A project on “Universal Banking”

                             

            The latest mantra is Universal Banking, which is combination of Commercial & Investment Banking.

 The concept of U.B. is mainly popular in Germany, USA & UK, Barclays Bank, Chase Manhattan and Citicorp are some of the examples of it.        

          Universal banking is the solution to FIs problems.

        The merger of ICICI and ICICI bank is probably the largest merger seen in corporate India Industry, which has redefine banking in the highly competitive era of globalization and liberalization

 Post merger, the new entity- ICICI Bank is the first Universal Bank in India and the second largest commercial bank in the country after SBI.

Financial Institutions & Insurance Companies are now merging ahead to capture new business areas and leading towards Universal Banking.

INTRODUCTION TO UNIVERSAL BANKING

       Since the early 1990s, structural and functional changes of profound magnitude came to be witnessed in global banking systems. Large-scale mergers, amalgamations and acquisitions among banks and financial institutions resulted in the growth in size and competitive strengths of the merged entities. There thus emerged new financial conglomerates that could maximize economies of scale and scope by 'bundling' the production of financial services. This heralded the advent of a new financial service organization, i.e. Universal Banking, bridging the gap between banking and financial-service-providing institutions. Universal Banks entertain, in addition to normal banking functions, other services that are traditionally non-banking in character such as investment-financing, insurance, mortgage-financing, securitisation, etc. Parallelly, in contrast to this phenomenon, non-banking companies too entered upon banking business. Universal banking usually takes one of the three forms i.e. in-house, through separately capitalized subsidiaries, or through a holding company structure. Three well-known countries in which these structures prevail are Sweden and Germany, the UK and the US.

HISTORY OF UNIVERSAL BANKING IN INDIA

       Historically, India followed a very compartmentalized financial intermediaries allowed to operate strictly in their own respectively fields. However, in the 1980s banks were allowed to undertake various non-traditional activities through subsidiaries. This trend got momentum in the early 1990s i.e., after initiation of economic reforms with banks allowed to undertake certain activities, such as, hire-purchase and leasing in –house. While this in a way represented a gradual move towards universal banking, the current debate about universal banking in India started with the demand from the DFIs that they should be allowed to undertake banking activity in-house. In the wake of this demand, the Reserve Bank of India constituted in December 1997, a working group under the chairmanship of Shri S.H. Khan, the Chairman & the Managing Director of IDBI (hereafter referred to as Khan Working Group-KWG). The KWG, which submitted its report in May 1998, recommended a progressive move towards universal banking. The Second Narsinham Committee appointed by Government in 1998 also echoed the same sentiment. In January 1999, the Reserve Bank issued a Discussion Paper setting out issues arising out of recommendations of the KWG and the Second Narsinham Committee. Since then a debate has been going on about universal banking in general and conversion of DFIs into universal banks in particular. With the opening up of the insurance sector to the private participation, the debate has gone beyond the narrow concept of universal banking.        

DEFINITION AND CONCEPTS

      The term ‘universal bank’ has different meanings, but usually it refers to the combination of commercial banking (collecting deposits & making loans) and investment banking i.e. issuing, underwriting and trading in securities, this is the narrow definition of universal banking. In a very broad sense, the term ‘universal bank’ refers to those banks that offer a wide range of financial services, such as, commercial banking & investment banking and other activities especially insurance. It is a multi-purpose and multi-functional financial supermarket providing both banking and financial services through a single window. According to World Bank the concept is explained as follows - "In universal banking, large banks operate extensive networks 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."

       Universal Banking (UB) usually takes one of the three forms, i.e., in-house, through separately capitalized subsidiaries, or through a holding a capital structure. Three well-known countries in which these structures prevail are Sweden and Germany, the UK & US. Universal in its fullest or purest form would allow a banking corporate to engage ‘in-house’ in any activity associated with banking, insurance, securities, etc. However, there are very few countries, such as, Sweden and Hong Kong, which allow universal banking in its purest form. In Germany, banking and investment activities are combined, but separate subsidiaries are required for certain other activities. Under German banking statutes, all activities could be carried out within the structure of the parent bank except insurance, mortgage banking and mutual funds, which require legally, separate subsidiaries. In the UK, a broad range of financial activities is allowed to be conducted through separate subsidiaries of the bank. The third model, which is found in the US, generally requires a holding company structure and separately capitalized subsidiaries.    

