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‡ The quality of credit assets deteriorated, as the
process of sanctioning loans became more of a
mechanical process rather than an absolute credit
assessment decision. Political interference also has
been an additional problem. There was very little
appraisal involved in the process of giving loans. With
such a process of lending, obtaining credit seemed to
have become the privilege of every borrower. Added
to this, were the credit facilities extended to the priority
sector at concessional rates. Such credit disbursals
that were done without proper post-sanction
supervision led to the deterioration in the quality of the
loan assets of the banks. Further, the subsidized
lending rates coupled with high levels of how yielding
SLR investments also adversely affected the
profitability of the banks.
‡ Yet another outcome of this rapid expansion has been
the squeeze on profitability of banks arising primarily due
to an increase in the fixed costs. With the proliferation of
branches, there was also the resulting strain on the
managerial resources that resulted in enlarged
manpower resources. The operational costs of the banks
enhanced on account of the continuous servicing
requirements of the extensive branch network of the
banks.
‡ While branch expansion was taken as a means to
achieve the goals of nationalization, the inherent evils of
haphazard expansion of branches crept into the banking
system. The existence of branches with higher operating
costs resulted in profit erosion, since in most of the
cases the branches added more costs than returns.
 þ
 |  |
|
‡ The government of India framed its policies in the year
1991-92, keeping in view the benefits of liberalization. It
was expected that in the process of opening its economy
to the outside world, increased competition could turn
the banks more efficient, bring about improvements and
ultimately benefit the customers.
‡ Some of the root causes that were behind the dull
performance of banks prompted the initiation of the
banking sector reforms. Some of these causes were :
* Greater emphasis on directed credit ;
* Regulated interest rate structure ;
* Lack of focus on profitability ;
* Lack of transparency in the banks¶ balance sheets;
* Lack of competition ;
* Lack of grasp on the risks involved ;
* Excessive regulations on organization¶s structure
and managerial resources ; and
* Excessive support from government.
The reforms were initiated with an aim to bring about a
paradigm shift in the banking industry. The
recommendations made by the high level committee on
the financial sector reforms, chaired by
Mr. M. Narasimham, laid the foundation for the banking
sector reforms. The Committee, which was set up in
1991, submitted its report in 1992. Another committee
was constituted again under the chairmanship of
Mr. M. Narasimham, which submitted its report in 1998.
‡ These reforms tried to enhanced the viability and
efficiency of the banking sector. To tackle the internal
deficiencies of the sector, new norms relating to
accounting practices, prudential norms and capital
adequacy requirements were suggested. In order to
improve the external environment, the reforms aimed at
transforming the highly regulated environment into a
market ± oriented one.
‡ While most of the recommendations made by the
committee in phase I have been accepted for
implementation, either in a single step or in phased
manner, some of them however are yet to be
considered. The measures implemented so far that have
been given further, have revolutionized the structure and
operations of the banking industry.
‡ The liberalization of the Indian banking system had led to
the following improvements :
@   @  The Indian industry
apparently lacked a competitive environment,
thereby affecting its efficiency. To induce
competitiveness in this sector, the industry was
opened up to participation by private sector banks
and foreign banks. Apart from allowing the Indian
banks to enter into joint ventures with foreign banks
(20 percent of equity), the foreign banks were also
permitted to set up their shop in India either as
branches or as subsidiaries. With this lowering of
entry barriers, many new players entered the
market.
b. „@  | @  One of the major
reform measures undertaken is the phased
deregulation of interest rates. As against the
administered interest rate regime, the banking sector
now operates in a deregulated environment. Directives
have been issued for total deregulation of the interest
rates on deposits and almost total deregulation of the
lending rates. With this deregulation of interest rates,
banks now have gained flexibility in their operations.
Further, the concessional rates of interest in priority
sector lending have been withdrawn for borrowers of
higher credit amounts. The general rates of interest
will be applicable to these borrowers.
O  @  Vranch licensing has been
abolished and branch expansion norms have been
relaxed enabling the banks to revamp their
organizational structures. Vanks have been given the
freedom to open or close branches as suitable to their
operations / viability.
|@O  !@"@
The onset of liberalization has brought about changes
in the way the banks operate. Terms like customer
relationship, and competition among the existing
players and the new banks have taken the front seat.
