FDI in banking

The UPA Government had chosen to carry forward the policy of banking deregulation, following the footsteps of the NDA Government. On 28^th February, 2005, the same day that the Union Budget 2005-6 was presented before the Parliament, the Reserve Bank at the instance of the Finance Minister, released a roadmap for the presence of foreign banks in India. The RBI notification formally adopted the guidelines issued by the Ministry of Commerce and Industry under the previous government on March 5, 2004 which had raised the FDI limit in Private Sector Banks to 74 per cent under the automatic route, and went on to spell out the steps that would operationalise these guidelines.

The RBI roadmap demarcates two phases for foreign bank presence. During the first phase, between March 2005 and March 2009, permission for acquisition of share holding in Indian private sector banks by eligible foreign banks will be limited to banks identified by RBI for restructuring. RBI may, if it is satisfied that such investment by the foreign bank concerned will be in the long term interest of all the stakeholders in the investee bank, permit such acquisition subject to the overall investment limit of 74 percent of the paid up capital of the private bank. Appropriate amending legislation will also be proposed to the Banking Regulation Act, 1949, in order to provide that the economic ownership of investors is reflected in the voting rights. Further, the notification announces that foreign banks will be permitted to establish presence by way of setting up a wholly owned banking subsidiary (WOS) or conversion of the existing branches into WOS. A clause on one-mode-presence, i.e. one form of banking presence, as branches or as WOS or as a subsidiary with a foreign investment in a private bank, has been added as the only safeguard against concentration. There are no caps specified for individual ownership (except the 74 per cent overall limit), which in the first phase would be left to RBI’s discretion.⁶

The second phase will commence on April 2009 after a review of the experience of the first phase. This phase would allow much greater freedom to foreign banks. It would extend national treatment to WOS, permit dilution of stake of WOS and allow mergers/acquisitions of any private sector banks in India by a foreign bank subject to the overall investment limit of 74 percent.

Regulation of Foreign Investment in India

General Rules Limiting Foreign Investment in Indian Companies

A traditional argument against foreign equity participation in domestic companies is that these

businesses involve strategic national interests and therefore, operational and strategic control must be

retained domestically (Lam, 1997). This view held sway in India until the early 1990’s and foreign

3 investment in all domestic companies was restricted and could be undertaken only with the prior approval of the Government of India.The New Industrial Policy of 1991 was the first step toward liberalization. It introduced foreign direct investment (FDI) via the “automatic route”, allowing companies in selected industries to raise new equity capital (in some industries, up to fifty-one per cent ownership) by issuing new shares in foreign markets without prior approval from the Ministry of Commerce and Industry (MCI). Banking was not one of the thirty-five industries where foreign direct investment via the automatic route was allowed.The next significant step occurred in late 1992 when foreign institutional investors were first allowed to invest in outstanding domestic securities. Such investments are referred to as foreign institutional investment (FII). Initially, the holding of any single foreign institutional investor was limited to five percent of the company’s total shares with an aggregate cap of twenty-four percent of the issued and paid-up capital for all foreign institutional ownership. These FII limits were intentionally designed to prevent a controlling interest by any foreign investor or group of investors. On April 4, 1997, the upper limit for FII was allowed to be increased up to thirty percent by the company concerned if its Board of Directors passed a resolution to that effect that was also ratified by its shareholders. Over time, the upper limit on FII was gradually increased – first to forty percent (March 1, 2000) and ultimately to the industry’s sectoral cap. In every instance, the new upper limit was subject to the same conditions (called the “special procedure”) as the thirty percent limit. Table 1 provides additional detail on the sequence of

changes in FII limits. While FDI and FII both enable foreign institutions to invest in Indian firms, FDI and FII are quite different and are subject to very different regulatory treatment. FDI via the automatic route was viewed by the government as a source of new capital and was expected to create large block investors who would have a long term relationship with the firm and its management. On the other hand, FII did not directly generate new capital for the firm since investment was via secondary trading in existing securities and investment by any single institution was limited with the explicit objective of preventing significant influence by any foreign investor or group of investors. As a result of these different purposes and views 4 by the government, FDI and FII were regulated by different governmental bodies and were subject to separate legal limitations and regulatory procedures. The regulations were complex and allowed for different combinations of caps on FII and FDI. Depending on the industry, the caps could be independent or cumulative. Cumulative caps limited the sum of FII and FDI and the cumulative cap could be less than the sum of the two individual caps. For example, FII and FDI could each be allowed up to forty percent individually, but the sum could also be limited to a maximum of forty percent.2 A further complication is that the FDI regulation could include sub-limits based on the purchaser of the newly issued shares. For example, regulation that specified a forty percent limit on FDI could have a sub-limit of twenty percent on capital raised from foreign institutions but allow non-resident Indians (NRIs, or entities they controlled) to invest up to the full forty percent limit.

