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Over the past decade the banking industry has witnessed many positive developments. The banking industry in India compares quite well with many of its international counterparts on metrics such as growth, NPAs, ROA, etc. Although the Indian banking industry has witnessed significant growth in last few years, comparatively lower levels of financial inclusion remains a concern. A large proportion of the population is still financially excluded, with the number of bank branches per one lakh (hundred thousand) adults being low (by global standards) at 9.4 branches. Further, the progress made during past decade is limited to a small part of the industry. While the onus for tackling the emerging challenges lie mainly with bank managements, a facilitating policy and regulatory framework will be critical for the further development of the banking industry. The following are some of the challenges faced by the Indian banking sector.

Increase penetration of banking in India- tackle demand supply mismatch

Primarily supply side constraints are responsible for the high levels of financial exclusion in the country, as they have a causal effect in keeping demand low from certain factions of the population. The demand supply mismatch, which is reflected in measures of financial exclusion, shows the limitations on the banks’ ability to supply products and services.

A large proportion of the population in India, largely concentrated in rural areas is believed to be financially excluded from formalized credit markets (implies having access to bank credit) and payments systems (implies not having access to bank accounts). Inaccessible institutional credit drives these people to use the services of unorganized credit markets which charge interest at rates in the range of 35-60%. According to the Report of the Committee on Financial Inclusion (NABARD, 2008) and NSSO, 45.9 million farmer households in India do not have access to credit, even from noninstitutional sources. Only 27% of farmer households have loans from institutionalized sources, two-thirds of which also borrow from the unorganized sector. Among the urban poor class, financial exclusion level is not determined with certainty, since this population group is highly migratory. But, clearly, north eastern, eastern and central regions suffer more from financial exclusion than other regions of the country.

Many initiatives are being taken by the RBI and other banks in the country, notably public sector banks, to increase supply of financial services to the unbanked areas. Introduction of ‘no frills’ account (2005) and utilizing services of NGOs and other civil organizations for providing financial services (2006) are some steps in that direction. The ability of banks to supply products and services is clearly reflected in the population being served by them per branch, or their physical presence geographically.

Foreign banks committed to making a play in India will need to adopt alternative approaches to win the “race for the customer” and build a value-creating customer franchise in advance of regulations potentially opening up post 2009. At the same time, they should stay in the game for potential acquisition opportunities as and when they appear in the near term. Maintaining a fundamentally long-term value-creation mindset will be their greatest challenge.

Credit disbursement to the priority sector:

One of the major challenges faced by the banking system in India is to provide timely and cost effective credit to the priority sectors especially the agriculture and Small scale industries, which are critical in generating employment and support the growth momentum of the economy. After witnessing robust growth between FY05-FY07, the growth in agriculture credit witnessed some moderation in FY08. Thus banks are required to ensure availability of credit to the agriculture sector, which forms the backbone of the Indian economy. With significant slowdown in economic activity and exports during the latter part of FY09, the credit growth to the micro and small experienced some moderation. While it is important for the banks to maintain the asset quality, they also need to direct the credit flow towards small and medium enterprises which play a critical role in India’s economic development.

Maintain asset quality:

The secured advances made by banks have shown a mild decline in FY09. The unsecured advances of banks particularly of credit card receivables have increased substantially. In FY09, the quality of assets of banks has come under scrutiny, as the rising interest rates started putting pressure on the repayment by borrowers in the H1 FY09. While the interest rates began to soften in the latter part of the fiscal, the risk of default persisted mainly due to slowdown in economic activity. Thus a major challenge in the current economic scenario for the Indian banks is to maintain the gains made with respect to asset quality over the past few years.

In such situations, unsecured advances possess greater risk to business. The sensitive sector advances is an important indicator towards the quality of assets held by banks. Though this does not in itself indicate a high risk, the higher exposure signals a greater need for monitoring by the banks as the susceptibility increases. This is of even greater importance in the current scenario when capital markets and real estate are extremely risky sectors. The exposures of SCBs to sensitive sectors have increased inexplicably from less than 3.5% to over 20% within a span of two years. New private sector banks have the highest exposure to sensitive sectors, largely due to the exposure in real estate.

Improve risk management mechanism:

Strategies to combat the problem of high risk perception must be taken up by banks on priority basis. Increased usage of rating services must be employed to reduce risk. Besides, SME specific risk management procedures must be setup to make the business more viable, as the risk perception associated with lending to small enterprises is generally very high. Further, the banks would also be required to acquire skill for managing emerging risks resulting from innovations in financial products as well as technological advancements.

The availability and ease access to reliable data/information to both banks and regulators/supervisors of the banking system is a key for prudent risk management. Hence, strengthen the existing system would be another challenge for the banking industry. More over the recent global financial market turmoil has accentuated the need for further improvement in the transparency and disclosure standards.

Technology adoption:

The problem of resistance from workforce has largely been neutralized over the years, but the primary issue involved with the adoption and rapid integration of technological processes within banks still related to human resources- the availability of technically skilled resources is scarce. Technology is not among the core competencies of financial institutions, which necessitates outsourcing. Banks in India are different from banks in many other countries, in ways that they have a very large branch network and varied needs specific to regions and customers. Most off the shelf solutions are not exactly in conformity to the needs of the banks, which makes room for large customizations.

Besides, a serious concern in implementing complex technologies is protection against frauds and hackings. Security concern slows down technology adoption significantly for the banking industry. A fast pace of development of security systems is imperative to the adoption of large scale innovations in the industry.

Another issue is that of business process reengineering, which is required after computerization. Failure to successfully carry out BPR neutralizes the benefits that an institution wishes to accomplish via adoption of a technological process.