentiallossthatcouldcrystaliseontradingpositionorportfolio
duetovariationsinmarketinterestratesandprices,usingagivenconfidencelevel,usually95%
to99%,withinadefinedperiodoftime.TheVaRmethodshouldincorporatethemarketfactors
againstwhichthemarketvalueofthetradingpositionisexposed.Thetopmanagementshould
putinplacebankwideVaRexposurelimitstothetradingportfolio(includingforexandgold
positions, derivative products, etc.) which is then disaggregated across different desks and
departments.Thelossmakingtolerancelevelshouldalsobestipulatedtoensurethatpotential
impactonearningsismanagedwithinacceptablelimits.ThepotentiallossinPresentValue
BasisPointsshouldbematchedbytheMiddleOfficeonadailybasisvisvistheprudential
limitssetbytheBoard.TheadvantageofusingVaRisthatitiscomparableacrossproducts,
desksandDepartmentsanditcanbevalidatedthroughbacktesting.However,VaRmodels
requiretheuseofextensivehistoricaldatatoestimatefuturevolatility.VaRmodelalsomaynot
give good results in extreme volatile conditions or outlier events and stress test has to be
employedtocomplementVaR.Thestresstestsprovidemanagementaviewonthepotential
impactoflargesizemarketmovementsandalsoattempttoestimatethesizeofpotentiallosses
duetostressevents,whichoccurinthetailsofthelossdistribution.Banksmayalsoundertake

scenario analysis with specific possible stress situations (recently experienced in some
countries)bylinkinghypothetical,simultaneousandrelatedchangesinmultipleriskfactors
presentinthetradingportfoliotodeterminetheimpactofmovesontherestoftheportfolio.
VaRmodelscouldalsobemodifiedtoreflectliquidityriskdifferencesobservedacrossassets
overtime.InternationalbanksarenowestimatingLiquidityadjustedValueatRisk(LaVaR)by
assumingvariabletimehorizonsbasedonpositionsizeandrelativeturnover.Inanenvironment
whereVaRisdifficulttoestimateforlackofdata,nonstatisticalconceptssuchasstoplossand
gross/netpositionscanbeused.
9.6BankingBook
Thechangesinmarketinterestrateshaveearningsandeconomicvalueimpactsonthebanks
bankingbook.Thus,giventhecomplexityandrangeofbalancesheetproducts,banksshould
haveIRRmeasurementsystemsthatassesstheeffectsoftheratechangesonbothearningsand
economic value. The variety of techniques ranges from simple maturity (fixed rate) and
repricing (floating rate) to static simulation, based on current onandoffbalance sheet
positions,tohighlysophisticateddynamicmodellingtechniquesthatincorporateassumptions
onbehaviouralpatternofassets,liabilitiesandoffbalancesheetitemsandcaneasilycapture
thefullrangeofexposuresagainstbasisrisk,embeddedoptionrisk,yieldcurverisk,etc.
9.7MaturityGapAnalysis
9.7.1
ThesimplestanalyticaltechniquesforcalculationofIRRexposurebeginswithmaturity
Gap analysis that distributes interest rate sensitive assets, liabilities and offbalance sheet
positionsintoacertainnumberofpredefinedtimebandsaccordingtotheirmaturity(fixed
rate) or time remaining for their next repricing (floating rate). Those assets and liabilities
lackingdefiniterepricingintervals(savingsbank,cashcredit,overdraft,loans,exportfinance,
refinancefromRBIetc.)oractualmaturitiesvaryfromcontractualmaturities(embeddedoption
inbondswithput/calloptions,loans,cashcredit/overdraft,timedeposits,etc.)areassigned
timebandsaccordingtothejudgement,empiricalstudiesandpastexperiencesofbanks.
9.7.2
Anumberoftimebandscanbeusedwhileconstructingagapreport.Generally,mostof
thebanksfocustheirattentiononneartermperiods,viz.monthly,quarterly,halfyearlyorone
year.Itisverydifficulttotakeaviewoninterestratemovementsbeyondayear.Bankswith
largeexposuresintheshorttermshouldtestthesensitivityoftheirassetsandliabilitiesevenat
shorterintervalslikeovernight,17days,814days,etc.
9.7.3
Inordertoevaluatetheearningsexposure,interestRateSensitiveAssets(RSAs)ineach
timebandarenettedwiththeinterestRateSensitiveLiabilities(RSLs)toproducearepricing
Gapforthattimeband.ThepositiveGapindicatesthatbankshavemoreRSAsthanRSLs.A
positiveorassetsensitiveGapmeansthatanincreaseinmarketinterestratescouldcausean
increaseinNII.Conversely,anegativeorliabilitysensitiveGapimpliesthatthebanksNII
coulddeclineasaresultofincreaseinmarketinterestrates.Thenegativegapindicatesthat
bankshavemoreRSLsthanRSAs.TheGapisusedasameasureofinterestratesensitivity.The
Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the
EarningsatRisk(EaR).TheEaRmethodfacilitatestoestimatehowmuchtheearningsmight
beimpactedbyanadversemovementininterestrates.Thechangesininterestratecouldbe
estimatedonthebasisofpasttrends,forecastingofinterestrates,etc.ThebanksshouldfixEaR

whichcouldbebasedonlast/currentyearsincomeandatriggerpointatwhichtheline
managementshouldadoptonoroffbalancesheethedgingstrategiesmaybeclearlydefined.
9.7.4
TheGapcalculationscanbeaugmentedbyinformationontheaveragecoupononassets
andliabilitiesineachtimebandandthesamecouldbeusedtocalculateestimatesofthelevel
ofNIIfrompositionsmaturingordueforrepricingwithinagiventimeband,whichwouldthen
provideascaletoassessthechangesinincomeimpliedbythegapanalysis.
9.7.5
Theperiodicgapanalysisindicatestheinterestrateriskexposureofbanksoverdistinct
maturities and suggests magnitude of portfolio changes necessary to alter the risk profile.
However,theGapreportquantifiesonlythetimedifferencebetweenrepricingdatesofassets
andliabilitiesbutfailstomeasuretheimpactofbasisandembeddedoptionrisks.TheGap
reportalsofailstomeasuretheentireimpactofachangeininterestrate(Gapreportassumes
thatallassetsandliabilitiesarematuredorrepricedsimultaneously)withinagiventimeband
andeffectofchangesininterestratesontheeconomicormarketvalueofassets,liabilitiesand
offbalancesheetposition.Italsodoesnottakeintoaccountanydifferencesinthetimingof
paymentsthat mightoccurasaresultofchangesininterestrate environment.Further,the
assumptionofparallelshiftinyieldcurvesseldomhappeninthefinancialmarket.TheGap
report also fails to capture variability in noninterest revenue and expenses, a potentially
importantsourceofrisktocurrentincome.
9.7.6
Incasebankscouldrealisticallyestimatethemagnitudeofchangesinmarketinterest
ratesofvariousassetsandliabilities(basisrisk)andtheirpastbehaviouralpattern(embedded
optionrisk),theycouldstandardisethegapbymultiplyingtheindividualassetsandliabilities
by how much they will change for a given change in interest rate. Thus, one or several
assumptionsofstandardisedgapseemmoreconsistentwithrealworldthanthesimplegap
method.WiththeAdjustedGap,bankscouldrealisticallyestimatetheEaR.
9.8DurationGapAnalysis
9.8.1
Matching the duration of assets and liabilities, instead of matching the maturity or
repricingdatesisthemosteffectivewaytoprotecttheeconomicvaluesofbanksfromexposure
toIRRthanthesimplegapmodel.Durationgapmodelfocusesonmanagingeconomicvalueof
banksbyrecognisingthechangeinthemarketvalueofassets,liabilitiesandoffbalancesheet
(OBS) items. When weighted assets and liabilities and OBS duration are matched, market
interestratemovementswouldhavealmostsameimpactonassets,liabilitiesandOBS,thereby
protectingthebankstotalequityornetworth.Durationisameasureofthepercentagechange
intheeconomicvalueofapositionthatwilloccurgivenasmallchangeinthelevelofinterest
rates.
9.8.2
Measuring the duration gap is more complex than the simple gap model. For
approximationofdurationofassetsandliabilities,thesimplegapschedulecanbeusedby
applyingweightstoeachtimeband.Theweightsarebasedonestimatesofthedurationof
assetsandliabilitiesandOBSthatfallintoeachtimeband.Theweighteddurationofassetsand
liabilitiesandOBSprovidearoughestimationofthechangesinbankseconomicvaluetoa
givenchangeinmarketinterestrates.Itisalsopossibletogivedifferentweightsandinterest
ratestoassets,liabilitiesandOBSindifferenttimebucketstocapturedifferencesincoupons
andmaturitiesandvolatilitiesininterestratesalongtheyieldcurve.

9.8.3
Inamorescientificway,bankscanpreciselyestimatetheeconomicvaluechangestomarket
interestratesbycalculatingthedurationofeachasset,liabilityandOBSpositionandweigheachof
themtoarriveattheweighteddurationofassets,liabilitiesandOBS.Oncetheweighteddurationof
assetsandliabilitiesareestimated,thedurationgapcanbeworkedoutwiththehelpofstandard
mathematicalformulae.TheDurationGapmeasurecanbeusedtoestimatetheexpectedchangein
MarketValueofEquity(MVE)foragivenchangeinmarketinterestrate.

