It gives me great pleasure and privilege to
participate in the Seminar jointly hosted by Indian Merchants' Chamber and IBA
at a juncture when financial services sector across jurisdictions is going through
a strong phase of increasing globalisation. Integration of economies leads to
integration of financial markets catalyzing the globalisation process. The growing
role of the financial sector in allocation of resources has significant potential
advantages for the efficiency with which our economy functions. Consequently,
the adverse consequences of malfunction of the financial system are likely to
be more severe than they used to be in the past. Hence, all our efforts today
are focused at ensuring greater financial stability. Given the significance
of the Indian banking system, one cannot afford to underplay the importance
of a robust and resilient banking system.
2. The enhanced role of the banking sector
in the Indian economy, the increasing levels of deregulation along with the
increasing levels of competition have facilitated globalisation of the India
banking system and placed numerous demands on banks. Operating in this demanding
environment has exposed banks to various challenges. The last decade has witnessed
major changes in the financial sector - new banks, new financial institutions,
new instruments, new windows, and new opportunities - and, along with all this,
new challenges. While deregulation has opened up new vistas for banks to augment
revenues, it has entailed greater competition and consequently greater risks.
Demand for new products, particularly derivatives, has required banks to diversify
their product mix and also effect rapid changes in their processes and operations
in order to remain competitive in the globalised environment.
Globalisation – a challenge as well as an opportunity
3. The benefits of globalisation have been
well documented and are being increasingly recognised. Globalisation of domestic
banks has also been facilitated by tremendous advancement in information and
communications technology. Globalisation has thrown up lot of opportunities
but accompanied by concomitant risks. There is a growing realisation that the
ability of countries to conduct business across national borders and the ability
to cope with the possible downside risks would depend, inter-alia, on the soundness
of the financial system and the strength of the individual participants. Adoption
of appropriate prudential, regulatory, supervisory, and technological framework
on par with international best practices enables strengthening of the domestic
banking system, which would help in fortifying it against the risks that might
arise out of globalisation. In India, we had strengthened the banking sector
to face the pressures that may arise out of globalisation by adopting the banking
sector reforms in a calibrated manner, which followed the twin governing principles
of non-disruptive progress and consultative process1.
Global challenges in banking
4. Recently I was afforded an opportunity
to speak on the challenges faced by the Indian banking industry. To recapitulate,
I had identified a few broad challenges faced by the Indian banks in the following
areas, viz., enhancement of customer service; application of technology; implementation
of Basel II; improvement of risk management systems; implementation of new accounting
standards; enhancement of transparency & disclosures; and compliance with
KYC aspects. If we were to identify a few global challenges which banks face
today, I am sure we would cover some common ground. An overview of the global
challenges would include the following: Basel II implementation; enhancing corporate
governance; alignment of regulatory and accounting requirements; outsourcing
risks; and application of advanced technology. I propose to cover these aspects
now.
Basel II implementation
5. Basel II implementation is widely acknowledged
as a significant challenge faced by both banks and the regulators internationally.
It is true that Basel II implementation may be seen as a compliance challenge.
While it may be so for some banks, I would venture to mention that Basel II
implementation has another dimension which offers considerable opportunities
to banks. I would like to highlight two opportunities that are offered to banks,
viz., refinement of risk management systems; and improvement in capital efficiency
6. Comprehensive risk management: Under
Basel I banks were focused on credit and market risks. Basel II has brought
into focus a larger number of risks requiring banks to focus on a larger canvas.
Besides the increase in the number of risks, banks are now beginning to focus
on their inter-linkages with a view to achieve a more comprehensive risk management
framework. Basel II implementation, therefore, is being increasingly seen as
a medium through which banks constantly endeavour to upgrade the risk management
systems to address the changing environment. Further, in the initial stages,
banks were managing each risk in isolation. It is no longer adequate to manage
each risk independently. Enterprises worldwide are, therefore, now putting in
place an integrated framework for risk management which is proactive, systematic
and spans across the entire organisation. Banks in India are also moving from
the individual silo system to an enterprise wide risk management system. While
the first milestone would be risk integration across the entity, banks are also
aware of the desirability of risk aggregation across the group both in the specific
risk areas as also across the risks. Banks would, therefore, be required to
allocate significant resources towards this endeavour.
7. Capital efficiency: Basel II prescriptions
have ushered in a transition from the traditional regulatory measure of capital
adequacy to an evaluation of whether a bank has found the most efficient use
of its capital to support its business i.e., a transition from capital adequacy
to capital efficiency. In this transition, how effectively capital is used will
determine return on equity and a consequent enhancement of shareholder value.
