Banking Reforms in India

Banking Reforms in India

Charting a Unique Course

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Economic and Political WeeklyMarch 31, 20071110as a reflection of the problems inherent in public sector enter-prises. Performance must always be judged in relation to objec-tives. The PSBs were asked to grow their books, to focus onfinancial deepening and they did so. To construe this in retrospectas non-performance in relation to some other objective, such asefficiency or profitability, is inappropriate.Secondly, it is worth emphasising that in a regulated setting,where the spread between the lending rate and the borrowingrate is fixed, growing the balance sheet is the natural thing fora bank to do. This has happened in many other banking systemsas well. The focus on asset quality came later, consequent toderegulation when there was an apprehension that spreads wouldbe squeezed and you could not rely on high spreads to take careof provisions for non-performing assets. So it is not as if the Indianbanking system in the regulated era went down some path nottrodden by banking systems elsewhere or committed sins un-known to regulated banking systems elsewhere.Thirdly, there is always the danger of viewing performancein a compartmentalised way – pre-reform versus post-reform asthough the two phases have nothing to do with each other. Thefact is to the contrary. If the PSBs have done extremely wellinthe post-reform phase – and this is something we will touch uponsoon – that owes in no small measure to the investment madein the previous decades in creating a wide network of branches.The network gives them access to deposits and that too at lowcost. It is the ability of the Indian banking system to fund itselfthrough deposits (as distinct from market borrowings) thatconstitutes its fundamental strength. The improvement in per-formance that we have seen in recent years is thus a pay-off tothe investment made in distribution in the earlier years.I remember reading about a famous multinational consumercompany failing to make a profit after about 10 years of operationin India. The CEO of the company was quoted as saying thathe was not worried because he saw the first 10 years as a periodin which the company was investing in distribution – the profitwould come later. Evidently, to some, this is wisdom when itcomes from MNCs but it is a folly when it is practised by PSBs!There is one other point that I must make about the pre-reformphase since it is generally portrayed as a dark period for thebanking system. The spread of bank branches helped bring aboutan increase in the savings rate to rise from around 10 per centin the early 1970s to over 20 per cent in the early 1980s. It mustbe understood that savings are not money under the mattress.Savings are what come into the financial system. To the extentthat the spread of bank branches helps sweep money in the handsof individuals into the financial system, it increases savings asthe term is understood by economists.The doubling of the savings rate set the stage for an increasein investment and the acceleration in growth from the Hindu rateof 3.5 per cent to over 6 per cent in the 1980s. This was no meanachievement when you remember the pessimism about India’sgrowth possibilities in the 1970s. The acceleration in India’seconomic growth in the 1980s, which took many by surprise,was made possible by the expansion of the banking system underthe public sector.It is true, however, that regulation and balance sheet growthare not conducive to the promotion of discipline in banking,attitudes tend to become lax. This did happen in Indian bankingand as a result the PSBs showed a return on net worth of -1 percent in 1992-93. The financial soundness was in jeopardy andneeded to be rectified. A focus on efficiency had to be introducedin keeping with such a focus in other sectors of the economy.This is what has been attempted through banking sector reforms.IIImpact of ReformsHow have the reforms impacted on efficiency and stability?These can be judged in relation to a variety of measures. A centralproposition that is sought to be addressed here is whether thedominant public sector presence in banking has been conduciveto or detracted from efficiency and stability. So, I provide figuresfor PSBs but the conclusions apply to the banking sector as awhole (Table 2).(1)Profitability: As measured by net return on assets, profit-ability in PSBs rose from -0.4 per cent in 1992-95 to 0.8 percent in 2005-06, with the peak of 1.12 per cent beingachievedin2003-04. It is not just that Indian banks have achieveda turnaround. They have gone onto become among the mostprofitable in the world. Internationally, a return of 1 per cent onTable 1: Progress of Commercial Banking in IndiaIndicators/YearJune 69June 75June 80June 85June 05March03March04Number of scheduled commercial banks (including RRBs*)7374148264297288286Of which:RRBs--73183196196196Other scheduled commercial banks--75811008886Number of bank offices8,26218,73032,41951,38567,86868,50069,071Population per office (thousands)64322115151616Number of PSB offices6,66915,06425,82835,62947,49447,92348,150Per capita deposits (Rs)882084941,0268,54212,25314,313Per capita credit (Rs)681483276784,5557,2758,404Note:*RRBs - regional rural banks.Sources:Report on Currency and Finance (1999), Statistical tables relating to banks in India (2003-04).Table 2: Financial Indicators of Public Sector BanksYearNet IncomeIntermediationNetProfit/Cost/Net Non-SpreadCost/TotalTotal AssetsIncomePerformingAssetsAssets/Total Assets1992-95(average)2.722.68-0.4068.2NA1995-963.082.99-0.0766.7NA1996-973.162.880.5764.33.651997-982.912.660.7762.73.271998-992.82.660.4265.93.141999-002.72.530.5763.22.942000-012.862.720.4267.02.722001-022.732.290.7254.92.422002-032.912.250.9647.81.932003-042.982.211.1245.11.282004-052.922.090.89NA0.992005-062.852.060.82NA0.72Sources:Report on Trendand Progress in Banking (RBI); for cost/income ratioRakesh Mohan (2005).

