Challenges & Concerns of the Central Bank: Opportunities & Role for the Commercial Banks

Challenges & Concerns of the Central Bank: Opportunities & Role for the Commercial Banks Bankers’ Club Thiruvananthapuram, Kerala June 10, 2013 Harun R Khan Deputy Governor Reserve Bank of India

The 10 Challenges & Concerns • Propelling revival of domestic growth • Controlling persistent inflation • Mitigating external sector vulnerabilities • Deepening the financial markets • Maintaining robust banking system • Ensuring integrity of the financial system • Building efficient Government banking business models • Moving towards a less-cash society • Better customer service orientation of the banks • Enhancing the quality of financial inclusion

I. Propelling revival of domestic growth • Global economic activity remains moderated amidst signs of diverging growth paths across major economies • Eurozone is still in recession, the US recovery continues to remain sluggish, Japanese turnaround is mostly policy induced and the Chinese growth is no longer in double digits • Indian recovery rather sharp and swift in 2009-10 (8.6 per cent) and sustained in 2010-11 (9.3 per cent) • Thereafter, overall GDP growth witnessed sharp decline to 6.2 per cent in 2011-12 and further to 5 per cent in 2012-13 (provisional)

The challengedeclining domestic savings • Growth cannot be revived without increasing the level of investment or gross domestic capital formation • In India, the level of investment has been mostly financed by domestic savings. • Due to high level of inflation for a long period • Decline in gross domestic savings as a percentage to GDP • Decline in financial savings of households • Increase in physical savings • This trend is not conducive to growth as physical savings are not available for further investment.

The challengeexternal flows supplementing investments` • Investments in India were supplemented by external savings only • external current account deficit as proportion to GDP at an average of 1.2 per cent during 2004-05 to 2008-09 • thereafter, the CAD widened further and likely to reach a very high level of about five (5) per cent. • implication for composition of external debt, debt servicing ratio and risks associated with flight to safety • India has to finance higher level of investment through domestic savings • possible only through containing inflation so that households can get a positive rate of return on their deposits • Challenge for Reserve Bank of India has been how to address growth risks without losing control over inflation

Opportunities for banksamidst nascent signs of revival of growth • The manufacturing sector • share of the sector in GDP stagnated at around 15 per cent for the last ten years • competitive manufacturing sector is necessary for • taking advantage of the demographic surge and sustaining growth • the New Manufacturing Policy aims enabling manufacturing to contribute at least 25 per cent of GDP in the next one decade and create additional 100 million jobs. • The MSME sector • deceleration in credit observed • Kamath Committee looked into the entire gamut of credit flow related issues pertaining to the sector • as per a recent survey of the Confederation of Indian Industry, bankers expect 20 per cent increase in credit for the sector in the financial year 2013-14.

Opportunities for banksamidst nascent signs of revival of growth • The agriculture sector • step up credit delivery to the agriculture sector, particularly for small & marginal farmers in aggregation models, investment credit and for value addition in the sector • with expected normal monsoon and good levels of harvests, increasing purchasing power and huge labour shortage for farm activities, demand for consumer goods and capital goods like farm equipments is likely to register growth • The housing sector • a recent survey of the CNN Money has identified housing as the primary driver of economic growth this year • the existing levels of mortgage penetration remain stagnant at around 7 per cent of the GDP • reflects the potential to grow at a rapid pace • housing is the second largest generator of employment, next only to agriculture, with both forward and backward linkages in nearly 300 sub-sectors

Opportunities for banksamidst nascent signs of revival of growth • The infrastructure sector • development of adequate and quality infrastructure is necessary to maintain the growth momentum • financial intermediaries, such as, banks have a critical role to play • banking services required for the entire life cycle of the project • spread across a wide spectrum of products including advisory, lending, transaction banking, debt and equity raising, etc. • new opportunities of takeout finance, infrastructure debt funds for better ALM.

II. Controlling persistent inflation • The average WPI inflation rate was 3.8 per cent in 2009-10, shot up to 9.6 per cent in 2010-12 and moderated marginally to 8.9 per cent and 7.4 per cent in 2010-11 and 2012-13 respectively • Major causes of persistence – demand and supply side factors • high fiscal deficit aiding demand pressures, rising food prices due to structural factors like income levels of people, change in dietary habits with focus on proteins • inefficient supply chain management (1-2-3-4 phenomenon) • acceleration of wages, particularly rural wages • high commodity prices • The challenge is to strike a balance between the two primary objectives of monetary policy • the threshold level of inflation in India is about five per cent beyond which inflation harms growth by putting sands on the wheels of commerce

The challengefiscal consolidation and inflation control • Not only the household savings but also government saving which could be augmented by inflation control • higher the inflation, higher is the net government expenditure, leading to higher gross fiscal deficit, other things remaining constant • As the Union Government is currently under the fiscal consolidation program, unless inflation is controlled, it may be difficult to check revenue expenditures. • inflation control will help achieve fiscal consolidation without cutting capital expenditure.

