HDFC Bank 2007-2008 Annual Report

HDFC BANK LIMITED

ANNUAL REPORT 2007-2008

DIRECTOR'S REPORT

To The Members,

Your Directors have great pleasure in presenting the of your Bank together with the audited accounts for the Fourteenth Annual Report on the business and operations year ended March 31, 2008.

Financial Performance:

(Rs. in crores) For the year ended March 31, 2008 March 31, 2007

Deposits and Other Borrowings 105,247.5 71,113.3Advances 63,426.9 46,944.8Total Income 12,398.2 8,164.2*Profit before Depreciation and Tax 2,552.4 1,858.4Net Profit 1,590.2 1,141.5Profit brought forward 1,932.0 1,455.0Total Profit available for Appropriation 3,522.2 2,596.5Appropriations:Transfer to Statutory Reserve 397.5 285.4Transfer to General Reserve 159.0 114.1Transfer to Investment Reserve Account (net) 38.5 3.0Proposed Dividend 301.3 23.6Tax including Surcharge and Education Cess 51.2 38.0on Dividend Dividend paid for Prior Years 0.1 10.4Balance carried over to Balance Sheet 2,574.6 1,932.0

* Change pursuant to reclassification.

The Bank posted total income and net profit of Rs. 12,398.2 crores and Rs.1,590.2 crores respectively for the financial year 2007-08 as against Rs.8,164.2 crores and Rs. 1,141.5 crores respectively in the previous year. Appropriations from the net profit have been effected as per the table given above.

Dividend:

Your Bank has had a consistent dividend policy of balancing the twin objectives of appropriately rewarding shareholders and retaining capital to maintain a healthy capital adequacy ratio to support future growth. It has had a consistent track record of moderate but steady increases in dividend declarations over the last so many years with the dividend payout ratio ranging between 20% and 25%. In line with this, and in recognition of the robust performance during 2007-08, your directors are pleased to recommend a dividend of 85% for the year ended March 31, 2008, as against 70% for the year ended March 31, 2007. This dividend shall be subject to tax on dividend to be paid by the Bank.

Awards:

As in the past years, awards and recognition have been conferred on your Bank by leading domestic and international organizations during the fiscal 2007-08. Some of them are:

* For the fifth consecutive year, your Bank has bagged the Business Today's Best Bank Award.

* Outlook Money and NDTV Profit's Best Bank in the private sector category.

* Bombay Stock Exchange and Nasscom Foundation's Business for Social Responsibility Award.

* 'Dun & Bradstreet -American Express Corporate Best Bank Award 2007.' There were 26 categories in all, including FMCG, Telecom and Software & IT.

* The Financial Express-Ernst &Young Best Bank award in the Private Sector category - Your bank shared the top slot with another bank

* The Asia Pacific HRM Congress in Mumbai -Your Bank bagged as many as ten awards including "Organisation with innovative HR Practices".

* Business Today Survey conducted by the Monitor Group Innovation Study - Your Bank is one of India's most innovative 28 companies across ten major business sectors

* The `Asian Banker Excellence in Retail Financial Service Awards'- The Best Retail Bank in India

Ratings:

The Bank has its deposit programs rated by two rating agencies - Credit Analysis & Research Limited (CARE) and Fitch Ratings India Private Limited. The Bank's Fixed Deposit programme has been rated `CARE AAA (FD)' [Triple A] by CARE, which represents instruments considered to be "of the best quality, carrying negligible investment risk0". CARE has also rated the bank's Certificate of Deposit (CD) programme "PR 1+" which represents "superior capacity for repayment of short term promissory obligations". Fitch Ratings India Pvt. Ltd. (100% subsidiary of Fitch Inc.) has assigned the "tAAA (ind)" rating to the Bank's deposit programme, with the outlook on the rating as "stable". This rating indicates "highest credit quality" where "protection factors are very high".

The Bank also has its long term unsecured, subordinated (Tier II) Bonds rated by CARE and Fitch Ratings India Private Limited and its Tier I perpetual Bonds and Upper Tier II Bonds rated by CARE and CRISIL Ltd. CARE has assigned the rating of "CARE AAA" for the subordinated Tier II Bonds while Fitch Ratings India Pvt. Ltd. has assigned the rating "AAA(ind)" with the outlook on the rating as "stable". CARE has also assigned "CARE AAA [Triple A] for the Banks Perpetual bond and Upper Tier II bond issues. CRISIL has assigned the rating "AAA/Stable" for the Bank's perpetual Debt programme and Upper Tier II Bond issue. In each of the cases referred to above, the ratings awarded were the highest assigned by the rating agency for those instruments.

Additional Capital:

In June 2007, the Bank allotted 1,35,82,000 equity shares of Rs. 10/- each at a premium of Rs. 1,013.49 per share on a preferential basis to Housing Development Finance Corporation Ltd. (HDFC) aggregating to Rs. 1,390 crores. In July 2007, the Bank made a public offering of 6,594,504 American Depository Shares (ADS), each ADS representing three equity shares, at a price of $ 92.10 per ADS aggregating to of Rs. 2,394 crores (net of underwriting discounts and commissions).

During the year under review, 16.78 lacs shares were allotted to the employees of your Bank pursuant to the exercise of options under the Employee Stock Option Scheme of the Bank.

Employee Stock Options:

The information pertaining to Employee Stock Options is given in an annexure to this report.