The following are some of the changes seen in the
banking sector after liberalization.
@ OO@ #  Information technology
has become an integral part of most of the banks
throughout the world. Vy leveraging this technology,
banks are able to develop the necessary management
information system that would aid in taking scientific
decisions. Further, such information systems are also
being used to analyze the customer needs to innovate
their product portfolio accordingly.
Operational aspects and decision-making processes of
banks are closely linked to the speed and accuracy
with which information is collated and transmitted into
meaningful reports. More so, in the deregulated
interest rate regime, quick investment and credit
decisions may also result in greater spreads to the
banks.
 To enable quicker decision-making and that too in a
scientific manner, online inter-connectivity is most useful.
And the first step to this would be branch level
computerization. Most of the Indian banks have embarked
upon the process of computerizing their branches. Since
the major part of the transactions arise at the branches,
data processing and transmission will become
comparatively easier if these transactions are
computerized. Information technology has smoothened
back-office maintenance and improved the customer
service as well.
!   $#O  Information Technology in
banking business that is improving at a rapid pace, has a
more visible impact on the customer service. It has not just
resulted in product innovation, but it also enabling banks to
redesign their traditional services into more sophisticated
products.
O @  @O  These self-service
terminals, which are popularly known as ATMs, are cash
dispensers, which enable the customers to withdraw
cash even if the bank is closed. Advanced features of
ATMs include withdrawals at other cities, use of credit
cards on ATMs, facilitating cheque and cash deposits
and acceptance of requests for cheque books and
account statements. Also, by mutual arrangement, one
ATM terminal can be used as a cash dispenser for
various banks. This is known as the Shared Payment
Network System (SPNS). Further, these ATMs are set
up at locations other than bank branches. They are set
up at public places like airports, railway stations,
shopping complexes, etc.
d.
@O   Plastic money in the form of credit
cards, debit cards and SMART cards has also
entered the Indian markets. While the credit and the
debit cards have been in the Indian markets for over
a decade, the SMART card is a relatively new
concept and has superior features. All the
transactions taking place on the credit / debit cards
will be recorded on the SMART card. The SMART
card reader of the bank will record the deposit
amount available in the SMART account of the
customer¶s SMART card. Vased on this, withdrawal
or deposit of funds can be taken up at any branch by
the SMART cardholder.
 !@%  In telebanking, bankers, with the help of
dedicated telephone lines, will provide service to their
customers. With a telephone call, customers can get
the information they need which may relate to their
statement of accounts, Forex rates or any other
information relating to their transactions. Telebanking
is also being extended as a 24-hour service.
OO  @  &'  Through this
process, banks enable their customers to remit funds
using a computer terminal. Individuals and corporates
can transfer funds without leaving their premises. This
facility not only reduces the time lag in funds transfer,
but also eliminates error prone paper work. The
prerequisite for this facility is that the concerned bank
branch has the network connection to receive and
send the coded funds transfer messages.
g.  @%  This service, which is offered
by few banks in India, facilitates the customer to
transact from any branch of the bank. The details
regarding the customer are available in a central
computer linked to various branches. All the
information relating to the customer can be accessed
from this system. Vanks are now looking forward to
Relationship Vanking, which establishes a
relationship with the customer in such a way that all
the bank transactions of the customer ± domestic or
international ± and relating to the assets or liabilities
of the customer will be undertaken by a single bank.
  ($ | |
|„
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‡ In the aftermath of the nationalization of Vanks, increasing

use of technology, continuous mergers, modernizing
backroom operation and vigorous competition paved the
growth of the Indian banking system. Vy the early 90s, the
near monopoly of public sector banks faced competition
from the more customer-focused private sector entrants.
This competition demanded the older and nationalized
banks to revitalize their operations.
‡ The year 1992 proved calamitous to the Indian banking
system owing to the scam-tainted stock. Large proportion
of household saving moved into the banking system, which
recorded an annual growth of 20 percent in deposits.
‡ Vut along with the continuous growth and modernization,
several challenges still confront the banking sector. The
main challenges are the deployment of funds in quality
assets and the management of revenues and costs. The
problems of NPAs (non-performing assets), and the
overall credit recovery system exist too.
‡ The path of liberalization however has posed more
questions that remain to be answered. The data in Table
1 reveals the growing volumes of NPAs that is indeed
threatening.
