By Jayashree Jakhade

Worldover, financial institutions (FIs) have progressively transformed themselves into market-driven entities. As global markets get integrated, it is essential that Indian FIs too followed suit. This is critical. For, if the Indian FIs do not change their traditional mindset, they will never be able to maximise the benefits of global economic integration.

But, there are problems. The government continues to make crucial decisions, these FIs continue to remain shackled and depend on the North Block to a large extent for guidance and plans of action. And, rampant bureaucracy and red-tapism at all levels only hamper the FIs from integrating with the markets.

Autonomy needed
Operational freedom is what the FIs need and they should be allowed to work out market-driven plans. Indian FIs do enjoy decent credit ratings, are internationally recognised and many of these FIs have sizable stakes held by foreigners. Not just that, Indian FIs have successfully penetrated global financial markets through issuing depository receipts.

But, this is not enough. A lot more needs to be done, wherein the FIs can not only maximise their turnover but effectively penetrate the global financial markets with more sophisticated and innovative instruments of finance.

What needs to be done now? Provide ample autonomy so that they compete effectively with other private sector corporate players for funds and business. Important decisions continue to be taken by the FIs only after they are cleared by the concerned political powers, quite often on non-economic considerations.

Empowering the FIs would make them depend less on the concerned powers and enable them to take crucial decisions based on ground realities and market conditions. Such decisions can have a positive impact on the flowchart of FIs' future investments.

Ironically, in difficult situations, the government usually looks up to the FIs. Whenever there is a resource crunch, the government expects the FIs to come to its rescue. When the stockmarkets get overheated or when the Sensex swings dangerously, again the the FIs are expected to play the role of a stabiliser. And when the government failed to reach its PSU disinvestment target, again the FIs were expected to step in.

Adopt new strategies
Sure, most FIs have creative ideas, but they do not find expression due to restrictions. Perhaps, these ideas do not fit into the thought-framework of the concerned ministries. The world is fast moving into the cyberage and the Net is redefining the business initiatives of developmental financial institutions worldwide. And, the Indian FIs are still to demonstrate their keenness and ability to leverage information technology in the larger interests of the economy, the markets and the shareholders.

Indian FIs have to also work out strategies to counter threats such as rising competition from banks. They need to redesign plans to counter rising costs of funds, declining interest spreads and deterioration in asset quality. With the banking sector getting more and more integrated, the lines of demarcation between banks and the FIs are gradually disappearing. So, the FIs need to adopt new strategies to face emerging challenges.

Squeezed spreads
Sadly, the hangover from the preliberalisation era continues. FIs continue to be mired in totalitarian thinking and lack initiatives. Pre-1990, FIs had little freedom and operated in a sheltered environment. The cost of finance was low and funds were easily available.

Once the economic reforms were announced in 1991, the FIs had no option but to go to the market to mobilise resources to fund their lending operations. This posed serious challenges for them. For, once market factors came in, costs of funds moved up and fierce competition became the buzzword.

The FIs had to willy-nilly devise and offer lucrative investment options to attract investors. The immediate impact of this was seen in the FIs' interest spread for high-cost funds declining. Quickly, the difference between interest earned and interest paid out to creditors became unattractive. This exerted tremendous pressure on the FIs to function profitably. For, interest spreads are the largest contributors to FIs' profits.

This not only constrained resources, it made the entire financial sector undergo a dramatic change. The dividing lines between banks, non-banking financial service companies and FIs became increasingly blurred. A wave of competition started hitting the shores of FIs. With the rising trend towards privatisation, this trend can only gather momentum.

Universal banks
Fine, but there is little reason to cheer about. Generally, FIs peg their operating margins on the world commodity markets and industrial performance of the economy. When the FIs began gearing up to adjust to the new environment, commodity markets the world over collapsed and industrial performance of economies took a step back.

FIs had major customers in the manufacturing sector who had made heavy borrowings from them. Downturn in the business cycle made the FIs very vulnerable. FIs had major exposures in industries such as steel, chemicals and textiles. The industrial downturn led to many lenders failing to honour their commitments.