Economic and Political WeeklyMarch 31, 20071111assets is considered a benchmark of excellence. Table 3 providesprofitability figures for other banking systems (the figure forIndia is post-tax; for the others, pre-tax). In 2004, among theindustrial economies, only the US banking system did better thanthe Indian on a pre-tax basis. Among the Asian economies, onlyIndonesia did better in 2003 (Table 4). So much for the lamentthat the Indian banking sector lacks a “commercial orientation”because it happens to be dominated by commercial banks.(2)Intermediation costs: These costs as a proportion of assetshave declined from a high of 2.99 per cent in 1995-96 to 2.06per cent in 2005-06. It is often said that the intermediation costsin Indian banking are on the higher side. This is not entirely true.Our costs are lower than those of highly profitable bankingsystems such as those in the US and Australia and higher thanthose in the UK, Japan and Germany, whose systems are not asprofitable (Table 5). This suggests that looking at the interme-diation costs in isolation may not be a sensible thing to do – highercosts are okay, if the business model delivers higher profitability.(3)Net interest margin (spread): The spread for PSBs has risenfrom 2.72 per cent in 1992-95 to 2.85 per cent in 2005-06(Table2). So, the reduction in spreads that one expects to seein the wake of deregulation has not happened in India. This isbad for borrowers, but as we shall see, it has turned out to bea blessing for banks.(4)Cost/income ratio: The cost to income ratio has fallen steeplyfrom 73.7 per cent in 1992-93 to 45.1 per cent in 2003-04. Again,internationally a cost to income ratio of below 50 per cent isconsidered commendable.(5)Non-performing assets: In the area of non-performing assetsagain, the PSBs have shown great improvement. The net NPA/total asset ratio has declined from 3.65 per cent in 1996-97 to0.72 per cent in 2005-06.(6)Capital adequacy: At the onset of reforms, the PSBs werestruggling to meet the capital adequacy norm of 8 per cent. Thecapital adequacy has since risen to 12.4 per cent in 2006.In sum, there has been an improvement on several indicatorsof efficiency and stability. The London Economist, no admirerof the public sector, notes that the Indian banks are going “fromstrength to strength” (May 18, 2006). Having acknowledged theall-round improvement in performance, the Economist goes onto argue that “government has to get out of the way”. Earlier,it used to be argued that the government should get out of PSBsbecause they were doing badly. Now it is contended that thegovernment should get out because they are doing well!There is another important measure of performance that isworth-highlighting. This is the market capitalisation of listedPSBs. At the advent of reforms, the net worth of PSBs in theaggregate was negative. In February 2007, the market capitalisationof listed PSBs was Rs 1,63,000 crore. This figure needs to beadjusted for the market value of non-listed PSBs, but it does notjust change the basic conclusion.Just think of it – an investment of around Rs 20,000 crore hasmultiplied over eightfold in a period of 13 years! Remember,when the government pushed through the recapitalisation becauseof the need to comply with Basel norms for capital adequacy,the move was perceived by many as “money down the drain”.Many thought it was only a matter of time before further injectionsof capital were required. With one or two exceptions (on a smallscale), this has not happened.The PSBs have been able to freely raise capital on the backof their performance. An oversubscription of initial public of-ferings (IPOs) of PSBs is common. The most recent IPO of aPSB, Indian Bank, has been oversubscribed 31 times. This wasone of three banks that had been pronounced “weak” only afew years ago; some had even prescribed the closure of the bank.The performance of PSBs in the primary and secondary marketshas done wonders for the brand image of PSBs and also foremployee morale. It is fair to say that the PSBs have passed whatis regarded as the ultimate test of capitalism – the ability to enthusethe equity market on the strength of performance.IIIEvidence from ResearchIn the preceding section, we have presented data that point toimprovements in efficiency and stability in the Indian bankingsector in the post-reform period. A body of academic work onthe subject is also building up, much of it seeking to explorethe relationship between ownership and performance in Indianbanking. It is worth-citing this literature.The reference point for such studies is the work by La Portaet al (2000) that showed that government ownership is associatedwith slower subsequent development of the financial system,lower efficiency in the financial sector and lower economicgrowth.There is a complementary study by Barth, Caprio and Levine(2001)that shows that state ownership tends to heighten the probabilityof crises although this finding was not statistically significant.The literature on government ownership of banks is examinedby the World Bank (2001) which then goes on to make out thepredictable case for the elimination of government ownershipin banking. It should be added, however, that the World Bankprescription is hedged with several caveats and also the warningthat “privatisation can also be badly designed and lead to crises”and the recommendation that there must be a “deliberate andcredible” phasing out of state ownership accompanied by astrengthening of the regulatory framework.Table 3: Net Pre-Tax Profit of Banks(as percentage of assets) *200220032004US (12)1.72.01.99Canada (5)0.61.01.19Japan (11)-0.50.10.29UK (9)1.11.21.15Sweden (4)0.70.80.98Germany (9)0.1-0.20.09France (7)0.50.60.67Italy (6)0.50.81.03Spain (3)1.11.31.17India (97) **0.81.01.13Notes:Figures in brackets indicate number of major banks included.*Post-tax profit for India.**Pertains to 97 scheduled commercial banks in 2002 and 93 for2003. Financial year is April-March.Sources:Report on Trend and Progress of Banking in India, 2003-04 (RBI);BIS, Annual Report (2005).Table 4: Net Profit of Banks of Major Asian Countries(as percentage to total asset)YearChinaIndonesiaKoreaMalaysiaPhilippinesThailandIndia19960.291.010.171.402.06-0.560.7119970.30-0.39-0.841.031.63-1.170.9019980.20-46.92-3.100.040.85-5.570.5419990.17-9.20-1.400.960.10-5.880.7020000.210.46-0.371.29-0.03-0.150.4820010.200.870.760.680.481.460.6920020.201.300.601.030.600.210.9720030.121.610.151.081.080.631.14Source:Rakesh Mohan (2005).