The challengefood inflation • Food inflation persisting despite large buffer stocks • upward pressure reinforced with significant increase in the MSPs of most cereals and pulses • Cost of agriculture has been going up sharply • Volatility in prices of vegetables and fruits • Significant price increase in protein rich food items, such as, eggs, fish and meat • The persistence of food inflation calls for • a relook at the agriculture price policy of the country • revisit of the buffer stock policy

Role of the banks • Bank financing for mitigating production constraints and infrastructural deficits • focussing on supply and value chain financing • monitoring productivity of increasing bank credit to the agriculture sector • helping in risk-proofing of the agriculture sector by adopting a credit plus approach • ensuring timely, adequate and sustainable credit flows to various segments of the economy to remove supply bottlenecks • micro financing of vegetable vendors

III. Mitigating external sector vulnerabilities • External sector has been a source of strength for the Indian economy • Indian economy is, however, affected by 7C channels: Commerce, Capital flows & Confidence, Contagion, Contamination, Currency risk and Credit Rating, • vulnerabilities have increased mainly due to unusually high CAD • Capital flows cannot be taken for granted as QE by the advanced economies may not continue indefinitely • a significant proportion of capital flows are in the form of volatile FII and debt flows • Moderation in exports due to slowdown in developed economies • exports more severely impacted than most of the peer group economies • Restraining imports of gold • Oil and gold account for 45 per cent of total merchandise imports • uncertainty regarding persistence of softening bias in international commodity prices & consumer behaviour regarding gold demand • import may grow as the economy picks up and thereby the CAD may remain high in the coming period. • Deceleration in private transfers • The World Bank April 2013 Report on Remittances forecast • remittances received by South Asian countries including India, would grow at a lower rate of 6.9 percent in 2013 as compared to 12.3 per cent in 2012.

Role of banks • Banks should provide adequate, timely and cost effective lines of funding for exports • implementation of Padmanabhan Committee recommendations • Banks need to tap their widespread network of branches spread across 55 countries for • providing inputs to the Indian exporters for exploring new markets and creating a niche in the untapped economies • attracting investment especially in the form of foreign direct investments for enhancing technology-led production capacity and also for addressing the CAD challenges • taping the Indian diaspora • Checking the gold rush – implementing RBI directions in letter and spirit • Refrain from aggressive selling of gold coins • such an activity should not be construed as the core business activity • Banks should encourage IIBs using their wide customer base

IV. Deepening financial markets • Deeper and broader financial markets desirable for public policy objectives • critical for improving the efficiency of capital allocation within the economy • Predominantly institutional participation in the G-Sec market • Reserve Bank of India has recognized merit in promoting retail participation. • small and medium sized investors enabled to participate in the primary auction of G-Sec through a “Scheme of Non-competitive Bidding” • Primary Dealers (PDs) have been mandated minimum retailing targets. • Corporate bond market is relatively under developed • developing a vibrant corporate bond market has become an important agenda • Challenges include • taking measures to improve liquidity, • setting up a suitable framework for market making in corporate bonds, • providing tools to manage credit, market and liquidity risks, • developing a smooth yield curve for the government securities market for efficient pricing of the corporate bonds, • calibrated opening of the corporate bond market to the foreign investors, • lack of appetite for innovative products

Role of banks • Promoting expansion of investor base in G-sec/corporate bonds • Low levels of participation of the treasuries of the public sector banks • look at the prevailing incentive structure so that banks can participate actively in the market with a supportive risk management framework

V. Maintaining robust banking systemcapital requirements • Over a decade and a half, the health and resilience of the banking system has improved • asset quality has improved significantly since the reforms in the banking sector • successfully migrated to Basel II and now moving towards full implementation of Basel III • Since 2010 there has been some deterioration in the resilience and stability of the banking system • FSR of December 2012 observed increasing risks to the banking sector • primary factors include tight liquidity, deteriorating asset quality and reduced capital ratio • Capital adequacy ratios of banks in India have been declining though they currently remain well above the regulatory prescription • banks presently meet the minimum capital requirements of Basel III at an aggregate level but individual banks may have to top up their capital • as banking penetration needs become more pronounced and as the economy goes through a structural transformation, Indian banks will need to raise additional capital both to support the growth process and to meeting regulatory requirements.