In this upheaval, the industrial structure went in for a toss and a reduction in tariffs saw the once-promising industries teetering in the face of competition from overseas. This sudden onslaught saw the local players struggling with neither the expertise nor the efficiency to become price-competitive.

Naturally, the FIs were thrown to the wolves. At once, they had to face the music from everywhere: declining government support, rising degrees of overlapping in the operations of financial sector players and a crippling industrial downturn.

All these forced the FIs to suffer dips in profits and declines in the quality of assets held by them. So, the FIs began looking at diversification as the sole way out of this predicament.

Soon, FIs realised that their traditional roles would no longer take them far. So, they had to develop diversification and universal banking models. As an universal bank, the FIs are expected to function like a supermarket, where the customer can make choices from a variety of financial products.

Universal banking was seen as a progressive move. Realisation dawned that they had to diversify and offer new value-added services. Thus, players such as ICICI and IDBI took the lead and set up subsidiaries to offer a host of financial services and products. Fine. But, FIs are still to enjoy the sort of freedom banks have in accepting demand deposits which can bring down the cost of funds.

Retail lending
Nevertheless, the FIs are looking ahead. They are keen to set up universal banks and diversify their revenue streams. However, while some FIs expanded and diversified their portfolios faster, others did not.

If the portfolios of the FIs expand, they are less vulnerable to losses. And if the additional portfolio is independent of the initial assets held, then the loss that can be expected with an unfavourable development will not rise proportionately with the total value of the portfolio. Under such circumstances, FIs discovered retail lending to be less riskier than corporate or wholesale lending.

Infrastructure financing
Thanks to the onset of the Net and the telecom revolution, there is a quiet change happening among the Indian FIs. These FIs are making their bond offerings attractive by distributing them over the Net.

Several options on a cumulative basis are being offered making the schemes more attractive for potential investors. Such strategies are helping the FIs to explore new avenues and expand their portfolio base.

No wonder, ICICI has latched on to online brokerage services with the launch of ICICIDirect.com. The ICICI online broking subsidiary ICICI Web Trade has made an impressive beginning. Such online initiatives might be small compared to the traditional retail lending operations. But, these initiatives are definitely helping the FIs to bolster their bottomlines.

And many FIs see potential for profitable growth in infrastructure financing.

Infrastructure financing provides FIs ideal business opportunities because of its unique nature. The sheer size of financing needed, the set of special skills required to appraise an infrastructure project and the long gestation period of projects make infrastructure financing a great opportunity for the FIs.

While it is widely accepted that infrastructure financing offers lucrative business opportunities for the FIs, progress on this front is generally constrained by the confusion over policy issues and by the lack of depth in the Indian capital markets. Though power, roads and ports are the focal points, the Indian FIs have taken power sector financing more seriously.

For instance, ICICI has committed around 8.9 per cent, IDBI around 6.7 per cent and IFCI has disbursed 17.3 per cent of its total outstandings towards the power sector. Thus, the Indian power sector is the largest sectoral exposure of the FIs. But, this is where the government should step in and see to it that imbalances in power financing do not arise. For, such imbalances could reduce the scope for financing other infrastructure projects.

Another constraint in infrastructure financing is the absence of depth in the Indian capital markets. Infrastructure financing generally requires loans with maturity periods of about 10 years. In contrast, term-financing is usually for five to seven years.

What happens in such situations is this: since the period of maturity and the assessment period of the loan do not match, the FIs usually end up with asset-liability mismatches.

That is why the FIs need to resort to innovative financing options such as "take-out" financing. Take-out financing is an arrangement to avoid asset-liability mismatches by transferring outstanding loans to the books of another institution on a pre-determined basis.

The NPA obstacle
There is one more obstacle the FIs have to overcome in order to become profitable market-driven entities. That is managing the problem of non-performing assets (NPAs) effectively. Only effective management of NPAs can help the FIs caught in the vortex of competition grab opportunities to diversify their portfolio without any major long-term consequences.