Economic and Political WeeklyMarch 31, 20071112Ram Mohan (2005) reviews the literature on bank reforms inthe initial years. Much of this is not relevant today because therehas been a marked improvement in the performance of the Indianbanking sector along with that of the overall economy in recentyears. For instance, Sarkar et al (1998) found a weak ownershipeffect but their sample covered only two early years in the post-reform period: 1993-94 and 1994-95.What is notable, however, is that the studies that went evenonly up to the late 1990s have detected a certain convergencein performance between public sector banks and foreign andprivate banks [Das 1997; Ram Mohan 2002 and Ram Mohan2003; Ram Mohan and Ray 2003]. Bhaumik and Dimova (2004)provide further confirmation of this trend. Their results suggestthat, although domestic private and foreign banks performedbetter than public sector banks at the onset of competitionin 1995-96, the gap tended to narrow over time. By 1999-2000,the authors found, there was no observable relationship betweenownership and performance in the Indian banking industry.This suggested that the PSBs had responded better to com-petitive forces than their private sector counterparts. Theseconclusions accord with what has been observed in the literatureon privatisation: competition, deregulation and the impositionof hard budget constraints do have a positive impact on theperformance of state-owned firms.IVFactors Underlying Performance ImprovementThe improvement in PSBs’ performance is thus undeniable.How did this improvement come about? It is often suggested thatluck played a big part in the PSBs’ turnaround and thereby theturnaround in the Indian banking system. The most commonrefrain that you will hear is that the PSBs profited in a big wayfrom capital gains on their large holding of government securities.Consequent to the imposition of the Basel norms and giventhat they were operating close to the capital adequacy norm of9 per cent, the PSBs raised their investment in statutory liquidityratio (SLR) securities way above the statutory requirement of25 per cent – at one point, their holdings were over 40 per cent.When interest rates declined, the PSBs reaped a huge windfallthrough capital appreciation on their investment portfolios.I have two observations to make on this point. First, the Indianbanking system is not unique in benefiting from a long-termdecline in interest rates. In the US, the banking system wasbattered towards the end of the 1980s on account of huge exposuresto Latin America, a region that had plunged into economic crisis.There was much speculation that the American banks would beswallowed up by the large Japanese banks. Then, the US Congresspassed the Balanced Budget Amendment Bill. The resultingdecline in interest rates led to a recapitalisation of the Americanbanking system. By the early 1990s, the American banks hadcome roaring back onto the world stage.Secondly, while it is true that treasury gains boosted PSB banks’profits, it is not the whole story. In 2003-04, which was amongthe best years for treasury, the share of trading income at PSBswas 11 per cent of total income. In 2004-05, trading incomehalved to 6 per cent of total income as interest rates began risingfrom October 2004. Many analysts had forecast that, with adecline in trading income, the days of high profitability for PSBswould come to an end. This did not happen. Profitability diddecline in 2004-05, but the decline was not steep – the returnon assets was a healthy 0.9 per cent of total assets. In 2005-06,which saw interest rates rising through the year, profitabilitydeclined only slightly to 0.82 per cent.Trading income boosted profitability following the decline inthe interest rates towards the late 1990s. But profitability im-provements had happened even before and several factors con-tributed. Table 6 indicates the role played by these factors overtwo different periods: 1993-2000 and 2000-06.Improvements in operating profit can result from the following:an increase in spread, an increase in other income and a decreasein operating costs. The improvement in net profit will reflect thesefactors and also decrease in provisions and contingencies. Twoitems do not figure in the table: change in volume of advancesand investments, which would impact on operating profit; andchanges in taxes which would impact on net profit. The unex-plained portion of the net profit increase in the table can beascribed to these two factors.Comparing 1999-2000 with 1992-93, the first year of reforms,itcan be seen that the fall in provisions and contingencies was byfarthe biggest contributor to the increase in profitability. Whenwecompare 2000-06 with 1999-2000, we find that a decrease inoperat-ing costs was the biggest contributor. This is understandable. Inthis period, there was a huge increase (54 per cent) in the volumeof advances and investments in PSBs while manpower actuallyreduced through the introduction of a voluntary retirement scheme.An increase in spread contributed to the increase in profitabilityin both the periods, the contribution being bigger in the firstperiod. Other income (which includes treasury gains) declinedin the second period. If we add the increase in spread and thedecrease in operating costs in this period and subtract the fallin operating income, we get an increase in operating profit of0.35 percentage points. The remaining increase – 0.08 percentagepoints – may