Capital Adequacy Ratio:

Your Bank's total Capital Adequacy Ratio (CAR) stood at a healthy 13.6%, well above the regulatory minimum of 9.0%. Of this, Tier I CAR was 10.3%.

Amalgamation of Centurion Bank of Punjab Limited with the Bank:

On March 27, 2008, the shareholders of the Bank accorded their consent to a scheme of amalgamation of Centurion Bank of Punjab Limited with HDFC Bank Limited. The shareholders of the Bank approved the issuance of one equity share of Rs.10/- each of HDFC Bank Limited for every twenty nine equity shares of Re.1/- each held in Centurion Bank of Punjab Limited. This is subject to receipt of approvals from the Reserve Bank of India, stock exchanges and other requisite statutory and regulatory authorities. The shareholders also accorded their consent to issue equity shares and/ or warrants convertible into equity shares at the rate of Rs. 1,530.13 each to HDFC and/or other promoter group companies on preferential basis, subject to final regulatory approvals in this regard. The Shareholders of the Bank have also approved an increase in the authorized capital from Rs. 450 crores to Rs. 550 crores.

SUBSIDIARY COMPANIES:

In terms of the approval granted by the Government of India, the provisions contained under Section 212(1) of the Companies Act, 1956 shall not apply in respect of the Bank's subsidiaries namely, HDFC Securities Limited (HSL) and HDB Financial Services Limited (HDBFSL). Accordingly, a copy of the balance sheet, profit and loss account, report of the Board of Directors and Report of the Auditors of HSL and HDBFSL have not been attached to the accounts of the Bank for the year ended March 31, 2008.

Investors who wish to have a copy of the annual accounts and detailed information on HSL and HDBFSL may write to the Bank for the same. Further, the said documents shall also be available for inspection by the investors at the registered offices of the Bank, HSL and HDBFSL.

MANAGEMENT'S DISCUSSIONS AND ANALYSIS:

Macro-economic and Industry Developments:

In the 25 years till 2007, the country's real GDP grew on an average at 6.2% per annum. In the last four years, however, GDP growth has been faster at 8.8% per annum. The real GDP growth for 2007-08 is expected to have been between 8.7-8.9%. Investment expenditure, so crucial to economic growth, increased from 22.8% of GDP in FY02 to 35.9% in FY07. The domestic savings rate increased from 23.5% in FY02 to 34.8% in FY07.

The services sector with a share of nearly 60% in India's GDP and accounting for almost three-fourth in its overall growth, continues to be the key driver. The manufacturing sector has shown good growth too on the back of domestic and export-led demand. The country's merchandise exports have grown by a healthy 21.6% in the April 07-January 08 period as compared to 23.7% in the corresponding period of previous year.

For most part of the year, liquidity in the banking system was volatile but largely in surplus due to strong capital flows and softening credit demand. The Reserve Bank of India (RBI) followed a tight monetary policy to check inflationary pressures arising to a large extent, out of hardening global energy and commodity prices. The RBI increased reserve requirements to suck out excess liquidity from the banking system directly and raised the Cash Reserve Ratio (CRR) by 150 basis points during the financial year ended March 31 2008.

Deposit rates remained flat (7.50% to 9.00% p.a.) for most of the first half of the year, but rose by about 0.5% p.a. across tenors in September 2007, primarily due to the onset of the `busy' credit season and tightening of monetary policy. Longer tenor yields, however fell by roughly 0.5% on the back of falling credit demand. The short tenor deposit rates, however, moved up by 0.25% in December 2007 but did not see the sharp spike that had been experienced in the March 2007 quarter.

The yield on the one-year government security (G-sec), which largely reflects the liquidity in the economy, fell by 15 basis points to 7.52% in first half of the financial year. The 10-year G-sec yield dropped by about 40 basis points to 7.6% during the same period. However, high inflation numbers in March 2008, and market apprehensions of large debt issuance by the government pushed the yields up in the second fortnight of March 2008.

Some signs of moderation in growth became apparent in 2007-08. Retail consumer borrowing and spending slowed down in the second half of 2006-07 in the wake of the monetary tightening. This has impacted sectors like automobiles and consumer durables where consumer credit has played a key role in driving demand. Rise in interest rates has also taken its toll on demand for housing and the growth of the real estate sector. Non-food credit clocked a 22% growth in the last fortnight of February 2008 as against 28.9% in the last week of March 2007. However, downward revisions (of 50 basis points on an average) in lending rates in the March 2008 by a number of banks could reverse this trend at least partially.

On the foreign trade side, though overall exports showed an accelerated growth during the last year, a number of sectors such as textiles, handicrafts, and leather products saw growth moderating. The rupee appreciated sharply over the last year (by as much as 11%), which was largely responsible for the deceleration in exports. The prospect of a slowdown in the global economy has increased the risk of a prolonged slowdown in exports.

Imports however remained robust in 2007-08, growing almost 30% in the first three quarters of the year (as against 22% for the corresponding period last year) on the back of higher global prices of oil and food. This widened the trade deficit to USD 67 billion in April-January FY08 from USD 45 billion in the corresponding period of previous year. Despite the increase in the trade deficit, overall, balance of payments was comfortable due to large capital inflows (comprising mainly foreign direct investment, portfolio inflows and external borrowings). Foreign exchange reserves grew by $107 billion during the year.

Indian equity markets gained sharply in the first nine-months of 2007-08. However, as the global financial crisis deepened, benchmark indices fell sharply in the last quarter. Markets are likely to track the global financial markets and remain volatile in 2008-09 although the Indian economic fundamentals still remain strong and attractive in absolute terms. Diminished risk appetite among investors could adversely impact capital inflows into emerging markets like India.