Impact of FDI on banking

India’s financial system has very little exposure to foreign assets and their derivative products and it is this feature that is likely to prove an antidote to the financial sector ills that have plagued many other emerging economies.

The global banking industry weathered turbulent times in 2007 and 2008. The impact of the economic slowdown on the banking sector in India has so far been moderate. Owing to at least a decade of reforms, the banking sector in India has seen remarkable improvement in financial health and in providing jobs. Even in the wake of a severe economic downturn, the banking sector continues to be a very dominant sector of the financial system. The aggregate foreign investment in a private bank from all sources is allowed to reach as much as 74% under Indian regulations.

The third quarter of 2008 saw the beginning of negative net capital inflows into the country. Notwithstanding this bleak scenario, the investment pattern with regard to foreign direct investment (FDI) and inflows from non-resident Indians remains resilient and FDI inflows into the country grew by an impressive 145% between fiscal 2006 and 2007 and by a respectable 46.6% between fiscal 2007 and 2008. However, owing to the economic downturn, the growth in FDI inflows in fiscal 2009 slowed to 18.6% from the previous fiscal.

Despite the surge in investments, the stringent regulatory framework governing FDI has proved to be a significant hindrance. However, FDI norms have been relaxed to a considerable extent with respect to certain sectors. Private banks, for instance.

Foreign investment, in addition to technological innovation and expertise, brings with it a plethora of risks. An unwarranted increase in the size of foreign holding in the banking sector will inevitably expose the country to risks not commensurate with those that an emerging market economy such as ours is equipped to grapple with.

At the same time, it is important to recognize that FDI in banking can address several issues pertaining to the sector such as encouraging development of innovative financial products, improving the efficiency of the banking sector, better capitalization of banks and better ability to adapt to changing financial market conditions.

Limits for FDI

FDI in the banking sector has been liberalized by raising FDI limit in private sector banks to 74 per cent under automatic root including investment by foreign investment in India. The aggregate foreign investment in a private bank from all sources will be 74 per cent of paid-up capital of the bank.

FDI and Portfolio investment in nationalized banks are subject to overall statutory limit of 20 per cent. The same ceiling also applies in respect of such investment in State Bank of India and its associate banks.

The Present Banking Scenario

In recent times economy is been pushing to increase the role of multi-national banks in the banking sector.

But it is opposed on the front that it will lead to state run insurers loosing business and workers their job. There are several reasons why giving foreign investors greater voting rights is fraught with dangers. When domestic or foreign investors acquire a large share holding in any bank and exercise proportionate voting rights, it creates potential problems not only of excursive concentration in the banking sector but also can expose the economy to more intensive financial crises at the slightest hint of panic.

Opposition is not considering the need of present situation. FDI in banking sector can solve various problems of the overall banking sector. Such as –

i) Innovative Financial Products
ii) Technical Developments in the Foreign Markets
iii) Problem of Inefficient Management

iv) Non-performing Assets
v) Financial Instability
vi) Poor Capitalization
vii) Changing Financial Market Conditions

If we consider the root cause of these problems, the reason is low-capital base and all the problems is the outcome of the transactions carried over in a bank without a substantial capital base. In a nutshell, we can say that, as the FDI is a non-debt inflow, which will directly solve the problem of capital base. Along with that it entails the following benefits such as –

Technology Transfer
As due to the globalization local banks are competing in the global market, where innovative financial products of multinational banks is the key limiting factor in the development of local bank. They are trying to keep pace with the technological development in the banks. Now a days banks have been prominent and prudent in the rapid expansion of consumer lending in domestic as well as in foreign markets. It needs appropriate tools to assess (how such credit is managed) credit management of the banks and authorities in charge of financial stability. It may need additional information and techniques to monitor for financial vulnerabilities. FDI's tech transfers, information sharing, training programs and other forms of technical assistance may help meet this need.