9.8.4
The difference between duration of assets (DA) and liabilities (DL) is banks net
duration. If the net duration is positive (DA>DL), a decrease in market interest rates will
increasethemarketvalueofequityofthebank.Whenthedurationgapisnegative(DL>DA),
theMVEincreaseswhentheinterestrateincreasesbutdecreaseswhentheratedeclines.Thus,
theDurationGapshowstheimpactofthemovementsinmarketinterestratesontheMVE
throughinfluencingthemarketvalueofassets,liabilitiesandOBS.
9.8.5
TheattractionofdurationanalysisisthatitprovidesacomprehensivemeasureofIRRfor
thetotalportfolio.Thedurationanalysisalsorecognisesthetimevalueofmoney.Duration
measureisadditivesothatbankscanmatchtotalassetsandliabilitiesratherthanmatching
individualaccounts.However,DurationGapanalysisassumesparallelshiftsinyieldcurve.For
thisreason,itfailstorecognisebasisrisk.
9.9 Simulation
9.9.1
Manyoftheinternationalbanksarenowusingbalancesheetsimulationmodelstogauge
theeffectofmarketinterestratevariationsonreportedearnings/economicvaluesoverdifferent
timezones.SimulationtechniqueattemptstoovercomethelimitationsofGapandDuration
approachesbycomputermodellingthebanksinterestratesensitivity.Suchmodellinginvolves
making assumptions about future path of interest rates, shape of yield curve, changes in
business activity, pricing and hedging strategies, etc. The simulation involves detailed
assessmentofthepotentialeffectsofchangesininterestrateonearningsandeconomicvalue.
The simulation techniques involve detailed analysis of various components of onand off
balancesheetpositions.Simulationscanalsoincorporatemorevariedandrefinedchangesin
theinterestrateenvironment,rangingfromchangesintheslopeandshapeoftheyieldcurve
andinterestratescenarioderivedfromMonteCarlosimulations.
9.9.2
The output of simulation can take a variety of forms, depending on users need.
Simulationcanprovidecurrentandexpectedperiodicgaps,durationgaps,balancesheetand
incomestatements,performancemeasures,budgetandfinancialreports.Thesimulationmodel
provides an effective tool for understanding the risk exposure under variety of interest
rate/balancesheetscenarios.Thistechniquealsoplaysanintegralplanningroleinevaluating
theeffectofalternativebusinessstrategiesonriskexposures.
9.9.3
The simulation can be carried out under static and dynamic environment. While the
currentonandoffbalancesheetpositionsareevaluatedunderstaticenvironment,thedynamic
simulationbuildsinmoredetailedassumptionsaboutthefuturecourseofinterestratesandthe
unexpectedchangesinbanksbusinessactivity.
9.9.4
Theusefulnessofthesimulationtechniquedependsonthestructureofthemodel,validity
ofassumption,technologysupportandtechnicalexpertiseofbanks.

9.9.5Theapplicationofvarioustechniquesdependstoalargeextentonthequalityofdataand
thedegreeofautomatedsystemofoperations.Thus,banksmaystartwiththegaporduration
gaporsimulationtechniquesonthebasisofavailabilityofdata,informationtechnologyand
technicalexpertise.Inanycase,assuggestedbyRBIintheguidelinesonALMSystem,banks
shouldstartestimatingtheinterestrateriskexposurewiththehelpofMaturityGapapproach.
Once banks are comfortable with the Gap model, they can progressively graduate into the
sophisticatedapproaches.
9.10FundsTransferPricing
9.10.1
TheTransferPricingmechanismbeingfollowedbymanybanksdoesnotsupportgood
ALMSystems.Manyinternationalbankswhichhavedifferentproductsandoperateinvarious
geographicmarketshavebeenusinginternalFundsTransferPricing(FTP).FTPisaninternal
measurementdesignedtoassessthefinancialimpactofusesandsourcesoffundsandcanbe
usedtoevaluatetheprofitability.Itcanalsobeusedtoisolatereturnsforvariousrisksassumed
intheintermediationprocess.FTPalsohelpscorrectlyidentifythecostofopportunityvalueof
funds.AlthoughbankshaveadoptedvariousFTPframeworksandtechniques,MatchedFunds
Pricing(MFP)isthemostefficienttechnique.MostoftheinternationalbanksuseMFP.The
FTPenvisagesassignmentofspecificassetsandliabilitiestovariousfunctionalunits(profit
centres)lending,investment,deposittakingandfundsmanagement.Eachunitattractssources
andusesoffunds.Thelending,investmentanddeposittakingprofitcentresselltheirliabilities
to and buys funds for financing their assets from the funds management profit centre at
appropriatetransferprices.Thetransferpricesarefixedonthebasisofasinglecurve(MIBOR
orderivedcashcurve,etc)sothatassetliabilitytransactionsofidenticalattributesareassigned
identicaltransferprices.Transferpricescould,however,varyaccordingtomaturity,purpose,
termsandotherattributes.
9.10.2
TheFTPprovidesforallocationofmargin(franchiseandcreditspreads)toprofitcentres
onoriginaltransferratesandanyresidualspread(mismatchspread)iscreditedtothefunds
managementprofitcentre.Thisspreadistheresultofaccumulatedmismatches.Themarginsof
variousprofitcentresare:

Depositprofitcentre:
TransferPrice(TP)ondepositscostofdepositsdepositinsuranceoverheads.

Lendingprofitcentre:
Loanyields+TPondepositsTPonloanfinancingcostofdepositsdepositinsurance
overheadsloanlossprovisions.

Investmentprofitcentre:
Securityyields+TPondepositsTPonsecurityfinancingcostofdepositsdeposit
insuranceoverheadsprovisionsfordepreciationininvestmentsandloanloss.

FundsManagementprofitcentre:

TPonfundslentTPonfundsborrowedStatutoryReservescostoverheads.
Forillustration,letusassumethatabanksDepositprofitcentrehasraiseda3monthdeposit@
6.5%p.a.andthatthealternativefundingcosti.e.MIBORfor3monthsandoneyear@8%and
10.5%p.a.,respectively.LetusalsoassumethatthebanksLoanprofitcentrecreatedaone
yearloan@13.5%p.a.Thefranchise(liability),creditandmismatchspreadsofbankisas
under:
ProfitCentres
Total
Deposit
Funds
Loan
InterestIncome
8.0
10.5
13.5
13.5
InterestExpenditure
6.5
8.0
10.5
6.5
Margin
1.5
2.5
3.0
7.0
LoanLossProvision(expected)

1.0
1.0
DepositInsurance
0.1

0.1
ReserveCost(CRR/SLR)

1.0

1.0
Overheads
0.6
0.5
0.6
1.7
NII
0.8
1.0
1.4
3.2
Under the FTP mechanism, the profit centres (other than funds management) are
precludedfromassuminganyfundingmismatchesandtherebyexposingthemtomarketrisk.
Thecreditorcounterpartyandpricerisksare,however,managedbytheseprofitcentres.The
entiremarketrisks,i.einterestrate,liquidityandforexareassumedbythefundsmanagement
profitcentre.
9.10.3TheFTPallowslendinganddepositraisingprofitcentresdeterminetheirexpensesand
pricetheirproductscompetitively.Lendingprofitcentrewhichknowsthecarryingcostofthe
loansneedstofocusontopriceonlythespreadnecessarytocompensatetheperceivedcredit
riskandoperatingexpenses.Thus,FTPsystemcouldeffectivelybeusedasawaytocentralise
thebanksoverallmarketriskatoneplaceandwouldsupportaneffectiveALMmodelling
system.FTPalsocouldbeusedtoenhancecorporatecommunication;greaterlinemanagement
controlandsolidbaseforrewardinglinemanagement.
10.ForeignExchange(Forex)Risk
10.1
Theriskinherentinrunningopenforeignexchangepositionshavebeenheightenedin
recentyearsbythepronouncedvolatilityinforexrates,therebyaddinganewdimensiontothe
riskprofileofbanksbalancesheets.
10.2
Forexriskistheriskthatabankmaysufferlossesasaresultofadverseexchangerate
movements during a period in which it has an open position, either spot or forward, or a
combination of the two, in an individual foreign currency. The banks are also exposed to
interestraterisk,whicharisesfromthematuritymismatchingofforeigncurrencypositions.
Even in cases where spot and forward positions in individual currencies are balanced, the
maturitypatternofforwardtransactionsmayproducemismatches.Asaresult,banksmaysuffer
lossesasaresultofchangesinpremia/discountsofthecurrenciesconcerned.
10.3
Intheforexbusiness,banksalsofacetheriskofdefaultofthecounterpartiesorsettlement
risk.Whilesuchtypeofriskcrystallisationdoesnotcauseprincipalloss,banksmayhaveto

undertakefreshtransactionsinthecash/spotmarketforreplacingthefailedtransactions.Thus,
banksmayincurreplacementcost,whichdependsuponthecurrencyratemovements.Banks
alsofaceanotherriskcalledtimezoneriskorHerstattriskwhicharisesoutoftimelagsin
settlementofonecurrencyinonecentreandthesettlementofanothercurrencyinanothertime
zone.Theforextransactionswithcounterpartiesfromanothercountryalsotriggersovereignor
countryrisk.
10.4ForexRiskManagementMeasures
1. Setappropriatelimitsopenpositionsandgaps.
2. Clearcutandwelldefineddivisionofresponsibilitybetweenfront,middleandbackoffices.
ThetopmanagementshouldalsoadopttheVaRapproachtomeasuretheriskassociatedwith
exposures.ReserveBankofIndiahasrecentlyintroducedtwostatementsviz.Maturityand
Position(MAP)andInterestRateSensitivity(SIR)formeasurementofforexriskexposures.
Banksshouldusethesestatementsforperiodicalmonitoringofforexriskexposures.
11.CapitalforMarketRisk
11.1
The Basle Committee on Banking Supervision (BCBS) had issued comprehensive
guidelinestoprovideanexplicitcapitalcushionforthepriceriskstowhichbanksareexposed,
particularlythosearisingfromtheirtradingactivities.Thebankshavebeengivenflexibilityto
useinhousemodelsbasedonVaRformeasuringmarketriskasanalternativetoastandardised
measurementframeworksuggestedbyBasleCommittee.Theinternalmodelsshould,however,
complywithquantitativeandqualitativecriteriaprescribedbyBasleCommittee.
11.2
Reserve Bank of India has accepted the general framework suggested by the Basle
Committee. RBI has also initiated various steps in moving towards prescribing capital for
marketrisk.Asaninitialstep,ariskweightof2.5%hasbeenprescribedforinvestmentsin
Governmentandotherapprovedsecurities,besidesariskweighteachof100%ontheopen
positionlimitsinforexandgold.RBIhasalsoprescribeddetailedoperatingguidelinesfor
AssetLiabilityManagementSysteminbanks.Astheabilityofbankstoidentifyandmeasure
marketriskimproves,itwouldbenecessarytoassignexplicitcapitalchargeformarketrisk.In
themeanwhile,banksareadvisedtostudytheBasleCommitteespaperonOverviewofthe
Amendment to the Capital Accord to Incorporate Market Risks January 1996 (copy
enclosed).WhilethesmallbanksoperatingpredominantlyinIndiacouldadoptthestandardised
methodology,largebanksandthosebanksoperatingininternationalmarketsshoulddevelop
expertiseinevolvinginternalmodelsformeasurementofmarketrisk.
11.3
The Basle Committee on Banking Supervision proposes to develop capital charge for
interest rate risk in the banking book as well for banks where the interest rate risks are
significantly above average (outliers). The Committee is now exploring various
methodologiesforidentifyingoutliersandhowbesttoapplyandcalibrateacapitalchargefor
interestrateriskforbanks.OncetheCommitteefinalisesthemodalities,itmaybenecessary,at
leastforbanksoperatingintheinternationalmarketstocomplywiththeexplicitcapitalcharge
requirementsforinterestrateriskinthebankingbook.

