Indian Banks’ Association BANCON 2011

Competing in the defining decade for Indian Banking

The Indian Banking System – Challenges Ahead

by Dr. C. Rangarajan

Chairman Economic Advisory Council to the Prime Minister

November 5, 2011

Indian Overseas Bank Chennai

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The Indian Banking System – Challenges Ahead

by

Dr. C. Rangarajan Chairman

Economic Advisory Council to the Prime Minister

It gives me great pleasure to be in your midst this

morning and to participate in the BANCON 2011. These

annual conferences have been extremely useful in

highlighting the important problems faced by the banking

industry. I am sure you will have fruitful discussions today

and tomorrow.

In any economy the financial sector plays a critical role in

facilitating economic growth. It does so through the

institutionalization of savings and investment. Financial

institutions, instruments and markets constitute the financial

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sector. It acts as a channel for the transfer of resources from

net savers to net borrowers. The gains to the real sector of

the economy depends on how efficiently the financial sector

performs the basic function of intermediation. The financial

sector performs the basic function of intermediation through

four transformations. These are: (1) liability-asset

transformation, (2) size transformation, (3) maturity

transformation, and (4) risk transformation. Thus the financial

system undertakes the tasks of pooling resources,

transferring resources across time and space, managing risks

and clearing and settling payments. An efficient financial

system performs these functions at a minimum cost and

through avoidance of systemic instability.

The Indian financial system comprises of an impressive

network of banks and financial institutions and a wide range

of financial instruments. There is no doubt that there has

been a considerable widening and deepening of the Indian

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financial system, particularly in the last two decades. The

extension of banking and other financial facilities to a larger

cross-section of the people stands out as a significant

achievement. As a ratio of GDP at current prices, bank

deposits increased from 18 per cent in 1969-70 to 45.3 per

cent by end-March 1995. Since then it has increased to 73 per

cent. All the indicators of financial development, such as, the

“finance ratio”, “financial interrelations ratio” and

“intermediation ratio” have significantly increased, implying

the growing importance of financial institutions in the

economy and the growth of financial flows in relation to

economic activity.

Contours of Reforms

The induction of reforms beginning early Nineteen

Nineties is an important landmark in the evolution of the

banking system in our country. Reform measures in India

were intended to create an enabling environment for banks to

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overcome the external constraints and operate with greater

flexibility. Such measures related to dismantling of

administered structure of interest rates and reduction of

several preemptions in the form of reserve requirements.

Interest rate deregulation was in stages and this allowed the

build up of sufficient resilience in the system. This is an

important component of the reform process which has

imparted greater efficiency in resource allocation. Parallel

strengthening of prudential regulation, improved market

behaviour, gradual financial opening and, above all, the

underlying improvements in macroeconomic management

helped the financial sector liberalisation process to run

smooth. The interest rates have now been largely deregulated.

The latest decision to deregulate the interest rate on savings

deposits nearly completes the picture. Without the

dismantling of the administered interest rate structure, the

rest of the financial sector reforms could not have meant

much.

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As regards the policy environment on public ownership,

the major share of financial intermediation has been on

account of public sector during the pre-reform period. As a

part of the reforms programme, initially there was infusion of

capital by Government in public sector banks, which was

subsequently followed by expanding the capital base with

equity participation by private investors up to a limit of 49 per

cent. The share of the public sector banks in total banking

assets has come down from 90 per cent in 1991 to below 75

per cent currently: a decline of about one percentage point

every year. Diversification of ownership, while retaining

public sector character of these banks has led to greater

market accountability and improved efficiency without loss of

public confidence and safety. It is significant that the infusion

of funds by government since the initiation of reforms into the

public sector banks amounted to less than 1 per cent of

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India’s GDP, a figure much lower than that for many other

countries.

Another major objective of banking sector reforms has

been to enhance efficiency and productivity through

increased competition. Establishment of new banks was

allowed in the private sector and foreign banks were also

permitted more liberal access. Nine new private banks are in

operation at present, accounting for around 10-12 per cent of

commercial banking assets. Yet another step towards

enhancing competition was allowing foreign investment in

private sector banks up to 74 per cent from all sources. The

policy relating to foreign banks is coming up for a fresh

review.

