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Nature and extent of diversification in Indian banking sector.

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Introduction

Diversification in the banking sector has emerged from a host of considerations. Elimination of the unevenness of the geographical reach, stimulation of product process innovation, diversification of risk etc. are some such considerations. The term "Diversification" is characterized by the concept of multi dimensionality. As per Ansoff (1957,1958) diversification commonly refers to "entering new market with new products". According to Rumelt (1974) diversification strategy as a firms "commitment to diversity per se, together with the strengths, skills or purpose that span this diversity, shown by the way in which business activities are related to one another'. (Rumelt 1974: 29). Banks adopt diversification move as a part of growth strategy. They may go for expansion via diversifying geographically or/and via product market diversification. i.e., by adding new products and business lines. Broadly, banking industry may adopt diversification route in the following forms;-

1) Vertical or horizontal integration to create diversified financial group

2) Alliance diversification via joint ventures, tie-ups etc.

Before discussing the nature of diversification in banks, a brief discussion is given on the underlying relationship between the three important segments of financial markets. i.e., commercial banks, insurance and investment business. This relationship provides a base for diversification of banking activities and integrating these three different businesses. Investment and insurance business generally finance a growing volume of assets and do not have adequate capital base. In such situations commercial banks can provide a substantial capital base. Also, commercial bank's branch wide network can provide scope to investment and insurance business for the distribution of their financial products like mutual funds, debentures, policies etc. Moreover, as in the present scenario when the proportion of bank credit in corporate debt is declining. The banks are increasingly turning turned to new, non-traditional financial activities as a way of maintaining their position as financial intermediaries . Integration of all the three business in the form of diversified financial group can play a compensatory role. But inspite of this significant relationship these three businesses require varying business skills and operational skills. There is also a difference in attitude towards risk. Commercial banks avoid risk, insurance business aims to cover risk while investment banks specialize in risk management. Moreover, these three business have different approach towards customers. Therefore, these factors have to be kept in consideration, while integrating and diversifying the banking operations.

Rationale Behind Diversification

During the second half of the 1990s many Indian banks have indeed adopted universal banking structures (in different forms and degrees) as a strategic response to increased competition in both domestic as well as global market. Bank s pursue diversification move for variety of reasons which may both be proactive and defensive. Disintermediation in commercial banking in combination with new capital adequacy rules and narrowing interest margins led to an increased pressure on the banks profitability. In response, commercial banks are diversifying by moving towards generating income from nontraditional sources like fee and fund based services. Beside this, Diversification in the banking sector has emerged from a host of considerations. Diversification helps a bank in eliminating the unevenness of geographical reach, product-process innovation, exploit economies of scale and scope, reap benefit of advanced technology, diversify risk along with mobilization of additional capital. Diversification has opened the door for commercial banks to earn fee income from investment banking, merchant banking, insurance agency, securities brokerage, and other nontraditional financial services. Ali- Yrkko (2002), classifies the banks' motive to diversify as synergy (or economic) motive, managerial motive, value maximization motive, increased market power motive, capital strength and risk diversification motives etc. Determinants of diversification can be categorized into two categories. External determinants such as Economies of Scale and Scope, Dynamics of bank Competition, Global presence of Financial Conglomerates and Disintermediation in banking activities. While the internal determinants include risk reduction motive, decline in interest margin, cost of production, low cost of capital, technology upgradation etc.

In this paper an attempt is made to study the nature and extent of diversification in Indian banking sector. The paper has been structured as follows. In the beginning, a brief introduction and rationale for diversification in banks is given. Section I deals with research methodology .In Section II, nature and extent of diversification in banks is studied. Degree of diversification is empirically measured in section III. This is followed by results and implications for the banking sector.

Section I

The objective of this paper is to analyze the

1) Nature and Extent of Diversification in the Indian Banking Sector

2) To Measure the Degree of Diversification in Indian Banks.

Research Methodology and Data Source

The purpose of the first part of this research paper is to study the pattern of diversification followed by banks in India and to analyze the extent to which they are diversified in respect of their operation and location. For this, it is required to differentiate between diversified banks from non-diversified banks. In the present study, those banks will be included in the definition of diversified banks, which have at least one insurance subsidiary or investment institution or both. These may be in the form of a subsidiary, joint venture or in any other mode such as alliance distribution etc. Second objective of the study is to measure the degree of diversification in banks. The degree of diversification is a measure of the diversity status of the bank and gives an indication how diversified a bank is. The entropy index prescribed by (Jacquemin and Berry, 1979) will be used to measure the degree of diversification. The present study will be focused to Indian banking sector only and analysis will be restricted to all the public and private sector banks excluding foreign sector and regional rural sector banks. Foreign sector banks are excluded from the study because most of these banks are well diversified. Moreover they have a minor presence in India in the form of a representative office or a branch office. For instance, Bank of America has a maximum of only 13 branches operating in India.