(Sources: Ministry of Finance, RBI, CSO)

Industry structure and development:

Indian banks faced a new set of challenges brought about by changes in both the international and domestic environment. International credit markets tightened considerably on the back of rising defaults and foreclosures in the US mortgage market and the resultant risk aversion. Its impact was first felt in the mortgage-linked securities and the inter-bank money markets. A number of large US and European banks reported large loan losses and writedowns. The contagion effects subsequently spread to other asset classes including emerging markets bonds and equities. The expectation is that the turmoil in the financial sector will spill over to the real estate sector. Growth in the G-7 economies, particularly the US is expected to be lower in 2008 and this is likely to impinge on growth in other economies, including India.

The Indian economy appeared to have entered a phase of moderation in 2007-08. The Central Statistical Organisation (CSO) has estimated a decline in the growth rate of India's Gross Domestic Product (GDP) to 8.7% in 2007-08 from 9.6% in 2006-07. The growth in credit off-take from scheduled commercial banks (measured year on year) has fallen to 21.9% in the last fortnight of February 2008 from 28.2% in the first half of April 2007.

Risks and concerns:

While Indian banks have limited direct exposure to the international markets for mortgage linked securities, they are unlikely to be completely insulated from the turmoil in the global financial markets. Reduced availability of global finance through external commercial borrowings on the back of rising risk aversion in the global markets could affect domestic growth, particularly investments in capacity expansion. This in turn could have some impact on demand for domestic credit.

Lower capital inflows could also impact domestic liquidity, which has largely been a function of external capital inflows for most of 200.7-08 with the ratio of net foreign exchange assets to reserve money consistently exceeding 100%.

The initial moderation in bank credit growth rates in 200708 seems to have been largely confined to the retail segment (housing, consumer durables and auto loans). It is possible that the moderation in growth in 2008-09 could be more broad-based, affecting both retail and certain wholesale segments, due to trends in consumption and capital formation. This has obvious implications for the credit portfolio of the banking system. A low 2.1% growth in the `capital goods' component of the index of industrial production (IIP) for January 2008 seems to indicate a further decline in investment demand going forward which could affect overall credit growth for the banking system, particularly in term loans and project finance.

Rising global commodity prices created inflationary pressures for most of 2007-08. A benign `base-effect' and the suppression in the petroleum product prices kept headline wholesale price inflation in a comfort zone for the first three quarters of the year. However, given the focus on managing underlying price pressures rather than headline inflation, monetary policy showed no signs of easing in 2007-08. Thus banks operated in an environment where the central bank did not allow any surplus liquidity in the system, resulting in interest rates remaining firm.

Despite the prospect of a slowdown in the global economy, commodity price pressures, particularly those in food and mineral oils, show little sign of abating. As the base-effect wears off, headline inflation is likely to ramp up to well over 7%. So, inflation concerns are likely to influence monetary policy stance going forward and the prospect of an economic slowdown need not entail immediate monetary easing. Thus, the operating environment of banks in 200809 could be a combination of slower credit growth and some upward bias in interest rates.

Opportunities:

The financial system in India has witnessed considerably less turmoil and volatility than that in advanced economies.

Given this scenario, domestic corporates are more likely to turn to local sources of funding. Cyclical slowdown is unlikely to impact segments of the economy such as agriculture where a structural shift is under way. The rural economy has been the greater focus of government policy in recent years, and significant opportunities lie for banks here where the penetration of credit and financial products is still relatively low.

The central and state governments appear to be driving an ambitious programme in the infrastructure sectors. The eleventh five year plan (2007-2012) envisages an investment of USD 500 billion, with approximately USD 80 billion envisaged for 2008-09 alone. This presents a major opportunity for banks and financial institutions to finance these investments.

Although growth in retail credit has moderated in the last year, the low penetration levels of retail credit (estimated at less than 12% of GDP), the shift in demographics towards a higher proportion of younger working population, the changing attitudes towards borrowings, higher income levels amongst the growing middle class, and the large pent-up demand for housing, cars etc., all augur well for the long-term, sustainable growth of retail lending in the Indian market.

Outlook:

The Indian economy seems likely to see some moderation in growth rates in 2008-09 relative to 2007-08. It is still likely to experience healthy growth in absolute terms and will probably remain one of the fastest growing economies in the world. Nonetheless, with a lower GDP growth coupled with tighter liquidity conditions (as RBI tackles concerns on inflation) and stable or slightly higher interest rates, system credit growth is likely to be lower than in 2007-08. Downward pressures on economic growth may not immediately translate into an expansionary monetary policy, given the continued risks of inflation from global energy and commodity prices. Thus, slightly slower credit growth could coexist with firm, if not rising, interest rates. Given India's strong macro-economic fundamentals, however, structural drivers will continue to support growth which is a positive for banks as well.

Mission end Business Strategy:

Our mission is to be "a World Class Indian Bank", benchmarking ourselves against international standards and best practices in terms of product offerings, technology, service levels, risk management and audit & compliance. The objective is to build sound customer franchises across distinct businesses so as to be a preferred provider of banking services for target retail and wholesale customer segments, and to achieve a healthy growth in profitability, consistent with the Bank's risk appetite. We are committed to do this while ensuring the highest levels of ethical standards, professional integrity, corporate governance and regulatory compliance.