   In certain countries these type of universal banking are successfully functioning. Universal banking is nothing but broad based bank where you can do commercial banking, investment, insurance, and other financial business. It is largely found in different countries in different forms. Like:-

   

A] In Germany

B] In Britain

C] In America

           Basically it is a holding company and three subsidiary companies have formed. According to Glass Steegal Rules in 1933 commercial banking have been separated   by investment banking. Recently this rule has been modified.

           Therefore banking can also work together with investment banking.

PRACTICE OF UNIVERSAL BANKING IN SELECTED COUNTRIES

  1. The traditional home of universal banking is central and northern Europe, in particular, Germany, Austria, Switzerland and Scandinavian countries. Universal banking in countries like Germany, Austria and Switzerland evolved in response to a combination of environmental factors besides regulation. The direct involvement of German banks in industry through equity holdings was the result partly of banks converting their loans into equity stakes in companies experiencing financial pressures. A combination of environmental factors and unique historical events enabled banks in different European countries to establish themselves in particular segments of the corporate financing market.

  1. While countries like Germany and Switzerland never imposed any restriction on combining commercial and investment banking activities, the U.S. passed the Banking Act, 1933(Glass-Steagall Act has come to mean those sections of the Banking Act, 1933 that refer to bank’s securities operations), whereby banks were prohibited from combining investment and commercial banking activities. The Glass-Steagall Act was enacted to remedy the speculative abuses that infected commercial banking. The legal provisions of the Banking Act, 1933(Glass-Steagall Act) established a distinct separation between commercial banking and investment banking and made it almost impossible for the same organization to combine these activities.

  1. The competition in the banking industry has intensified following financial deregulation and innovations and introduction of new information technologies.

  1. The restrictions on banks engaged in securities business have been relaxed considerably worldwide during the last two decades. Three groups of countries can be distinguished. While countries, such as Germany, the Netherlands, and several Nordic countries, have imposed very little restriction on the combination of traditional banking and securities business, Canada and most European countries have entirely removed barriers to acquisition of securities firms and hence access to stock exchanges [Borio and Filosa, 1994]. Even in the U.S., where commercial and investment banking have been legally separated, market participants have tried to take advantage of some of the loopholes in the Glass-Steagall Act. For example, taking advantage of practices and institutional structure as well.

  1. Universal banking usually takes one of three forms, i.e., in-house, through separately Capitalized subsidiaries, or through a holding company structure. Universal banking in its fullest or purest form would allow a banking corporation to engage ‘in-house’ in any activity associated with banking, insurance, securities. Three well-known countries in which these three structures prevail are Germany, the U.K. and the U.S. In Germany, banking and investment activities are   combined, but separate Subsidiaries.

ADVANTAGES AND LIMITATIONS OF UNIVERSAL BANKING

  • Advantages

  • Greater economic efficiency

                 The main argument in favour of universal banking is that it results in greater economic efficiency in the form of lower cost, higher output and better products. This logic stems from the reason that when sector participants are free to choose the size and product-mix of their operations, they are likely to configure their activities in a manner that would optimize the use of their resources and circumstances. In particular, the following advantages are often cited in favour of universal banking.

  • Economies of scale 

                  It   means lower average costs, which arise when larger volume of operations are performed for a given level of overhead on investment. Economies of scope arise in multi-product firms because costs of offering various activities by different units are greater than the costs when they are offered together. Economies of scale and scope have been given as the rationale for combining the activities. A larger size and range of operations allow better utilisation of resources/inputs. It is sometimes argued that acquisition of some information technologies becomes profitable only beyond certain production scales. Larger scale could also avoid the wasteful duplication of marketing, research and development and information-gathering efforts [ Borio and Filosa, 1994].

  • Easy handling of business cycles

               Due to various shifts in business cycles, the demand for products also varies at different points of time. It is generally held that universal banks could easily handle such situations by shifting the resources within the organization as compared to specialized banks. Specialized firms are also subject to substantial risks of failure,

 Because their operations are not well diversified. Proponents of universal banking thus argue that specialized banking system can present considerable risks and costs to the economy. By offering a broader set of financial products than what a specialized bank provides, it has been argued that a universal bank is able to establish long-term relationship with the customers and provide them with a package of financial services through a single window. It is important to note that this benefit stems from the very nature/purpose of universal banking.