be ascribed to the increase in volume of credit overthe second period.Thus, it is possible to overstate the role of treasury income(which goes into “other income”) in explaining the improvementin performance of PSBs. At various points, a decrease inTable 5: Operating Costs at Select Banking Systems (2004)US (12)3.48Canada (5)2.77Japan (11)1.12Australia (4)2.55UK (9)2.07Switzerland (5)1.65Sweden (4)1.24Austria (2)1.84Germany (9)1.35France(7)1.41Italy (6)2.73Netherlands (3)1.82Spain (5)1.79India (97)2.2Note:Figures in brackets refer to number of banks.Sources:BIS,Annual Report (2005); RBI, Report on Trend and Progress inBanking (2004-06).Table 6: Factors Underlying Performance Improvement at PSBsAs Percentage ofChange in 1999-2000Change in 2005-06Total Assetsover 1992-93over 1999-2000Interest spread0.310.15Other incomeNA-0.27Intermediation cost0.10-0.47Operating profitNA0.43Provisions and contingencies-1.030.23Net profit1.560.25Source:Several issues of RBI, Trend and Progress in Banking.

Economic and Political WeeklyMarch 31, 20071113provisioning costs, an increase in spread and a decrease inoperating costs have been the key factors. It is the increase inspread consequent to deregulation that marks out India from manyother economies that went through bank deregulation. Withderegulation, one expects spreads to decline – after all, that isone of the objectives of deregulation.In India, this has not happened for two reasons. One, there hasbeen a surge in liquidity thanks to unexpectedly large inflowsofcapital. Two, thanks to the loss of confidence in the capitalmarketsconsequent to scams of one sort or another, there has been noflight of deposits from the banking system for most of the post-reform period. In other words, disintermediation on the liabilitiesside did not take place for most of the post-reform period.Of late, the confidence in the stock market has revived andpostal savings pose a threat to deposits. As a result, we arebeginning to see some pressure on the deposit side and we shouldexpect spreads to get narrower. But this will happen only gradu-ally because banks’ access to deposits is not confined to retaildeposits – there are the float funds that arise because of varioustransaction products.Even if the spread narrows, that would not pose a big threatto bank profitability in the near future because now anotherfavourable factor has emerged – high volume growth in credit.In 2004-07, credit to the commercial sector (non-food credit) hasgrown by around 30 per cent per annum (as against the growthrate of 18.2 per cent in 1994-95 to 2003-04). The RBI would liketo see it slow down to 20 per cent in 2006-07 but the indicationsare that credit growth could end up growing faster than that. Muchof the growth in credit has come from retail credit but, goingforward, we can see a more balanced growth in credit with boththe retail and the wholesale sides contributing. This will happenfor two reasons. It will be difficult to sustain high retail growthon a high base. Secondly, the strong revival in investment meansthat corporate demand for credit will grow strongly.The sharp rise in commercial credit growth will, of course,impact favourably on bank profitability but it is noteworthy foranother reason. It goes some way towards debunking anothermyth about PSBs, namely, that they are congenitally averse torisk. It used to be said that in PSBs, the incentives are solidlyagainst lending because more loans means more trouble for bankofficers. It was claimed that this was the reason that PSBs hadshifted massively towards investment in government securitiesin the second half of the 1990s. Banerjee and Duflo (2004) lentsupport to the view that the incentive structure biases PSBsagainst taking incremental credit risk.There is, however, another plausible explanation for the shifttowards government securities, one that is consistent with arational assessment of the risks to which banks were exposed.Indian industry and especially the small and medium enterprise(SME) sector was going through a process of restructuringconsequent to reforms and the outlook for manufacturing wasuncertain. Secondly, capital adequacy was close to the regulatorynorm in the initial years after reforms. Banks can have a healthyappetite for lending only when they have a healthy cushion ofcapital. Indeed, some of the new private sector banks came to griefprecisely because they ignored risks in the manufacturing sector.By 2004, when the economic turnaround began, the PSBs’capital adequacy ratio had risen to 12.9 per cent. The prospectsfor industry had improved. In addition, the PSBs, like other banks,woke up to the potential of the retail market. These factorstogether explain why non-food credit has grown at a rate wherethe RBI wants to put the brakes on credit expansion. There isevery prospect that the SLR ratio in the system will come downto the minimum of 25 per cent sometime in 2007 as banks liquidatetheir SLR holdings to fund credit growth.The explosion in credit growth since 2004 as much as the tardypace of credit growth earlier together paint a flattering picture ofPSBs: they suggest that the PSBs are indeed taking the right creditdecisions based on a proper evaluation of the underlying risk. Wheneconomic conditions were bad, the PSBs tilted towards govern-ment securities. When conditions improved, they tilted towardscredit. The initial tilt towards government securities appears evenmore appropriate when one factors