‡ Considering these developments, the Reserve Vank of
India came up with a number of measures to control the
situation thereby reducing the percentage of non-
performing assets against advances and leading to
better management of banks. The following steps were
taken to reform bank operations.
a.
@   Prudential norms were introduced
to strengthen the banks¶ balance sheets and enhance
transparency. These prudential norms which relate to
income recognition, asset classification, provisioning
for bad and doubtful debts and capital adequacy serve
three important purposes ± first, the income recognition
norms reflect a true picture of the income and
expenditure of the bank. Secondly, the asset
classification and provisioning norms help in assessing
the quality of the asset portfolio of the bank. Finally, the
capital adequacy which is based on the classification of
assets suggests whether the bank is in a viable
position to meet any adverse situations due to a
decline in the quality of its assets.
‡ Guidelines have been issued to identify non-
performing assets and classify them so that
room for subjectivity is eliminated. A time frame
was provided to implement the same and
ensure that the system becomes compliant to
the rigorous guidelines. This move was
supported by capitalization of the public
 )*@@@|+ O@
¬ Progressive reduction in pre-emptive reserves ± Cash Reserves
(CRR) and Statutory Liquidity Reserves (SLR)
¬ Liberalization of branch expansion policy
¬ Introduction of Prudential norms ± Capital Adequacy, Asset
Classification, Provisioning, Income Recognition.
¬ Decrease in the emphasis laid on directed credit.
¬ Phasing out concessional rate of interest to priority sector.
¬ Deregulation in the entry norms for private and foreign banks
¬ 33 percent reduction of government stake in banks
¬ Greater emphasis on asset-liability management
¬ Setting up Asset Reconstruction Funds to takeover Non-
Performing Assets.
¬ Consolidation of banking industry by merging strong banks.
sector banks to ensure that over a given timeframe, they
could comply with the norms and yet strive to march
towards the future. These norms have been gradually
tightened and beginning with the April 1998 Monetary
Policy, they were made applicable to the government
guaranteed advances as well. Provisioning will also have to
be made for advances which are both non performing and
performing.
To assess the capital adequacy ratio, weights were
assigned to the asset portfolio based on their riskiness. As
per the Narasimham Committee Report I, except for cash
and bank balances and SLR investments, all other assets
were assigned risk weights. However, with the Committee¶s
second report, came the guidelines to assign risk weight to
the government approved securities.
! @@ ,@O ,  Vased on the
risk-weighted assets of the banks, the prudential
norms also prescribe the minimum capital to be
maintained. Initially, the international standard of 8
percent capital adequacy laid down by the Vasle
Committee was accepted. However, a capital
adequacy of 9 percent is to be maintained by all the
Indian banks with effect from 31 March 2000. These
high standards are expected to strengthen the
financial soundness of the banks, while continuing to
keep them in the line with International standards.
It is aimed to induce financial discipline into the
operations of the banks through these regulations.
These regulations enhance transparency and
accountability in the operations of the banks thereby
compelling them pay greater attention to the quality of
lending. In addition, these regulation conform to the
international accounting standards and would enable to
Indian players to operate in the global markets. Hence,
adherence to the guidelines would enhance the
sustainability of banks and make the competitive.
The reform measures were aimed at not only liberalizing
the regulation framework, but also to keep them in tune
with the international standard. And since the banks had
to move from a highly regulated environment to
deregulated environment, some of the public sector
banks had to bear the orderal of reformaton.
 In an attempt to stabilize the banks¶ positions during this
transition phase, the Government contributed capital to a
few among the weak nationalized to strengthen their
capital base. It also permitted some of these banks to set
off their accumulated losses against their capital. All
these measures were taken in order to ensure that the
Indian banking system reaches the global standards.
O @ „O  From the year 2002 onwards,
the notes to the balance sheets contain information
about the movement of provisions for NPAs as well as
these held towards depreciation on investments. Non-
SLF investments made through the private placement
route should disclose information about the composition
of the issuer and non-performing investments in a similar
manner. Efforts have been made to identify and monitor
early warning indicators of financial crises.