Better Risk Management

As the banks are expanding their area of operation, there is a need to change their strategies exert competitive pressures and demonstration effect on local institutions, often including them to reassess business practices, including local lending practices as the whole banking sector is crying for a strategic policy for risk management.

Through FDI, the host countries will know efficient management technique. The best example is Basel II. Most of the banks are opting Basel II for making their financial system more safer.

Financial Stability and Better Capitalization

Host countries may benefit immediately. From foreign entry, if the foreign bank re-capitalize a struggling local institution. In the process also provides needed balance of payment finance. In general; more efficient allocation of credit in the financial sector, better capitalization and wider diversification of foreign banks along with the access of local operations to parent funding, may reduce the sensitivity of the host country banking system and lead towards financial stability.

So due to the aforesaid benefits economy has consistent flow of FDI over the past few years. In addition to that, the govt. has also taken step to enhance the FDI (eg. Telecom, civil aviation) FDI up to 100% through the Reserve Bank's automatic route was permitted for a no. of new sectors in 2005-06 such as Greenfield airport projects, export trading. All these measures have been contributing towards increasing direct investment.

This overall FDI is evident from the above graph.

'FDI & FII have risen sharply during the 1990s reflecting the policies to attract non-debt creating flows.

Cumulative foreign investment flows have amounted to US & 106 billion since 1990-91 and almost evenly balanced between direct invest flows (US & 49 bn) and portfolio flows (US & 57 bn). Since 1993-94, FDI flows have exceeded portfolio flows in the 5 years while portfolio flows have exceeded FDI in the remaining 8 years. As a proportion to FDI flows to emerging market and developing countries, FDI flows to India have shown a consistent rise from 1.6% in 1998 to 3.7% in 2005'1.

India's FDI growth of above 30% during past 2 years is encouraging. Although the FDI inflows into India are small as compared to other emerging markets, their size is growing on the back of growing interest by many of the world's leading multinationals. India has improved its rank from fifteenth (in 2002) to become the second most likely FDI destination after China in 2005'1.

The IMF's study is in supportive to the above-discussed features of FDI. This study talks about the optimism over India emanates from a contribution of following factors.

* India contributed nearly one fifth of Asian domestic demand growth over 2000-05. Looking forward, India slated to be the second largest demand driver in the region, after China.

* India accounts for almost one quarter of the global portfolio flows to emerging market economies, nearly $ 12 bn in 2005.

* India is the world's leading recipient of remittances, accounting for about 20% of the global flows.

Even though above discussed factors are fair enough for the development of economy. But it is a noted fact that, economy drivers are reluctant towards more liberalization for FDI in the banking sector. As the ceiling rates are not increased, FDI in Financial Sector is not getting a wholesome environment. But the foreign investment is finding its own way to come in the economy. May be the way of FII. It is evident from the diagram.

Now a days, foreign commercial and investment banks have quietly begun picking up public sector bank's bond issues. Bankers said that the funds were coming into these bonds; some of the foreign banks were also using the banks' bonds as an arbitrage opportunity in view of the increasing liquidity.

So, therefore from last 2 years FIIs have exceeded the FDI and in portfolio investment into India since 2003-04 reflects both domestic and global factors. Compared with FII always FDI has a greater and long-term effect on the Indian market due to the whimsical nature of FII. (As it is considered as hot money)

The present scenario looks more closely at the paradigm of exponential growth and laments that India's role as an engine for global growth has been limited by the still relatively closed nature of its economy.

Growth Prospect

Advantage India – FDI

The Reserve Bank of India (RBI), has allowed foreign players to set up branches in rural India and take over weak banks with an investment of up to 74 per cent, and further relaxations are on the anvil by 2010, with the second phase of opening expected to com-mence in April 2009.

Some of the biggest names in global financial services and banks like Credit Suisse, Rabo Group and ANZ are seeking a banking license in India. The RBI has, in recent months, given fresh banking licenses to UBS - Switzerland's largest bank, Dresdner Bank and United Overseas Bank.