in the treasury gains that thePSBs realised once interest rate started trending downwards.True, the PSBs, like other banks, are reluctant to lend to SMEsbut this is again rational behaviour in light of the entire universeof opportunities open to them. On a broader note, conclusionsdrawn about the Indian banking system prior to 2004, like thoseabout the underlying economy, are increasingly suspect in lightof the developments that have followed.To sum up the analysis of improvement in performance in theIndian banking sector since reforms, there has been a series ofhelpful factors. Initially, it was lower provisioning; then therewere treasury gains and a widening spread; now you have volumegrowth. The presence of retail assets, with housing loans domi-nating, is a big plus because non-performing assets (NAP) aremuch lower in retail assets compared to wholesale assets, al-though we should not expect the NPA levels to continue at thevery low levels of the past.In macroeconomics, they talk of the “impossible trinity”. Ofthe three variables – monetary policy, exchange rate and capitalaccount convertibility, not all three can be controlled. One couldposit a similar impossible trinity in banking – you can’t havehigh volume growth, high spreads and low NPAs together. Ifyour spreads are high, then your volume growth will be low.If your volume growth is high, you should expect high NPAs.Not so in India – the impossible seems to have become possiblebecause of the peculiarities of the Indian market. High spreadscontinue because of the surge in liquidity and public confidencein bank deposits relative to other savings opportunities; highgrowth in volume is the result of the turnaround in economicprospects and the fact that the retail market has developed onlyrecently; and low NPAs can be ascribed to the large presenceof retail loans, the improved economic environment with the SMEsector especially having become stronger through restructuringand better risk management.While the banking system has benefited from a combinationof favourable factors, it should also be understood that bankingTable 7: Commercial Credit as Percentage of GDP (2004)CountryBrazil35Chile63China120Hong Kong, China150India41Indonesia24Korea98Malaysia130Mexico17Philippines35Russian Federation25Singapore107Sri Lanka32Thailand97UK156US249Source: RBI Annual Report (2005-06).

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Economic and Political WeeklyMarch 31, 20071115stability has helped create these favourable conditions in thefirstplace.The end result is that, some 14 years after reforms, the bankingsector is stronger than ever before. This is an extraordinaryachievement by international standards. The experience withderegulation in banking elsewhere is that, within five to sevenyears after deregulation, the banking system experiences a crisis– there is a widespread failure of banks. Banks that had beenprivatised have had to be re-nationalised or sold to foreigners.The cost of cleaning up the banking system ranges from 5-35per cent of GDP, and economic growth is set back by severalyears. This happens because deregulation causes spreads to narrow,banks’ profitability comes under pressure, banks try to shore upprofits through risky lending and this ultimately undermines thebanks. We have not gone through this sequence. Why?There are a number of reasons. First and most important, sincethe banks happened to be state-owned, government couldrecapitalise them at the beginning of reforms. If the banks hadbeen privately owned, the government would have had to waitfor a collapse, then taken them over. Pre-emptive recapitalisationin India helped bolster balance sheets before the reforms wereset in motion. Second, as noted, public confidence in government-owned banks relative to capital markets meant that deposits didnot exit the banking system and, as a result, spreads did not comeunder pressure. Third, government-owned banks tend to beinherently risk averse. This may be a shortcoming in otherbusinesses, but in banking, it is not a bad thing. Fourth, we havehad stringent regulations on the two assets that have commonlyled to the downfall of banking systems, namely, stocks and realestate. Fifth, the Indian banking system already had the presenceof domestic and foreign banks. Reforms meant giving thesegreater play than before. So, the mechanisms for exposing PSBsto greater competition and giving scope for innovation in thesystem were already in place. Sixth, we have taken a measuredapproach to capital account convertibility; the rush towards fullconvertibility has proved the undoing of many a banking system.Seventh, the investment in retail branches made in the earlierera has turned out to be a big source of strength for PSBs byproviding access to low-cost deposits, a key source of competitiveadvantage in banking.This combination of factors that explains why India’s expe-rience with bank deregulation has been rather unique and whythe recapitalisation cost in India – of around 1 per cent of GDP– is, perhaps, the lowest that any country has incurred onrecapitalising its banking system consequent to deregulation.Government ownership of banks, it must be emphasised, hasturned out to be a strength, not a drawback, in the revitalisationof the Indian banking system.Some commentators, while acknowledging the turnaround in theIndian banking system, are apt to emphasise that it is still wantingin one respect: financial deepening or the level