Reforms in the Government securities market were aimed

at imparting liquidity and depth by broadening the investor

base and ensuring market-related interest rate mechanism.

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The important initiatives introduced included a market-related

government borrowing and consequently, a phased

elimination of automatic monetisation of Central Government

budget deficits. This, in turn, provided a fillip to switch from

direct to indirect tools of monetary regulation, activating open

market operations and enabled the development of an active

secondary market. The gamut of changes in market

development included introduction of newer instruments,

establishment of new institutions and technological

developments, along with concomitant improvements in

transparency and the legal framework.

Role of Regulation

The current international financial crisis has important

lessons for the management of the financial system in general

and for the banking system in particular. Regulation has

emerged as a major factor in maintaining the solvency of

individual financial institutions and preventing systemic risk.

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What stands out glaringly in the current crisis is the

regulatory failure in the developed world. The failure was two-

fold. First, some parts of the financial system were either

loosely regulated or were not regulated at all, a factor which

led to “regulatory arbitrage” with funds moving more towards

the unregulated segments. Examples of “soft-touch”

regulation are investment banks, hedge funds and rating

agencies. Second, there was imperfect understanding of the

implications of various derivative products. In addition,

regulators failed to recognize the limits of financial markets.

It is ironic that such a regulatory failure should have

occurred at a time when intense discussions were being held

in Basle and elsewhere to put in place a sound regulatory

framework. There is a degree of consensus on how the

regulatory framework should be re-shaped. Some of the key

elements that should be integral to a reformed regulatory

structure are:

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1. The regulatory framework should cover all segments of

the financial markets. The rigour of regulation must be

uniform among all segments to avoid “regulatory

arbitrage”;

2. Systemically-important financial institutions should

receive special attention. Apart from additional

regulatory obligations, such institutions may be required

to conform to stricter and enhanced prudential norms.

Large institutions having operations across countries

may require coordinated oversight of regulators of

different jurisdictions. In fact, there is a proposal to

prevent financial institutions, particularly banks, from

growing beyond a certain size so that the dilemma of

“too big to fail” can be avoided. It is not clear at this point

how practical this will be.

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3. Institutions may be required to set up buffers in good

times to be drawn down in bad times. This may entail

varying capital adequacy and provisioning requirements

according to the phase of the business cycle. They may

be allowed to rise and fall with the business cycle.

4. Excessive leverage in banks may be contained through

additional supplements to the risk-based capital ratio.

Also, there is a proposal to set a limit on the leverage

ratio.

Apart from protecting individual financial institutions,

there is a greater focus on limiting systemic risk. Systemic

risk may be defined as widespread disruption to the provision

of financial services. In view of this, efforts are on to identify

macro prudential indicators and the appropriate tools aimed

at containing systemic risk. Macro prudential indicators

include aggregate indicators of imbalances, indicators of

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market conditions, and matrix of concentration of risks in the

system. National authorities and international institutions are

evolving the tools to reduce the risk in the financial system as

a whole. The macro prudential instruments that are used

commonly fall into three categories: (1) tools to address

threats from excessive credit expansion in the system, (2)

tools to address key amplification mechanisms of systemic

risk, and (3) tools to mitigate structural vulnerabilities and

limit spillovers from stress.

Challenges Ahead

The Indian banking system has emerged strong as a

result of the reforms introduced since early 1990s. It is this

which has enabled the Indian banking system to withstand the

impact of the international financial crisis. However, as we

move ahead, there are certain challenges and I would like to

highlight some of them.

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1. Capital Adequacy

The Indian banking system remains well capitalized. The

capital adequacy ratio for all scheduled commercial banks is

now estimated at 14.17 per cent, well above the required 9 per

cent. This high ratio means that the implementation of Basle

II standards will not pose much difficulty. However, public

sector banks face a peculiar problem. Given the current

Government policy of no stake dilution below 51 per cent,

capital for the public sector banks will have to come from the

Government budgets, banks’ own resources and from public

issues. The availability of capital through budget sets a limit

on the extent of expansion of credit by these banks. With

credit growth between 15 and 20 per cent per annum, if the

public sector banks are to retain their market share, there will

be need for continuous injection of capital into these banks.

