Ans 8 (a)

Universal Banking is a multi-purpose and multi-functional financial supermarket (a

company offering a wide range of financial services e.g. stock, insurance and real-
estate brokerage) providing both banking and financial services through a single
window.

Definition of Universal Banking: As per the World Bank, "In Universal Banking, large
banks operate extensive network of branches, provide many different services, hold
several claims on firms(including equity and debt) and participate directly in the
Corporate Governance of firms that rely on the banks for funding or as insurance
underwriters".

In a nutshell, a Universal Banking is a superstore for financial products under one roof.
Corporate can get loans and avail of other handy services, while can deposit and
borrow. It includes not only services related to savings and loans but also investments.

However in practice the term 'universal banking' refers to those banks that offer a wide
range of financial services, beyond the commercial banking functions like Mutual Funds,
Merchant Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans,
Investment banking, Insurance etc. This is most common in European countries.

For example, in Germany commercial banks accept time deposits, lend money,
underwrite corporate stocks, and act as investment advisors to large corporations. In
Germany, there has never been any separation between commercial banks and
investment banks, as there is in the United States.

THE CONCEPT OF UNIVERSAL BANKING

The entry of banks into the realm of financial services was followed very soon after the
introduction of liberalization in the economy. Since the early 1990s structural changes of
profound magnitude have been witnessed in global banking systems. Large scale
mergers, amalgamations and acquisitions between the banks and financial institutions
resulted in the growth in size and competitive strengths of the merged entities. Thus,
emerged new financial conglomerates that could maximize economies of scale and
scope by building the production of financial services organization called Universal
Banking.

By the mid-1990s, all the restrictions on project financing were removed and banks
were allowed to undertake several in-house activities. Reforms in the insurance sector
in the late 1990s, and opening up of this field to private and foreign players also resulted
in permitting banks to undertake the sale of insurance products. At present, only an
'arm's length relationship between a bank and an insurance entity has been allowed by
the regulatory authority, i.e. IRDA (Insurance Regulatory and Development Authority).
The phenomenon of Universal Banking as a distinct concept, as different from Narrow
Banking came to the forefront in the Indian context with the Narsimham Committee
(1998) and later the Khan Committee (1998) reports recommending consolidation of the
banking industry through mergers and integration of financial activities.

UNIVERSAL BANKING – PROS AND CONS

The solution of Universal Banking was having many factors to deal with, which can be
further analyzed by the pros and cons.

Advantages of Universal Banking

• Economies of Scale. The main advantage of Universal Banking is that it results

in greater economic efficiency in the form of lower cost, higher output and better
products. Many Committees and reports by Reserve Bank of India are in favour
of Universal banking as it enables banks to explit economies of scale and scope.
• Profitable Diversions. By diversifying the activities, the bank can use its existing
expertise in one type of financial service in providing other types. So, it entails
less cost in performing all the functions by one entity instead of separate bodies.
• Resource Utilization. A bank possesses the information on the risk
characteristics of the clients, which can be used to pursue other activities with the
same clients. A data collection about the market trends, risk and returns
associated with portfolios of Mutual Funds, diversifiable and non diversifiable risk
analysis, etc, is useful for other clients and information seekers. Automatically, a
bank will get the benefit of being involved in the researching
• Easy Marketing on the Foundation of a Brand Name. A bank's existing
branches can act as shops of selling for selling financial products like Insurance,
Mutual Funds without spending much efforts on marketing, as the branch will act
here as a parent company or source. In this way, a bank can reach the client
even in the remotest area without having to take resource to an agent.
• One-stop shopping. The idea of 'one-stop shopping' saves a lot of transaction
costs and increases the speed of economic activities. It is beneficial for the bank
as well as its customers.
• Investor Friendly Activities. Another manifestation of Universal Banking is bank
holding stakes in a form : a bank's equity holding in a borrower firm, acts as a
signal for other investor on to the health of the firm since the lending bank is in a
better position to monitor the firm's activities.

Disadvantages of Universal Banking

• Grey Area of Universal Bank. The path of universal banking for DFIs is strewn
with obstacles. The biggest one is overcoming the differences in regulatory
requirement for a bank and DFI. Unlike banks, DFIs are not required to keep a
portion of their deposits as cash reserves.
• No Expertise in Long term lending. In the case of traditional project finance, an
area where DFIs tread carefully, becoming a bank may not make a big difference
 to a DFI. Project finance and Infrastructure finance are generally long- gestation
projects and would require DFIs to borrow long- term. Therefore, the
transformation into a bank may not be of great assistance in lending long-term.
• NPA Problem Remained Intact. The most serious problem that the DFIs have
had to encounter is bad loans or Non-Performing Assets (NPAs). For the DFIs
and Universal Banking or installation of cutting-edge-technology in operations are
unlikely to improve the situation concerning NPAs.

