Fiscal year 2008-09 is expected to initiate the reform process in the banking sector with several banks complying with Basel II guidelines and others gearing up for the same compliance in 2009. The second phase of opening up of Indian banking sector would commence in April 2009.

Foreign banks will have the opportunity to own up to 74 per cent of Indian private sector banks and 20 per cent of government owned banks. These foreign banks with huge capital reserves, cutting edge technology, best international practices and skilled personnel will create a major competitive challenge for Indian banks, especially the public sector banks.

According to official estimates, to maintain an average capital adequacy ratio of 12.0 per cent by March 2010, the public sector banks would roughly require an additional capital of Rs 3,000 bn. This is arrived at after considering requirements of capital to fund growth, expected NPA write offs and investments in IT and other infrastructure. Structural hurdles like restrictions on capital availability (due to high government ownership), restrictions on credit deployment and restrictive labour laws, weak corporate governance - have impaired the ability of Indian public sector banks to intermediate efficiently. Also, there are stringent restrictions on FII and FDI participation in the public sector banks.

Industry wish list

Rupa Rege Nitsure - Chief Economist, Bank of Baroda [Get Quote]

• In the Union Budget 2008-09, the government should openly kick-start the process of consolidation amongst the public sector banks, which will go a long way in strengthening this sector.
• The government may also think of introducing a few fiscal incentives for bank deposits, which are facing a tough competition from the capital market schemes as well as housing sector. As 85 to 90 per cent of the banks' funds still come from deposits, the government should introduce a few incentives, which can make these deposits an attractive avenue for investment for the household sector.
• Currently, 2 per cent interest rate subvention is provided to crop loans up to a limit of Rs 0.3 m. The banks are charging an interest rate of 7 per cent on these loans and take interest subvention of 2 per cent per annum from the Government of India, thus yielding an effective interest rate of 9 per cent per annum. It is felt that the interest rate subvention of 2 per cent is to be increased to 3.5 per cent making the effective interest rate of 10.5 per cent per annum for banks.
• Reducing the government ownership in PSU banks to 33 per cent as promised by the previous government.
• Granting more managerial autonomy to PSU banks so that they have better specialists working for them at market-related packages and more independent directors on their boards
• Allowing PSU banks to close down loss-making rural branches
• Further liberalisation of directed lending norms

CII and FICCI

• Levy of BCTT (banking cash transaction tax) should be made applicable only in those cases where people buy drafts from banks without quoting their Permanent Account Number (PAN). All other assesses should be outside the purview of this levy.
• Increase the FII/ FDI limit in PSU banks from 20% to 49%.
• Allow another round of VRS in PSU banks and more powers to attract suitable talent

Budget over the years

Budget 2005�06

• Autonomy to RBI to implement reforms in banking sector.
• Amendment of the Banking Regulation Act.
• Allow banking companies to issue preference shares to boost their Tier-I capital.
• Introduce provisions to enable the consolidated supervision of banks and their subsidiaries by RBI.
• Increase bank lending to agricultural sector by 30% and PSU banks to increase number of agricultural borrowers by 5 m.
• Remove the lower and upper bounds to the statutory liquidity ratio and removal of the limits on the cash reserve ratio to provide flexibility to RBI to prescribe prudential norms
• 0.1% banking transaction tax to be imposed on cash withdrawals above Rs 10,000 on a single day.
• Enable RBI to lend or borrow securities by way of repo, reverse repo or otherwise.
• Removal of benefits available to depositors (Section 80-L)

Budget 2006�07

• Banks to increase disbursements to farmers to Rs 1,750 bn by FY07 (with addition of 5 m farmers) and open a separate window for self-help groups (SHGs). Additional 0.4 m SHGs to be credit-linked by FY07 in association with NABARD.
• Farmers to be extended short-term credit at interest rate of 7% p.a. with an upper limit of Rs 0.3 m on the principal amount.
• Net capital support to banking sector (by way of issuance of special non-tradable government securities), standing at Rs 228 bn at the end of 9mFY06, to be restructured by their conversion to tradable SLRs.
• Fixed deposits with tenures of not less than 5 years to be included under Section 80 C for tax exemptions.
• Loans to food processing sector to be included in the priority-sector lending basket.
• ATM operations and collection services provided by banks in public issues to be brought under the service tax net.
• Banking Cash Transaction Tax (BCTT) to continue for some more time until the AIR system is able to capture all significant financial transactions.