ofintermediationjudged by at least one critical ratio: commercial loans/GDP. Table7 gives the comparative position as of 2004. India does lag behindmany economies. However, the acceleration incommercial creditover the last three years suggests that the Indian banking systemis on its way to rectify this shortcoming as well.Table 8 shows that in 2005-06, the commercial credit/GDP ratiohadrisen to 48 per cent. If commercial credit grows at around 25per cent, it will not be long before the Indian banking system catchesup with Korea and Thailand. Moreover, it is not just the degreeof financial deepening or the size of the banking system that isimportant; it is also important that the banking system be profitable.India’s banking system may not have the depth of China’s butitis much more profitable (as Table 4 shows). Indeed, Table 8indicates that, after a period of rapid deepening consequent tonationalisation, there was a pause in deepening as the Indianbanking system focused on greater efficiency in the first decadeafter reforms.Having improved its viability, the banking system is nowaddressing the issue of balance sheet growth. As in the case ofmanagement of the portfolio of loans and investment, which wetouched upon earlier, one discerns a certain logic in the way inwhichthe banking sector has approached the issue of financial deepening.VIs Credit Growth a Concern?The acceleration in credit growth that has boosted bankprofitability in recent years has itself become a cause for concern.There was a time when Indian banks were being chided for “lazybanking”, that is, not lending enough and parking their fundsinstead in government securities. Now they are being chided forlending too much. This in itself says something about the trans-formation in Indian banking in the last three years.Is the present rate of credit growth a cause for concern? Asthe IMF (2004) notes, credit can grow rapidly for three reasons:financial deepening, normal cyclical upturns and excessive cyclicalmovements. Only the last qualifies as a “credit boom” that ispotentially destabilising.Credit typically grows faster than GDP as an economy develops– that is what financial deepening is all about. It can alsogrowfaster thanGDP because firms’ investment and workingcapital needs fluctuate with the business cycle. The problem ariseswhen asset prices get magnified. For instance, when stock pricesshoot up, firms’ net worth rises sharply. Banks may then betempted to lend more. When stock prices collapse, banks cometo grief.How to tell an unhealthy credit boom from a healthy one? TheIMF identifies the following warning signs: a surge in capitalinflows; a consumption or investment boom; a sharp rise in stockprices; a worsening of corporate leverage and an increase inbanks’ external borrowings.How do we relate to these warning signs? The first three arein evidence in India but not the last two. The RBI (2005-06) notesthat the debt/equity ratio of corporates declined from 69 per centin 1998-2002 to 53 per cent in 2004-05. High external borrowings– whether of firms or banks – and a fixed rate regime are a lethalcombination. This combination is missing in India. Foreigncurrency liabilities are less than 2.5 per cent of total liabilitiesof Indian banks [RBIa 2005-06].As for the sharp rise in capital inflows, it is portfolio flows,not debt, that account for most of the rise. And the portfolio flowshave historically proved more stable than debt flows. In India,Table 8 : Financial Deepening in Indian BankingPeriodCommercial Credit as Percentage of GDP1970-71 to 1974-7515.61975-76 to 1979-8021.81980-81 to 1984-8526.91985-86 to 1989-9030.31990-91 to 1994-9529.01995-96 to 1999-200028.62000-01 to 2004-0533.52005-0648.0Source: RBI.

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Economic and Political WeeklyMarch 31, 20071117net portfolio flows have been negative only for one year eversince the economy was opened to such flows.The composition of credit is also important in judging whethera given rate of credit growth is healthy, that is, whether it posessystemic risk. Retail credit grew at 40 per cent in both 2004-05 and 2005-06 and it is largely responsible for the accelerationin growth in the past three years. Retail loans accounted for 25.5per cent of all advances in March 2006. Housing loans have beenthe fastest growing component of credit and these account fornearly 50 per cent of all retail loans [RBIa 2005-06].India’s ratio of household credit to personal disposable incomeof 9.7 per cent is way below the average of 35 for emergingmarkets in 2004 and even lower the average for mature marketsof 84. This suggests that, on an incremental basis, some 40 percent of credit is insulated from high risk. A key indicator ofrisk is exposure to the “sensitive sectors”, namely, capital markets,real estate and commodities. Such exposure accounted for 19 percent of all loans in 2005-06. This is a steep increase over thelevel of 3.5 per cent over the previous year but it is still not sohigh as to constitute a major risk.On the whole, therefore, the acceleration in credit growth bodeswell for bank profitability without posing systemic risk. Thisacceleration, along with the long period of persistence in highspread, has undermined a central tenet of reforms, namely, thatthe banking system will quickly separate winners from losers.Many people were sure who the losers would be: the PSBs. Thenew private banks and foreign banks would take away