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Convergence and Divergence of Indian Banking

The Reserve Bank of India's report 'Trend and Progress of Banking in India 2006-07' states that the Indian commercial banking system has achieved remarkable soundness, dynamism and resilience. And that there is also a convergence in the levels of soundness of public sector banks and new private banks. However, the RBI's claim that the indicators of soundness for Indian banks compare well with international standards is not convincing.


Convergence and Divergence of Indian Banking end March 2007. Thus, in terms of the two crucial soundness indicators, the Indian banking sector remained comfortably placed at end March 2007 [RBI 2007: 91]. Much more important is the direction in which most of the soundness indicators of
K B L Mathur the public sector banks (PSBs) have moved,

The Reserve Bank of India’s report ‘Trend and Progress of Banking in India 2006-07’ states that the Indian commercial banking system has achieved remarkable soundness, dynamism and resilience. And that there is also a convergence in the levels of soundness of public sector banks and new private banks. However, the RBI’s claim that the indicators of soundness for Indian banks compare well with international standards is not convincing.

K B L Mathur ( retired as economic adviser (banking), ministry of finance, government of India.

he recent Reserve Bank of India (RBI) report ‘Trend and Progress of Banking in India 2006-07’, (Report, henceforth), is a routine annual progress report of the Indian banking with a special focus on “financial stability”. It is a fitting reply to the sceptics, who even against the hard facts, continue to maintain that the Indian banking sector remains weak mainly because of the dominance of state-owned banks (SOBs).

In brief, the Report leaves no doubt over the fact that over a period, the Indian commercial banking segment of the financial system has achieved remarkable soundness, dynamism and resilience in a nondisruptive manner, notwithstanding the continuing dominance of public sector banks.

The capital to risk-weighted ratio (CRAR) of scheduled commercial banks (SCBs), a measure of the capacity of the banking system to absorb losses, was at 12.3 per cent at end March 2007, significantly above the stipulated minimum of 9.0 per cent. For as many as 79 out of the 81 SCBs, the CRAR was above 10 per cent. This was despite the tightening of norms and a sharp increase in risk-weighted assets during the last three years. Gross non-performing assets (NPA) ratio for SCBs declined to

2.7 per cent at end March 2007 from 12.4 per cent at end March 2001. The net NPA ratio touched the lowest at 1.0 per cent at showing a convergence with the levels obtained by the new private sector banks.

Even so, the RBI claim in the Report that the indicators of the soundness for Indian banks compare well with international standards is hardly convincing. Most certainly, there still remains a significant divergence between the levels of soundness of Indian banks when compared to international levels.


Based on the facts and analysis of the progress of the Indian banking system in the Report, this limited attempt is to comment on the two rather provocative policy statements in the current literature. The first is from the OECD Economic Survey [OECD 2007], first of its kind on India, wherein one of the policy recommendations for “reforming the financial system” is, to “move to a completely privately owned banking sector and allow foreign banks to fully own Indian banks”. The survey’s recommendation is based on its analysis, which includes the constraints imposed on public sector banks such as the directed credit stipulations, limits of foreign shareholding, vigilance possibilities, manpower rigidities, etc.

The second one is from a financial expert [Mistry 2007] asking a few questions regarding SOBs in the following form:

When SOBs are our weakest link – because they are inefficient, under-managed, over-staffed,

december 22, 2007 Economic & Political Weekly


over-unionised, customer-unfriendly, and techno-phobic – should we be considering a Rs 10,000 crore public capital infusion for State Bank of India (SBI)?... Do SOBs serve the public interest or the interests of the poor (in whose name they were nationalised)? Or do they serve limited interests, i e, those of their managers, staff bureaucrats, and politicians (sorely lacking in ethical, moral and intellectual fibre)?

While a detailed response to the above questions is beyond the scope of this short piece, the question relating to the weakness of SOBs, common to both the above mentioned studies can be replied to, in very brief, simply by citing a few latest available facts from the Report, which show a near total convergence in almost all the financial indicators between the PSBs and the new private banks (NPBs) (Table 1).

The convergence in most of the soundness and financial indicators of PSBs and NPBs as is visible from Table 1 mainly reflects the remarkable success of the reform measures including ownership diversification of PSBs instead of complete privatisation, strong regulatory and supervisory techniques of international standards followed by the regulator, improved technology, increased competition, and better management practices adopted by the PSBs. Admittedly, the PSBs have a significantly

Table 1: Indicators of Soundness (End March 2007, in %)

Indicators Public Sector New Private Banks Banks

A Soundness Capital adequacy ratio 12.4 12.0

Asset quality Net NPA ratio 1.1 1.0

Gross NPA ratio 2.7 1.9

Cumulative provision to gross NPAs 56.8 49.1

B Cost and return on funds Cost of funds 4.4 4.5

Return on funds 7.6 7.7

Spread (ii-i) 3.2 3.2

C Profitability Operating profit to assets ratio 1.73 1.88

Net profit to assets ratio 0.83 0.91

D Operationalefficiency Total operating expenses to assets 1.77 2.11

Wage bill to assets 1.14 0.61

Source: RBI (2007).

Table 2: Spread of Branches

Number of % to Total Branches Branches PSBs NPBs PSBs NPBs

Rural (population up to 9,999) 18,112 130 36.5 5.2
Semi-urban (population 10,000
to 99,999) 11,728 554 23.6 22.2
Rural plus semi-urban 29,840 684 60.1 27.4

Total number of branches 49,666 2497 100.0 100.0

Source: RBI (2007).

Economic & Political Weekly december 22, 2007

higher wage bill component in operating expenses compared to the new private sector banks. However, this needs to be seen in the backdrop of the most glaring difference in the spread of branches particularly in rural and semi-urban areas between the two bank groups.