12.OperationalRisk
12.1
Managingoperationalriskisbecominganimportantfeatureofsoundriskmanagement
practicesinmodernfinancialmarketsinthewakeofphenomenalincreaseinthevolumeof
transactions, high degree of structural changes and complex support systems. The most
important type of operational risk involves breakdowns in internal controls and corporate
governance. Such breakdowns can lead to financial loss through error, fraud, or failure to
performinatimelymannerorcausetheinterestofthebanktobecompromised.
12.2
Generally,operationalriskisdefinedasanyrisk,whichisnotcategoriedasmarketor
creditrisk,ortheriskoflossarisingfromvarioustypesofhumanortechnicalerror.Itisalso
synonymous with settlement or payments risk and business interruption,administrativeand
legal risks. Operational risk has some form of link between credit and market risks. An
operationalproblemwithabusinesstransactioncouldtriggeracreditormarketrisk.
12.3 Measurement
Thereisnouniformityofapproachinmeasurementofoperationalriskinthebankingsystem.
Besides,theexistingmethodsarerelativelysimpleandexperimental,althoughsomeofthe
internationalbankshavemadeconsiderableprogressindevelopingmoreadvancedtechniques
forallocatingcapitalwithregardtooperationalrisk.
Measuringoperationalriskrequiresbothestimatingtheprobabilityofanoperational
losseventandthepotentialsizeoftheloss.Itreliesonriskfactorthatprovidessomeindication
of the likelihood of an operational loss event occurring. The process of operational risk
assessment needs to address the likelihood (or frequency) of a particular operational risk
occurring,themagnitude(orseverity)oftheeffectoftheoperationalriskonbusinessobjectives
andtheoptionsavailabletomanageandinitiateactionstoreduce/mitigateoperationalrisk.The
setofriskfactorsthatmeasureriskineachbusinessunitsuchasauditratings,operationaldata
suchasvolume,turnoverandcomplexityanddataonqualityofoperationssuchaserrorrateor
measure of business risks such as revenue volatility, could be related to historical loss
experience.Bankscanalsousedifferentanalyticalorjudgmentaltechniquestoarriveatan
overall operational risk level. Some of the international banks have already developed
operationalriskratingmatrix,similartobondcreditrating.Theoperationalriskassessment
shouldbebankwidebasisanditshouldbereviewedatregularintervals.Banks,overaperiod,
shoulddevelopinternalsystemstoevaluatetheriskprofileandassigneconomiccapitalwithin
theRAROCframework.
Indianbankshavesofarnotevolvedanyscientificmethodsforquantifyingoperational
risk.Intheabsenceanysophisticatedmodels,bankscouldevolvesimplebenchmarkbasedon
anaggregatemeasureofbusinessactivitysuchasgrossrevenue,feeincome,operatingcosts,
managedassetsortotalassetsadjustedforoffbalancesheetexposuresoracombinationof
thesevariables.
12.4RiskMonitoring
Theoperationalriskmonitoringsystemfocuses, interalia,onoperationalperformancemeasures
suchasvolume,turnover,settlementfacts,delaysanderrors.Itcouldalsobeincumbentto

monitoroperationallossdirectlywithananalysisofeachoccurrenceanddescriptionofthe
natureandcausesoftheloss.
12.5ControlofOperationalRisk
Internalcontrolsandtheinternalauditareusedastheprimarymeanstomitigateoperational
risk.Banks couldalsoexploresettingup operationalrisklimits, based onthe measuresof
operationalrisk.Thecontingentprocessingcapabilitiescouldalsobeusedasameanstolimit
theadverseimpactsofoperationalrisk.Insuranceisalsoanimportantmitigatorofsomeforms
ofoperationalrisk.Riskeducationforfamiliarisingthecomplexoperationsatalllevelsofstaff
canalsoreduceoperationalrisk.
12.6 PoliciesandProcedures
Banksshouldhavewelldefinedpoliciesonoperationalriskmanagement.Thepoliciesand
proceduresshouldbebasedoncommonelementsacrossbusinesslinesorrisks.Thepolicy
should address product review process, involving business, risk management and internal
controlfunctions.
12.7InternalControl
12.7.1
Oneofthemajortoolsformanagingoperationalriskisthewellestablishedinternal
controlsystem,whichincludessegregationofduties,clearmanagementreportinglinesand
adequateoperatingprocedures.Mostoftheoperationalriskeventsareassociatedwithweak
links in internal control systems or laxity in complying with the existing internal control
procedures.
12.7.2
Theidealmethodofidentifyingproblemspotsisthetechniqueofselfassessmentof
internalcontrolenvironment.Theselfassessmentcouldbeusedtoevaluateoperationalrisk
alongwith internal/external audit reports/ratings or RBI inspection findings. Banks should
endeavourfordetectionofoperationalproblemspotsratherthantheirbeingpointedoutby
supervisors/internalorexternalauditors.
12.7.3
Alongwithactivatinginternalauditsystems,theAuditCommitteesshouldplaygreater
roletoensureindependentfinancialandinternalcontrolfunctions.
12.7.4
TheBasleCommitteeonBankingSupervisionproposestodevelopanexplicitcapital
chargeforoperationalrisk.
13.RiskAggregationandCapitalAllocation
13.1Mostofinternallyactivebankshavedevelopedinternalprocessesandtechniquestoassess
andevaluatetheirowncapitalneedsinthelightoftheirriskprofilesandbusinessplans.Such
bankstakeintoaccountbothqualitativeandquantitativefactorstoassesseconomiccapital.The
Basle Committee now recognises that capital adequacy in relation to economic risk is a
necessaryconditionforthelongtermsoundnessofbanks.Thus,inadditiontocomplyingwith
theestablishedminimumregulatorycapitalrequirements,banksshouldcriticallyassesstheir
internalcapitaladequacyandfuturecapitalneedsonthebasisofrisksassumedbyindividual

lines of business, product, etc. As a part of the process for evaluating internal capital
adequacy,abankshouldbeabletoidentifyandevaluateitsrisksacrossallitsactivitiesto
determinewhetheritscapitallevelsareappropriate.
13.2
Thus,atthebanksHeadOfficelevel,aggregateriskexposureshouldreceiveincreased
scrutiny.Todoso,however,itrequiresthesummationofthedifferenttypesofrisks.Banks,
across the world, use different ways to estimate the aggregate risk exposures. The most
commonlyusedapproachistheRiskAdjustedReturnonCapital(RAROC).TheRAROCis
designedtoallowallthebusinessstreamsofafinancialinstitutiontobeevaluatedonanequal
footing.Eachtypeofrisksismeasuredtodetermineboththeexpectedandunexpectedlosses
usingVaRorworstcasetypeanalyticalmodel.KeytoRAROCisthematchingofrevenues,
costsandrisksontransactionorportfoliobasisoveradefinedtimeperiod.Thisbeginswitha
cleardifferentiationbetweenexpectedandunexpectedlosses.Expectedlossesarecoveredby
reservesandprovisionsandunexpectedlossesrequirecapitalallocationwhichisdetermined
ontheprinciplesofconfidencelevels,timehorizon,diversificationandcorrelation.Inthis
approach, risk is measured in terms of variability of income. Under this framework, the
frequencydistributionofreturn,whereverpossibleisestimatedandtheStandardDeviation
(SD) of this distribution is also estimated. Capital is thereafter allocated to activities as a
functionofthisriskorvolatilitymeasure.Then,theriskypositionisrequiredtocarryan
expectedrateofreturnonallocatedcapital,whichcompensatesthebankfortheassociated
incrementalrisk.Bydimensioningallrisksintermsoflossdistributionandallocatingcapital
bythevolatilityofthenewactivity,riskisaggregatedandpriced.
13.3
ThesecondapproachissimilartotheRAROC,butdependslessoncapitalallocationand
moreoncashflowsorvariabilityinearnings.ThisisreferredtoasEaR,whenemployedto
analyseinterestraterisk.Underthisanalyticalframeworkalsofrequencydistributionofreturns
for any one type of risk can be estimated from historical data. Extreme outcome can be
estimated from the tail of the distribution. Either a worst case scenario could be used or
StandardDeviation1/2/2.69couldalsobeconsidered.Accordingly,eachbankcanrestrictthe
maximum potential loss to certain percentage of past/current income or market value.
Thereafter,ratherthanmovingfromvolatilityofvaluethroughcapital,thisapproachgoes
directly tocurrent earningsimplications froma risky position.This approach, however, is
basedoncashflowsandignoresthevaluechangesinassetsandliabilitiesduetochangesin
market interest rates. It also depends upon a subjectively specified range of the risky
environmentstodrivetheworstcasescenario.
13.4
Giventhelevelofextantriskmanagementpractices,mostofIndianbanksmaynotbein
apositiontoadoptRAROCframeworkandallocatecapitaltovariousbusinessesunitsonthe
basisofrisk.However,atleast,banksoperatingininternationalmarketsshoulddevelop,by
March31,2001,suitablemethodologiesforestimatingeconomiccapital.
Pure-play internet banking
For banks, as for other firms, the internet has opened up a new distribution channel and a new
business model. The internet increases competition by enabling new entrants to compete with
established banks in local markets, which can no longer be dominated simply by a banks physical
presence. In practice, a bank can choose between two internet strategies. Most banks maintain their
traditional network of branch offices while establishing a website that customers can use to
complete transactions online. This business model is known as a click-and-mortar strategy.