ANZ and Rabobank Group, the Dutch Group, is now in the process acquiring a banking license. The Rabobank Group already holds 18.2 per cent stake in another local private bank YES Bank. Some of the existing players such as StanChart, Citi and HSBC, hold India as one of their top markets.

Due to current Global crisis, we expect the deadline for second phase i.e. April 2009 to be extended further. However, banking authorities has not announced about the extension of the phase.

INDIAN BANKS AND THE GLOBAL CHALLENGES

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.

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

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

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.

Basel II Implementation

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, Basel II implementation has another dimension which offers considerable opportunities to banks, two opportunities that are offered to banks, viz., refinement of risk management systems; and improvement in capital efficiency.

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.

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

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.

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 marketplace 3.

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 structures 4.

Compliance with international accounting standards

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 banks 5.

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.

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.

Outsourcing Risks

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.

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.

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

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

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.

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.

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.

WHY GLOBAL BANKS ARE BANKING ON INDIA

Follow the money for a sure bet, they say -- and the world's big and small banks are doing just that in India's juggernaut economy. India is viewed as one of the biggest growth stories among emerging markets explains only part of the attraction for foreign banks. The country's central bank has outlined the roadmap for foreign players to grow, allowing them to set up branches in rural India and take over weak banks with an investment of up to 74% and promises to do more.

Credit off-take has grown 25%-30% annually in recent years, with most of the new

action in retail consumer lending, which tends to be happy hunting ground for foreign banks.

Not everybody in the industry is happy, of course, to see bigger room for foreign banks, which some view as not adequately embracing India's developmental agenda. Mirroring India's economic bounties, India's banking industry has been on a high since the beginning of this decade, with advances growing annually at an average of 23%. The Indian banking industry is made up of 28 public sector banks, 30 foreign banks and 29 private banks, excluding cooperative banks and regional rural banks.

Globalisation is here to stay

the most dramatic impact of globalization is on remote servicing in India of banks' back-office processes. the huge improvements in telecommunications and computing technology combined with vast variations in factor costs across the world and tight immigration laws will lead to large shifts in work that doesn't require customer interface. The beginning of this trend is evident mostly in outsourcing of voice-based services. This will lead to huge improvements in the efficiency of the financial services industry's operations both in cost and quality and lead to a further integration of the global financial industry. Tarashankar Bhattacharya, managing director of India's largest bank, the State Bank of India, says he welcomes foreign banks so long as he has a level playing field with them. One of his chief complaints here is while Indian banks have to lend a minimum of 40% of their assets to government-specified "priority sectors" such as agriculture and small scale industries, that requirement is lower at 32% for foreign banks operating in India. Banks don't relish priority sector lending because they come with low profit margins and a high incidence of delinquencies.

Bhattacharya's lament is shared by CEOs of most state owned banks in India. They complain that they are constantly reined in from competing effectively. They cannot, for instance, pay market-linked salaries. Except in rare cases, they are unable to create or hold onto the best talent. They cannot acquire other banks without lengthy and often unsuccessful bureaucratic wrangling. And, as Bhattacharya says, they cannot lend or invest in the booming stock markets as they please. Nor can they raise much needed capital easily. All this, government-owned bankers privately admit, is because they continue to be viewed as instruments of social policy, rather than as commercial institutions by their principal owner, the government. And yes, along with the rest of Indian industry, they cannot downsize at will.

The RBI appears to recognize this. The regulator says a calibrated approach is necessary in the absence of a safety net and labor law reforms. It takes some pride in the fact that India has never faced significant financial sector turmoil like other emerging markets. It wants to ensure consolidation in the domestic sector first before allowing foreign banks a freer entry. The RBI also wants the large public sector banks to merge with each other to create big banks.

Many private banks have taken the cue, albeit with gentle nudges, and have grown with acquisitions. But the big state-owned banks are yet to follow. In September 2005, Indian finance minister P. Chidambaram made a strong pitch for mergers and acquisitions amongst public sector banks. He was speaking at the centennial celebrations of the Bank of India, another large bank. "A country as large as India cannot be content with one large bank (referring to the State Bank)," he said. "Bank of India should lead the way in creating a giant bank which will take on the world's best and biggest."

