Banks adopting approaches with a larger risk appetite will require to set apart more capital to meet unexpected losses

Over the last few years, the increasing need to enhance income, especially fee-based income, improve market share, improve quality of service and reduce cost of operations has forced most banks to rethink and adopt varying business strategies and models. Key elements of strategies seen to be adopted by leading Indian banks include building a strong presence in India and international markets, customer-focussed product innovation, financial resilience and a strong operating environment. Strong prudential and supervisory norms are requiring banks in India to conform to higher standards. Three key buzzwords are the current focus of the industry today:

CAPITAL
Raising capital to meet the growing domestic and international expansion needs, as well as ensuring compliance with the recent guidelines issued by the Reserve Bank of India.

CONSOLIDATION
The increasing need to improve market share, improve scale of operations and compliance with regulatory requirements is forcing banks to seriously consider consolidation as one of their key strategies.

CORPORATE GOVERNANCE
Improved corporate governance through better information management and transparency in disclosures-an enabler to a more effective interface with all stakeholders.

This is perhaps evident in the underlying tone of the regulator as well. In a recently concluded CII conference on banking, Rakesh Mohan, the then Deputy Governor of RBI, while discussing the draft guidelines on ownership and governance in private sector banks in India issued by RBI in July 2004, stated: "The intention of the policy is to ensure adequate capital and consolidation in the banking industry with the regulator being aware of the intention of existing and potential shareholders."

Need For Additional Capital

The new financial landscape has been a key impetus for banks to start looking at strategies and new business models to operate. As per a recent survey on the status of the Indian banking industry conducted by Federation of Indian Chambers of Commerce and Industry (FICCI), about 84 per cent of the respondents claimed that Indian banks will require fresh issuance of capital to enhance their competitiveness. Increase in the capital deployed is required for providing banks with the ability to support a large growth in its business asset and deposit portfolio, clean up balance sheets, cushion against shocks and achieve critical mass, in addition to being compliant with current and future regulatory requirements.

CREDIT GROWTH IN THE NEAR FUTURE IS EXPECTED TO BE STRONG
With the improvement in the overall economy, there is a strong rebound in demand for retail and corporate credit. For example, the corporate lending activity that saw a flat growth over the past few years is expected to grow in the near term, especially considering other factors such as the decreasing preference for banks to invest in government securities due to the rise in interest rates and having a lower risk weight.

INCREASING EXPANSION INTO INTERNATIONAL MARKETS
Many leading banks in India are increasingly seen to focus on building their presence and operations in international markets. Sufficient capital will need to be allocated by banks to meet these growth requirements, including compliance with the foreign country regulations, etc.

Corporate lending activity, which saw flat growth over the past few years, is expected to grow in the near term

MIGRATION TO BASEL II WILL DEMAND MORE CAPITAL
The Reserve Bank of India (RBI) has announced in its annual policy statement in May 2004 that banks in India should examine in-depth the options available under Basel II, which requires stringent and higher capital adequacy norms and allocation of capital towards market and operational risk in addition to credit risk. This implies that banks adopting approaches with a larger risk appetite will require to set apart more capital to meet the unexpected losses that go with it. However, there are opportunities in the advanced methods to also reduce the capital managed on the basis of better risk management practices-this in the Indian context may require banks to change the way they collate and use operational risk information. As per the RBI guidelines, banks are also required to draw up a roadmap by end December 2004 for migration to Basel II and review the progress made thereof at quarterly intervals.

MINIMUM CAPITAL THRESHOLD INCREASED FOR PRIVATE SECTOR BANKS
The recently-issued draft guidelines on ownership and governance in private sector banks has proposed an increase in the minimum capital in private sector banks to Rs 300 crore from an earlier requirement of Rs 200 crore. Today, the Indian banking industry has a mix of large-, mid- and small-sized banks either with a national and/or regional focus and some being far less capitalised than those existing in other parts of the world. While some of the large private sector banks already have a capital base over the threshold limit, a number of existing banks, which are relatively smaller in size, will have to plan increase in capital within the specified time frame of three years.

Additionally, the awaited draft subsidiarisation guidelines that will allow for foreign banks to operate in the country as 100 per cent subsidiaries and/or new licensed private banks are also required to comply with the minimum capital threshold requirements of Rs 300 crore. With the opening up of the financial sector or greater international competition under the WTO, the capital requirement can only be expected to increase further in order to build up scale.

The primary sources of additional capital for banks in India will be through public issues, investments by existing private players in the market, foreign direct investments (FDI) or from investments by foreign banks and FIIs. As per Prime Database, about 14 banks are likely to approach the capital markets in 2005 to collectively raise around Rs 4,000 crore. However, the key challenge is whether the Indian capital market has the appetite for absorbing the entire additional capital requirement of the banking sector.

Foreign capital (e.g., through private equity or strategic investment) is another source for increasing the capital of banks. There are several examples in the region where such private equity investors have also played a vital role in turning around the distressed banks such as Korea First Bank, Shinsei Bank, Koram Bank, etc. Investment institutions globally, whether through FDI or private equity, expect to hold a minimum stake to optimise their resources with relatively large positions across a relatively small number of businesses.

A number of interested constituents have highlighted the impediments to achieving the stated objectives and have, in particular, sought changes and/or clarifications on the shareholding cap, 10 per cent voting rights cap, convergence of RBI guidelines and Ministry of Finance circulars, etc. Resolution and clarification of these issues and the awaited detailed guidelines is expected to provide a further impetus to capital mobilisation and consolidation through M&A transactions.

Is Consolidation Imminent?