DeYoung (2005) states that the strategic value of the click-and-mortar business model lies in
channeling the routine, low value-added transactions through the internet, while channeling
customized, high value-added transactions through the more costly branch network. The bank thus
offers clients the option to conduct their transactions online, without losing those customers who
prefer banking via branch office employees.

This paper focuses on the second strategy: the pure-play internet bank (PPI). In this business
model, a bank establishes a virtual, branchless or internet-only bank (Furst et al. 2000). The
strategic value of PPI derives from its lack of physical presence. First, the absence of an
expensive branch network may lower overhead costs compared to traditional banks. This cost
advantage can be further increased by offering a limited range of commoditized financial
products. Second, internet banking may increase the scalability of banking operations, i.e. the
ability to cope with increased business volumes without experiencing a negative effect on the
contribution margin. Low costs and easy scalability allow internet banks to capture market
share fast.
At a first glance, PPI and relationship banks share some traits. Both rely on deposit funding, are
active in the retail segment and may engage in multiple transactions with one client, either across
product ranges or over time (cf. Boot 2000). However, an important ingredient in relationship
banking a banks investment in obtaining proprietary or sector-specific client information is not
central to the PPI strategy. PPI banks do not engage in customized

corporate lending, but mostly offer commoditized loans (mortgages) to households. In

processing loan applications, PPI banks will typically rely on hard information, which is easy
to quantify, store and transmit (Petersen 2004). The absence of a local physical presence
precludes the collection of so-called soft information, which is qualitative, difficult to transfer
and collected in person. Any client-specific information that a PPI bank collects, will require
little investment and generate few rents. Thus, most mortgages originated (and often
securitized) by large financial institutions or PPI banks can be characterized as transaction
loans.

In terms of funding, the PPI business model is built on the ability to quickly capture market share in
mature savings markets. If this strategy is successful, lack of funding is not an issue. In contrast to
transaction banks, PPI banks therefore do not rely on wholesale funding.

Figure 2-1: Positioning of PPI banking

Investment in client-specific information

Customer orientation

Large

Small

Consumers

relationship banks

SMEs

relationship banks

Financial
markets

PPI banks

transaction banks

Figure 2-1 summarizes the preceding discussion by positioning the PPI model along the
dimensions customer orientation and client-specific information. It suggests that the PPI
model is a hybrid business model, combining aspects of both relationship and transaction
banking. We also conclude that PPI banks lack relationship banks key source of competitive
advantage, which is the investment in proprietary client information. In its place come lower
costs and easy scalability.
The small literature on PPI banking focuses on the presumed cost advantage and financial
performance of PPI banks (DeYoung 2001, 2005, Delgado et al. 2007). DeYoung (2001) finds that US
PPI banks do not have lower overhead costs and are significantly less profitable than regular banks.
High ICT expenditures are one reason why the cost advantage turns out to be illusive. PPI banks
cannot use the excess system capacity of the mother firm for customer

supp
ort,
com
pute
r
netw
orks,
data
proc
essin
g or
the
unde
rwrit
ing
of
loans
.
Cust
omer
s
expe
ct
arou
ndtheclock
servi
ce,
so
oper
ating
a
24/7
call
cente
r is a
basic
nece
ssity.
PPI
labor

costs
are
also
high
er.
DeYo
ung
(2001
)
finds
that
on
avera
ge
PPI
bank
s pay
$7,00
0
more
per
year
than
the
avera
ge
bran
ch
bank
,

as

inter
net
bank
ing
requi
res a
more
highl
y
educ
ated
and

thus
more
expe
nsive
work
force
.
Final
ly,
PPI
bank
s
mark
eting
costs
are
high
er, as
they
need
to
estab
lish a
bran
d
with
out
the
pro
moti
onal
bene
fits
of

phys
ical
bran
ch
netw
ork.
For
non-

finan
cial
retail
ers,
Rose
n
and
How
ard
(2000
) find
that
onlin
e
retail
ers
spen
d ten
time
s

as

muc
h on
mark
eting
and
adve
rtisin
g
than
phys
ical
retail
ers
do.
DeYo
ung
s
(2001
)
sam
ple
cont

ains
man
y
youn
g
bank
s,
whic
h
have
been
testi
ng a
relati
vely
new
busi
ness
mod
el.
This
hold
s out
the
possi
bility
that
the
mod
el is
viabl
e, as
bank
s
prog
ress
alon
g the
learn
ing
curv
e. In

a
follo
w-up
pape
r,
DeYo
ung
(2005
)
argu
es
that
PPI
bank
s
may
achie
ve
scale
econ
omie
s

in

the
futur
e. In
anot
her,
more
recen
t
publi
catio
n,
Cyre
e

et

al.
(2009
)
argu
e
that
altho

ugh
their
acco
unti
ng
profi
ts are
still
not
up to
par,
the
profi
t
effici
ency
of
inter
net
bank
s

is

high
er
than
that
of
brick
sandmort
ar
startups,
thus
attest
ing
to
their
pote
ntial
once
scale

is
achie
ved.
Yet
in

glob
al
sam
ple,
Delg
ado,
Hern
ando
and
Diet
o
(2007
) find
that
PPI
bank
s
have
been
outp
erfor
med
by
their
tradi
tiona
l
com
petit
ors.
The
failu
re to
find
concl
usive
empi

rical
evid
ence
for
the
profi
tabili
ty of
the
PPI
bank
ing
mod
el
contr
asts
with
a
num
ber
of
acad
emic
case
studi
es
trum
petin
g the
succ
ess
of
ING
Dire
ct,
the
large
st
glob
al
PPI,
provi

ding
lowcost
and
highinter
est
finan
cial
servi
ces
(Der
mine
2005,
Hesk
ett
2005,
Sequ
ira et
al.
2007,
Verw
eire
and
Van
den
Berg
he
2007)
.
While the pre-crisis literature has focused on the presumed cost advantage of PPI banks, the
credit crisis has drawn attention to the pros and cons of easy scalability in the banking
industry. Analyzing the Northern Rock failure, Onado (2009, p. 102) points to aggressive
growth as the fundamental cause of the crisis. This growth could only be maintained given an
unlimited supply of funding to creditworthy banks in the wholesale markets. Due to their easy
scalability in savings markets, PPI banks also have a strong potential for aggressive growth. As
in the case of Northern Rock, this raises questions concerning their financial stability.
Introducing the PPI concept in a mature market can expose a bank to a mismatch in the
scalability of assets and liabilities. The loan department may find it difficult to keep up with
strong deposit growth and earn the high yield needed to satisfy its interest sensitive clients. As
a result, either lending standards will be relaxed or funds will be reinvested in (risky)

securities, introducing further financial instability on the asset side of the balance sheet.
PPI banks may also suffer from a less stable funding base compared to traditional banks. PPI banks
are likely to attract relatively interest rate sensitive clients. DeYoung (2001) calls these the financially
savvy hit-and-run customers, who search the web for attractive deposit rates and are not
interested in purchasing other services. Most banks initially try to attract savers with high teaser
rates, which, over time, start to lag behind market rates. With hit-and-run customers this pricing
strategy does not work. The interest rate sensitivity of PPI customers
15

implies that PPI banks need to keep interest rates at high levels to keep customers or be faced with
deposit outflow as well as inflow and thus a high volatility of its depositors-base.

To these micro-prudential concerns about the stability of the individual PPI bank one can add
concerns about the stability of the market as a whole. By offering high rates whilst operating
under deposit guarantee schedules, PPI banks may erode the funding base of the traditional
relationship banks. When their savings are tapped by PPI banks, relationship banks will find it
harder to extend credit to firms. Especially in an economic downturn, relationship banks are
needed to reduce SMEs liquidity constraints and diminish their probability of bankruptcy, as
shown by Ferri, Kang and Kim (2001) for Korean businesses during the Asian financial crisis.
Finally, insofar as PPI banks are active as cross-border branches within the EU or EEA, they
provide a challenge for supervisory authorities and complicate the system of deposit
insurance. When the Icelandic banks failed, foreign savers had to rely on the ability of the
Icelandic government to guarantee an amount of deposits which by far exceeded Icelandic
GDP.
Summing up, PPI banking can be conceived as a hybrid business model, positioned in between
the traditional relationships-oriented banking model and a transactions-oriented banking
model. The pre-crisis literature has raised question marks as to the profitability of PPI banks.
The credit crisis has added further doubts related to their financial stability. Below we will
address these questions and doubts using the case of ING Direct.

The Impact of Internet Banking on Bank

Performance and Risk: The Indian Experience
Internet technology holds the potential to fundamentally change banks and the
banking industry. An extreme view speculates that the Internet will destroy old models
of how bank services are developed and delivered (DeYoung, 2001a). The widespread
availability of Internet banking is expected to affect the mixture of financial services
produced by banks, the manner in which banks produce these services and the
resulting financial performances of these banks. Whether or not this extreme view
proves correct and whether banks take advantage of this new technology will depend
on their assessment of the profitability of such a delivery system for their services. In
addition, industry analysis outlining the potential impact of Internet banking on cost
savings, revenue growth and risk profile of the banks have also generated considerable
interest and speculation about the impact of the Internet on the banking industry
(Berger, 2003).
Banking through internet has emerged as a strategic resource for achieving higher
efficiency, control of operations and reduction of cost by replacing paper based and
labour intensive methods with automated processes thus leading to higher productivity
and profitability. However, to date researchers have produced little evidence regarding
these potential changes. Nonetheless, recent empirical studies indicate that Internet
banking is not having an independent effect on banking profitability, although these
findings may change as the use of the Internet becomes more widespread.
More recently in India too, a wider array of financial products and services have
become available over the Internet (Malhotra and Singh, 2004), which has thus become
an important distribution channel for a number of banks. Banks boost technology
investment spending strongly to address revenue, cost and competitiveness concerns.
For some activities, banks hope to see a near-term impact on profitability. Other
investments are motivated more by a desire to establish a competitive position or
avoid falling behind the competition. The purpose of present study is to analyze such
effects of Internet banking in India, where no rigorous attempts have been undertaken
to understand this aspect of the banking business.