In effect, banks may adopt a more dynamic approach to use of capital, in which
capital will flow quickly to its most efficient use. This revised efficiency
approach is expected to guide the return-on-equity strategy and influence banks’
business plans. With the extension of capital charge for market risks to the
AFS portfolio this year and the coming into force of Basel II norms in March
2007, banks would need to shore up the capital levels not only for complying
with these requirements but also for supporting the balance sheet growth. With
a view to enhancing the options available to banks for augmenting their capital
levels, the Reserve Bank has recently permitted banks to issue new capital instruments,
including perpetual instruments. A notable feature of these instruments is that
these are designed to help banks in not only managing their capital effectively
but also efficiently.
Enhancing corporate governance
8. The issues related to corporate governance
have continued to attract considerable national and international attention
in light of a number of high-profile breakdowns in corporate governance. This
becomes all the more relevant for banks since they not only accept and deploy
large amount of uncollateralized public funds in fiduciary capacity, but also
leverage such funds through credit creation. Banks are also important participants
in the payment and settlement systems. In view of the above, legal prescriptions
for ownership and governance of banks in Banking Regulation Act, 1949 have been
supplemented by regulatory prescriptions issued by RBI from time to time.
9. In view of the importance of the banking
system for financial stability, sound corporate governance is not only relevant
at the level of the individual bank, but is also a critical ingredient at the
system level. Effective risk management systems determine the health of the
financial system and its ability to survive economic shocks. To a large extent,
many risk management failures reflect a breakdown in corporate governance which
arise due to poor management of conflicts of interest, inadequate understanding
of key banking risks, and poor Board oversight of the mechanisms for risk management
and internal audit. Corporate governance is, therefore, the foundation for effective
risk managements in banks and thus the foundation for a sound financial system2.
Therefore, the choices which banks make when they establish their risk management
and corporate governance systems have important ramifications for financial
stability. These systems can affect how the institution functions and how others
perceive it in the marketplace3.
10. A good "governance culture"
is crucial for financial stability but since it is an ‘intangible’, rules may
not be able to capture its essence effectively. Therefore, banks may have to
cultivate a good governance culture building in appropriate checks and balances
in their operations. There are four important forms of oversight that should
be included in the organisational structure of any bank in order to ensure appropriate
checks and balances: (1) oversight by the board of directors or supervisory
board; (2) oversight by individuals not involved in the day-to-day running of
the various business areas; (3) direct line supervision of different business
areas; and (4) independent risk management, compliance and audit functions.
In addition, it is important that key personnel are fit and proper for their
jobs. Although some ownership structures might have the potential to alter the
strategies and objectives of a bank, these banks will also face many of the
same risks associated with weak corporate governance. Consequently, the general
principles of sound corporate governance should also be applied to all banks
irrespective of their unique ownership structures4.
Compliance with international accounting standards
11. One of the prime international standards
considered relevant for ensuring a safe and sound banking system is the ‘Core
Principles for Effective Banking Supervision’ issued by the Basel Committee
on Banking Supervision (BCBS). Accounting standards are now a part of the set
of twelve standards that have been identified by the Financial Stability Forum
as conducive to a robust financial infrastructure. Financial reporting and prudential
supervision have slightly different perspectives. While the former is oriented
towards capturing the historical position, the latter has a forward looking
element particularly with reference to measurement of impairment and capital.
An important challenge, therefore, is to ensure that accounting standards and
prudential frameworks are mutually consistent. While working towards achieving
this consistency between the two sets of standards, it is essential for the
regulators to be in a position to address any implications that the changes
in accounting standards may have for the safety and soundness of banks5.
12. Derivative activity in banks in India
has been increasing at a brisk pace. While the risk management framework for
derivative trading, which is a relatively new area for Indian banks (particularly
more in respect of structured products), is an essential pre-requisite, the
absence of clear accounting guidelines in this area is matter of significant
concern. It is widely accepted that as the volume of transactions increases,
which is happening in the Indian banking system, the need to upgrade the accounting
framework needs no emphasis. The World Bank’s ROSC on Accounting and Auditing
in India has commented on the absence of an accounting standard which deals
with recognition, measurement, presentation and disclosures pertaining to financial
instruments. The Accounting Standards Board of the Institute of Chartered Accountants
of India (ICAI) is considering issue of Accounting Standards on the above aspects
pertaining to financial Instruments. These will be the Indian parallel to International
Financial Reporting Standard 7, International Accounting Standards 32 and 39.
The proposed Accounting Standards will be of considerable significance for financial
entities and could therefore have implications for the financial sector. The
formal introduction of these Accounting Standards by the ICAI is likely to take
some time in view of the processes involved. In the meanwhile, the Reserve Bank
is considering the need for banks and financial entities adopting the broad
underlying principles of IAS 39. Since this is likely to give rise to some regulatory
/ prudential issues all relevant aspects are being comprehensively examined.
The proposals in this regard would, as is normal, be discussed with the market
participants before introduction. Adoption and implementation of these principles
are likely to pose a great challenge to both the banks and the Reserve Bank.