Our business strategy emphasizes the following:

* Increase our market share in India's expanding banking and financial services industry by following a disciplined growth strategy focusing on balancing quality and volume growth while delivering high quality customer service;

* Leverage our technology platform and open scaleable systems to deliver more products to more customers and to control operating costs;

* Maintain high standards for asset quality through disciplined credit risk management;

* Develop innovative products and services that attract our targeted customers and address inefficiencies in the Indian financial sector;

* Continue to develop products and services that reduce our cost of funds; and

* Focus on healthy earnings growth with low volatility.

Financial Performance:

The financial performance during the fiscal year 200708 remained healthy with total net revenues (net interest income plus other income) increasing by 50.7% to Rs. 7,511.0 crores from Rs.4,984.7 crores in 2006-07. The revenue growth was driven principally by an increase in net interest income. Net interest income grew by 50.7% primarily due to increase in the average balance sheet size by 39.8% and an increase in net interest margin from 4.0% to around 4.4%. The key driver in volumes was growth in advances. Margin expansion was contributed by increase in yields across all products partially offset by increase in time deposit costs.

The other income (non-interest revenue) increased by 50.6% to Rs. 2,283.2 crores primarily due to fees and commissions, profit/(loss) on revaluation / sale of investment and income from foreign exchange and derivatives income. In 2007-08, commission income increased by 32.7% to Rs. 1,714.5 crores with the main drivers being commission from distribution of third party mutual funds and insurance, fees on debit/credit cards, transactional charges/fees on deposit accounts, processing fees of retail assets and cards, and fees from trade products. The Bank earned a profit on sale / revaluation of investments of Rs. 241.8 crores during the year. Foreign exchange and derivatives revenues grew from Rs. 280.3 crores to Rs. 319.8 crores which largely related to customer transactions. Of this, 80% of the revenues came from plain vanilla foreign exchange transactions.

Operating (non-interest) expenses increased from Rs. 2,420.8 crores in 2006-07 to Rs. 3,745.6 crores in 200708, due to higher infrastructure and staffing expenses in relation to the expansion in the branch network, (including branches which were in the process of being set up and would be commissioned in the June 2008 quarter) and growth in the retail loan and credit card businesses. Operating cost to net revenues increased to 49.9%, from 48.6% in the corresponding year. Staff expenses accounted for 34.7% of non-interest expenses in 2007-08 as against 32.1% in 2006-07, due to an increase in staff strength and increase in average salary levels. A large portion of the increase has been in the direct sales infrastructure which stepped the pace of liability and card account acquisitions substantially during the year. Loan loss provisions and provision for standard assets increased from Rs. 861.0 crores to Rs. 1,216.0 crores in 2007-08 which was broadly in line with the increase in retail loans and the product mix across various loan products. The Bank also provided Rs. 264.4 -crores as contingent provisions for tax, legal and other contingencies.Net profit increased by 39.3% from Rs. 1,141.5 crores in 2006-07 to Rs.1,590.2 crores in 2007-08. Return on average net worth was lower at 16.1% as against the previous year of 19.4% due to expansion of networth as a result of infusion of over Rs. 3,800 crores of capital during the year. The Bank's basic earning per share increased from Rs.36.3 to Rs.46.2 per equity share.

During 2007-08, the Bank's total balance sheet size increased by 46.0% to Rs. 133,177 crores. Total Deposits increased from Rs. 68,298 crores (as of March 31, 2007) to Rs. 100,769 crores (as of March 31, 2008). With Savings account deposits at Rs. 26,154 crores and current account deposits at Rs.28,760 crores, demand (CASA) deposits were around 54.5% of total deposits as of March 31, 2008. During 2007-08, gross advances grew by 35.8% to Rs.67,582 crores. This was driven by a growth of 38.8% in retail advances to Rs. 39,316 crores, and an increase of 31.8% in wholesale advances to Rs.28,266 crores.

Business Segment Update:

As in the past, this year too the bank has been able to achieve healthy growth across various operating and financial parameters. This performance reflects the strength and diversity of the bank's three primary business franchises- retail banking, wholesale banking and treasury, and of its disciplined approach to risk - reward management.

The retail banking business continued its growth in 2007-08. In this business, your Bank has positioned itself as a one-stop shop financial services provider, catering primarily to the middle class, mass affluent and high networth customers. Your Bank's range of retail financial products and services is fairly exhaustive and includes deposit products of virtually all types, loans, credit cards, debit cards, depository (custody services), investment advisory, bill payments and several transactional services. Apart from its own products, your Bank sells third party financial products like mutual funds and insurance too. To provide its customers greater flexibility and convenience as well as to reduce servicing costs, the bank has invested in multiple channels - branches, ATMs, phone banking, internet banking and mobile banking. The success of the Bank's multi-channel strategy is evidenced in the fact that almost 83% of customer initiated transactions are serviced through the non-branch channels. Your Bank's data warehouse and Customer Relationship Management (CRM) solutions have helped it target existing and potential customers more effectively and cost effectively and offer them products appropriate to their profile and needs. Reduced costs of acquisition apart, this has also led to deepening of customer relationships and lower credit losses.

Your Bank's total customer base increased to over 11.6 million. On the distribution side, your Bank added 77 new branches during the year to take the total to 761 branches (across 327 cities) as of March 2008 from 684 branches (in 316 cities) in March 2007. 372 new ATMs were also added during 2007-08 taking the size of the ATM network from 1605 to 1977. Your Bank's focus on semi-urban and under-banked markets continued, with 58% of the Bank's r branches now outside the top nine Indian cities. Savings account deposits, which reflect the strength of the retail liability franchise, grew by 33.5% to Rs 26,154 crores in 2007-08. The retail gross loan portfolio grew 38.8% to Rs 39,316 crores during the year.