The primary aim is to advance the understanding of how Internet banks are different
from the non-Internet banks in terms of profitability, cost efficiency, asset quality and
other characteristics by examining bank financial statements from year end 1998 to
year end 2006. The present study tests not only whether the Internet delivery channel
affected the financial performance of the commercial banks in our sample, but also
how these changes happened. The study examines a comprehensive set of 10
measures of financial performance that allow us to look inside the black box of bank
performance. By developing a deeper understanding of these phenomena, we can
draw more insightful inferences about the impact of the Internet on banking business
strategies, production processes and financial performance. Increasing this type of
knowledge is vital for both academic literature and also for bank marketers who cannot
count on the initial success achieved by the Internet banking investment.
The paper is organized as follows. The next section reports a brief review of the
literature on Internet Banking, comparing and contrasting conclusions of previous
research. Section 3 describes the data and current status of Internet banking in India.
Section 4 explores whether there is a financial gap between the Internet and nonInternet banks in India by using univariate analysis on banks balance-sheet data
collected by various regulatory authorities (Reserve Bank of India and Indian Banks
Association). Section 5 explores whether Internet banking has had a noticeable impact
on Indian Banks performance and risk, using multivariate (OLS model) analysis.
Section 6 concludes the paper.

4. Internet and Non-Internet Banks: Comparison of Performance

Evaluating bank performance is a complex process that involves assessing interaction
between the environment, internal operations and external activities. In general, a
number of financial ratios are usually used to assess the performance of banks.
Financial performance has been studied under different yardsticks of performance i.e.,
size, profitability, financing pattern, economic efficiency, operational efficiency, asset
quality, diversification and cost of operations.
This section reports the results of univariate analysis to differentiate the Internet and
non-Internet banks. The null hypothesis regarding the financial performance of Internet
and non-Internet banks is:
H1: The financial performance of banks adopting Internet banking is not different from
those of banks choosing not to adopt Internet banking, in terms of size, profitability,
operating capability, financing, asset quality, diversification and cost of operations.
The decision to accept or reject null hypothesis is made on the basis of the value of the
test statistic obtained from the data at hand. In the present study, the statistical
significance of the means of various test statistics is determined by using the two
independent samples t-statistic. For each pair of observations in a table, a probability
(p) value is provided for the hypothesis that the means in the Internet and non-Internet
samples are the same. A lower p-value indicates a greater likelihood that the two
figures compared represent real differences between the two categories of banks
(Internet vs. non-Internet, etc.).

4.1 Size
Table 3 shows the size variables for the Internet and non-Internet banking group.
Internet banks are statistically and significantly larger than non-Internet banks in terms
of total assets and employees. The results are similar to Furst et al. (2000a, 2000b,
2002a and 2002b), Hasan et al. (2002) and Hernando and Nieto (2005). Table 3 shows
that Internet banks are larger in almost every category of bank.

4.2. Profitability, Operating Efficiency and Financing

Table 4 compares the profitability, operating efficiency and financing pattern of

Internet banks with non-Internet banks. On an average, Internet banks are more
profitable than non-Internet banks and are operating with lower cost as compared to
non-Internet banks, thus, representing the efficiency of the Internet banks. The results
are similar to Furst et al. (2000a, 2000b, 2002a and 2002band Hernando and Nieto
(2005).
Internet banks in public sector, particularly, in nationalized bank category are more
profitable than non-Internet banks. Comparatively, both the categories of private

sector Internet banks are less profitable than non-Internet banks but the difference is
not statistically significant. The lower profitability of these banks may be due to higher
operating expenses, both fixed cost as well as labour cost.

4.3. Asset Quality and Diversification

Asset quality indicators measure the changes in the banks loan quality. The Internet
banks show higher asset quality as compared to non-Internet banks. Internet banks are
having lower net Non Performing Assets (NPAs) to net advances as compared to nonInternet banks. Differences in the business strategies of Internet and non-Internet
banks also are evident. The second column shows the ratio of non-interest income to
total income, which is a rough proxy for the amount of revenue generated by
nontraditional activities. Internet banks generated a lower proportion of their income
from non-traditional activities compared to non-Internet banks. However, the difference
is not statistically significant. Internet banks in public sector particularly nationalized
banks and banks in private sector particularly new private sector rely more heavily on
non-traditional sources of income.

4.4. Cost of Operations

In addition to revenue enhancement, Internet banking may enable banks to reduce
costs of operation, in particular, by allowing them to reduce expenditures on brick and
mortar. To the extent this may be so, Internet banking could be considered a
causal factor in generating lower expenses related to maintaining physical branches.
On the other hand, banks with relatively high expenses in maintaining their branch
networks may be expected to have the incentive to adopt Internet banking. The
adoption of Internet banking would thus be the effect of existing characteristics of
banks (Furst et al., 2002). The data in Table 6 shows that, consistent with the first
hypothesis, overall Internet banks had lower expenses for building and equipment.
While, nationalized Internet banks and Internet banks in private sector follow the
second hypothesis. This difference may indicate that these banks with high costs of
maintaining a branch network are motivated to adopt Internet banking by the prospect
of future cost savings.

5. Multivariate Analysis

Although, the univariate analyses depict a tremendously higher performance by banks

in the Internet group(s) relative to non Internet bank group, however, it is hard to make
any conclusive statement on the actual impact of the Internet adoptions on firm
performance without a multivariate analysis. Here a multivariate regression model is
estimated to investigate whether there is a link between offering Internet banking and
banks performance and risk.
The focus of the investigation is to see if Internet banking has an effect on bank
performance and risk. A dummy variable (INTERNET) was created that takes a value of
1 if the bank has adopted Internet banking activities; otherwise it takes a value of zero.
The coefficient associated with this Internet Adoption dummy will indicate the possible
association between the Internet adoption by banks and their overall performance. The
other variables affecting the banks performance have been developed from the
available literature on determinants of banks performance (e.g. Scholtens, 2000;
Naceur, 2003; Camilleri, 2005; Demirg-Kunt and Huizinga, 1999; Athanasoglou et al.,
2005; Shanmugam and Dass, 2004; Barth et al., 1997; Goddard et al., 2004;
Alzaidanin, 2003; Hassan and Bashir, 2003; Claeys and Vennet, 2004; DeYoung and
Rice, 2003; Buser et al., 1981; Bashir, 2000; Caprio and Summers, 1993; Stiglitz and
Marilou, 1996; Short, 1979; Bourke, 1989; Molyneux and Thornton, 1992; DemirgucKunt and Huizinga, 2000 and many more) and literature on Internet banking
performance (Furst et al., 2002a; Carlson et al., 2001; DeYoung, 2001c and 2005;
Hasan et al., 2002; Delgado et al., 2004 and 2006; Hernando and Nieto, 2005; Sathye,
2005; DeYoung et al., 2006).
Return on Assets and Return on Equity are used as performance measures and Ratio of
Net NPAs to net advances has been used as a measure of bank risk. In selecting
potential factors associated with performance and risk, various bank characteristics are
used as proxies for the banks internal measures, e.g., size, capital, risk management
and expenses management ratios and bank ownership dummies while macro-economic
indicators are used to represent the external measures.
A linear equation, relating the performance measures to a variety of financial indicators

is specified. Following model has been used to examine the relationship between the
performance of banks and adoption of Internet banking after controlling the other
variables affecting the performance and risk.
Yit = c + *INTERNETit + iXit + it

(1)

Where Yit presents profitability and bank risk measures of bank i at time t, c is a
constant term, the it are explanatory variables and it is the disturbance term. The
subscript i indexes bank level observations and the subscript t indexes time in years.
INTERNET is a dummy variable equal to 1 for Internet banks and the
coefficient provides the main static test. A statistically significant value for
indicates a financial performance gap between the Internet banks and the non-Internet
banks at the means of the data. The coefficients are estimated by employing OLS
regressions on a sample of all banks as well as samples of different categories of
banks.

Indian Banking Industry: Challenges and Opportunities

5. CHALLENGES FACED BY INDIAN BANKING INDUSTRY
Developing countries like India, still has a huge number of people who do not have access to
banking services due to scattered and fragmented locations. But if we talk about those people
who are availing banking services, their expectations are raising as the level of services are
increasing due to the emergence of Information Technology and competition. Since, foreign
banks are playing in Indian market, the number of services offered has increased and banks
have laid emphasis on meeting the customer expectations.
Now, the existing situation has created various challenges and opportunity for Indian Commercial
Banks. In order to encounter the general scenario of banking industry we need to understand the
challenges and opportunities lying with banking industry of India.
5.1 Rural Market
Banking in India is generally fairly mature in terms of supply, product range and reach, even
though reach in rural India still remains a challenge for the private sector and foreign banks. In
terms of quality of assets and capital adequacy, Indian banks are considered to have clean,
strong and transparent balance sheets relative to other banks in comparable economies in its
region.
Consequently, we have seen some examples of inorganic growth strategy adopted by some
nationalized and private sector banks to face upcoming challenges in banking industry of India.
For example recently, ICICI Bank Ltd. merged the Bank of Rajasthan Ltd. in order to increase its
reach in rural market and market share significantly. State Bank of India (SBI), the largest public
sector bank in India has also adopted the same strategy to retain its position. It is in the process
of acquiring its associates. Recently, SBI has merged State Bank of Indore in 2010.
5.1 Management of Risks
The growing competition increases the competitiveness among banks. But, existing global banking
scenario is seriously posing threats for Indian banking industry. We have already witnessed the
bankruptcy of some foreign banks.
According to Shrieves (1992), there is a positive association between changes in risk and capital.
Research studied the large sample of banks and results reveal that regulation was partially effective
during the period covered. Moreover, it was concluded that changes in bank capital over the period
studied was risk-based [1].
Wolgast, (2001) studied the Merger and acquisition activity among financial firms. The author
focused bank supervisors in context with success of mergers, risk management, financial system
stability and market liquidity. The study concluded that large institutions are able to maintain a

superior level of risk management [2].

