NOTE: SBINEWS DOES NOT PERMIT CIRCULATION OF ATTACHMENTS. ATTACHMENTS, IF ANY, CIRCULATED WILL BE ONLY BECAUSE OF VIRUSES. PLEASE,THEREFORE, IGNORE ATTACHMENTS IF ANY IN SBINEWS MESSAGES ************************************************************************ Universal Banking: The Road Ahead? Economic historians have long emphasized the importance of financial institutions in industrialization. More recently, economists have begun more intensive investigation of the links between financial system structure and real economic outcomes. In theory, the organization of financial institutions partly determines the extent of competition among financial intermediaries, the quantity of financial capital drawn into the financial system, and the distribution of that capital to ultimate uses. The choice between universal and specialized banking may affect interest rates, underwriting costs, and the efficiency of secondary markets in securities. Furthermore, the presence or absence of formal bank relationships may affect the quality of investments undertaken, strategic decision-making, and even the competitiveness of industry. Particularly since World War II, many economists and historians have argued that German-style universal banks offer advantages for industrial development and economic growth. Universal banking efficiency combined with close relationships between banks and industrial firms, they hypothesize, spurred Germany?s rapid development at the end of the nineteenth century and again in the post-World War II reconstruction. A corollary to this view holds that countries that failed to adopt the universal-relationship system suffered as a consequence. Adherents suggest that British industry has declined over the past hundred years or more, and that the American economy has failed to reach its full potential, due to short-comings of the financial system that lead to relatively high costs of capital. In Indian context, the phenomenon of universal banking?as different from narrow banking?has been in the news in the recently. With the last Narasimham Committee and the Khan Committee reports recommending consolidation of the banking industry through mergers and integration of financial activities, the stage seems to be set for a debate on the entire issue. A universal bank is a ?one-stop? supplier for all financial products and activities, like deposits, short-term and long-term loans, insurance, investment banking etc. Global experience with universal banking has been varied. Universal banking has been prevalent in different forms in many European countries, such as Germany, Switzerland, France, Italy etc. For example, in these countries, commercial banks have been selling insurance products, which have been referred to as Banc assurance or Allfinanz. After the stock market crash of 1929 and banking crisis of the 1930s, the US banned all forms of universal banking through what is known as the Glass- Steagall Act of 1933. This prohibited commercial banks from investment banking activities, taking equity positions in borrowing firms, selling insurance products etc. The idea was to mitigate risky behaviour by restricting commercial banks to their traditional activity of accepting deposits and lending. Research on the effects of universal banking has been inconclusive as there is no clear-cut evidence in favour of or against it anywhere. Nevertheless, the United States has once again started moving cautiously towards universal banking through the Gramm-Leach-Bliley Act of 1999 which rolled back many of the earlier restrictions. Some recent phenomenon, like the merger between Citicorp (banking group) and Travelers (insurance group) confirmed the fact that universal banking is here to stay. Hence it becomes all the more imperative to know whether we need universal banks in India. And whether it is a more efficient concept than the traditional narrow banking. What are the benefits to banks from universal banking? The standard argument given everywhere?also by the various Reserve Bank committees and reports?in favour of universal banking is that it enables banks to exploit economies of scale and scope. What it means is that a bank can reduce average costs and thereby improve spreads if it expands its scale of operations and diversifies its activities. By diversifying, the bank can use its existing expertise in one type of financial service in providing the other types. So, it entails less cost in performing all the functions by one entity instead of separate specialized bodies. A bank possesses information on the risk characteristics of its clients, which it can use to pursue other activities with the same clients. This again saves cost compared to the case of different entities catering to the different needs of the same clients. A bank has an existing network of branches, which can act as shops for selling products like insurance. This way a big bank can reach the remotest client without having to take recourse to an agent.Many financial services are inter-linked activities, e.g. insurance and lending. A bank can use its instruments in one activity to exploit the other, e.g., in the case of project lending to the same firm which has purchased insurance from the bank. Now, let us turn to the benefits accruing to the customers. The idea of ?one-stop-shopping? saves a lot of transaction costs and increases the speed of economic activity. Another manifestation of universal banking is a bank holding stakes in a firm. A bank?s equity holding in a borrower firm acts as a signal for other investors on the health of the firm, since the lending bank is in a better position to monitor the firm?s activities. This is useful from the investors? point of view. Of course, all these benefits have to be weighed out against the problems. The obvious drawback is that universal banking leads to a loss in economies of specialization. Then there is the problem of the bank indulging in too many risky activities. To account for this, appropriate regulation can be devised, which will ultimately benefit all the participants in the market, including the banks themselves. In spite of the associated problems, there seems to be a lot of interest expressed by banks and financial institutions in universal banking. In India, too, a lot of opportunities are there to be exploited. Banks, especially the financial institutions, are aware of it. And most of the groups have plans to diversify in a big way. Even though there might not be profits forthcoming in the short run due to the switching costs incurred in moving to a new business. The long-run prospects, however, are very encouraging. At present, only an ?arms-length? relationship between a bank and an insurance entity has been allowed by the regulatory authority, i.e. the Insurance Regulatory and Development Authority (IRDA). This means that commercial banks can enter insurance business either by acting as agents or by setting up joint ventures with insurance companies. And the RBI allows banks to only marginally invest in equity (5 per cent of their outstanding credit). Development financial institutions (DFIs) can turn themselves into banks, but have to adhere to the statutory liquidity ratio and cash reserve requirements meant for banks. Even then, some groups like the HDFC (commercial banking and insurance joint venture with Standard Assurance), ICICI (commercial banking), SBI (investment banking) etc., have already started diversifying from their traditional activities through setting up subsidiaries and joint ventures. In a recent move, the Life Insurance Corporation increased its stakes in Corporation Bank and is planning to sell insurance to the customers of the Bank. Corporation Bank itself has been planning to set up an insurance subsidiary since a long time. Even a specialized DFI, like IIBI, is now talking of turning into a universal bank. All these can be seen as steps towards an ultimate culmination of financial intermediation in India into universal banking. Kamal Sehgal (MBA 2002-04) IIFT ===== Web Address: http://rspai.tripod.com __________________________________ Do you Yahoo!? Yahoo! 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