Transformation of the Banking System

N.A. Mujumdar

It may be recalled that the Reserve Bank of India (RBI) introduced theme based Reports on Currency and Finance since 1998-99. The Report for 2005-06 belongs to this genre and addresses the issue of Financial Market Development. (The Report on Currency and Finance, 2005-06: Development of Financial Markets and Role of the Central Bank, 2006). This 322 page Report is a highly analytical document which covers, Money, Credit, and Foreign Exchange Markets, Government Securities Market, Corporate Debt and Equity Markets and the whole range of issues relating to financial market integration.

Historically, financial systems in emerging market and developing economies have been dominated by their banking systems. This is also true of India. This pattern has remained more or less unaltered over the years. Households invest only a small portion of their savings in the securities market directly or indirectly through mutual funds. There is a need therefore to "develop a diversified financial system over a period of time in which both financial institutions and financial markets play important roles" (page 5). What are the basic objectives of financial market development? To aid economic growth and development. The primary role of financial markets is to intermediate resources from savers to investors, and allocate them in an efficient manner among competing uses in the economy, thereby contributing to growth, both through increased investment and through enhanced efficiency in resource use.

While this broader theme is interesting in itself, what is more exciting is the story, that the Report unfolds, of the transformation of the Indian banking system, through reforms from a highly regulated system to a dynamic system which responds to the market signals. No banker can afford to miss this fascinating story. This article seeks to sum up the story under the following four topics. Deregulation and Liberalisation of the Banking System, Runaway Expansion of Credit, Credit Penetration, and Inequitable Interest Rate Structure.

Deregulation and Liberalisation of Banking System

Before the early 1990s, banks operated under a regulatory framework characterized by barriers to entry, administered interest rates, pre-emption of resources through high statutory liquidity ratio (SLR) and cash reserve ratio (CRR) and allocation of resources through mechanisms such as maximum permissible bank finance (MPBF) and selective credit controls. Banks suffered from several inefficiencies such as high intermediation cost, low profitability and high non-performing assets (NPAs). It is against this background, that banking sector reforms were initiated in the early 1990s in a phased manner to move away from a financially repressed regime to a liberalised regime through measures such as deregulation of interest rates, entry of new private sector banks, enhanced presence of foreign banks, reduction in statutory pre-emption, introduction of prudential norms, and permitting banks to raise capital from the market. These measures subjected banks to market discipline, enhanced competition and provided productivity and efficiency gains. This is reflected in the intermediation cost (operating expenses as a percentage to total assets) which decelerated from 2.77 per cent in 1996 to 2.11 in 2006 (page 155). Gross NPAs of scheduled commercial banks as a percent of gross advances to all sectors declined from 11.4 in 2001 to 3.3 in 2006 (page 140).

With a view to enhancing efficiency and productivity through competition, guidelines were laid down for establishment of new banks in the private sector. Since 1993, 12 new private sector banks have been set up. Foreign banks have been allowed more liberal entry. Foreign direct investment in the private sector banks is now allowed upto 74 per cent. Further, the banking sector is under-going a phase of consolidation. These were 12 mergers/amalgamations since 1999. 137 Regional Rural Banks (RRBs) were amalgamated to form 43 new RRBs bringing down the total number of RRBs to 102 from 196 in March 2005. Two major DFIs, namely ICICI and IDBI were converted into banks, and there was weeding out of unsound NBFCs. There has thus been structural transformation of the banking system.

Runaway Expansion of Credit

Another interesting feature of commercial banking operations is the runaway expansion of bank credit: during the three years 2004-05 to 2006-07, bank credit expanded by a phenomenal annual average rate of 30 per cent. Is this a "robust growth", as the Report puts it, or is it a worrying development? Let us look at the factors underlying the acceleration of credit. The major factors responsible for this explosion in credit were: pick up in economic growth, improvement in the asset quality of the credit institutions, decline in interest rates and rising incomes of households (page -131). As a result of various measures taken by the Government and RBI, credit flow to agriculture doubled from the annual growth rate of 10.6 per cent during the period 1990-91 to 1999-00 to 22.2 per cent during the period 2000-01 to 2004-05.

The other two sectors which witnessed rapid growth in credit were households or personal loans and housing loans. Household personal loans registered, on an average, a rise of 38.2 per cent during the five year period ended March 2005, as compared with the expansion of 25.2 per cent in the 1990s. The share of personal loans in total bank credit increased from 9.4 per cent at end-March 1990 to 25.2 per cent at end-March 2006.

This rapid expansion is attributed to the fact that restrictions on personal loans were removed and banks were given freedom to decide the quantum, rate of interests, margin requirements and repayment period. These relaxations have had a positive impact on the expansion of personal loans, as reflected in the sharp rise in the number of personal loan accounts.