Database of Banks

Data used for the paper is secondary in nature. Data is collected from several sources which include database provided by Reserve Bank of India, Indian Bankers Association, Prowess and Capitaline software's. The data on bank-specific variables have been extracted from the statistical tables relating to banks in India, an annual publication of the Reserve Bank of India (RBI), which provides bank-wise information on balance sheet as well as profit and loss indicators.

Section II

Banking sector practices a wide range of organization structures to expand their business. To study the Nature and Extent of Diversification in Banks , the approach developed by Ramanujam and Varadarajan(1987) will be used. In their study, the authors have used a two dimensional, categorical measure of firm diversity that builds on the work of Berry (1971) and Wood (1971). Wood (1971) has defined two patterns of diversification i.e., NSD (Narrow Spectrum Diversification) and BSD (Broad Spectrum Diversification). These two types of categorizations will be used with little variation along with a third category that is AD (Alliance Diversification). This is a common diversification strategy used in service sector. For the purpose, following definitions will be used to study nature and extent of diversification in Indian banking sector.

* BSD(unrelated product diversification)--Broad Spectrum Diversification refers to expansion other than vertical integration into a different four-digit business. i.e., into a different non-banking business like merchant banking, factoring etc.

* NSD(related product diversification)--Narrow Spectrum Diversification refers to expansion through vertical integration into similar banking business through banking subsidiaries.

* AD- Alliance Diversification refers to expansion of banking and non banking through tie-ups, joint ventures.

* BSD (Broad Spectrum Diversification) and UB (Unrelated Business)

* NSD (Narrow Spectrum Diversification) and RB (Related Business)

* AD (Alliance Diversification)

Figure 1 shows the nature of diversification in Indian banking sector. In respect of public sector banks in India, out of a total of 21 banks, 12 banks are diversified and 9 banks are non diversified as on 31st March 2008. This includes IDBI ltd (other public sector bank) which is a well diversified bank. State Bank of India, has adopted both BSD (Broad spectrum diversification) move and NSD (Narrow spectrum diversification) move along with AD(Alliance diversification). It has six banking subsidiaries and four non banking subsidiaries along with many foreign subsidiaries. SBI has entered a number of new businesses with strategic tie ups - Pension Funds, General Insurance, Custodial Services, Private Equity, Mobile Banking, Point of Sale, Mergers and Acquisition, Advisory Services, Structured Products etc. Bank of Baroda is another bank which has adopted all the three moves for diversification. In NSD, it has one associate bank i.e., Nanital Bank and several subsidiaries dealing with banking and non banking business. It has diversified into areas of merchant banking, housing finance, credit cards and mutual funds as a move to become a one stop financial supermarket. Banks like Canara bank, Central Bank of India, Corporation Bank, Allahbad bank have diversified through BSD move. Canara Bank has been scaling up its market position to emerge as a major 'Financial Conglomerate' with nine subsidiaries/sponsored institutions/joint ventures in India and abroad. While Allahbad bank Instituted AllBank Finance Ltd., a wholly owned subsidiary for Merchant Banking. Andhra Bank , Canara Bank, Indian Bank and Punjab and Sind Bank have started diversification move through AD .i.e., Alliance Diversification. Andhra Bank entered MoU with Bank of Baroda and Legal and General Group of UK to form a joint venture life insurance company.