Maintaining robust banking systemunhedged exposures • lure of cheaper foreign currency denominated funds has led to higher foreign currency borrowings by Indian corporates • external debt helps the corporate sector to diversify the funding sources • excessive reliance, however, could pose balance sheet risks • risk is magnified when availability of funding liquidity is subject to sharp volatility in the international markets • heightened volatility makes the debt rollovers difficult or at high interest rates

Maintaining robust banking systemasset quality • Recent trends in the asset quality of the banking system have been somewhat disquieting • in 2012-13, the gross NPAs of banks increased by 31.8 per cent while restructured standard advances increased by over 40 per cent. • primarily due to the prevailing domestic & global macroeconomic situation and underlying issues in credit assessment and NPA management of banks • Q4 of 2013 has recorded an improvement in the asset quality though too early to state with certainty that the trend of deteriorating asset quality has reversed • In view of extraordinary increase in restructuring of advances, a Working Group (Chairman: Shri. B Mahapatra) has reviewed the existing prudential guidelines • implementation of these measures has commenced and will contribute to increased resilience of the banking system and more transparent accounting of asset quality

Role of banks • Banks need to be sensitive to • Improve the credit appraisal and monitoring mechanism • reducing reliance on short term liabilities, especially volatile liabilities, such as, bulk deposits • rigorous evaluation of the unhedged forex exposure risks and build it into pricing of credit • Banks will need to provide concerted attention to their ALM policies • reduce reliance on short term and volatile liabilities • issue of long-term bonds (as recommended by Vohra Committee) • Risk management systems and early warning systems need to be improved • Improve the information sharing mechanism

VI. Ensuring integrity of the financial system • High level of trust and integrity in the financial system is an important requirement if the financial sector has to serve the real sector in a sustainable manner • Recent episodes have highlighted certain irregularities/deviations/aberrations in conduct of banking transactions • failure to adhere to the laid down guidelines pertaining to KYC/AML • Reserve Bank is contemplating tightening of wealth management guidelines • A major source of unethical practices has been the incentive structure • no segregation marketing function from the approval process • incentive structures not aligned to desired behaviors across the organization • penalty by regulators is not the panacea

Role of banks • Commitment to regulatory compliance in letter and spirit by the bank managements is necessary • Banks should address the incentive structure at bank branches • segregate marketing functions from the approval process • incentive structures are aligned to desired behaviors across the organization • Banks should check strength of their internal systems • for identifying missing or invalid KYC profile certifications required to block transactions • Critical to strike balance between integrity of the financial system and expansion of banking outreach for financial inclusion • Hassle-free KYC procedure for general customers, particularly those doing small ticket transactions

VII. Building efficient Government banking business models • Growing need for electronification of Central and State Governments transaction processing • migration would bring in higher efficiencies in operations • Banks would be spared of the work relating to issue, handling, clearing and passing of paper based cheques which come with the attendant risks. • processing in a ‘Straight Through’ manner using CBS platforms • e-transactions are superior to paper instruments in terms of traceability, transparency and efficiency, apart from being a green initiative • Governments of Madhya Pradesh, Odisha, West Bengal, Uttar Pradesh and Uttarakhand have initiated implementation of e-receipts

E-Kuber • e-Kuber of RBI was implemented about a year ago and is one of the foremost central bank oriented Core Banking Systems of the world and has stabilised well. • Provision of a single account for each bank across the country, decentralised access to this account from anywhere, anytime usage using the portal based services in a safe manner and the ease of operations are some of the features of the e-Kuber which have been well received by banks. • Government users can view their balances – of all types including the Ways and Means Advances, drawings, funds positions and the like – all in a consolidated manner through the e-Kuber so as to help then in better funds management. • The capability of consolidating revenue collections by banks through the e-Kuber offers the potential for better flexibility for the Government in managing its finances apart from moving over towards higher levels of electronic based banking

Role of banks • Direct Benefit Transfer (DBT) envisages transfer of benefits by lessening the tiers involved in flow of the transactions, • accurate targeting of the beneficiary and curbing pilferage and duplication. • rollout of DBT presents a number of challenges • but it also presents a great business prospect as banks will be paid a transaction fee of one per cent of the value for every payment made • Creates a big market of small customers • Banks should recognize the immense business potential of conducting government business • earlier models should be replaced with technology led banking platforms and payment system infrastructure • benefit of getting agency commission • Greater efficiency in handling government business will create a distinct brand-value for the bank • enable greater share of business • widening of customer base by catering to various departments of the Government