  • Limitations

  • Failure Risk System

                 The larger the banks, the greater the effects of their failure on the system. The failure of a larger institution could have serious ramifications for the entire system in that if one universal bank were to collapse, it could lead to a systemic financial crisis. Thus, universal banking could subject the economy to the increased systemic risk.

  • Risk of increase in Monopoly power

                  Historically, an important reason for limiting combinations of activities has been the fear that such institutions, by virtue of their sheer size, would gain monopoly power in the market, which can have significant undesirable consequences for economic efficiency [Borio and Filosa, 1994]. Two kinds of concentration should be distinguished, viz., the dominance of universal banks over non-financial companies and concentration in the market for financial services. The critics of universal banks blame universal banking for fostering cartels and enhancing the power of large non-banking firms.

  • Bureaucratic and inflexible

                     Some critics have also observed that universal banks tend to be bureaucratic an inflexible and hence they tend to work primarily with large established customers and ignore or discourage smaller and newly established businesses. Universal banks could use such practices as limit pricing or predatory pricing to prevent smaller specialized banks from serving the market. This argument mainly stems from the economies of scale and scope.

UNIVERSAL BANKING IN INDIA


           In India Development financial institutions (DFIs) and refinancing institutions (RFIs) were meeting specific sectoral needs and also providing long-term resources at concessional terms, while the commercial banks in general, by and large, confined themselves to the core banking functions of accepting deposits and providing working capital finance to industry, trade and agriculture. Consequent to the liberalization and deregulation of financial sector, there has been blurring of distinction between the commercial and investment banking.

        Reserve Bank of India constituted on December 8, 1997, a Working Group under the Chairmanship of Shri S.H. Khan to bring about greater clarity in the respective roles of banks and financial institutions for greater harmonization of facilities and obligations. Also report of the Committee on Banking Sector Reforms or Narasimham Committee (NC) has major bearing on the issues considered by the Khan group. The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to RBI to discuss the time frame and possible options for transforming itself into an universal bank. Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance, its proposed policy for universal banking, including a case-by-case approach towards allowing Domestic financial institutions to become the universal banks.

    Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit their plans for transition to a universal bank for consideration and further discussions. FIs need to formulate a road map for the transition path and strategy for smooth conversion into an universal bank over a specified time frame. The plan should specifically provide for full compliance with prudential norms as applicable to banks over the proposed period.

KHAN COMMITTEE ON UNIVERSAL BANKING & FIs

The khan committee on harmonizing the role and operations of development financial institutions and banks submitted its report on April 24, 1998 with following recommendations: -

  • Give banking license to DFIs
  • Merge banks with banks, DFIs
  • Bring down CRR progressively
  • Phase out SLR
  • Redefine priority sector
  • Set up a super regulator to coordinate regulators’ activities
  • Develop risk-based supervisory framework
  • Usher in legal reforms in debt recovery
  • State level FIs be allowed to go public and come under RBI
  • DFIs be permitted to have wholly-owned banking subsidiaries
  • Remove cap on FIs’ resources mobilization
  • Grant authorized dealers’ license to DFIs
  • Set up a standing committee to coordinate lending policies

SOME CONCEPTS…

  • About Universal Banking

         Universal banking refers to elimination of the distinction between the development financial institutions and the banks and market segmentation that presently exists between them.

  • About Harmonization Of Role Of Banks And DFIs

              Harmonization means the introduction of universal banking in a limited sense, wherein the DFIs could become banks and intermediate in the short-term end of the financial market (say finance for working capital) and commercial banks could enter the long-term end of the financial market (say project financing). In other words, the harmonization allows the DFIs and banks to move freely to the other end than where they are presently placed.

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  • About The Main Areas Of Operations Of Dfis And Banks Presently And How  

     Universalisation Will Change That Role In Future.

           DFIs are specialist institutions catering to different sectors, appraising projects from technical and financial parameters and finance long-term investment requirements. This specialization has given edge to DFIs in terms of project appraisal. On the other hand, the banks meet the short term investment and production requirements and they have developed expertise in providing working capital finance to industry, exports, imports, small industry, agriculture etc. They can take as intermediates in a ...

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