In credit cards, your Bank continued with its strategy of focusing on quality customer acquisitions and improving processes to reduce cycle times and bringing in cost efficiencies. Your Bank had 3.8 million cards in force as at March 2008. It has a significant presence in the "merchant acquiring" business also with the total number of point-of sale'(POS) terminals installed at over 61,000. On housing loans, your Bank continued originating home loans under its arrangement with Housing Development Finance Corporation with monthly home loan origination crossing Rs.550 crores (sanctions) by March 2008. During the year, the Bank did not exercise its option to take any part of the 70% of its HDFC home loan origination that it has the right to take back on its books as "AAA" mortgage backed securities.

The wholesale banking business too registered a robust growth in 2007-08. In this business, the Bank provides its corporate and institutional clients a wide range of commercial and transactional banking products, backed by high quality service and relationship management. The Bank's commercial banking business covers not only the top end of the corporate sector but also the emerging corporate segments and other small and medium enterprises (SMEs). The Bank now has four business groups catering to various SME customers with a wide range of banking services covering their working capital and term finance, trade services, cash management, foreign exchange and electronic banking requirements.

During financial year 2007-08, growth in the wholesale banking business continued to be driven by new customer acquisition and higher cross-sell with a focus on optimizing yields and increasing product penetration. Your Bank's cash management and vendor & distributor finance products continued to be an important contributor to growth in the corporate banking business. Your Bank further consolidated its position as a leading player in the cash management business (covering all outstation collection, disbursement and electronic fund transfer products across the Bank's various customer segments) with volumes growing to over Rs. 24 trillion an increase of more than 80% over the volumes in FY 2006-07. Your Bank also strengthened its market leadership in cash settlement services for major stock exchanges and commodity exchanges in the country. Yet again, your Bank met the overall priority sector lending requirement of 40% of net bank credit and improved its performance in certain sublimits where it fell short of the requirements.

Your Bank also achieved healthy growth in its agriculture and micro-finance portfolios. With products including the Kisan Gold Card, rural supply chain initiatives and commodity finance the Bank is well positioned to meet its customers' requirements across the entire agriculture financing cycle.

Your Bank's experience with its hub and spoke model for rural markets has been positive so far. Through this route, your Bank has targeted potential outreach locations within a certain radius of its semi-urban and rural branches, distributing a set of products that includes savings accounts, fixed deposits, two-wheeler and auto loans, kisan card crop loans, tractor loans and warehouse receipt loans. The Bank has also rolled out special rural fixed deposit and savings account products. The specially designed rural savings account includes features such as mobile banking, net banking, instant alerts and payable-at-par cheque books. The Bank also has specialised Agri Desks at certain branches across the country which works as a single point contact for farmers.

The Bank has relationships with 110 micro finance institutions and has extended credit facilities, whereby 1.61 million households have been beneficiaries of financial inclusion. In addition, the Bank under the direct SHG linkage programme, has credit-linked and financed over 32,000 Self-Help Groups with roughly half a million households benefiting from this.

The treasury group manages the Bank's balance sheet and is responsible for compliance with reserve requirements and management of liquidity and interest rate risk. On the foreign exchange and derivatives front, revenues are driven primarily by spreads on customer transactions based on trade flows and customers' hedging needs. During 200708, revenues from foreign exchange and derivative transactions grew by 14.1% to Rs. 319.8 crores where the revenues were distributed across large corporate, emerging corporate, business banking and retail customer segments for plain vanilla forex products and across primarily large corporate and emerging corporate segments for derivatives. The Bank offers Indian rupee and foreign exchange derivative products to its customers, who use them to hedge their market risks. The Bank enters into forex and derivative deals with counterparties after it has set up appropriate counterparty credit limits based on its evaluation of the ability of the counterparty to meet its obligations in the event of crystallization of the exposure. Appropriate credit covenants may be stipulated where required as trigger events to call for collaterals or terminate a transaction and contain the risk. In the event of any customer default, the Bank, at the minimum, conforms to the Reserve Bank of India guidelines with regard to provisioning requirements for non-performing assets. On a conservative basis, the Bank may make incremental provisions based on its assessment of impairment of the credit. Where the Bank enters into foreign currency derivative contracts with its customers it lays them off in the inter-bank market on a matched basis. For such foreign currency derivatives, the Bank does not have any open positions or assume any market risks but carries only the counterparty credit risk (where the customer has crystallized or mark-to-market losses). The Bank also deals in Indian rupee derivatives on its own account including for the purpose of its own balance sheet risk management. The Bank recognizes changes in the market value of all rupee derivative instruments (other than those designated as hedges) in the profit and loss account in the period of change. Rupee derivative contracts classified as hedge are recorded on an accrual basis.

Given the regulatory requirement of holding government securities to meet the statutory liquidity ratio (SLR) requirement, your Bank has to necessarily maintain a large portfolio of government securities. While a significant portion of these SLR securities are held in the "Held-to-Maturity' (HTM) category, to the extent some of these are held in the "Available for Sale" (AFS) category, this enables the Bank to realise gains in a declining interest rate environment and exposes the Bank to losses or depreciation in value of investments when yields rise.