In case of Private sector banks, old private sector banks are not diversified at all, while most of the new generation private sector banks are highly diversified. HDFC Bank, ICICI Bank, Indusind Bank, Kotak Mahindra Bank and ING Vysya Bank are categorized as banks that have followed BSD (Broad spectrum Diversification) and AD (Alliance Diversification) to expand their banking and non banking products and services. HDFC Bank's target market ranges from large, blue-chip manufacturing companies in the Indian corporate to small and mid-sized corporate and agri-based businesses. The bank provides a wide range of commercial and transactional banking services, including working capital finance, trade services, transactional services, cash management, etc. ICICI Bank is India's second-largest bank in India. ICICI Bank offers a wide range of banking products and financial services to corporate and retail customers through a variety of delivery channels and through its specialized subsidiaries and affiliates in the areas of investment banking, life and non-life insurance, venture capital and asset management. Most of these banks are diversifying through Broad Spectrum diversification, either through their own non-banking subsidiaries such as securities houses or insurance companies or have become heavily involved in product sales such as bancassurance or mutual funds etc. In private sector banks, UTI Bank and Yes bank are not diversified and are dealing in single banking business only.

Section III

Measurement of Degree of Diversification

To measure the degree of diversification numerous methods like Entropy measure(Jacquemin and Berry, 1979) Concentric Index, and Herfindhal Index have been used in the litreature of strategic and financial management. However , entropy measure "quantified as a continuous one" has remained widely used as a measures for diversification. The entropy measure is attractive, it is argued, because it takes into account "two elements of diversification: (i) the number of segments in which a firm operates, and (ii) the relative importance of each of the segments in the total sales" reviewed (Palepu, 1985). The entropy measure of a firm's diversification is defined as "a weighted average of a firm's diversification within sectors" (Jacquemin and Berry, 1979, p. 362), "a weighted average of the shares of the segments" (Palepu, 1985, p. 252). The weight is assumed to be the logarithm of the inverse of the proportion of total business in each segment (Chatterjee and Blocher, 1992). The higher this index, the more diversified the bank is.

Enropy measure = [n.summation over (i=1)] [P.sub.i] where [Pi] is the proportion of total operations within segment I,n is number of segments in which the bank operates.

In the table below, diversification index for banking groups namely SBI (State Bank of India and associates), NBs (National banks) and Pvt banks(New Generation Private Bank)* operating in India is computed for the time period between 1994 to 2007.This time period is selected because most banks have started diversification moves after the implementation of economic and financial sector reforms of 1991. From these respective groups income of those banks which are not diversified(as shown in table 1) is excluded as they operate in single banking business. For computing Pi i.e, proportion of 'income from diversified operation and services', Income from other sources i.e, income from other than interest income is computed. Income from other sources consist of commission, exchange and brokerage, net profit (loss) on sale of land, building and other assets, net profit (loss) on exchange transaction, miscellaneous income, net profit (loss) on sale of investments, net profit (loss) on revaluation of investments, is taken. By using the entropy index of Jacqueimin and Berry (1979), diversification index of banking sector operating in India is computed.

As shown in the table 1, in the year 1994-1995, diversification level is highest in SBI (0.529) followed by National banks (.4099). It the least i.e, (0.223) in private sector banks. This was the period when new generation private sector banks were being setup . By 1995-96, a total of nine private sector banks were in operation. Over this period, index of private banks have increased continuously indicating that these banks started to rely more on diversified source of income that is on "other income". Diversification index of state bank of India, over the time period of 1994 to 2006 remained the highest with six banking subsidiaries and a number of non banking subsidiaries and joint ventures. In the year 2007, the diversification index of private banks rose to 0.516 which is even higher then SBI group followed by national banks. In respect of national banks, a mixed trend is seen in their diversification index.

Conclusion

To conclude, the study reveals that out of a total sample of 48 banks operating in India consisting of public and private sector banks, 18 banks are diversified while majority of banks i.e, 30 banks are not diversified. But it is significant to mention that the non diversified banks hold very less proportion in term of market and asset size signifying that the bigger banks have gone in for diversification. The trend towards diversification in banks is found higher in respect of public sector banks as12 public sector banks are diversified while out of private sector banks, only new generation banks are diversified. SBI has emerged as one of the well diversified bank by venturing into number of banking and non banking business through subsidiaries, joint ventures and tie-ups. In second part, degree of diversification in banks is measured by using entropy index of diversification. Diversification index of State Bank of India has remained highest over the time period of 1994 to 2006. While private sector banks have started diversification move in 1994-1995 with their emergence. On an average as per entropy measure they have become more diversified from the year 2000 onwards with index at 0.403 and reaching upto as high as 0.516 in 2007. The diversification index of National Banks shows a fluctuating trend. This shows that even though only new generation private sector banks have diversified but their degree of diversification is higher than national banks.

References

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Sangeeta Arora

Senior Lecturer,

Guru Nanak Dev University, Amritsar.