Today, the FIs are trying to scale down the ratio of NPAs to total assets. All attempts are being made now to downsize the risks associated with projects.

Large provisions towards NPA erodes the profitability of FIs. The collaterals that the FIs hold against loans disbursed hardly serve the purpose.

Another factor that reduces the credibility of the FIs is this: for equity shareholders and other investors, a rise in NPAs triggers doubts about the actual magnitude of the problem leading to questions on the credibility of financial data. So, the FIs are setting up separate cells to monitor recovery of loans and expedite collections.

Restructuring efforts
Restructuring is another strategy the Indian FIs are thinking about. Such a strategy should help the FIs not only improve the quality of their working environment, but also their credit ratings. And better ratings can help the FIs gain easy access to international financial markets and bring down their cost of funds.

One factor that can catalyse the progress of Indian FIs is a friendly monetary policy that is in step with global developments. This can help to boost industrial growth and in turn can improve the financial recovery of the FIs. It is high time that FIs moved away from traditional financing models that limit their operational boundaries and make them unfit for global competition.

WTO commitments
That calls for eliminating the demarcation between banks and the FIs and allowing the later to move towards universal banking. Such a plan of action would not only improve the balance sheets of the FIs, but would also help them compete globally.

If the WTO agreement has to be fulfilled, the Indian financial sector will have to be opened up, protectionism minimised and foreign competition welcomed. The implication of such a move: competition would intensify in the financial services industry thus making survival possible only for the fittest.

So, the only solution lies in the domestic FIs preparing themselves for the new era by turning themselves into universal banks and hastening the process of erasing the boundaries that separate commercial banks from FIs.

Coming consolidation
Another factor that is on the verge of redrawing the profiles of Indian FIs is the ongoing process of consolidation. Mergers and acquisitions are seen by FIs as long-term solutions that have the potential to create giants in the field of financial services. With conventional wisdom dictating that size, expertise and global reach are crucial to the viability and survival of FIs, there is no second opinion about the need for mergers among the FIs.

The apex bank should then allow the FIs to merge. Such mergers will result in economies of scale in universal banking. This would not only bring about systemic efficiency but a fair degree of risk management skills too. Universal banks with the right economies will not only enlarge the scope of investment by increasing the retail base, but in the long run it would lead to scale-related benefits too. Costs would drop because volume of investments would be larger for a given level of overheads for an investment.

There are ample reasons why the government should refrain from influencing the lending decisions of domestic FIs. Consider: the government very often frames a macro credit policy which is flawed. Thanks to the absence of autonomy, the FIs more often settle down for loan portfolios that are not consistent with the desired risk-return trade-offs. Thus, the FIs are exposed to either low returns or to high-risk borrowers. In such a situation, the framework of guidelines is responsible for the under-performance of the FIs and for the increase in the level of their NPAs.

True, India has thrown its gates open for foreign investment. It is also true that there are many entities around who operate in the domestic market and access the financial market for short, medium and long-term loans. Where have we gone wrong? We have failed to understand that there is a differentiation on a case-to-case basis and no uniformity in laws is maintained. Unless and until the government puts all its laws and governing mechanism in place, matters will continue to complicate and foreign investors will be encouraged to make backdoor-entries.

Why not allow foreign entities to tap the domestic financial markets? There is a very strong argument against this: if foreign entities are allowed to tap the domestic financial markets, it defeats the whole purpose of inviting them. But on the other hand, if the domestic FIs are capable enough to source foreign funds to finance ongoing projects, it becomes foreign exchange-neutral.

And if the FIs are given driving powers, if they are more capable of sourcing cheaper foreign funds and are capable of forecasting the future trends in the Rupee value, which might make the foreign investor reluctant to bring in foreign funds, there is no reason why the domestic FIs should not be made fully independent when it comes to decision-making. If the FIs can source external funds at favourable parity terms, they should be allowed to do so without any hindrances from the government.