Service Quality Initiatives:

Your Bank continued to seek and drive process improvement in all spheres of business through structured Quality Projects using Lean Sigma Project Management Methodology. Over 1,000 projects were executed during the year that resulted in substantial Cost and Turn Around Times reduction, and productivity and process efficiency improvement.

Service Quality initiatives were refined to capture and improve upon real customer experiences at various touchpoints. New elements were added and renewed improvement schemes installed to provide customer delight. Your Bank launched a Service Quality improvement drive for some of the key support departments as well. Customer feedback was taken into account to introduce new services using technology to ensure customer convenience, secured transactions and, reduced cost of transactions.

Your Bank plans to use this platform to drive systemic changes and process re-engineering using technology, Lean Six Sigma tool-kit, 5 S and other business excellence initiatives to further enhance customer experience and value to business.

Risk Management & Portfolio Quality:

Taking on various types of risk is integral to the banking business. Sound risk management and balancing risk-reward trade-offs are therefore critical to a bank's success. Business and revenue growth have therefore to be weighed in the context of the risks implicit in the Bank's business strategy. Of the various types of risks the Bank is exposed to, the most important are credit risk, market risk (which includes liquidity risk and price risk) and operational risk. The identification, measurement, monitoring and management of risks remain a key focus area for the Bank. For credit risk, distinct policies and processes are in place for the retail and wholesale businesses. In retail loan businesses, the credit cycle is managed through appropriate front-end credit, operational and collection processes. For each product, programs defining customer segments, underwriting standards, security structure etc., are specified to ensure consistency of credit buying patterns. Given the granularity of individual exposures, retail credit risk is managed largely on a portfolio basis, across various products and customer segments. For wholesale credit exposures, management of credit risk is done through target market definition, appropriate credit approval processes, ongoing post-disbursement monitoring and remedial management procedures. Overall portfolio diversification and reviews also facilitate mitigation and management.

The Risk Monitoring Committee of the Board monitors the Bank's risk management policies and procedures, vets treasury risk limits before they are considered by the Board, and reviews portfolio composition and impaired credits. From an industry concentration perspective, as of March 31, 2008, the following table gives industry wise classification of the loans and investments outstanding (excluding SLR investments, equity shares, Bank certificate of deposits and mutual fund units).

(Rs. Crores) Funded % to total exposure exposure

Automobiles and Auto Ancillaries 5,203 7.0%

Transportation 5,144 6.9%

Trade 4,111 5.5%

Banks and Financial Institutions 3,152 4.2%

Other Financial Intermediaries 2,644 3.6%

Food Processing 1,695 2.3%

Metals and Metal Products 1,560 2.1%

Engineering 1,487 2.0%

Other industries <2% each of loans and 16,235 21.8%investments outstanding (43 industries)

Retail-Except where otherwise classified 33,130 44.6%

Total 74,361 100.0%

Note:

Classification of exposure to real estate sector under Exposures in Sensitive Sectors (as disclosed in Notes to the Financial Statements) is as per the RBI guidelines. This includes not only exposure to borrowers in the real estate industry but also exposures to borrowers in other industries, where the exposures are primarily secured by real estate and investment in home finance institutions and securitisation.

As of March 31 , 2008, the Bank's ratio of gross non-performing assets (NPAs) to total customer assets was 1.29%. Net non-performing assets (gross non-performing assets less specific loan loss provisions, interest in suspense and ECGC claims received) were 0.42% of customer assets as of March 31, 2008. The specific loan loss provisions that the Bank has made for its non-performing assets continue to be more conservative than the regulatory requirement. The Basel Committee on Banking Supervision (BCBS) released the International Convergence of Capital Measurement & Capital Standards in June 2004, providing the New Framework for Capital Adequacy (Basel II). Pursuant to this Accord, Reserve Bank of India came out with its final guidelines in April 2007. In terms of these guidelines, Indian banks having operational presence outside India are required to migrate to the selected approaches (Standardised Approach for credit risk and Basic Indicator Approach for operational risk) with effect from March 31, 2008. All other scheduled commercial banks are required to migrate to these approaches no later than March 31, 2009. The Bank is in preparedness to adopt the above approaches as per the final guidelines issued in April 2007. Meanwhile, Reserve Bank of India has published its amendments to the final guidelines in March 2008. The Bank has examined these amendments and is in the process of reconfiguring its systems and processes to account for these changes. While the Bank, to begin with, will migrate to the above approaches defined in the Reserve Bank of India guidelines, the initiatives undertaken are geared towards enabling the Bank comply with the standards set out for the more advanced capital approaches under Basel II. These initiatives include augmentation of the risk management systems in terms of architecture, capabilities, technology, etc., in areas such as ratings systems, borrower segmentation, exposure consolidation, risk mapping, risk estimation, capital computation, etc. The Bank has been investing appropriately in augmenting its risk management systems and capabilities. The implementation of the Basel II framework is in harmony with the Bank's objective of adopting international best practices in risk management.

INTERNAL AUDIT & COMPLIANCE:

The Bank has Internal Audit & Compliance functions which are responsible for independently evaluating the adequacy of all internal controls and ensuring operating and business units adhere to internal processes and procedures as well as to regulatory and legal requirements. The audit function also pro-actively recommends improvements in operational processes and service quality. To ensure independence, the Audit department has a reporting line to the Chairman of the Board of Directors and the Audit & Compliance Committee of the Board and only indirectly to the Managing Director. To mitigate operational risks, the Bank has put in place extensive internal controls including restricted access to the Bank's computer systems, appropriate segregation of front and back office operations and strong audit trails. The Audit & Compliance Committee of the Board also reviews the performance of the Audit & Compliance functions and reviews the effectiveness of controls and compliance with regulatory guidelines.