VIII. Moving towards a less-cash society • The dominance of cash oriented economy and informal financial system, organization of economic activity, proportion of migrant workers are factors driving the need for cash in a society – cash to GDP high at 13% • Cash is widely used • for the Confidenceit exudes, has very high Acceptability, is extremely Safefor undertaking and completing a financial transaction and is Highlyliquid • Challenges to Reserve Bank • ensuring availability of adequate quantity of banknotes and coins in the system, • ensuring good quality banknotes and ascertaining their genuineness • high cost of printing and distribution • Associated risks for individuals • theft, idle cash itself does not generate income, time and cost for making payments can be exorbitantly high and the danger of forged currency notes in circulation. • Challenges for the banks • cost of handling cash is higher as compared to electronic modes - more transaction time • more expensive to maintain security and operational hassles (e.g., segregation of re-issuable notes, detection of forgeries)

Role of banks • Reserve Bank has been promoting • usage of electronic payments like mobile payments, payments through internet banking and card based banking • wider participation to ensure wide network of payment system infrastructure • greater security features in the e-payments systems – February 28, 2013 guidelines • exploring alternate payment system mechanism (e.g. GIRO) • Banks need to rationalize their network and promote non-cash instruments • Banks need to tap technologies to cater to the growing needs of the customers and also to the growing number of customers • notion that customers are unable to adopt to technology stands defeated with wide success and usage of mobile phones • Banks need to focus on 7A’s (Accessibility, Availability, Awareness, Acceptability, Affordability, Assurance and Appropriateness) to promote cash-less banking • Partner with RBI in its e-BAAT like initiatives to popularize electronic banking

IX. Better customer service orientation of banks • Banks need to be wary of retaining existing customers while working towards expanding the customer base • key to an efficient and courteous customer service emanates from having the right orientation keeping different customer segment in mind • pensioners require special attention and assistance • Reserve Bank has issued several instructions to ensure efficient customer service • Survey by Ernst & Young • for the banks to remain competitive, they must • give customers the opportunity to choose by making service offers more transparent, and • rebalance fee structures to achieve clarity and sustainability required by regulators and investors • Implementation of Damodaran Committee recommendations • Banks need to develop business strategies that would amalgamate strength and immediacy of erstwhile style of banking with the capabilities of nex-Gen multi-media collaborative technology • translates into re-orientation of customer service beyond applications that provide solutions to problems and needs of today – focus on Gen-next customers

X. Quality of financial inclusion • financial inclusion has emerged as the buzzword in the Indian financial system • banks have collaborated with business correspondents (BCs) to extend the formal banking services to unbanked regions and people • quantity became the more important factor than the quality to show the extent of financial inclusion • significant number of No-Frill Accounts remained inoperative • meaningful financial inclusion hinges on four critical parameters • all adults in each family have an operative bank account through which regular credits and withdrawals take place • providing small overdraft/credit facilities to the people who need it • providing remittance services through the banks and • providing micro insurance through the bank • sustaining momentum of financial inclusion is dependent on efforts for economic inclusion • Providing financial services alone would not suffice • Economic inclusion efforts require not only banking the unbanked but also retaining and engaging current and potential bank customers to prevent them from becoming unbanked or under-banked

Role of bankers • Plugging the loopholes in the ICT based BC models • Increase the levels of engagement at the grass-root level • Ensure higher levels of financial activities through the banking system • even if it involves low ticket business • Provide more meaning to the spirit of financial inclusion than to the statistics of financial inclusion • Financial inclusion is critical from the perspective of financial stability • small value deposits from the large source of customers at the ‘bottom of the pyramid’ offer more stability and resilience to the deposit base • Banks should appreciate that financial inclusion is much beyond social obligation and business proposition • Review and replicate the Ernakulam model of meaningful financial inclusion

Concluding thoughts • Be sensitive to the 10 challenges and concerns of Reserve Bank viz., • propellingrevival of domestic growth, • controlling persistent inflation, • mitigating external sector vulnerabilities, • deepening the financial markets, • maintaining robust banking system, • ensuring integrity of the financial system, • building efficient Government banking business models, • moving towards a less-cash society, • better customer service orientation of the banks • enhancing the quality of financial inclusion and the role that banks play in meeting these challenges and converting them as opportunities for sustainable business growth with enhanced brand equity

Concluding thoughts • Given the magnitude of challenges, Reserve Bank attaches a lot of significance to the role of banks • the traditional role of financial intermediation played by banks needs to be redefined • Banks need to play a more pro-active role • continuously strive to raise the levels of awareness of general public so as to increase usage of banking channels • Recent survey by Gallup revealed that nearly 70 per cent of the respondents reposed faith in the Indian banking system • recent findings of non-adherence to KYC/AML norms, deterioration of asset quality, lack of proper MIS, unethical practices of some of the banks’ staff in mis-selling financial products have potential of denting the respectability of the system Hence, time to take a deep breath and then start off to do right things rightly

Thank you for your patient hearing.

Challenges & Concerns of the Central Bank: Opportunities & Role for the Commercial Banks