Two Faces of Banking Sector Reforms

Dr. N.A. Mujumdar
Former Principal Advisor
Reserve Bank of India

A perceptive analysis of the current discussions on banking sector reforms reveals that banking sector reforms in India have acquired two distinct faces: one which may be broadly categorised as the Basle face and the other Indian face. While the Basle face is the most visible, only the contours of the Indian face are now beginning to emerge. We must realize that for India's economic development, the Indian face is as important as the Basle face.

The Basle Face :

In the 1990s, the endeavour of the policy-maker, was to benchmark the services of the Indian banking system against "international best practices and standards". This objective was sought to be achieved by implementing the Basle I norms. For instance, the minimum Capital to Risk Assets Ratio (CRAR) has been set at 9 per cent, that is, one point above the international norms. The actual CRAR now stands at 12 per cent. Similarly, risk management models evolved by the Bank for International settlement (BIS) have been sought to be transplanted on to the Indian banking system. Commercial banks are now poised to implement Basle II norms from March 2007; and this would require more capital due to the fact that operational risk is not captured under Basle I.

One of the major objectives of banking sector reforms was to enhance efficiency and productivity of banks through competition. The administered structure of interest rates was dismantled and the level of pre-emption of resources for reserve requirement was reduced, New banks were allowed to be established in the private sector and the conditionalities of entry of foreign banks liberalised. Since 1993, 12 new private sector banks came into existence. Foreign direct investment (FDI) in private sector banks is now allowed upto 74 per cent, subject to guidelines. What has been the over-all impact of these reforms on the banking system? As Dr. Y.V. Reddy, Governor, Reserve Bank of India has shown concretely: "the overall efficiency and stability of the banking system in India" has greatly improved. (See Governor's, Speech: Banking Sector Reforms in India: An Overview, RBI Bulletin, June 2005). As we have seen, capital adequacy of Indian banks is at the international level. The percentage of gross non-performing assets (NPAs) to gross advances has declined from 14.4 per cent in 1998 to 7.2 per cent in 2004. During the last five years, the business per employee for public sector banks more than doubled to around Rs. 25 million in 2004. So far so good.

What does the future hold for the Indian banking system? In this context, we need to ponder over Dr. Reddy's prophetic pronouncement: "Consolidation, competition and risk management are not doubt critical to the future of banking but I believe that governance and financial inclusion would also emerge as the key issues for a country like India, at this stage of socio-economic development" (reference cited above). This brings us to the Indian face of banking sector reforms.

The Indian Face :

While the objectives of evolving "giant size" banks by consolidation and of making such Indian banks "globally competitive" are indeed laudable medium-term objectives to be aimed at, there are some neglected areas in domestic banking which need to be addressed immediately. In the milieu of the new banking culture fostered by reforms, lending to agriculture and priority sectors generally had become unfashionable. The relative magnitude of the flow of credit to agriculture had shrunk and the interest rate regime discriminated openly against agriculture. There was a significant reduction in small farmer borrowers. The rural credit delivery system had become practically moribund. These issues which are, in away, unrelated to the Basle reforms, have now acquired a sense of urgency because we need to step up agricultural growth to 4 per cent, from the average level of 1.5 per cent posted in more recent years.

It is this realisation which has led the Government of India to take policy initiatives in the following three areas: Enlarging the flow of bank credit to agriculture and small scale industries, and rebuilding the cooperative credit structure. In all these three areas, the elements of "inclusion" and "governance", to which Dr. Reddy reforms, are prominent.

First, the new Common Minimum Programme (NCMP) announced by the UPA Government in 2004 stipulates that bank credit to agriculture be doubled in the next three years. Public Sector banks (PSBs) have applied themselves seriously to attaining this target. In the first year itself, credit to agriculture has been stepped up by some 30 per cent. This is indeed a welcome development.

Second, the policy package announced by the Ministry of Finance, Government of India, in August 2005, for small and medium enterprises (SMEs) stipulates that credit to SMEs should be doubled in the next five years: from Rs.67,000 Crore in 2004-05 to Rs. 1,35,000 Crore in 2009-10. That is, PSBs should achieve a 20 per cent year-on-year expansion on credit to this sector. (For details see. Economic and Political Weekly, August 20, 2005).

Third, about the rebuilding of the cooperative credit institutions. The Government of India constituted in August 2004, a Task Force, under the Chairmanship of Prof. A. Vaidyanathan to formulate a practical and implementable plan of action and also assess the broad dimensions of the financial assistance that Government of India will have to extend to rejuvenate the rural cooperative credit structure. In its Report submitted in February 2005, the Task Force has placed the overall financial assistance required at Rs. 10,839 Crore and an additional Rs. 4,000 Crore towards contingencies needs to be provided. NABARD has been designated as the Nodle Agency to coordinate the implementation of the entire programme (see NABARD, Annual Report, 2004-2005).

Micro-Finance Institution :

While on this subject it is necessary to refer to another subtle reform that is taking place in the rural credit delivery system, namely, micro-finance. The programme of linking Self-Help Groups (SHGs) with the banking system has emerged as the major micro-finance programme. The RBI has been seeking to create an appropriate environment for the nurturing of non-governmental organistions engaged in micro-finance activities. Banks are being encouraged to adopt the agency model by using the infrastructure of civil society organisations, rural kiosks and village knowledge centers for providing credit support to farm or rural sector generally. (see RBI Annual Report, 2004-05).

The main thrust of this article is that reform of the rural credit delivery system is as important as the reform of the commercial banks. Rural Credit needs to be treated not as an appendage to the commercial banking system but as an integral part of it.

The views in the article are that of the author and the Institute may not necessarily subscribe to the contents.

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