marketshare, leaving the PSBs struggling to make profit.This has not happened. True, the PSBs have lost market share.Their share of assets declined – in one of the periods for whichwe have examined trends in profitability earlier, 2000-06, themarket share of PSBs has declined from 83 per cent to 76 percent in 2005-06. However, profitability over the period hasactually increased. One factor, as noted in Section III, is thegrowth in volume as the overall pie expanded faster than beforeto offset the impact of the decline in the market share. The PSBshave defied the dire prognostications of those who saw profit-ability being eroded by the declining capital gains from treasury,high NPAs and poor technology [Basu 2005].Banking reforms have turned out to be, not a zero sum game,but a win-win game. We have seen the same phenomenon in othersectors, such as insurance and automobiles. The entry of newplayers opens up the market, so that there is enough growthforeverybody. A buoyant economy has tended to raise allbanking boats.VIPrivatisation and Foreign BanksIt is against this background that we must view the questionsof privatisation and foreign ownership. Let me first deal withthe issue of privatisation. In the present statutory framework,there is no scope for privatisation, although there is no legalconstraint on the expansion of private banks. Under the presentstatutes, shares in PSBs cannot be sold and government ownershipcan decline only through the issue of additional shares to public.Moreover, even if government ownership falls below 50 percent, the “public sector character” of banks remains undisturbed.This is something that the sections of the polity are not happywith and attempts have been made to amend the act suitably butwith no success so far, thanks partly to fierce resistance frombank unions. I believe it makes a sense for unions to showflexibility in respect of majority shareholding of government, ifthis comes in the way of banks’ raising additional capital –provided the provision relating to the “public sector character”of banks is retained.Further, in its road map for private banks, the RBI has madeclear what “private” means. It means that, in general, no singleentity can own more than 10 per cent shares in a bank,although a higher shareholding will be possible with prior RBIapproval. In keeping with international practices, the RBIwantsdiversified private ownership. Where this stipulation isnot met at present, shareholding must be brought down in anagreed time frame.Thus, there is no room for replicating in the banking sectorthe ownership pattern that obtains in much of Indian industry.If at all the PSBs are to be privatised, that can happen not throughsale to domestic industrial houses but through sale to banks,domestic or foreign, that satisfy the criterion of diversifiedownership. In practical terms, this means that only two domesticprivate banks, HDFC Bank and ICICI Bank, have even a theo-retical prospect of acquiring PSBs.For the most part, if at all privatisation takes place down theroad, the main contenders, both in terms of satisfying “fit andproper” criteria and in terms of financial muscle, will be foreignbanks. It should be clear, therefore, that any talk of privatisatingPSBs boils down to a greatly enlarged foreign presence in thefinancial sector. Is this necessary or desirable, with or withoutprivatisation of PSBs?Three considerations must be borne in mind. First, greateraccess to India’s financial sector must necessarily be a part of thenegotiations going on under the Doha round of the WTO. Ouroffer at present is to allow foreign banks a total share of 15 percent of total banking assets – the current share of foreign banksis around 12 per cent, comprising both balance sheet and off balancesheet items. If we are to go beyond the offer of 15 per cent, whatdo we get in return? The unilateral opening up to foreign bankscan be carried only so far. Any Indian bank, public or private,will tell you what an uphill task it is to acquire a branch licence,not just in the developed world, but also in east Asia.Secondly, foreign presence in the Indian banking can only bein keeping with regulatory capacity. There is a basic problemin regulating a foreign bank – the economic decisions are oftentaken abroad, while the risks are borne locally. Getting foreignbanks to have local subsidiaries does not make much of a dif-ference unless there is substantial local shareholding as well. TheRBI’s concerns about the regulation of foreign banks are thusentirely legitimate.Thirdly, the foreign bank presence must dovetail into ourbanking priorities. Agriculture remains a priority and it is thePSBs that carry the burden of catering to this sector. Hence, thefocus of policy must be on measures that strengthen PSBs, notweaken them.Foreign bank presence in the developed countries is quite low– about 10-15 per cent of banking assets. It is higher in manyemerging market economies – about one-third of banking assets.However, a striking, but little noticed, fact about high levels offoreign ownership in the banking sector in central Europe, LatinAmerica and parts of east Asia is that this is a sequel to bankingcrises. Banks failed, they needed infusions of capital whichgovernments could not afford, so foreign banks stepped in. Itis not meaningful to extrapolate this experience into an economysuch as India where the banking system has grown in efficiencyand soundness in the post-reform period.