‡ The overall approach is to combine the use of micro-
prudential indicators with macroeconomic indicators in
order to develop a set of aggregate macro-prudential
indicators. This brings about a mix between bottom-up
and top-down assessment. As the methodology gets
refined and the indicators are stress-tested for predictive
power, financial stability surveillance will be significantly
improved. This process will involve greater transparency
and objectivity in the disclosure practices of banks.
Steps are taken to setup a Credit Information Vureau,
which collects and shares information on borrowers and
improves the credit appraisal of banks and financial
institutions within the domain of the existing legislation.
The Vureau has been incorporated by, the State Vank of
India in collaboration with Housing Development Finance
‡ Corporation (HDFC) and foreign technology partners.
Collection and sharing of some items of information have
already been initiated. Steps are also being taken to collect
and share information on private placement of debt under
the Vureau so that there is greater transparency in such
trades. The possibility of collecting and disseminating
information on suit-filed accounts by the Vureau (in place of
the Reserve Vank) is being explored by, a working group
constituted for this purpose with representations from
across the financial system. The group will also examine
the prospects of online supply of information and the
processing of queries. A draft legislation covering various
aspects of information sharing, including issues relating to
rights, responsibilities, and privacy has been prepared,
which would considerably strengthen the functioning of the
Vureau.
 O@%@@|@@$@@
Further to the above mentioned steps taken in
response to the challenges posed by liberalization,
steps were also taken to benchmark the Indian
banking practices with the international standards. For
this purpose, efforts are being made to ensure that the
universally accepted standards and codes are
practiced. The leading international agencies like the
World Vank and IMF are emphasizing on following the
global standards. In India the process has begun with
the regulators and government concentrating on
universally acceptable standards and codes for
benchmarking domestic financial systems. With this
the private sector can also bring into its purview issues
relating to market discipline, corporate governance,
insolvency procedures and credit rights.
‡ The new standards and codes are not final goals but
instruments to enhance efficiency in financial intermediation
while ensuring financial stability as well. There are three
levels at which action is necessary, viz., legal, policy and
procedures, and market practices by participants. In
several areas, fundamental changes in the legal and
institutional infrastructure are pre-requisites. Since these
changes can influence the socio-cultural as well as political-
economic culture to a great extent, appropriate adoption
and some prioritization in implementation are unavoidable.
In several areas, the issues are of a technical nature.
Accordingly, the Standing Committee on International
Standards and Codes, setup in December 1999,
constituted ten Advisory Groups comprising eminent
experts, generally non-official, to
 bring objectivity and experience into studying the
applicability of relevant international codes and
standards to each area of competence. The Advisory
Groups have submitted their reports. They have set out
a road map to implement appropriate standards and
codes in the light of existing levels of compliance, the
cross ± country experience, and the existing legal and
institutional infrastructure.

|O@ %  @% $O

Risks manifest themselves in many ways and the risks in
banking are a result of many diverse activities, executed
from many locations and by numerous people.
)-@@@ ||+ O@
¬ This Committee constituted in January 1998 submitted
its report in April 1998. The major recommendations
were :
¬ Capital adequacy requirements should take into
account market risks also.
¬ In the next three years, entire portfolio of government
securities should be marked-to-market.
¬ Risk weight for a government guaranteed account must
be 100 percent.
¬ CAR to be raised to 10 percent from the present 8
percent ; 9 percent by 2000 and 10% by 2002.
¬ An asset should be classified as doubtful if it is in the
sub-standard category for 18 months instead of the
present 24 months.
¬ Vanks should avoid ever greening of their advances.
¬ There should be no further re-capitalization by the
government.
¬ NPA level should be brought down to 5 percent by 2000
and to 3 percent by 2002.
¬ Vanks having high NPAs should transfer their doubtful
and loss categories to ARCs, which would issue
government bonds representing the realizable value of
the assets.
¬ Move towards international practice of income
recognition by introducing the 90-day norm instead of
the present 180 days.
¬ A provision of 1 percent on standard assets is required.
¬ Government guaranteed accounts must also be
categorized as NPAs under the usual norms.
¬ Vanks should update their operational manuals, which
should form the basic document of internal control
systems.
¬ Institute an independent loan review mechanism
especially for large borrowal accounts to identify
potential NPAs.
¬ Recruitment of skilled manpower directly from the
market to be given urgent consideration.
¬ Rationalize staff strength ; introduce an appropriate
VRS.
