India's banking industry is at a watershed. It has met and successfully overcome several challenges over the last decade. But bigger challenges lie ahead. Some of these are captured in the distance Indian banking has still to go before it can claim to be at the head of the Asia-Pacific pack.

According to an analysis by Standard & Poor's of the risks facing the Indian banking industry, it is ahead of those of China, Indonesia, the Philippines and Vietnam. But not only are the banking industries of Australia, New Zealand, Singapore, Hong Kong and Japan ahead, so also are those of Malaysia, South Korea, Taiwan and Thailand.

A strong performance in the current year, strengthening the positive trends of the past, will certainly improve the short-term risk perception but focus must rest on key structural changes that have to occur if Indian banking is to be a positive force and not a drag on the rest of the economy.

The first and most obvious challenge will come from rising interest rates. The current perception is that interest rates have stopped falling and are likely to remain steady, but if demand for resources picks up as firms start to invest in new capacity and boom conditions fuel consumption demand, then there may be a tightening of liquidity and upward pressure on interest rates.

This will act like a double-edged sword. Rising interest rates will put an end to the investment income bonanza of banks but they will also raise their interest income.

A second challenge will come when real time gross settlement, the online payment system, is introduced in the banking system from next June. This will put an end to a lot of the 'float' that banks enjoy, the interest free deposit that customers maintain to meet payment obligations.

The resultant efficiency gains in the payment system will enable fund managers of firms to manage their cash much better and consequently take away from banks a part of the cost free deposits. To overcome this challenge, banks will have to redo a good part of their pricing.

At the end of the day, RTGS will lower, not raise, transaction costs of the banking industry as a whole. But the gainers will be the more efficient banks that have a clear idea of their costs and can price themselves effectively.

A third and a key challenge will be the introduction of Basle II capital adequacy norms. These will make two demands on banks. They will have to measure the risks they bear much better. For this they will need to overhaul their management information systems so that they have a clear and quantifiable idea of their risks.

Then they will have to look for capital to back that risk and ultimately earn enough to be able to service that capital. R Ravimohan, managing director of Crisil, feels that the future is all about technology and risks. There is a huge potential for undertaking risk assessment by using technology. It is imperative for banks to grow but the key issue is deciding where and how.

New ways or managing risk and asset-liability mismatches, like asset securitisation, which unlocks resources and spreads risk, are likely to be increasingly used.

The fourth and perhaps the cardinal challenge facing the banks will be not to get caught between two developments which act as pincers. One, there is a secular trend of falling core profitability, as distinct from fortuitous gains made from changing interest rates, and this trend will continue with growing competition.

Two, the intermediation cost in Indian banking, which stands at between two and three per cent, is high and reducing this will be a challenge not just in business but also in political terms.

The jobs shed by the banking sector in the last decade through VRS are small compared to what organised industry has shed. The challenge implicit in the massive downsizing and reskilling that has to come about if Indian banking is to be globally competitive cannot be over emphasised.

Again, there is a silver lining to this. The reach of banking in the Indian economy, measured by things like bank finance enjoyed by retail customers, is minuscule compared to most other Asian economies. So there is a huge potential customer base for banks waiting to be tapped.

By reskilling their staff and extensively using technology, banks can raise productivities without commensurate downsizing. But to do this, they have to understand and be able to use technology and redo processes so that small businesses and the rural sector can be serviced at a profit.

This is not impossible; it is simply waiting to be done. Not just commercial banks but regional rural banks and cooperative banks will have to undergo a sea change in different ways. Banks formalising their working with self-help micro credit groups could provide a key answer to issues like cost and security of lending.

The regulator and the government should give up thinking in terms of imposing priority sector lending targets and start introducing incentives for doing business with this small sector. The nation's and the banks' future lies in this.

To change, you have to change your thinking. A key player who does not seem to have done so is Dalbir Singh, CMD of Central Bank of India and a former chairman of IBA. He says corporates who can afford to pay are paying the lowest interest rates and deserving poor borrowers are paying the highest interest rates.

These corporates have their vocal trade bodies whereas the common man is voiceless. If his argument of affordability is carried to its logical conclusion, HDFC Bank could be asked to subsidise Central Bank as it can afford to do so. The corporates can beat down prices because they are efficient and can go shop elsewhere.

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