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Economic and Political WeeklyMarch 31, 20071119The RBI’s road map for foreign banks must viewed againstthis background. The road map envisages two phases, 2005-09and thereafter. In phase I, foreign banks can expand in keepingwith present branch licensing policy and also by acquiring privatebanks identified by the RBI for restructuring. After April 2009,foreign banks are free to acquire any private banks and they canhold a stake of up to 74 per cent, subject to an assessment madeby the RBI of the extent of foreign penetration in Indian banking.I do not believe that after 2009, foreign banks’ appetite forthe Indian market will be satisfied through private bank acqui-sition. The real meat is in the PSBs. We can, therefore, expectpressures in favour of privatisation to build up. To the extentthat PSBs continue to do well, it will be difficult for anygovernment to justify privatisation. Non-performance, however,plays into the hands of advocates of privatisation. All bankemployees must be mindful of this fact.VIIBank ConsolidationLet me now turn to a subject that has been very much in thenews of late, bank mergers. I have written at length on this subject[Ram Mohan 2005a], so on this occasion I will confine myselfto summarising my main thoughts.One, mergers are required where the potential for organicgrowth is exhausted or limited. This is hardly the case with PSBs– we are seeing growth in both the top line and bottom line. Two,mergers, as a tool for increasing efficiency, are rather suspect.The evidence is that nearly two-thirds of all mergers fail toenhance overall value – that is, the value of the acquiring firmand the acquired firm put together. Three, mergers cannot bedictated by abstract considerations as to the relationship betweensize and efficiency – meaning the bigger the bank, the greaterthe efficiency. We do know from the literature that up to a certainsize, efficiency increases, then it tends to decline. We need toestablish, in the Indian context, what would be the optimal size.To my knowledge, such a study does not exist. So, we need tobe guided by broad evidence: is efficiency improving in thesystem and at individual PSBs? The answers, as we saw earlier,are in the affirmative. Where there is a general trend towardimprovement in efficiency, the case for mergers is weakened.Four, to say that the Indian banks are small by internationalstandards and need to grow bigger is a poor argument to makebecause no amount of merger is going to give Indian banks thesize to take on international majors in their own turf. The questionwe need to ask is: do we have the requisite size to cope withinternational majors on our own turf?For an international bank, a credible size in India would beat least Rs 75,000 crore of assets by 2009. This would requirean upfront investment of $ 1.5 bn, not a small figure for anemerging market investment even for an international bank, andeven this would not deliver a branch network formidable enoughto threaten PSBs. So, it is not lack of size that poses a threatto PSBs so much as the quality of human resources. Mergerscreate fresh human resource development (HRD) problems andare unwelcome for that reason alone.There is room for consolidation in Indian banking but that isin different segments altogether – the old private sector banksand cooperative banks. At present, many of these banks pose asystemic risk because of their weakness. Through mergers, manyof these banks have the potential to emerge as viable, regionalplayers. So, it is a bottom up approach, rather than a top downone, that makes more sense in our present conditions. In general,mergers among PSBs cannot be a priority, they would be anirritating and wasteful distraction for bank management.VIIIChallenges before UnionsI mentioned the HRD challenges before PSBs. This is an areato which all employees and unions need to give a great deal ofattention. Let me touch upon a few issues.The perception of bank unions among the general public israther negative. Unions are in the news when they make wagedemands and go on strike pursuant to those demands. Bankemployees, for some reason, are seen as a pampered lot. Perhapsthis has to do with perceptions about employee productivity andwage levels in banks that may have been true many years ago,but are no longer valid today.Unfortunately, whether we like it or not, the world is ruledby perceptions – and we have to deal with these. It is importantfor unions to deal with these because it is ultimately the goodwillof the public – those who are customers and also those who arenot – that will determine the fate of PSBs in the long run. Througha determined effort, bank employees can leverage the formidablecustomer base they have into a powerful source of competitiveadvantage. The two things together can help create a brand imageamongst the wider public that alone will guarantee the long-termsurvival of PSBs.For this to happen, unions must be in the news for reasonsother than wage demands and strikes. To begin with, let unionstake responsibility for customer service. Unions can arrange forcomplaint boxes of their own to be placed in branches. Theyshould themselves deal with errant employees. In consultationwith management, surplus staff in other areas can be used fordealing with customer complaints and also for pampering pre-ferred customers – through service calls at home, follow-up phonecalls, etc. Let superior customer service become substantially aunion responsibility. For a change, let unions agitate and takeout morchas demanding better-looking branches, better upkeepand better ambience!Banks need badly to upgrade HRD skills and resources. Thisis a problem that needs to be tackled in several ways. Unionsmust give the lead in demanding high-quality training – let unionrepresentatives on boards make this a priority. This could startwith a benchmarking exercise that identifies where the PSBemployees need to improve vis-à-vis their foreign and privatebank counterparts.Compensation needs to improve at PSBs but I have gravereservations about performance-linked incentives if only becausethese are difficult to implement at the best of times. I would rathersee base pay improve. For this to happen, unions must move awayfrom industrywide settlements. Such settlements could relate tominimum levels. But individual banks should be free to set higherlevels depending strictly on their capacity to pay. Unions havean important role to play in making their members understandthat this is crucial to the survival of PSBs. To stick to industrywisesettlements is to create conditions where PSBs sink together.There is a dire need for induction of high quality people atentry levels and also through lateral recruitment. The PSBs needto focus on campus recruitment and must be willing to offerpackages that are attractive enough to at least the second-tierbusiness schools. Here again, bank employees need to showforesight. This means a willingness to accommodate young entrants

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