Budget 2007�08

• Farm credit target for FY08 set at Rs 2,250 bn with an addition of 5 m new farmers to the banking system and provision of Rs 17 bn for 2% interest subvention for short-term crop loans
• To augment resources for refinancing rural credit cooperatives, NABARD to issue Government guaranteed rural bonds to the extent of Rs 50 bn
• SARFAESI Act to be extended to loans advanced by Regional Rural Banks (RRBs). RRBs to be permitted to accept NRE/FCNR deposits and those that have a negative net worth to be recapitalised
• Cooperative banks to be allowed deduction in respect of provision for bad and doubtful debts under section 36(1)(viia). Also, amalgamation and de-merger of banking companies is tax neutral. This benefit to be extended to cooperative banks
• Cash withdrawals by Central and State Governments to be excluded from the scope of Banking Cash Transactions Tax (BCTT). Exemption limit for individuals and HUFs to be raised from Rs 25,000 to Rs 50,000
• The government has proposed to acquire RBI's equity holding in State Bank of India [Get Quote] (59% currently). It has provided a sum of Rs.400 bn for this purpose, but the transaction will be deficit neutral to the government. Also, the fund of Rs 7.5 bn created for awarding 0.1 m (of Rs 6,000 each per year) will be placed with the SBI, and the yield from the fund will be used for awarding the scholarships.
• Increase in dividend distribution tax from 12.5% to 15%.
• 1% higher education cess to charged.

Key positives:

Guidelines on bank mergers: The RBI's guideline on bank mergers cleared the ambiguity persisting regarding the route that banks need to follow for their inorganic growth. While 'voluntary' merger between two banks requisite approval by two-thirds of the total board members and disclosure of the valuation details, financials and share price movements, dissenting shareholders would get the value as per the valuation computed by the RBI.

Liberalisation of ECB norms: The government also liberalised the ECB norms to permit financial sector entities engaged in infrastructure funding to raise ECBs. This enabled banks and financial institutions, which were earlier not permitted to raise such funds, explore this route for raising cheaper funds in the overseas markets.

Restriction of voting rights: In another move to narrow down the impact of foreign entities on managements of domestic banks, the government in its new norms for ADR/GDR issues has specified that the voting rights of ADR/GDR holders will be restricted to 10% (which is as per RBI norms).

Credit classification: To accelerate the initiatives for credit efficiency of the banking entities post Basel II (FY07 onwards), the RBI has suggested that banks will need to classify loans above Rs 50 m as 'non -retail exposure' and exercise credit rating on the same through their internal rating mechanism.

Ceiling on dividends: The RBI has raised the ceiling on the dividends that commercial banks are permitted to pay to 40% of a bank's net profits, from the earlier 33.3 %. The caveat, however, is that banks can now pay dividends if their NPAs are less than 7% of their total advances and they have had a capital adequacy ratio (CAR) of at least 9% for three consecutive years. As not meeting any of the said guidelines makes a bank ineligible for dividend payment, it ensure that bank sustain a healthy asset book in the longer term.

Hybrid capital: In an attempt to relieve banks of their capital crunch, the RBI has allowed them to raise perpetual bonds and other hybrid capital securities to shore up their capital. If the new instruments find takers, it would help PSU banks, left with little headroom for raising equity. Significantly, FII and NRI investment limits in these securities have been fixed at 49%, compared to 20% foreign equity holding allowed in PSU banks.

Final guidelines on securitisation: The apex bank having issued the draft guidelines on securitisation in April 2005 is expected to issue the final mandate on the same by the end of February 2006. The move is aimed at ensuring that standard assets securitised constitute a true sale and an arm's length is maintained between the originating bank and the special purpose vehicle (SPV) to which the assets are transferred.

Key negatives:

Holding structure conundrum: The RBI expressed its discomfort with regard to creating intermediate holding companies and has suggested exploring the possibility of creating banks or financial holding companies on the lines of financial structure operating in the US. Currently a typical bank-centric organisation structure is followed in India.

However, the proposed structure will involve a multi-layered financial conglomerate and may also have a few tiers of intermediate holding companies apart from the holding company at the top. This derailed the plans of banks like ICICI Bank [Get Quote] SBI to list their insurance subsidiaries separately.

No interest on CRR: The staggered three-staged rise in the CRR from 6% to 7.5% bore a telling impact on the banking sector's liquidity scenario. Besides together locking in liquidity to the tune of approximately Rs 25 bn from being deployed in productive revenue-generating resources (advances and investments), the removal of interest payable by the RBI on CRR maintained by banks above 3.5% of net demand and time liabilities, made it completely non-remunerative for the latter.

Interest rate dampener: The interest rate movement in the short term is likely to be with an upward bias as is evident from the RBI's 25 basis points rise in the repo rate.  A corresponding rise in deposit rates, not commensurate with rise in yields, may pressurise the margins (NIMs) for the sector.

Increase in risk weightage: The National Housing Bank (NHB) has further tightened norms for housing finance companies (HFC) in the wake of the risk foreseen due to high asset prices. The NHB has increased the risk weightage for loans to the commercial real estate sector from 100% to 125%. Also, the investment in mortgage-backed-securities (MBS) will attract risk weightage of 125%. The decision comes close on the heels of the NHB increasing the risk weightage on home loans from 50% to 75%.

Refusal to dilute stake in PSU banks: The government has refused to dilute its stake in PSU banks below 51% thus choking the headroom available to these banks for raining equity capital.

Higher provision for standard assets: The RBI has increased the provisioning requirement on standard assets from 0.25% to 0.4%, thus increasing the provisioning liability for banks.

Impediments in sectoral reforms: Opposition from Left and resultant cautious approach from the North Block in terms of approving merger of PSU banks may hamper their growth prospects in the medium term.