Al-Tamimi and Al-Mazrooei (2007) examined the risk management practices and techniques in
dealing with different types of risk. Moreover, they compared risk management practices between
the two sets of banks. The study found the three most important types of risk i.e. commercial banks
foreign exchange risk, followed by credit risk, and operating risk [3].
Sensarma and Jayadev (2009) used selected accounting ratios as risk management variables and
attempted to gauge the overall risk management capability of banks. They used multivariate
statistical techniques to summarize these accounting ratios. Moreover, the paper also analyzed the
impact of these risk management scores on stock returns through regression analysis. Researchers
found that Indian banks' risk management capabilities have been improving over time. Returns on
the banks' stocks appeared to be sensitive to risk management capability of banks. The study
suggest that banks want to enhance shareholder wealth will have to focus on successfully
managing various risks [4].
5.3 Growth of Banking
Zhao, Casu and Ferrari (2008) used a balanced panel data set covering the period of 1992-2004
and employing a Data Envelopment Analysis (DEA)-based Malmquist Total Factor Productivity
(TFP) index. The empirical study indicated that, after an initial adjustment phase, the Indian banking
industry experienced sustained productivity growth, which was driven mainly by technological
progress. Banks' ownership structure does not seem to matter as much as increased competition in
TFP growth. Foreign banks appear to have acted as technological innovators when competition
increased, which added to the competitive pressure in the banking market. Finally, our results also
indicate an increase in risk-taking behaviour, along with the whole deregulation process [5].
It was found in the study of Goyal and Joshi (2011a) that small and local banks face difficulty in
bearing the impact of global economy therefore, they need support and it is one of the reasons for
merger. Some private banks used mergers as a strategic tool for expanding their horizons. There is
huge potential in rural markets of India, which is not yet explored by the major banks. Therefore
ICICI Bank Ltd. has used mergers as their expansion strategy in rural market. They are successful
in making their presence in rural India. It strengthens their network across geographical boundary,
improves customer base and market share [6].
5.4 Market Discipline and Transparency
According to Fernando (2011) transparency and disclosure norms as part of internationally
accepted corporate governance practices are assuming greater importance in the emerging
environment. Banks are expected to be more responsive and accountable to the investors. Banks
have to disclose in their balance sheets a plethora of information on the maturity profiles of assets
and liabilities, lending to sensitive sectors, movements in NPAs, capital, provisions, shareholdings
of the government, value of investment in India and abroad, operating and profitability indicators,
the total investments made in the equity share, units of mutual funds, bonds, debentures, aggregate
advances against shares and so on [7].
5.5 Human Resource Management
Gelade and Ivery (2003) examined relationships between human resource management (HRM),
work climate, and organizational performance in the branch network of a retail bank. Significant
correlations were found between work climate, human resource practices, and business
performance. The results showed that the correlations between climate and performance cannot be
explained by their common dependence on HRM factors, and that the data are consistent with a
mediation model in which the effects of HRM practices on business performance are partially
mediated by work climate [8].

Bartel (2004) studied the relationship between human resource management and establishment
performance of employees on the manufacturing sector. Using a unique longitudinal dataset
collected through site visits to branch operations of a large bank, the author extends his research to
the service sector. Because branch managers had considerable discretion in managing their
operations and employees, the HRM environment could vary across branches. Site visits provided
specific examples of managerial practices that affected branch performance. An analysis of
responses to the banks employee attitude survey that controls for unobserved branch and manager
characteristics shows a positive relationship between branch performance and employees
satisfaction with the quality of performance evaluation, feedback, and recognition at the branch
the incentives dimension of a high-performance work system. In some fixed effects specifications,
satisfaction with the quality of communications at the branch was also important [9].
5.6 Global Banking
It is practically and fundamentally impossible for any nation to exclude itself from world economy.
Therefore, for sustainable development, one has to adopt integration process in the form of
liberalization and globalization as India spread the red carpet for foreign firms in 1991. The impact
of globalization becomes challenges for the domestic enterprises as they are bound to compete
with global players.
If we look at the Indian Banking Industry, then we find that there are 36 foreign banks operating in
India, which becomes a major challenge for Nationalized and private sector banks. These foreign
banks are large in size, technically advanced and having presence in global market, which gives
more and better options and services to Indian traders.
5.7 Financial Inclusion
Financial inclusion has become a necessity in todays business environment. Whatever is produced
by business houses, that has to be under the check from various perspectives like environmental
concerns, corporate governance, social and ethical issues. Apart from it to bridge the gap between
rich and poor, the poor people of the country should be given proper attention to improve their
economic condition.
Dev (2006) stated that financial inclusion is significant from the point of view of living conditions of
poor people, farmers, rural non-farm enterprises and other vulnerable groups. Financial inclusion, in
terms of access to credit from formal institutions to various social groups. Apart from formal banking
institutions, which should look at inclusion both as a business opportunity and social responsibility,
the author conclude that role of the self-help group movement and microfinance institutions is
important to improve financial inclusion. The study study suggested that this requires new
regulatory procedures and de-politicisation of the financial system [10].
5.8 Employees Retention
The banking industry has transformed rapidly in the last ten years, shifting from transactional and
customer service-oriented to an increasingly aggressive environment, where competition for
revenue is on top priority. Long-time banking employees are becoming disenchanted with the
industry and are often resistant to perform up to new expectations. The diminishing employee
morale results in decreased revenue. Due to the intrinsically close ties between staff and clients,
losing those employees completely can mean the loss of valuable customer relationships. The retail
banking industry is concerned about employee retention from all levels: from tellers to executives to
customer service representatives because competition is always moving in to hire them away.
The competition to retain key employees is intense. Top-level executives and HR departments
spend large amounts of time, effort, and money trying to figure out how to keep their people from
leaving.

Sekaran, U. (1989) studied a sample of 267 bank employees, this study traced the paths to the job
satisfaction of employees at the workplace through the quality of life factors of job involvement and
sense of competence. Results indicated that personal, job, and organizational climate factors
influenced the ego investment or job involvement of people in their jobs, which in turn influenced the
intra-psychic reward of sense of competence that they experienced, which then directly influenced
employees' job satisfaction [11].
Mitchell, Holtom, Lee and Graske (2001) asserted in their study that people often leave for reasons
unrelated to their jobs. In many cases, unexpected events or shocks are the cause. Employees also
often stay because of attachments and their sense of fit, both on the job and in their community
[12].
Saxena and Monika (2010) studied a case of 5 companies out of 1000 organizations and 8752
respondents surveyed across 800 cities in India by Business Today. The survey was on nine basic
parameters like career and personal growth, company prestige, training, financial compensation
and benefits and merit based performance evaluation. It was concluded that the biggest challenge
for organizations is that when new employees appointed, it is difficult to merge them in
organizational culture. Each organization has its own unique culture and most often, when brought
together, these cultures clash. When there is no retention, employees point to issues such as
identity, communication problems, human resources problems, ego clashes, and intergroup
conflicts, which all fall under the category of cultural differences [13].
5.9 Customer Retention
Levesque and McDougall (1996) investigated the major determinants of customer satisfaction and
future intentions in the retail bank sector. They identified the determinants which include service
quality dimensions (e.g. getting it right the first time), service features (e.g. competitive interest
rates), service problems, service recovery and products used. It was found, in particular, that
service problems and the banks service recovery ability have a major impact on customer
satisfaction and intentions to switch [14].
Clark (1997) studied the impact of customer-employee relationships on customer retention rates in
a major UK retail bank. He revealed that employee and customer perceptions of service quality are
related to customer retention rates and that employee and customer perceptions of service quality
are related to each other [15].
Clark (2002) examined the relationship between employees perceptions of organizational climate
and customer retention in a specific service setting, viz. a major UK retail bank. Employees
perceptions of the practices and procedures in relation to customer care at their branch were
investigated using a case study approach. The findings revealed that there is a relationship between
employees perceptions of organizational climate and customer retention at a micro-organizational
level. He suggested that organizational climate can be subdivided into five climate themes and that,
within each climate theme, there are several dimensions that are critical to customer retention [16].
Hansemark and Albinsson (2004) explored how the employees of a company experience the
concepts of customer satisfaction and retention. They used phenomenological method, allowing the
informants own interpretations to be discovered. Satisfaction was discussed from three
perspectives: definition of the concept, how to recognise when a customer is satisfied, and how to
enhance satisfaction. The informants experience pertaining to these three categories varied, and a
total of seven ways to define, recognise or enhance satisfaction were discovered. These were:
service, feeling, chemistry, relationship and confidence, dialogue, complaints and retention. All
except the first two of these categories of experience were found to enhance retention, implying that
the informants have found that strategies for enhancing both satisfaction and retention are similar
[17]. The strongest connection between retention and satisfaction strategies turned out to be in
terms of relationship and confidence.

5.10 Environmental Concerns

It is quite clear from the recently formed Copenhagen Climate Council (CCC) that there is a severe
need for environmental awareness among all the countries of the world. CCC published Thought
Leadership Series on Climate Change which is a collection of inspirational, concise and clearly
argued pieces from some of the world's most renowned thinkers and business leaders on climate
change. The objective of the pieces is to assist in enhancing the public and political awareness of
the actions that could have a significant impact on global emissions growth and to disseminate the
message that it is time to act. The Thought Leadership Series was aimed at explaining and
spreading awareness of the key elements in the business and policy response to the climate
problem. The rationale for the Thought Leadership Series was to change the focus of people.
5.11 Social and Ethical Aspects
There are some banks, which proactively undertake the responsibility to bear the social and ethical
aspects of banking. This is a challenge for commercial banks to consider the these aspects in their
working. Apart from profit maximization, commercial banks are supposed to support those
organizations, which have some social concerns.
Benedikter (2011) defines Social Banks as banks with a conscience. They focus on investing in
community, providing opportunities to the disadvantaged, and supporting social, environmental, and
ethical agendas. Social banks try to invest their money only in endeavours that promote the greater
good of society, instead of those, which generate private profit just for a few. He has also explained
the main difference between mainstream banks and social banks that mainstream banks are in
most cases focused solely on the principle of profit maximization whereas, social banking
implements the triple principle of profit-people-planet [18].
Goyal and Joshi (2011b) have concluded in their study on social and ethical aspects of Banking
Industry that Banks can project themselves as a socially and ethically oriented organization by
disbursement of loans merely to those organizations, which has social, ethical and environmental
concerns [19].