But the State Bank, which typically sets the ideological agenda for the rest of the banking industry, now openly says that thinking global is critical to domestic success. The State Bank of India hasn't had much traction in acquiring other Indian banks, but it has made significant strides internationally. It kicked off that effort in February 2005 when it paid $10 million for a 51% stake in Indian Ocean International Bank, the fourth largest in Mauritius.

year, State Bank bought two other banks -- Indonesia's PT Bank IndoMonex and Kenya's Giro Commercial Bank. It is now actively scouting for other acquisitions in Asia and Africa. State Bank's current chairman O. P. Bhatt, however, has said his bank would not acquire small banks any more. "We would buy reasonably big banks if there is a strategic fit," he says.

Citibank's Nayar says globalization forces local banks in emerging-market countries to adopt international best practices in order to stay competitive. These areas include risk management techniques, technology upgrades, more efficient capital allocation tools, focus on marketing and sales and other such areas resulting in improved operating and financial leverage. 'But it is not entirely a one-way street," he says. "There are also areas where international banks are adapting and learning from local best practices, particularly in areas like SME

(small and medium enterprises) lending and agri-financing. The main impact is higher efficiency levels in the banking system in terms of more optimal capital allocation, better profitability, prudent risk management and greater competition, which ultimately benefits the end customer through new products and services at affordable prices."

ALL ROADS LEAD TO CONSOLIDATION

Consolidation within the banking industry is imperative. Commoditization of the traditional banking products and the need to invest in technology, marketing and product innovation has made size and scale critical success factors in this industry. Consolidation is imminent, and foreign banks with their large capital and product expertise can play a significant role in this process. The Indian financial system is not yet very strong to take on stiff foreign competition. There is still not a level playing field between Indian banks and foreign banks; the latter does not have developmental obligations like 40% lending to the priority sector where returns are low." Foreign banks are not required to direct more than 32% of their net credit to the "priority sectors" identified by the RBI, which include agriculture, small-scale industries and exports. ICICI's Kamath concedes that over the years foreign banks have contributed to the development of the Indian banking industry in areas like product knowledge and risk management services, but doesn't see any new gains on the horizon. "Frankly, we have nothing to learn from them [now]," he says. "Both in terms of products and technology, we are ahead of them”.

Citibank's Nayar says the RBI's approach to opening up the banking sector to foreign investors is well calibrated, but would like quicker branch permissions and access to some government and public sector business. "Foreign banks continue to face constraints in these areas and this significantly impacts their ability to grow their footprint, customer base and restricts access to savings deposits," he adds. Kamath doesn't buy the contention of the foreign banks' lobby that they don't enjoy enough growth freedom. He in fact sees the current regulatory regime

offering them "sufficient flexibility," and points out that the central bank has stated its resolve to be liberal in granting branch licenses. "The only major restriction for them is on the acquisition of existing banks, and that too will be revisited in the second stage of the roadmap that the RBI has set out (beginning March 2009)," he says. "Essentially, the question is not one of the country's openness but of whether foreign banks are willing to commit capital and enter the Indian market for the long haul."

Nayar points out that India isn't alone in opening up the banking sector as globalization advances, and that foreign investors are focused on the opportunities these throw up in many developing countries. "The RBI has a well-calibrated approach for opening up of the banking sector to foreign investors," he says of the central bank's phased and cautious approach. "Countries like Korea, Russia and Brazil have opened up their banking sectors significantly." India's banking industry has so far avoided a major financial crisis, unlike those in other developing

countries, and that deserves a hand, says Nayar. "Indian banking has been relatively well managed and, more importantly, well regulated," he says. "Most of the other emerging economies have seen at least one period of significant turmoil in the last decade or so -- the Asian financial crisis in the late 1990s, the Latin American meltdown in 2001-02, and Mexico in the early 1990s."

Much now depends on how the RBI picks up the threads three years hence in 2009 when it reviews the progress achieved in the current opening-up phase. Boston Consulting Group's Sinha says the best course of action is to allow foreign banks entry into India up to a level that can be fixed in a variety of ways. "The Australians have a four-pillar policy where their biggest four banks cannot buy each other or be ought by foreigners" In India, says Sinha, this could the State Bank of India, the Life Insurance Corporation of India (an insurer and not a

commercial bank) and three other players who in turn would have consolidated with some smaller players Together they would control between 60 and 70% of total banking assets. This way, he says, all the constituents would be satisfied.