SOCIAL INITIATIVES:

In keeping with the HDFC Group philosophy, your Bank has always believed in making a difference to society at large. As a responsible corporate citizen, it has been your Bank's vision to empower the community through socioeconomic development of underprivileged and weaker sections of society. During 2007-08 your Bank further intensified its efforts in this direction. Most of the Bank's social activities revolve around educational initiatives (including school adoption projects, educational sponsorships of girl children, primary education to first generation learners etc.) and initiatives in the field of livelihood training and support. In the latter area, the Bank has been working with NGOs in providing non-formal vocational and technical education programs as well as skill up gradation courses to enable sustainable employment and income generation for economically weaker sections. To further integrate some of its Corporate Social Responsibility (CSR) initiatives with its banking operations, the Bank has started outsourcing some non-core back office operations to certain small semi-urban locations. This creates jobs for the local educated youth in those towns with obvious gains for the families (as the youth is gainfully employed without having to relocate to distant cities) and also gives a boost to the local economy in those locations.

Where relevant, the Bank coordinates its CSR activities with its microfinance and self-help group (SHG) financing. The Bank has relationships with 110 micro finance institutions and has extended credit facilities, whereby 1.61 million households have been beneficiaries of financial inclusion. In this regard, your Bank has also appointed around 150 NGOs across the country as business correspondents (BCs) to provide SHG - Bank linkage to help tribals, physically challenged, beggars, etc. to earn a livelihood and join the mainstream. The Bank under the direct SHG linkage programme, has credit linked over 32,000 SHGs and thereby roughly another half a million households have been brought under Financial Inclusion.

Employees are a key part of your Bank's social initiatives and are encouraged to participate in these activities, contributing their time and skills. The Bank also administers a payroll-giving programme whereby employees offer deductions from their salary to donate for specified charities or social causes of their choice and the Bank contributes an equivalent amount.

HUMAN RESOURCES:

The Bank's staffing-needs continued to increase during the year particularly in the retail banking and SME businesses in line with the business growth. Total number of employees increased from 21,477 as of March 31, 2007 to 37,836 as of March 31, 2008. The Bank continues to focus on training its employees on a continuing basis, both on the job and through training programs conducted by internal and external faculty. The Bank has consistently believed that broader employee ownership of its shares has a positive impact on its performance and employee motivation. The Bank's employee stock option scheme so far covers around 6,535 employees.

STATUTORY DISCLOSURES:

The information required under Section 217(2A) of the Companies Act, 1956 and the rules made there under, are given in the annexure appended hereto and forms part of this report. In terms of section 219(1)(iv) of the Act, the Report and Accounts are being sent to the shareholders excluding the aforesaid annexure. Any shareholder interested in obtaining a copy of the said annexure may write to the Company Secretary at the Registered Office of the Bank. The Bank had 37,836 employees as on March 31, 2008. Three hundred twenty six employees employed throughout the year were in receipt of remuneration of more than Rs. 24.0 lacs per annum and fifty employees employed for part of the year were in receipt of remuneration of more than Rs. 2.0 lacs per month.

The provisions of Section 217(1)(e) of the Act relating to conservation of energy and technology absorption do not apply to your Bank. The Bank has, however, used information technology extensively in its operations.

The report on the Corporate Governance is annexed herewith and forms part of this report.

RESPONSIBILITY STATEMENT:

The Board of Directors hereby state that:

i) In the preparation of the annual accounts, the applicable accounting standards have been followed along with proper explanation relating to material departures;

ii) We have selected such accounting policies and applied them consistently and made judgments and estimates that are reasonable and prudent so as to give a true and fair view of the state of affairs of the Bank as on March 31, 2008 and of the profit of the Bank for the year ended on that date;

iii) We have taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the provisions of the Companies Act, 1956 for safeguarding the assets of the Bank and for preventing and detecting frauds and other irregularities; and

iv) We have prepared the annual accounts on a going concern basis.

DIRECTORS:

Mr. Keki Mistry, Mrs. Renu Karnad and Mr. Vineet Jain will retire by rotation at the ensuing Annual General Meeting and are eligible for re-appointment.

The Board at its meeting held on October 12, 2007, appointed Mr. Harish Engineer and Mr. Paresh Sukthankar as Additional Directors as well as Executive Directors of the Bank subject to the approval of the shareholders and the Reserve Bank of India. The Bank sought the approval of shareholders by way of postal ballot for the appointment of Mr. Engineer and Mr. Sukthankar as Executive Directors of the Bank. As per the scrutinizer's report, both the ordinary resolutions were approved by the shareholders with the requisite majority effective December 10, 2007.

The brief resume/details relating to Directors who are to be appointed/re-appointed are furnished in the report on Corporate Governance.

AUDITORS:

The Auditors M/s. Haribhakti & Co., Chartered Accountants will retire at the conclusion of the forthcoming Annual General Meeting and are eligible for re-appointment. Members are requested to consider their re-appointment on remuneration to be decided by the Audit and Compliance Committee of the Board.

ACKNOWLEDGEMENT:

Your Directors would like to place on record their gratitude for all the guidance and co-operation received from the Reserve Bank of India and other government and regulatory agencies. Your Directors would also like to take this opportunity to express their appreciation for the hard work and dedicated efforts put in by the Bank's employees and look forward to their continued contribution in building a World Class Indian Bank.