The spread of branches as seen in Table 2 partly explains the higher wage bill component for PSBs and if this is labelled as weakness of the PSBs in terms of being over-staffed than the possibilities of enhancement of financial inclusion can hardly be considered.

Thus, ownership neutrality hypothesis deserves serious consideration mainly because the strength of the banking sector has been gained without

almost seven to eight out of the 10 country indicators fare better than India.

Return on Assets: The return on total assets (RoA) of banks, defined as the ratio of net profits to total assets, is one of the most widely used indicators of profitability. A higher RoA indicates the commercial soundness of the banking system. And as the Report has mentioned, “from the financial stability” point of view, a high RoA provides a level of comfort against potential shocks to the system. The RoA for Indian banks at 0.9 is, however, lower compared to the ratios for eight out of the 10 countries included for comparison in the Report (Table 3).

Table 3: Indicators of Banking Soundness:

getting into unwarranted systemic

India and Select Countries (End March 2007, in %)

risk factors with high probability Countries Return on Gross Non- Provisions Capital Capital to Asset Performing to Non-Adequacy Asset

under a completely privatised

Ratio Loans to Performing Ratio Ratio Gross Loans Ratio

banking structure. It needs to be

Advances remembered that during 1990s, 63 Ratio

India 0.9 2.5 56.1 12.3 6.3

countries suffered from “systemic

Emerging markets:

banking crisis”.

Argentina 2.1 3.2 132.3 -13.7

Brazil 2.1 4.0 153.0 18.5 9.4

Among countries that experienced

Mexico 3.2 2.2 194.7 16.1 13.2**

such crisis, the direct cost of re

Korea 1.1 0.8 177.7 13.0 9.5

structuring the financial system was

South Africa 1.4 1.1 64.3* 12.7 7.8** typically very high: for example, re-Developed countries:

capitalisation of banks had cost 55 US 1.2 0.8 129.9 13.0 10.6

per cent of GDP in Argentina, 42 per UK 0.5** 0.9 56.1* 12.9* 8.9**

cent in Thailand, 35 per cent in Ko- Japan 0.4** 2.5** 30.3** 13.1* 5.3 Canada 1.0** 0.4** 55.3** 12.4 5.6

rea and 10 per cent in Turkey… It is,

Australia 1.8* 0.2 204.5** 10.4 4.9

therefore, particularly noteworthy

* Pertains to 2005, ** Pertains to 2006.

that India could pursue its process of

Source: RBI (2007).

financial deregulation and opening of the economy without suffering financial crisis during this turbulent period in world financial markets. The cost of recapitalisation of public sector banks at less than 1 per cent of GDP is, therefore, low in comparison [Mohan 2007].

International Comparison

The RBI report, in its attempt to benchmark the Indian banking sector, finds that “the Indian banking system now compares well with the global standards in terms of operational efficiency and soundness indicators” (p 240). A review of the stylised facts given in the Report and as partly compiled for the year 2007 in Table 3, however, hardly corroborate the claim made in the Report. On all the indicators analysed in the Report for comparing the Indian banking sector with select five emerging market economies and another five developed countries, it is found that Non-Performing Loans: The quality of assets of banks is a crucial indicator of the financial health of the banking system and hence, financial stability. As mentioned in the Report, a lower non-performing loan (NPL) ratio indicates prudent business strategy followed by a bank. The NPL ratio for Indian banks at 2.5 per cent is higher from ratios in seven out of the 10 select countries compared in the Report.

Further, a low ratio of provisioning to NPLs makes the banking system vulnerable to shocks. The ratio of provisioning to NPLs for Indian banks is significantly lower from the ratios in seven out of the 10 countries included in the Report for comparison (Table 3).

Capital Adequacy Ratio: A bank’s capital is used as an indicator of bank soundness because of its role as the final buffer


against losses that it may suffer. The Report claims that the capital adequacy ratio of Indian SCBs at 12.3 per cent is “comparable with most emerging markets and developed economies”, whereas for all the four emerging market economies as available in the Report, the ratios are higher at 18.5 (Brazil), 16.1 (Mexico) and

13.0 (Korea) and 12.7 (South Africa).

Capital to Asset Ratio: The simple capital to asset ratio of banks indicates the extent of leveraging enjoyed by banks. As the Report continues to specify, a low capital to asset ratio implies higher leverage and greater vulnerability of a bank. The capital to asset ratio for Indian SCBs at 6.3 per cent is significantly lower from such ratios in seven out of the 10 countries included in the Report for comparison.

A short point being made here is that without (in any way) undermining the remarkable improvement achieved in almost all the soundness and operational indicators of Indian banks during the last six years (2001-07) or so, the Indian banking system has yet to attain comparable levels of international standards. That appears to be the reason for a deputy governor of the RBI to conclude that “if the Indian banking system is to attain international excellence, it will require action on several fronts like the introduction of greater competition; convergence of activities and supervision of financial conglomerates; induction of new technology; improvement in credit risk appraisal; encouragement of financial innovations; improvement in internal controls; and establishment of an appropriate legal framework” [Mohan 2007].


Mistry, Percy S (2007): ‘Confusion Worse Confounded?’, Business Standard, November 29.

Mohan, Rakesh (2007): ‘India’s Financial Sector Reforms, Fostering Growth While Containing Risk’, December 4, RBI web site:

OECD (2007): OECD Economic Survey, India.

RBI (2007): ‘Trend and Progress of Banking in India, 2006-07’, Reserve Bank of India, Mumbai.

december 22, 2007 Economic & Political Weekly

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