HEALTH INSURANCE: TECHNOLOGY AS A KEY GROWTH DRIVER

ABSTRACT

The insurance sector in India has grown at faster rate after liberalization. Total premium is
significantly lower than Asian peers, like South Korea, Taiwan, Japan and Hong Kong which
boast an insurance density greater than 10%; growth potential remains promising. As a
transaction-intensive industry, health insurance has benefitted, and will continue to benefit,
from the efficiencies that technology brings to traditionally paper-driven processes. The
industry is at a crossroads. It not only must improve existing processes, it must also
develop new processes and capabilities to meet new customer demands
(http://www.insurancetech.com). Health insurance companies consider technology as an
enabler tool to respond challenges and opportunities. The business and IT agenda become
interchangeable. Technology becomes a driving force for health insurers interacting with
customers having new expectations like to be able to manage transactions how, when and
where they want.
This research paper is descriptive in nature and an attempt to through light on importance
of technology in growth of health insurance sector.

INTRODUCTION
The insurance sector in India has grown at faster rate after liberalization. Total premium grew
at a CAGR of 25% and reached total of $67 billion, yet, Indian Insurance penetration,
measured as ratio of premium underwritten to GDP was only at 5.2 % in 2010, significantly
lower than Asian peers, like South Korea, Taiwan, Japan and Hong Kong which boast an
insurance density greater than 10%; growth potential remains promising. As a transactionintensive industry, health insurance has benefitted, and will continue to benefit, from the
efficiencies that technology brings to traditionally paper-driven processes. The industry is at a
crossroads. It not only must improve existing processes, it must also develop new processes
and capabilities to meet new customer demands (http://www.insurancetech.com).

PRESENT POSITION
There are between 800 and 900 million people in India who do not have any medical cover;
expenditure on medical treatment is one of the constraints in poverty alleviation, expansion of
universal health insurance can be a good intervention. The coverage of health insurance continues
to be very low and only around 25% population receives any kind of health insurance (Choudhari,
2013). National and state wise health insurance coverage in 2010 was as follows:

Source: Choudhary, 2013.

CHALLENGES
Insurance awareness is lower especially in health insurance. The perceived value of buying
insurance products remains low due to high expectations on returns to which other financial
products normally offer and the belief that risk coverage is not needed. It makes insurance a
push product rather than a pull product in India (http://www.irda.gov.in). Reaching out to the
potential willing buyers and servicing them becomes challenge due to the scattered and
spread population, especially outside the metros and Tier-I cities. The insurance industry faces
challenges in acquiring and retaining internal and external channel teams considering the
huge gap between the demand and supply of dependable and skilled personnel, resulting into
high cost of customer acquisition and operations.

Rational
Despite the unexplored potential, insurance companies will continue to be confronted by different
challenges to achieve top-line and even in bottom-line performances. Apart from struggling to
maintain growth, insurance companies are called upon to meet the ever increasing dynamic needs
of price and service conscious insurance consumers, meet regulatory demands, enhance risk
management capabilities, re-evaluate business partnerships and joint ventures, adopt new
distribution models and build capabilities in more enabling but technology driven environment. Due
to the challenges and threats, accessing the next phase of growth requires identification and better
understanding of technology factor.

TECHNOLOGICAL
Health insurance companies consider technology as an enabler tool to respond challenges
and opportunities. The business and IT agenda become interchangeable. Technology
becomes a driving force for health insurers interacting with customers having new
expectations like to be able to manage transact io ns how, when and where t hey want (ht tp://
www.insurancetech.com). Advances in software and hardware transform big and large data
into actionable insights. As the insurance industry reaps productivity gains from wave of
automation, new technologies are significantly enhancing operational efficiencies, revenue
opportunities, and improving customer experience through growth in smart phones and
tablets; cloud computing, constant access to internet, exploded increase of computing power
and storage, enabling accumulation and analysis of large data and growth in active sensors
and devices connected through internet (CISCO, 2011). Technology makes health insurance
service-centric rather than server-centric architecture to create flexible, responsive and agile
business models and capabilities. Analysts rated technology at 91 percent as either critical or
important; current technology performance as poor and advised major improvement (http:/
/www.accenture.com). Cloud computing has yet to make greater impact in insurance as many
insurers are saddled with rigid and costly legacy systems that cannot be easily moved into
more agile and responsive, commercial systems, business processes. Cloud Investment
Intentions among Insurers is illustrated below:

(Source: Enterprise and SMB Hardware Survey, 2009).

By 2020, different biotechnologies will be available at nano-scale, providing ability to embed

devices and sensors unobtrusively within human body. Nanotechnology drug delivery market
is expected to grow impacting health insurance (http://www.researchandmarkets.com).
Consumers will use personalized medicine to create highly customized unique healthcare
solutions that actively change the body's biochemistry putting an impact on health insurance
sector. Medical advances will flatten cost curve as mortality and morbidity rates are
dramatically improving and reduce litigation costs as medical product manufacturers provide
evidence on efficacy of drugs trial. Risk management trend is to deepen and expand. Carriers
will move from passively identifying and pricing risk, and reactively paying claims proactively
under strategic decisions using big data in simulation techniques, real-time sensor data,
unstructured data from social networks and multimedia (http://www.fide.org). In the US, 10
percent of all property and casualty claims are fraudulent, yet only 20 percent of those are
detected (National Insurance Crime Bureau, 2013). Data analytics can improve the situation.
49% expected new sources and techniques in data analytics to be the key competitive
differentiator (http://www.pwc.com).

CONCLUSION
Technological factors have an impact on health insurance but not all changes will affect insurers
positively. Forward-looking health insurers in developed countries are likely to grow in local
markets by exploiting socio-demographic, technological, economical, environmental, eco-political,
administrative advancement and simultaneously targeting emerging markets for growth by
reshaping health insurance products for local markets while expanding on globally by building
technical expertise and real time working. The pace and nature of growth is to observe changes in
behaviors and dynamics of demand and supply; demand is increasing and supply is playing market
making role. Growth comes at a cost; private insurers have to incur high expenses in increasing
health insurance need-awareness, developing brand strength, establishing distribution channels
and setting-up branch net-work and other infrastructure like on line sale-purchase facility. Insurers'
plans of obtaining break-even within first 7 to 9 years of operations are burdened with threats and
challenges (http://www.deloitte.com).

Three basic sets of tools can be applied to health care industry: Internet applications;
enterprise systems; and mobile technologies. These tools can be used by health care
organizations to store internal organizational information based upon its different business
modules, including finance and accounting, human resources, payroll information, etc. Health
care organizations can use these numerous technologies to provide better patient care, by not
only obtaining more information from patients, but also giving more information on self-care
and disease management to patients (http://www.cs.cmu.edu).

SUGGESTIONS
Key trends critical in next five years are: reflexive and appropriate IT security that
identifies and prioritizes gaps and vulnerabilities. A risk-based approach to customer
data privacy is to be adopted. Social platforms to drive business intelligence and
create new customer channels should be used. User experience should be used as
driver of new products, services and marketing (http://www.insurancetech.com). The
key megatrends- technology is likely to influence health insurance sector as below:

TECHNOLOGICAL
Technology playing leading role on frontier of health insurance can help in detecting fraud.
Card-based payment can drive speed and efficiency of transaction processing (http://
www.insurancetech.com). As internet ensures real-time information and big data, insurers
should exploit it for better pricing, underwriting, and loss controlling to have competitive
advantage. Global investment in advanced analytical techniques is needed to develop
capabilities to process large unstructured and multimedia data as continuous real-time video,
life blogging and social chatter. Advances in artificial intelligence techniques, as machine
learning, natural language understanding and intelligent decision-making should be used to
advance transaction processing to decision-making. The health insurance industry must
improve existing processes; develop new processes and capabilities to meet new customer
demands by; Cloud Computing: The Cloud can change health insurance scenario by moving
at speed and scale to address new opportunities, improve responsiveness and enhance
processes like, underwriting. It permits scalable faster quote processing and more accurate
risk pricing. Cloud and digital mobile channels enables health insurer to 'stretch the walls' of
computing capacities and respond to peak demands at lower cost. Insurers can master huge
internal and external data to improve processes, enhance customer service, create products
around customer and meet regulations through cloud where security and data privacy permit
to maximize gain in productivity and profitability; Architecture around Business Goals: The
insurers are to move from architecture based servers to architecture built around service to
achieve business goals. Data should be used as platform to be distributed wherever it is
needed. The architecture should allow decoupling distribution from manufacturing to create
more agile and flexible systems that respond faster to product development and launch of
product factories. Insurers should provide product management staff with ability to configure
products using various variable inputs; test them and decide to launch or abandon without
referring supportive technical team.
Front office systems can be aggregated and integrated to deliver seamless channel experiences to
customers (http://www.insurancetech.com); Preventative Business Modeling: From reactive to
preventative business model shifting needs to be ensured. Connected devices and sensors to
develop and improve risk and loss management system to improve productivity

are needed in health insurance industry; Nano-technology Usage: Nano technologies,

having potential to dramatically improve health outcomes through enhanced monitoring
and preventive control over chronic disease be considered for envisioning health
insurance sector (http://www.researchandmarkets.com); Customized Health Care
Services: Medical service and treatment model needs to be evolved towards
customization of healthcare service to reduce cost and increase effectiveness; Loss and
Risk Management: Loss and risk management in health insurance needs more
sophisticated risk modeling and innovativeness in structuring risk-sharing and transfer
deals. Workable insights reduce losses and provide better risk management for good
customer experience and competitive advantage. New sensing, monitoring devices and
technology, together with risk transfer mechanisms, can extend general health, cushion
insurers and reinsurers against abnormal losses (http:// www.fide.org);
Data Analytics: Data analytical techniques can be used for decisions using unstructured data
as social media devices, video and audio. Complementing structured data should be ensured
in strategic forward-looking decisions to achieve enhanced customer insight and more efficient
business processes. Predictive and behavioral analytics integrated with business processes
can address changing customer behavior. Service product innovation becomes more effective
and faster when analytics are in the mix. Data analytics can assess likely take-up of health
insurance product. It can model the impact of price changes and different features; and create
real-time insights; fine-tune service products; and detect fraud in claims. Healthcare
organizations are increasingly using analytics to consume, unlock and apply new insights from
information. New methods of analytics can be used to drive clinical and operational
improvements to meet business challenges. From a traditional baseline of transaction
monitoring using basic reporting tools, spreadsheets and application reporting modules,
analytics in healthcare is moving toward a model that will eventually incorporate predictive
analytics and enable organizations to "see the future," create more personalized healthcare,
allow dynamic fraud detection and predict patient behavior(https://www.ibm.com).