During 2010-11, the Government had provided capital support

of Rs. 20,157 crore to the public sector banks. As against Rs.

6,000 crore budged for the current year, Government will

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have to come in with supplementary demands for grants

between Rs. 4,000 to Rs. 10,000 crore for meeting the capital

requirements. Thus the capital that needs to be injected by

the government will remain large and it has to be a

continuous process. Hence a long term programme of

injecting capital into the public sector banks will have to be

drawn up. Otherwise, the market share of the public sector

banks will have to come down and the slack will have to be

taken up by the existing and new private sector banks.

2. Non-Performing Assets

Besides the capital adequacy ratio, the other indicator of

the soundness of the banking system is the level of non-

performing assets. Asset quality of the Indian banks has seen

steady improvement. The gross and net NPA ratios have

shown a continuous decline. The gross NPA ratio of all

scheduled commercial banks stood at 14.6 per cent in March

1999. It declined steadily to 2.25 per cent in March 2008.

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However, during 2009-10, the gross NPA ratio increased to 2.4

per cent. Similarly, there was a rise in the net NPA ratio from

1.05 per cent in March 2009 to 1.2 per cent at March 2010.

This is the lagged impact of the crisis. Preliminary data

available indicate that the gross NPA ratio as of March 2011

may more or less of the same level as the previous year. In

the wake of the slowdown in growth in the current year, there

is some fear that the NPAs may raise. Higher interest rates

are also cited as a possible reason for the rise in non-

performing assets. It is true that in a period when growth

moderates, there is always a pressure on the quality of bank

assets. Interest rates by themselves are not a cause. It is

really the moderation in demand conditions that create

problems of recovery. The Indian banking system is also

exposed to some sectors of the economy such as power and

aviation which are not doing well. Non-performing assets in

all these areas will need continuous watch by banks. Banks

need to watch out as well for liquidity risk which will increase

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because of maturity mismatches. Increased exposure to real

estate and infrastructure will lengthen the maturity of the bank

assets. The dexterity of the bank management lies in

managing risk both in the upswing and downswing.

Profitability of banks will come under pressure for a

variety of reasons. The new capital rules as and when they

come into effect will increase the cost of operations. With the

deregulation of interest rate on savings deposits, the cost of

raising funds will go up. Financial inclusion agenda will also

have its own impact. In this context, apart from improving

operational efficiency, greater attention needs to be paid to

improving the recoveries of NPAs and on removing the

regulatory and procedural bottlenecks that come in the way.

3. Entry of New Banks

The Indian banking system remains reasonably

competitive even today. However, if the banking system is to

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remain competitive over time, there should be no bar on the

entry of new banks. A closed system can only become

oligopolistic. The “threat” of entry should not be eliminated.

It is upto the central bank to lay down the norms for entry. It

is also upto them to decide on who satisfies the criterion of

“fit and proper”. There is considerable controversy in the

country on whether corporate business entities must be

allowed to open banks. This is an issue on which “much

might be said on both sides”. Perhaps, the Reserve Bank

should keep this issue aside for the time being and find out if

there are “fit and proper” applicants from non-corporate

business segment.

4. Financial Inclusion

An aspect of the financial development which has

received much attention in recent days is financial inclusion.

The term financial inclusion has many dimensions. First, it

relates to bringing within the ambit of the organized financial

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system the vulnerable sections and people with low incomes.

Second, it denotes inclusion of all sectors of the economy –

agriculture, industry and services. Third, it also implies the

extension of the organized financial system to all

geographical regions. Thus, it has social, sectoral and

regional dimensions. However, the term financial inclusion

has largely been used to indicate the need to bring within the

scope of the organized financial system people in the bottom

deciles of population. It is herein equitable growth comes in.

Despite the faster rate of growth of manufacturing and

service sectors, bulk of the population still depends on

agriculture and allied activities for its livelihood. In this

background, one cannot over-emphasize the need for

expanding credit to agricultural and allied activities. While

banks have achieved a higher growth in provision of credit to

agriculture and allied activities last year, this momentum has

to be carried further. In this context, it has to be noted that

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credit for agriculture is not a single market. Provision of credit

for high-tech agriculture is no different from providing credit

to industry. Provision of credit to farmers with a surplus is

also of similar nature. Commercial banks in particular must

have no hesitation in providing credit to these segments

where the normal calculation of risk and return applies. It is

only with respect to provision of credit to small and marginal

farmers, special attention is required. They constitute a bulk

of the farmers and accounting for a significant proportion of

the total output.