Today, one observes that the Indian banks are not well represented in the list of global banks. Some of the smaller and mid-size banks have also had varying challenges in achieving growth rates in comparison to industry averages as a result of limited ability to expand operations, need for capital, aggressive competition, etc.

Consolidation is necessary to enable banks to compete on scale and grow at a national and international level, offering a faster and often cost-effective way to grow to a competitive size, an opportunity to share markets and reduce the costs of product development and delivery, and bring economies of scale. For example, consolidation within the PSU banks including overseas acquisitions is expected to enable the bigger balance sheets for competing with increasing competition from the private sector in pursuit of domestic operations and supporting global Indian companies as they reach out internationally.

There are three aspects to consolidation: clear legal and regulatory regime governing consolidation, enabling policy framework especially where several banks are owned by the Government, and market conditions that facilitate such consolidation, recognising that all mergers may not necessarily be in the interests of either the parties concerned or the system as a whole. Whilst till now consolidation of the public sector banks or distressed banks is more driven by government initiatives (e.g., Punjab National Bank with Nedungadi Bank, Oriental Bank of Commerce with Global Trust Bank), consolidation in the private players in general is more of a market-driven phenomenon (e.g., ICICI Bank and Bank of Madura, HDFC Bank with Times Bank) rather than any official policy direction.

While consolidation is imminent, one of the key challenges is the achievement of the desired synergies and objectives, which are thus very critical to the consolidation process. It is important for the organisation to recognise also that as the integration would lay the foundation for the 'new' business model, it should aim to build and strengthen necessary capabilities. A KPMG research indicates that players remain over-optimistic about their performance post M&As and many still fail to focus on and deliver enhanced shareholder value. While around 82 per cent respondents believed that the merger was a success, it was found that around 75 per cent of these projects had failed to deliver shareholder value. It is important that we learn from these experiences on future consolidation initiatives.

Implications On Corporate Governance

The dynamic growth of various banks over the last few years and in the future, the likely increase in the shareholding structure and consolidation activities, and the various risks associated with the growing business have made assessment and management of a bank's performance and control increasingly complex. Due to this changing business environment and the need for improved levels of corporate governance requirements, internal (e.g., Board of Directors) and external (e.g., RBI, analysts, customers, investors, etc.), stakeholders require a greater capture and timely availability of information. Also, some of the recent irregularities reported in the banking sector have increased the focus of the regulators on ensuring an appropriate governance framework to be followed by banks.

Do banks collate and share information that addresses the varied information needs of different internal and external stakeholders? The answer is likely that only some banks in India have adopted appropriate steps towards this.

More advanced markets like the United States of America, United Kingdom, etc., require for a greater disclosure of relevant information to internal and external stakeholders. Further, as Indian banks look to expand overseas, in addition to capital requirements for business expansion, the need is to build appropriate processes and systems that meet international standards on risk management (e.g., Basel II), anti-money laundering, transparent financial reporting, etc. Increasingly, the offsite monitoring regulatory mechanism relies on the quality and timeliness of information based on underlying corporate governance.

In order to meet the stakeholder needs and ensure greater governance and transparency of its operations, it is imperative for banks to provide answers to three key questions:

How is the bank organised and run? There is a need to present detailed information on these key components:

• The performance of the bank's strategy i.e., current and future plans, key business drivers, etc. For example, banks should be monitoring information on year-on-year performance information on individual business segments / units / products, etc.

• Adopt appropriate operating structure and performance measurement systems, which take a balanced view across various parameters, i.e., look at not only financial measures, but also define metrics on customers (e.g., customer satisfaction, market share, complaints, etc.), internal processes (e.g., service levels, cost income ratio to productivity, quality, etc.), learning and innovation (e.g., percentage of revenues from new products, training investments and returns, etc.).

• Management roles, i.e., clear articulation of roles and responsibilities and measure performance vis-à-vis the articulated roles.

• The governance framework adopted, i.e., articulation of the framework and the steps taken to adhere to it.

What is the financial health of the bank?

• Financial performance, i.e., multidimensional views of the financial position reported by geography, business line, SBU, etc., providing an ability to assess changes in position, future potential to repay, increase shareholder wealth, contribution to capital growth, etc.

• Financial position (i.e., capital, solvency and liquidity), clearly differentiating between regulatory and economic capital, and ability to predict the capability of the bank meet its commitments.

What are the risks faced by the bank in its operations and how does it manage these risks?

• Demonstrates the capabilities of the bank as well as the current activities undertaken to confirm that the control environment established is robust.

• Provides the stakeholders with a clear basis for understanding the risk profile of the bank as well as comparing it with others.

This raises challenges to be addressed for achieving the 'desired' level of information that is timely, accurate, relevant and available in a user-friendly manner. Banks will also need to understand the information needs of its stakeholders, review its current information gathering and reporting process and put in place steps to strengthen systems and processes for the same, and adopt appropriate standards and processes for enhancing the level of information captured and managed benefits in strengthening the overall banking system and in managing itself better. In addition, management of banks will also need to focus on building awareness and educate the various stakeholders on interpretation of information to assist in the better understanding of the bank, its operations and performance.

Going ahead, the Indian banking industry has a significant role to play in the economy, and appropriate management of the challenges arising out of managing capital, growth risks and governance will be critical to success.

Russell I. Parera is the National Industry Director for Financial Services, Manoj Kumar Vijai is a Director, and S. Mahesh is an Associate Director (Business Advisory Services) with KPMG in India. The views expressed in the article are the personal views of the authors and do not reflect the views of KPMG.