Outsourcing risks
13. Banks are increasingly using outsourcing
for achieving strategic aims leading to either rationalisation of operational
costs or tapping specialist expertise which is not available internally. 'Outsourcing'
may be defined as a bank's use of a third party, including an affiliated
entity within a corporate group, to perform activities on a continuing basis
that would normally be undertaken by the bank itself. Typically outsourced
financial services include applications processing (loan origination, credit
card), document processing, investment management, marketing and research, supervision
of loans, data processing and back office related activities etc.
14. Outsourcing might give rise to several
risks including, strategic risk, reputation risk, compliance risk, operational
risk, exit strategy risk, counterparty risk, country risk, access risk, concentration
risk and systemic risk. The failure of a service provider to provide a specified
service, ensure security/ confidentiality, comply with legal and regulatory
requirements can lead to financial losses/ reputational risk for the bank and
could also lead to systemic risks for the entire banking system in a country.
It would therefore be imperative for the bank outsourcing its activities
to ensure effective management of these risks.
15. It is in this background that RBI has
issued draft guidelines on outsourcing, which is intended to provide direction
and guidance to banks to effectively manage risks arising from such outsourcing
activities. The underlying principles for any outsourcing arrangement by a bank
are that such arrangements should neither diminish the bank’s ability
to fulfill its obligations to its customers and the RBI nor impede effective
supervision by RBI. Outsourcing banks, therefore, should take steps to ensure
that the service provider employs the same high standard of care in performing
the services as would be employed by the banks if the activities were conducted
within the banks and not outsourced. Accordingly, banks are not expected to
outsource any activity that would result in their internal control, business
conduct, or reputation being compromised or weakened.
Application of advanced technology
16. Technology is a key driver in the banking
industry, which creates new business models and processes, and also revolutionises
distribution channels. Banks which have made inadequate investment in technology
have consequently faced an erosion of their market shares. The beneficiaries
are those banks which have invested in technology. Adoption of technology also
enhances the quality of risk management systems in banks. Recognising the benefits
of modernising their technology infrastructure banks are taking the right initiatives.
While doing so, banks have four options to choose from: they can build a new
system themselves, or buy best of the modules, or buy a comprehensive solution,
or outsource. In this context banks need to clearly define their core competencies
to be sure that they are investing in areas that will distinguish them from
other market players, and give them a competitive advantage6. A further
challenge which banks face in this regard is to ensure that they derive maximum
advantage from their investments in technology and avoid wasteful expenditure
which might arise on account of uncoordinated and piecemeal adoption of technology;
adoption of inappropriate/ inconsistent technology and adoption of obsolete
technology.
Capacity building
17. As dictated by the changing environment,
banks need to focus on appropriate capacity building measures to equip their
staff to handle advanced risk management systems and supervisors also need to
equally equip themselves with appropriate skills to have effective supervision
of banks adopting those systems. In the likelihood of a high level of attrition
in the system, banks need to focus on motivating their skilled staff and retaining
them7. Skill requirements would be significantly higher for banks
planning to migrate to the advanced approaches under Basel II. Capacity building
gains greater relevance in these banks, so as to equip themselves to take advantage
of the incentives offered under the advanced approaches.
18. A relevant point in this regard is that
capacity building should be across the institution and not confined to any particular
level or any particular area. The demand for better skills can be met either
from within or from outside. It would perhaps be worthwhile to first glean through
the existing resources to identify misplaced or hidden or forgotten resources
and re-position them to boost the bank’s efforts to capitalise on available
skills. This does not undermine the benefits that a bank may derive by meeting
their requirements from the market, but is only intended to prioritise the process.
Conclusion
19. The global challenges which banks face
are not confined only to the global banks. These aspects are also highly relevant
for banks which are part of a globalised banking system. Further, overcoming
these challenges by the other banks is expected to not only stand them in good
stead during difficult times but also augurs well for the banking system to
which they belong and will also equip them to launch themselves as a global
bank.
Acknowledgements:
1. Dr. Y.V. Reddy on Banking Sector Reforms in India An Overview
at the Institute of Bankers of Pakistan, Karachi, Pakistan, May 18, 2005
2. Dr. Alan Bollard, Corporate governance in the financial
sector, Christchurch, New Zealand, 7 April 2003.
3. Mark W. Olson, Business Trends and Management
Challenges for the Banking Industry, Annual Economic Outlook Conference,
Middle Tennessee State University, Murfreesboro, Tennessee, 16 September 2005
4. Enhancing corporate governance for banking organisations,
Consultative document issued by BCBS, July 2005.
5. Malcolm D Knight, Banking and insurance regulation
and supervision: Greater convergence, common challenges, Madrid, 22-23 September
2004
6. UBS AG, The Bank for Banks Industry Challenges. August
2004
7. Ms. K.J.Udeshi, Financial System Stability and Basel
II - Way Forward, Sri Lanka, August 2005.
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