The National Sample Survey Organization has recently

released a Report entitled, “Indebtedness of Farmer

Households”. This Report contains a wealth of data relating

to the extent and nature of indebtedness. As per NSSO data,

51.4 per cent of the total farm households did not have access

to credit. Another fact that emerges is that there is a

substantial difference between marginal and sub-marginal

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farmers on the one hand and the rest of the farmer

households on the other regarding the purpose for which

loans are obtained and the sources of credit. For all farmer

households taken together, at the all-India level, institutional

sources were responsible for providing 57.5 per cent of the

total credit. But as far as farmer households owning one

hectare and less, this proportion is only 39.6 per cent. For all

farmer households, the proportion of loan going for

production purposes is 65.1 per cent as against 40.2 per cent

for marginal and sub-marginal farmer households. Thus, for

sub-marginal and marginal farmers, the proportion of

production loan is lower than for all farmers. Similarly, the

proportion of institutional credit is lower for sub-marginal and

marginal farmers than for all farmers. This, in fact, is true of

every state of the country. Thus, a critical issue is how to

meet the credit requirements of marginal and sub-marginal

farmers. What changes do we need to introduce so that credit

can flow to this class of farmer households? Can the banking

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system through its present mode of distribution of credit meet

this challenge? Should we think in terms of banks supporting

other institutions who are in a better position to lend to

marginal and sub-marginal farmers? Banks need to think

hard on how to effectively use the `facilitator and

correspondent’ models. These models have great potential to

reach out to small borrowers and depositors. In any case, a

re-look at the organizational structure of our rural branches is

called for. Banks need to think deeply on how to meet this

challenge of meeting the credit needs of marginal farmers.

Financial inclusion is no longer an option; it is a compulsion.

As far as banks are concerned financial inclusion has

two dimensions. One is in terms of providing deposits and

payment facilities to the disadvantaged and under-privileged.

The second relates to the provision of credit facilities to such

people. In some ways it is easier to tackle the former than the

latter. Technology has opened up the opportunities for

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providing improved facilities in terms of depositing and

withdrawing cash. The business correspondent model

combined with the new technology should be able to take

these banking facilities to the interior parts of the country and

to people who have remained un-banked so far. But the

provision of credit facilities to the people of low incomes is a

much harder task. Once credit is granted, the business

correspondents can take over but the grant of credit itself

requires some fundamental changes in the way the rural

branches of banks function. In taking credit to persons with

small means, banks will have to play a proactive role in

organising self help groups. This experiment so far has

proved to be useful. The scale and scope of activities of the

SHGs must be enlarged and this would enable the banks to

reach out to people with low incomes, including marginal

farmers. Thus the two key instruments for widening the ambit

of the organised financial system and making the banking

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system more inclusive will be the business correspondents

and SHGs.

The experience of the banks in relation to the operation

of the business correspondents’ model so far has not been

that satisfactory. While, in principle, the model should work,

apparently in practice, the progress has not been

encouraging. Most of the business correspondents now

operate through Sec. 25 ‘not for profit’ companies. The basic

remuneration offered does not seem to satisfy the business

correspondents. The direct employment of the business

correspondents by the banks also faces difficulties. While we

should make the system of business correspondents work

better, we must also look at other alternatives. We should

explore the possibilities of looking at low cost brick and

mortar branches in Panchayat Headquarters. Profitability

rests on making the operational cost of such branches low.

The cost effectiveness of opening such branches needs a

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probe by banks. It is also worthwhile in this context to reopen

the issue of setting up Local Area Banks. The business

model underlying such banks is not a flawed one. It is very

meaningful. Further, thought should be given to this by the

banking system and the monetary authority.