IMPLICATIONS
It implies that insurance is risk minimizing and mitigating financial product. Awareness and
financial inclusion especially in health care insurance is increasing due to IRDA. Technology is
playing a dynamic role in health insurance sector. Demand and supply in health care
insurance both are increasing in favorable environment but a lot is to be still covered.

TECHNOLOGY IN FUTURE
Electronic Health Records is a safe and confidential record of care that nurses, doctors,

nurse practitioners, other health care provider, and clinical office staff use to manage and document health
care assessments, interventions, and treatments. Electronic Prescribing gives prescribers the ability to write
and instantly send prescriptions directly to your pharmacy without the limitations and errors of paper
prescription, such as legibility, allergy, duplication, and other problems. These systems may be having an
ability to check whether your insurance covers the prescribed drug, and even recommends substitutes
(http://www.nursingworld.org). Radio frequency identification technology tracks patients throughout the
hospital, and links lab and medication tracking through a wireless communications system. It is neither mature
nor widely available, but may be an alternative to bar coding (http://www.medpac.gov).

CONSUMER ALERT
PROTECT YOURSELF: BUYING INSURANCE ON THE INTERNET
TheaccessibilityandeaseoftheInternethasrevolutionizedtheshoppingworld.Everythingfrompetfoodto
furnitureisavailable24hoursaday,sevendaysaweek,fromthecomfortofyourhome.Thatsameconvenience
nowextendsintotheinsuranceindustry.HerearesometipsfromtheNationalAssociationofInsurance
Commissioners(NAIC)tohelpyouprotectyourselfwhenbuyinginsuranceontheInternet.
securesiteaddressmaybeginwithhttps://insteadofthe
usualhttp://.Or,thesitemayhaveasmallkeyorclosed
1.RESEARCH,RESEARCH,RESEARCH
lockiconlocatedsomewhereinthebottomleftorright
Researchisbyfaryourbestprotection.Fortunately,theInternet
cornerofthescreen.
isalsoagreatresearchagent.Determinewhichinsurancecover
2.8
Ifyoucannotconfirmthesecurityofthebrowser,contact
agebestfitsyourneeds,thenshoparoundforcompanies,agents,
thecompanyoragentandsubmityourpaperworkviafax
premiumsandcoverage.
ormail.
2.9 Take extra precautions when paying with a credit card.
Some credit cards may be equipped with antitheft
Inordertosell insuranceinyourstate,thecompanyandthe
protections.Reviewyourcreditcardagreementforantitheft
agentmustbelicensed.Toconfirmthecredibilityofacompany
provisions.

2.DOUBLECHECKTHECOMPANYANDAGENT

oragent,checkwithyourstateinsurance
departmentforthefollowingthefacts:
ix) Isthecompanylicensedinyourstate?
x) Is the companylicensedtosell thelineof insuranceyouare
interestedinpurchasing?
xi) Istheagentlicensedinyourstateandalegitimaterepresentative
ofthecompany?
xii) Doesthecompanyhaveagoodrecordofhandlingpolicycom
plaints?
Yourstateinsurancedepartmentcanprovidealistofcompanies
andagentsthatarelicensedinyourstate.

3.PURCHASINGONTHEINTERNET
Onceyouvecheckedyourfactsandfoundthecompany,agent
andpolicythatsuitsyourneeds,yourereadytopurchase.At
thispoint,securityisthenameofthegame.Takesomeextra
precautionstoprotectyourpersonalinformation:
2.7 Updateyourbrowser.Thenewerbrowsersareequippedwith
morecurrentsecuritymeasures.Onewaytocheckifyouare
transmittingacrossasecuresiteisbycheckingtheaddress.A

clear.
3.1.4 Doyourresearch.Scamartistsmaytrytoconvinceyouto
Asyoucompleteyourresearchandpurchase,itsimportantto
keepdetailedrecords.Getallratequotesandkeyinformationin changecoveragequicklywithoutgivingyoutheopportunity
writingforyourfile.Also,onceyoudecidetopurchaseonline, todoadequateresearch.
3.1.5 Seekadvice.Ifaparticularpolicyrequiresalargesumde
keepacopyofallpaperworkyoucompleteandsign,aswellas
positinanaccount,askathirdpartysuchasareputable
anycorrespondence,specialoffersandpaymentreceipts.
localinsuranceagent,anaccountantorfinancialadvisor
Pleasenote:Youshouldreceiveacopynotaphotocopy
ofyournewpolicywithin30to60daysofpurchase.Ifyou foradvice.
Ifitseemstoogoodtobetrue,itprobablyis!
do not receive your copy, contact the insurance company 3.1.6

4.THEPROOFISINTHEPAPERWORK

immediately.

5.INSURANCEREDFLAGS
Herearesomequickredflagstowarnyouagainstpossible
insurancefraud:
3.1.3 Dontsubmittohighpressuretactics. Ifyouarebeingover
whelmedwithoffersfromaparticulargrouporagentthatmake
youuncomfortableoraggravated,trustyourinstinctsandsteer

6.GETMOREINFORMATION
Informationisyourbestpolicy.Visityourstateinsurance
department for more information on company and agent
requirements,aswellasproducts.Youcanlinktoyourstate
insurancedepartmentsWebsitebyvisitingwww.naic.org.
ClickonStateInsuranceRegulatorsWebSites,thenclick
onyourstate.

Historical developments in the Indian general

insurance industry
The overall general insurance industry growth has kept pace with the GDP growth in the
country and general insurance penetration has varied in a narrow band
After liberalisation of the Indian insurance industry in the year 1999-2000, the Indian general
insurance industry has witnessed rapid growth. The industry, in terms of gross direct premium, has
grown from INR 11,446 crore in FY02 to INR 57,964 crore in FY12, which corresponds to a
compounded annual growth rate (CAGR) of 17.6 percent. Insurance density, which is defined as the
ratio of premium underwritten in a given year to the total population, has increased from USD 2.4 in
2001 to USD
10 in 2011. The growth in the general insurance industry has kept pace with the nominal GDP
growth rate resulting in general insurance penetration remaining stable in the range of 0.55% to
0.75% over the last 10 years.
Exhibit 1: Growth in the Indian general insurance industry

Source: Handbook on Indian Insurance Statistics 2011-2012

Overall, while the industry achieved significant growth over the past 5 years, the profitability of
industry deteriorated sharply
A multitude of factors adversely impacted the industry profitability over the last five years

Price detariffication provided freedom to general insurance companies to decide the premium rates in most of the product
segments

Between FY06 and FY12, 10 new companies have entered the general insurance business. Intensifying competition and
focus on growth by the new entrants led to competitive pricing pressure
Focus on growth by the insurers across the industry led to higher bargaining power of the intermediaries and limited
control on the claims cost
Limited or no increase in the TP premium rates for a number of years coupled with issues pertaining to third party liability
caps as under The Motor Vehicles Act, led to extraordinarily high claims ratio in the segment which impacted the overall
profitability and solvency requirements for the general insurance companies.

Exhibit 3: Relative growth and profitability of the general insurance product segments

Source: IRDA annual reports 2010, 2011 and 2012

Note: Size of the bubble indicates segment size (GDP in INR Cr)

Future growth and profitability trends in the

General Insurance Industry

General insurance industry in India presents significant headroom for growth

While the Indian general insurance industry has evolved significantly over the past decade or so, the
insurance penetration and insurance density levels are significantly lower than the developed as well as
comparable developing countries. The under-penetration is driven by lack of overall financial awareness, lack
of understanding of general insurance products, low perceived benefits, and propensity to purchase insurance
based on reactive drivers such as insistence by financers, statutory requirements, etc.
Exhibit 4A: General insurance penetration in
percentage (Ratio of Premium to GDP)

Source: Swiss Re, Sigma Volumes 2/2011 and 3/2012,

Note: Data for India pertains to FY12 whereas for other
countries, it pertains to the year 2011

Exhibit 4B: General insurance density (Ratio of

premium in USD to population)

Source: Swiss Re, Sigma Volumes 2/2011 and 3/2012,

Note: Data for India pertains to FY12 whereas for other
countries, it pertains to the year 2011

Study of global benchmarks reveals a strong correlation between GDP per capita and insurance penetration.
The correlation suggests that the insurance penetration may increase up to 1 percent to 1.2 percent by FY20
considering the likely increase in the GDP per capita.

Indias expenditure pattern on healthcare suggests significant headroom for growth for
substitution of out-of-pocket expenditure by health insurance
Exhibit 5: Sources of Healthcare Expenditure

Source: World Health Statistics 2012 published by World Health Organization, KPMG Analysis, data pertains to year 2010

In India, the share of out-of-pocket expenditure in overall healthcare expenditure is significantly higher than
comparable developing countries as well as the developed countries. Moreover, the government focus on
healthcare spending is focussed on low income and below the poverty line segments. Considering the rising
healthcare cost inflation and changing disease pattern more towards lifestyle diseases in the urban areas, the
health insurance market would have significant headroom for growth as it would replace the out-of-pocket
expenditure.

Competitive strategies could considerably impact the growth and profitability of the
overall general insurance industry
Competitive strategies adopted by players would have considerable impact on the growth and profitability trends in
the general insurance industry. Different competition segments have different strategic imperatives based on the
historical business performance, capabilities developed over the period of time and strategic objectives of the
promoters.

New entrants targeting broad based presence

New entrants focussing on high growth across segments are likely to have low profitability in the initial years as
their aim would mainly be on price or channel payout-based competition. These players may rapidly replicate
the industry best practices since they would have limited legacy operating structures and assets. The same
could enable profitability and growth for these players in the medium term.
New entrants with niche focus
New entrants who are currently focussing on niche product-market segments may bring the international best
practices in products, managed care models, ancillary services such as wellness and disease management in the
medium to long