Within personal loans, housing loans accounted for over one-half of total loans. Housing loans grew at an average annual rate of 47.7 per cent during the five year period 2000-01 to 2004-05. The average housing loan amount increased four times between 2000 and 2005. The share of housing loans increased from 2.7 of total loans of banks in 1991 to 11 per cent in 2005.

Robust economic growth has increased the demand for credit. The average annual growth in GDP in the last four years was over 8 per cent: in fact the growth was 9 per cent in 2005-06 and 9.2 per cent in 2006-07. Banks were able to sustain such a high, growth in credit by unwinding surplus investment in SLR Securities. Now the banks SLR investments have reached the statutory minimum level of 25 per cent, the scope for financing faster growth in credit in future years is limited.

What should be the policy response to such rapid credit expansion? The dominant view seems to be that a generalised policy of tightening credit may prove counter-productive. The appropriate policy response would be to strengthen the financial system by adopting suitable prudential and supervisory norms. The risks involved are not significant because the aggregate ratio of credit to GDP is still moderate, capital adequacy ratios are sufficiently high and NPA ratios are low. "Nevertheless, keeping in view the risks arising out of rapid credit growth, the Reserve Bank initiated several prudential and monetary measures to slow down the flow of credit to the sensitive sectors and maintain asset quality of banking institutions. The need for banks is to strengthen credit appraisal and post disbursal monitoring" (page 161).

Credit Penetration

Another related subject on which there is considerable discussion in the Report is credit penetration. Although India has a well-diversified financial system with a wide variety of credit institutions, credit penetration continues to be relatively low in comparison with several developed and emerging economies. For instance, the number of loan accounts per 100 persons in India is 15.8, as compared with 41.8 in Chile, 77.6 a Greece, 32.9 in Malaysia and 24.8 in Thailand (page 153). Perhaps the rapid expansion of credit discussed earlier, may reflect, to an extent, increasing financial deepening. The All-India Debt and Investment Survey 2002 revealed that the share of institutional agencies in outstanding cash debts of households declined from 66.3 per cent in 1991 to 57.1 in 2002. Concerns about inadequate access to institutional credit in rural areas continue to remain. RBI has taken several measures to extend the out reach of credit institutions in underserved areas. Recently, banks have been permitted to use the services of business facilitators and business correspondents to extend their outreach. "Banks are now increasingly roping in non-government organizations, SHGs and MFIs to act as intermediaries" (page 157). The SHG-Bank linkage programme is expected to gain further momentum with NABARD taking up a programme for intensification of these activities in 13 identified States, which account for 70 per cent of the rural poor population. The recent emphasis of RBI on "financial inclusion" has to be interpreted against this background.

One of the major reasons for low credit penetration is lack of awareness of facilities. The under-privileged sections of the Society with low levels of income generally hesitate to visit the banks. There is therefore need to devise some mechanisms to impart financial education, especially in rural areas. The focus of education should be on educating the general public about the benefits of using formal credit institutions for their requirements.

Inequitable Interest Rate Structure

The Report provides valuable analytical insights into the structure of interest rates, which has been evolved during the low interest rate regime. It was in April 2003 that the system of PLRS (prime lending rate) was replaced by a system of benchmark prime lending rate (BPLR). However, the bulk of bank lending has been taking place at sub-BPLR rates: for instance, the share of sub-BPLR lending increased to 82 per cent by March 2007. While higher credit-rated corporates are getting credit at Sub-BPLR rates, agriculture and SSI sectors and other borrowers are generally charged BPLR or in some cases above BPLR rates. The administered interest rate is applicable only in the case of agricultural loans below Rs. 2 lakh, and short-term production credit upto Rs. 3 lakh, and export credit. According to the data of the All India Debt and Investment Survey 2002, about 82 per cent of the rural debt was in the interest range of 12 to 20 per cent, while PLRs of banks were in the region of 11 to 12 per cent. This raises several fundamental questions: "to compensate for sub-BPLR lending, other segments are charged higher rates of interest, thus leading to cross subsidisation of the economically well-off borrowers by the economically poor borrowers". (page 159). Though the RBI has been advising bank to evolve their own BPLR by taking into account the cost of funds, transaction cost, cover for riskiness, fixation of BPLR continues to be arbitrary rather than rule based. There is therefore the need to take a fresh look at the concept of BPLR with a view to making the interest rate structure transparent and equitable. This is an aspect of banking which is bound to receive greater attention of RBI in the near future, because of its critical importance to efforts towards financial inclusion.

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