5. Regulation and Innovation

Let me revert to a theme about which I had spoken last

year. As I mentioned earlier, the development of the financial

system is considered crucial to sustaining high economic

growth. However, in the wake of the current international

financial crisis some questions have been raised whether the

unfettered development of the financial markets and products

is good for the economy. It has been argued that not all

financial innovations are welfare maximising. Thus the recent

financial crisis has forced us to reevaluate the size, role and

rate of growth of the financial sector.

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Banking development has taken big strides in the last

two decades. The basic motivation for inducting new

financial products is to improve customer satisfaction. A

question that is being asked increasingly is whether the

financial sector today is inherently more volatile and

vulnerable than before. The very factors that have

contributed to the growth of the financial sector may well

have contributed to increase fragility. Close interdependence

among markets and market participants have increased the

potential for adverse events to spread quickly. They have

increased significantly the scope for and speed of contagion.

Some question whether the new financial products serve any

socially useful purpose. The Stiglitz Commission said “Much

of the recent innovation in the financial system has sought to

increase the short-run profitability of the financial sector

rather than to increase the ability of financial markets to

better perform their essential functions of managing risks and

allocating capital. In addition, innovation has engendered

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financial instability. Indeed from the point of view of the

economy as a whole, some innovations had a clearly negative

impact”. It would be inappropriate to classify all or even most

of the financial innovations introduced in the last few decades

as socially unproductive. Many of the financial products

satisfy a felt need. We are living in a world of uncertainty.

Customers need to protect themselves from the volatility in

exchange rates and interest rates. Appropriate hedging

mechanisms are therefore needed. It is the function of an

efficiently organized financial system to provide these

instruments. It is wrong to argue that the economic growth

seen by the industrially advanced countries in the recent

period particularly in the last decade and a half has not been

helped by the improvements in the financial markets. But

excesses in any field have their own dangers. There is no

argument that the regulatory regime needs to be restructured

to make the banking system more sound. Excessive risk

taking and leveraging by banks need to be discouraged by

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appropriate regulatory measures or controls. Of course, there

is the larger question whether the financial sector is growing

at a rate highly disproportionate to the growth of the real

sector. But to set the face against financial innovations is not

a wise policy. In developing economies like India the

structure of the economy is undergoing rapid change. The

financial system must be able to meet the diversified needs of

a growing economy. In this context, we must actually

encourage financial innovations. For example, in the Indian

context, I would like to cite two instances. First, there is the

need to encourage the emergence of a vibrant corporate debt

market. Efficient debt market will help not only large

industries but also small and medium enterprises. A number

of suggestions have been made to create an efficient debt

market in our country. Apart from other things, we will also

need institutions which will serve as market makers offering

two way quotes. This will provide the required liquidity to the

market and make it attractive to the investors. Second, there

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is the need to explore innovative ways of financing

infrastructure. Banks at present have certain limitations.

They have to take care of the mismatch in liability and asset

management. Of course, a vibrant debt market will also help

investors’ need for long term funding. ‘Take out financing’

has been suggested as one way by which the tenure of loan

can be increased. Thus the scope for financial innovation

continues to remain wide in India. We need to draw

appropriate lessons from the current international financial

crisis. Too little regulation may encourage financial instability

but too much of it can impede financial innovations which are

badly needed.

Regulatory oversight of innovations is necessary. But

the regulatory perspective on innovation must not become

too restrictive. In short, the policy makers must strike an

appropriate balance between the need for financial

innovations to sustain growth and the need for regulation to

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ensure stability. Financial innovations and regulations must

go hand-in-hand in order to ensure growth with stability in

real and financial sectors.

The theme of the conference which is ‘Competing in the

defining decade for Indian banking’ is most appropriate. In

many ways the coming decade will be crucial for India. It is

estimated that if India grows at 8 per cent per annum, India’s

per capita GDP will increase from the current level of $1,600 to

$8,000-10,000 by 2025. Then India will transit from being a low

income country to a middle income country. The Indian

banking system must assist India in this process of transition.

It is important that the banking system must develop to meet

the needs of a growing and diversifying economy. The

competitive environment is essential to make the banking

system cost efficient. Adequate availability of services to

customers both as depositors and borrowers must remain the

driving force. Obviously, regulation is important to steer the

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banking system towards prudence and stability. Within the

regulatory umbrella, we must nurture a competitive banking

system that will deliver efficient services at minimal cost.