INDIA'S BANKS IMPROVE PERFORMANCE
By Dipta Sen
With economic reforms entering their second phase,
attention is shifting to reforming the financial sector. In the initial phase of
reforms, some flexibility was introduced regarding interest rates and provision
of credit. However, with greater reliance being placed on the private sector and
the market, finance has to play a much larger role in allocating resources to
ventures with the highest risk adjusted returns.
There has to be a shift in perception about finance; it should not be treated
merely as an adjunct of public finance activities of the state. However, given
the volatile nature of prices of financial instruments, and also because
information is unequally distributed among various players in financial markets,
it is recognised that regulation has a much larger role in finance than in many
other sectors of the economy.
Banks constitute the dominant component of the Indian financial system. About 30
to 40 per cent of household savings are in the form of bank deposits. In the
changed outlook towards finance, there is need to pay greater attention not
merely to interest rates and credit allocations but also to bank regulation, as
well as to supervision and incentives. Moreover, these issues have to be looked
into not only regarding individual banks but also for the entire banking system.
Banks' credit and risk management will need to be improved, and systems to
identify and improve poorly performing banks will have to be put in place. To
this end, policymakers need to develop an incentive mechanism that allows and
encourages institutions and individuals to gather and process information so as
to make optimal decisions.
In financial markets, those who need funds for some purpose have more
information than do those who are going to provide such funds. In India, with a
dominant public sector banking system that has its attendant problem of a lack
of appropriate incentives, this
situation gets accentuated. Banks have been the victims of the 1992 Harshad
Mehta scam as well as the current Ketan Parekh scam. Questions were and are
again being raised about the inadequate supervision by the RBI.
Banks in India are monitored by the RBI under the RBI Act and the Banking
Regulations Act, 1949. Over a time banking regulations became so detailed and
complex that managerial discretion of commercial banks was eroded. Banks need to
apply to RBI for licences to open new branches. RBI suggests even the size of
staff. Till a few years ago, existing regulations prescribed the amount that
each bank could lend. Moreover, Indian banks are required to direct 40 per cent
of lending to 'priority sector' comprising specified areas of economic activity
such as agriculture and cottage industry.
There is no doubt that in the post-1969 period, the banking sector has expanded
significantly: the share of rural branches has gone up, population served per
branch has fallen, per capita deposits and credit, and deposit and credit per
branch has gone up. The problem has been that the focus came to be only on
quantitative achievements; hardly any attention was paid to profitability and
efficiency. The result has been that rates of returns have fallen, the capital
base has been whittled down, the quality of consumer service deteriorated, and
the banks became saddled with non-performing assets (NPAs). The last of these
has been the most serious of the problems in recent years.
Several reform measures regarding banks have been taken since liberalisation
started in 1991. In November 1991 the report of the first Narasimhan Committee
was presented. It recommended lowering of reserve ratios of banks, that is, SLR
and CRR. It also recommended the entry of private and foreign banks in
commercial banking, increased competition in lending between Direct Finance
Institutions and banks, sale of bank equity to the public, phasing out of
directed credit and deregulation of interest rates and bringing of interest
rates on government borrowing in line with market determined rates.
Over the years most of these recommendations have been accepted and put in
place, except that regarding directed credit. The Narasimhan Committee had
recommended lowering the proportion of direct credit from 40 per cent to 10 per
cent along with narrowing the definition of priority sector, but the Government
did not accept this. This liberalised scenario has gone together with the tight
monetary policy soon after liberalisation. There is increased competition today
in consumer lending between banks and non-bank finance companies and direct
finance institutes.
Entry to the banking sector was deregulated in January 1993. Capital norms of
foreign banks have been relaxed and joint ventures between foreign and Indian
banks have been permitted. Since October 1997, interest rates on all time
deposits have been freed. SLR and CRR have been progressively lowered. The main
challenges before the banking system today are to improve credit and risk
management of loans to the private sector and dealing with weak banks. CRR could
be lowered even further but for the high fiscal deficit, which requires support
from the RBI.
Beginning 1991, banks had by and large in place uniform capital adequacy norms
and uniform prudential standards by 1996. The level of capital adequacy ratios
in some cases is however still a matter of concern, especially when increase in
capital is brought about by injection of capital by the Government. However,
banks are showing signs of increasing operational efficiency. Several of them
have been able to attract private investors and have been able to raise capital
from the market. Banks portfolios have improved and a need has been feel
increasingly to improve the asset quality. There are also increased efforts to
reduce NPAs. Another positive sign is the grand success of the VRS scheme for
banks.
What more needs to be done? First, prudential norms must be aligned with
international practice. Capital adequacy norms need to be raised further.
Second, some have suggested inter-bank trading between banks that have exceeded
lending to priority sectors and those that fall short. Third, there is the
question of whether weak banks should be made stronger through mergers, or
whether they should be privatised. Fourth, should bank management be given more
autonomy? Finally, the Government needs to work out norms for supervision of
cooperatives. They are regulated both by the RBI as well as under the
Registration of Cooperative Societies Act. This creates problems of supervision
as was witnessed recently in the Ketan Parekh episode. -- CNF