On behalf of the Board of Directors

Place: Mumbai Jagdish Capoor Dated: April 24, 2008 Chairman

Annexure to Directors' Report for the year ended March 31, 2008:

EMPLOYEES' STOCK OPTIONS:

Details of the stock options granted, vested, exercised and forfeited & expired during the year under review are as under:

Scheme(s) A B C D E F

ESOS I 131.33 - - - - -ESOS II 225.43 - - 1500 - -ESOS III 226.96 - - 4600 3000 -ESOS IV 358.60 - - 155800 - 257800ESOS V 366.30 - - 71300 - 123100ESOS VI 362.90 - - 97400 - 108200ESOS VII 630.60 - 1474300 1095200 221500 3209400ESOS VIII 994.85 - 841900 148700 273000 2731900ESOS IX 994.85 - 787000 103300 265500 2450400ESOS X 1098.70 672000 - - 17000 655000ESOS XI 1098.70 1418500 - - 83000 1335500ESOS XII 1098.70 6215000 - - 148500 6066500Total 8305500 3103200 1677800 1011500 16937800

A = Exercise Price (Rs.)B = Options GrantedC = Options VestedD = Options Exercised & Shares Alotted*E = Options Forfeited & ExpiredF = TOtal Options in Force As on March 31, 2008

* One (1) share would arise on exercise of one (1) stock option.

Other details ore as under: Money realized by exercise of options The Bank received Rs. 1,67,78,000 towards share capital and Rs. 1,04,32,73,011/- towards share premium (net of Fringe Benefit Tax) on account of 16,77,800 stock options exercised and allotted during the year under review.

Pricing Formula for ESOS X, ESOS XI & ESOS XII Closing market price on the stock exchange where there is highest trading volume on the immediately preceding working day of the date of grant.

Details of options granted to:

i. Directors & Senior managerial personnel

Name Options Granted

Mr. Adiyta Puri 100000Mr. Harish Engineer 34000Mr. Paresh Sukthankar 34000Mr. A Parthasarthy 34000Mr. A. Rajan 27000Mr. Abhay Aima 34000Mr. Kaizad Bharucha 34000Mr. C.N. Ram 34000Mrs. Mandeep Maitra 34000Mr. Pralay Mondal 34000Mr. Sashi Jagdishan 29000

ii. Other employee who receives a grant in any one year of option amounting to 5% or more of option granted during that year:

None

iii. Identified employees who were granted option, during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant:

None

Variation of terms of Options:

Shareholders of the Bank vide Special Resolution dated 16th June 2007 have modified the terms of the existing stock option schemes incorporating the provision to recover from the relevant eligible employees, the fringe benefit tax in respect of options which are granted, vested or exercised by the eligible employee on or after the April 1, 2007 pursuant to the Income Tax Act, 1961.

Diluted Earnings Per Share (EPS) pursuant to issue of shares on exercise of option calculated in accordance with Accounting Standard (AS) - 20 (Earnings Per Share):

The Diluted EPS of the Bank calculated after considering the effect of potential equity shares arising on account of exercise of options is Rs.45.59.

Where the company has calculated the employee compensation cost using the intrinsic value of the stock options, the difference between the employee compensation cost so computed and the employee compensation cost that shall have been recognized if it had used the fair value of the options, shall be disclosed. The impact of this difference on profits and on EPS of the company shall also be disclosed.

Had the Bank followed fair value method for accounting the stock options, compensation expense would have been higher by Rs. 244.14 crores. Consequently profit after tax I would have been lower by Rs. 161.16 crores and the basic i EPS of the Bank would have been Rs. 41.54 per share (lower by Rs. 4.68 per share) and the Diluted EPS would have been Rs. 40.97 per share (lower by Rs. 4.62 per share;

Weighted-average exercise prices and weighted-average fair values of options shall be disclosed separately for options whose exercise price either equals or exceeds or is less than the market price of the stock options:

The weighted average price of the stock options exercised is Rs. 631.81 and the weighted average fair value is Rs. 971.93.

A description of the method and significant assumptions used during the year to estimate the fair values of options, including the following weighted-average information:

The Securities Exchange Board of India (SEBI) has prescribed two methods to account for stock grants; (i) the intrinsic value method; (ii) the fair value method. The Bank adopts the intrinsic value method to account for the stock options it grants to the employees. The Bank also calculates the fair value of options at the time of grant, using internally developed and tested model with the following assumptions:

i. Risk-free interest rate:

It will remain between 7.7% to-7.9%.

ii. Expected life:

1-4 years.

iii. Expected volatility:

It will be around 25.20%.

iv. Expected dividends, and

Around Rs. 7per share during the tenor of the ESOSs.

v. The price of the underlying share in market at the time of option grant:

The per share market price was Rs. 1098.70 at the time of grant of options under ESOS X, ESOS XI and ESOS XII.

Bringing quality growth to Wholesale Banking:

* Wholesale Banking Loans grew by over 30%.

* Cash Management Volumes grew around 80%.

* Collecting Banker to over 75 Corporate IPOs and around 450 NFOs of Mutual Funds during 2007-08.

* Market share of over 50% of cash settlement volumes on the two largest Stock and Commodities exchanges.

* Correspondent Bank to around 1200 Co-Operative Banks.

* Stable and healthy asset quality.