¬ A weak bank should be one whose accumulated losses
and net NPAs exceed its net worth or one whose
operating profits less its income on recap bonds is
negative for 3 consecutive years.
 ).  %
Vased on their origin and nature, risks are classified into various
categories. The most prominent financial risks to which the
banks are exposed are :
| @ %  Risk that arises when the interest income /
market value of the bank is sensitive to the interest rate
fluctuations.
 )O@ / O %  Risk that arises due to
unanticipated changes in exchange rates and becomes relevant
due to the presence of multi-currency assets and / or liabilities in
the bank¶s balance sheet.
, %  Risk that arises due to the mismatch in the
maturity patterns of the assets and liabilities. This mismatch may
lead to a situation where the bank is not in a position to impart
the required liquidity into its system ± surplus / deficit cash
situation. In the case of surplus situation, this risk arises due to
the interest cost on the ideal funds. Thus idle funds deployed at
low rates contribute to negative returns.
 %  Risk that arises due to the possibility of a
default / delay in the repayment obligation by the borrowers
of funds.
O %  Risk that arises due to the presence of
off-balance sheet items such as guarantees, letters of
credit, underwriting commitments, etc.

As a financial intermediary, banks borrow funds and land

them as a part of their primary activity. This intermediation
activity of banks exposes them to a host of risks (See box
µType of Risks¶). The volatility in the operating environment
of banks will aggravate the effect of the various risks. The
box discusses the various risks that arise due to financial
intermediation and by highlighting the need for asset
liability management it discusses the Gap Model for risk
management.
The intermediation activity of the banks exposes them to
various risks not by chance but by choice. The price at
which the banks mobilize and transfer funds depends
essentially on two parameters ± the time for which the
funds are made available and the credit worthiness of
the person to whom the funds are made available.
Considering that the long-term loans are priced higher
than short-term loans and a high-risk borrower pays high
interest rate, banks will have to take liquidity risk and / or
credit risk to earn the spreads. There is also a definite
linkage between the various risks faced by banks. For
example, if the bank charges its client a floating rate of
interest, in cases of increasing interest rate scenario, the
bank¶s interest rate risk will be lower. Consequently, the
payment obligation of the borrower increases. Other
things remaining constant, the default risk increases if
the client is not able to bear the burden of the rising
rates.
  0$|
‡ Indian banking has seen a great shift in the method of its
operations along with its focus. Techniques like customer
relationship management, unknown to the Indian Vanking
System till several years ago, have now acquired special
importance. Several scams that have occurred in the banking
sector in the recent past, have to a certain extent even
questioned the creditability of banks in maintaining savings
deposit accounts. However, different steps taken by the RVI
and the Government of India have helped to restore the co
nfidence of the public in the banks. Nationalized banks are
still considered the safest avenues to save money. The
bankruptcy of co-operative banks as Krushi Vank, Charminar
Vank and the involvement of Madhepura Mercantile Co-
operative Vank in security scams, raise serious questions
about the purpose behind their establishment. These events
have compelled intervention of Reserve Vank of India and
Government of India. A proper understanding and
implementation of Asset-Liability Management may offer
solutions to some of the problems faced by the banks and
confidence in the people.
‡ COMMERCIAL VANKS
‡ Valancing profitability with Liquidity
management: commercial banks ordinarily
are simple business or commercial
concerns which provide various types of
services to customers in return for
payment in one form or another, such as
interest,discounts,fees,commission and so
on. Their objective is to make profit.
‡ In India especially, banks are required to
modify their performance in profit making if
that clashes with their obligations in such
areas as social welfare, social justice, and
promotion of regional balance in
development. In any case, banks in
general have to pay much more attention
to balancing profitability with liquidity. It is
true that all business concerns face
‡ Liquidity constraint in various areas of their
decision making and therefore they have
to devote considerable attention to liquidity
management. Vut with banks, the need for
maintenance of liquidity is much greater
because of the nature of their liabilities.
Vanks deal in other people¶s money, a
substantial part of which is repayable on
demand. That is why for banks, unlike
‡ Other business concerns, liquidity
management is as important as
profitability management. This is reflected
in the management and control of
reserves of commercial banks.
‡ Management of reserves
‡ Creation of credit
‡ Vasis and process of credit creation