Shubpreet Kaur Sidhu

Lecturer in Commerce,

Lyallpur Kahlsa College, Jalandhar.
Table--I
Measure of Diversification in Indian Banks (Entropy measure)

Year   SBI        N B      Pvt. Bank

1994   0.529644   0.4099   0.223
1995   0.526056   0.4151   0.281
1996   0.53017    0.3286   0.408
1997   0.529484   0.3274   0.436
1998   0.521502   0.3275   0.383
1999   0.528029   0.3280   0.359
2000   0.522042   0.3294   0.403
2001   0.524283   0.3296   0.372
2002   0.499872   0.3221   0.443
2003   0.501679   0.4256   0.487
2004   0.512042   0.3231   0.457
2005   0.512246   0.3542   0.458
2006   0.509631   0.4301   0.487
2007   0.464591   0.3286   0.516

Figure--I
Measure of Diversification in Indian Banks (Entropy measure)

S. BANKS                    DIVERSIFIED    NON DIVERSIFIED
No.                         BANKS          BANKS

                            BSD     NSD    AD

I Public Sector Banks

1. State Bank of India      *****   ****   ****
   and Associates           UB      RB     RB & UB

2. Allahbad bank            ****
                            UB
3. Andhra Bank                             ****
                                           RB

4. Bank of Baroda           ****    ****   ****
                            UB      RB     RB

5. Bank of India            ****           ****
                            UB             RB & UB

6. Bank of Maharastra                                ****
                                                     ND

7. Canara Bank              ****           ****
                            UB             RB & UB

8. Central Bank of India    ****
                            UB

9. Corporation bank         ****
                            UB

10. Dena Bank                                        ****
                                                     ND

11. Indian Bank             ****           ****
                            UB             UB

12. Indian Overseas Bank                             ****
                                                     ND

13. Oriental bank of                                 ****
Commerce                                             N D

14. Punjab & Sind Bank                     ****
                                           UB

15. Punjab National bank                   ****
                                           UB

16. Syndicate Bank                                   ****
                                                     ND

17. Uco Bank                                         ****
                                                     ND

18. Union Bank of India                              ****
                                                     ND

19. United Bank of India                             ****
                                                     ND

20. Vijaya Bank                                      ****
                                                     ND
II Other Public Sector Bank

21. Idbi Ltd.               ****
                            UB

III Private Sector Banks

22. Bharat Overseas                                  ****
Bank                                                 ND

23. City Union Bank Ltd                              ****
                                                     ND

24. Development                                      ****
Credit Bank                                          ND

25. Karnataka Bank                                   ****
                                                     ND

26. Lord Krishna Bank                                ****
                                                     ND

27. Nainital Bank                                    ****
                                                     ND

28. SBI Commercial &                ****
International Bank                  RB

29. Tamilnad                                         ****
Mercantile Bank                                      ND

30. The Bank of                                      ****
Rajasthan Ltd.                                       ND

31. The Catholic Syrian                              ****
Bank Ltd.                                            ND

32. The Dhanlaxmi                                    ****
Bank Ltd.                                            ND

33. The Federal Bank Ltd                             ****
                                                     ND

34. The Ganesh Bank                                  ****
of Kurundwad Ltd                                     ND

35. The Jammu &                                      ****
Kashmir Bank Ltd.                                    ND

36. The Karur Vysya                                  ****
Bank Ltd                                             ND

37. The Laxmi Vilas                                  ****
Bank Ltd                                             ND

38. The Ratnakar                                     ****
Bank Ltd                                             ND

39. The Sangli Bank Ltd                              ****
                                                     ND

40. The South Indiian                                ****
Bank Ltd                                             ND

41. The United Western                               ****
Bank Ltd                                             ND

42. Hdfc Bank Ltd           ****           ****
                            UB             UB

43. Icici Bank Ltd          ****           ****
                            UB             UB

44. Indusind Bank Ltd       ****           ****
                            UB             UB

45. Kotak Mahindra          ****           ****
Bank Ltd                    UB             UB

46. Uti Bank Ltd                                     ****
                                                     ND

47. Yes Bank Ltd.                                    ****
                                                     ND

48. Ing Vysya Bank Ltd.     ****           ****
                            UB             UB

Total No. of Banks          14      3      13        30
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Author:Arora, Sangeeta; Sidhu, Shubpreet Kaur
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Date:Oct 1, 2009
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