Ans. 8 (b)

The Development Research Group (DRG) in the Reserve Bank of India has brought out
a study entitled "Capital Adequacy Requirements and the Behaviour of Commercial
Banks in India : An Analytical and Empirical Study", the twenty-second in the DRG
Study Series. The study is authored by Prof. D.M.Nachane, Shri Aditya Narain, Shri
Saibal Ghosh and Shri Satyananda Sahoo.

In the wake of the introduction of prudential regulation as an integral part of financial

sector reforms in India, there has been a growing debate as to whether capital
adequacy requirements are the best means to regulate the banking system. From cross
country experiences, there is some evidence of a positive association between
capitalisation and risk assumption by banks due to the possibility that the one-size-fits-
all capital adequacy ratio (CAR) causes bank leverage and asset risk to become
substitutes. At policy levels, this has driven research into alternative regulatory
methods.

Against this background, the study investigates the relationship between changes in risk
and capital in the Indian banking sector, with reference to public sector banks (PSBs).
The study seeks to identify key variables impinging upon the capital adequacy of banks
and to examine evidence for a shift in bank portfolios towards greater riskiness after the
introduction of capital adequacy norms. The study also attempts to draw implications of
the new capital adequacy framework proposed by the Basel Committee on Banking
Supervision (BCBS) for the Indian financial system and evaluates alternative regulatory
arrangements as complements to the CAR.

The major findings of the study are :

* Given the wide heterogeneity in terms of products and customer preferences among
PSBs as well as the adjustment response of PSBs, the regulatory framework should be
designed to encourage individual banks to maintain higher CAR, over and above the
stipulated minimum, so as to reflect differential risk profiles.

* While capital remains a useful regulatory tool for influencing bank behaviour, there is
no conclusive evidence that the introduction of CAR has led to risk aversion among
banks.

* Prompt Corrective Action (PCA) based on capital might prove to be an effective

strategy for arresting bank portfolio deterioration.

* Capital ratios of banks are a crucial determinant of banks ratings, in the short-term;
this has implications for India in terms of the new BCBS proposal which are built on
ratings.

Some points:-

1. The Basel Committee on Banking Supervision (BCBS) has released the document,
'International Convergence of Capital Measurement and Capital Standards: A Revised
Framework' on June 26, 2004. The revised Framework has been designed to provide
options for banks and banking systems, for determining the capital requirements for
credit risk and operational risk and enables banks / supervisors to select approaches
that are most appropriate for their operations and financial markets. The Framework is
expected to promote adoption of stronger risk management practices in banks.

2. The Revised Framework, popularly known as Basel II, builds on the current
framework to align regulatory capital requirements more closely with underlying risks
and to provide banks and their supervisors with several options for assessment of
capital adequacy. Basel II is based on three mutually reinforcing pillars - minimum
capital requirements, supervisory review, and market discipline. The three pillars
attempt to achieve comprehensive coverage of risks, enhance risk sensitivity of capital
requirements and provide a menu of options to choose for achieving a refined
measurement of capital requirements.

3. The Revised Framework consists of three-mutually reinforcing Pillars, viz. minimum

capital requirements, supervisory review of capital adequacy, and market discipline.
Under Pillar 1, the Framework offers three distinct options for computing capital
requirement for credit risk and three other options for computing capital requirement for
operational risk. These approaches for credit and operational risks are based on
increasing risk sensitivity and allows banks to select an approach that is most
appropriate to the stage of development of bank's operations. The approaches available
for computing capital for credit risk are Standardised Approach, Foundation Internal
Rating Based Approach and Advanced Internal Rating Based Approach. The
approaches available for computing capital for operational risk are Basic Indicator
Approach, Standardised Approach and Advanced Measurement Approach.
4. With a view to ensuring migration to Basel II in a non-disruptive manner, the Reserve
Bank has adopted a consultative approach. A Steering Committee comprising of senior
officials from 14 banks (private, public and foreign) has been constituted where Indian
Banks' Association is also represented. Keeping in view the Reserve Bank's goal to
have consistency and harmony with international standards it has been decided that at
a minimum, all banks in India will adopt Standardized Approach for credit risk and Basic
Indicator Approach for operational risk with effect from March 31, 2007. After adequate
skills are developed, both in banks and at supervisory levels, some banks may be
allowed to migrate to IRB Approach after obtaining the specific approval of Reserve
Bank.

5. On the basis of the inputs received from the Steering Committee 'draft' guidelines for
implementation of Basel II in India have been prepared and are enclosed. Banks are
requested to study these guidelines and furnish their feedback to us within three weeks
from the date of this letter. These draft guidelines are also placed on the web-site for
wider access and feedback.