Foreign Banks in Historical Perspective
This article views the operations of foreign banks in historical perspective, and taking a cue therefrom, provides an analysis of contemporary policy that has promoted their aggressive expansion. The paper begins with a brief overview of the genesis and development of foreign banks in India. This is followed by an account of their operations, relative to the concurrent growth of domestic banks, during the colonial period. It then moves on to an account of developments in the post-independence period, including legislation related to prudential regulation, demarcating the pre- and post-nationalisation phases, and the pre- and post-liberalisation phases. All along, the focus is on the changing dimensions of foreign banks relative to domestic banks.
A KARUNAGARAN
I Introduction
O
A number of studies have analysed various aspects of FBs’ operations, mainly focused on their profitability and productivity performance, etc, in India [Sharma 1987; Nag and Shivaswamy 1990; Angadi 1990; Charvaka 1993; Aparna Viswanathan 1993; Karunagaran 1995; Ram Mohan 2004]. This article, however, provides a historical perspective, and taking a cue therefrom, it analyses the contemporary policy aimed at the aggressive expansion of FBs’ presence in the present context, and its likely implications. Towards this end, despite enormous data constraints, an attempt is made to analyse key aspects of FBs’ operations, from the pre-independence period until the post-reform era. The article is structured as follows: Section II gives a brief overview of the genesis and development of FBs in India. Section III covers the pre-independence period with respect to the operational status of FBs, interspersed with a discussion on domestic banks, to give a flair of the relative position of FBs vis-à-vis the rest of the system. Section IV gives a broad sketch of legislative developments in signposts – prudential regulation in the post-independence era, covering the pre- and postnationalisation periods. A brief account of the type of representations of foreign banks in the global context is presented. Section V outlines the changing dimensions of FBs in the post-reform period in India, briefly also dealing with FBs in emerging market economics (EMEs). The concluding remarks are set out in the Section VI.
II Genesis and Development of Foreign Banks in India – An Overview
Modern commercial banking in India, similar to that of the European banking system, is believed to have its origin in the establishment of British owned FBs in India. FBs in India have been operating for more than a century and a half. Under the colonial rule, the British took the lead in establishing FBs in India. There were attempts to establish FBs as early as 1836, for instance, “The Bank of India”, to be headquartered in London, with branches spread across India. The next attempt was in 1840, to set up “The Bank of Asia”. These initiatives were however, scuttled by the agency houses and the East India Company, apprehensing that such developments might affect their business adversely, as most of the banking and other functions relating to remittance, discounting of foreign bills, etc, were the virtual monopoly of these agencies. The “Oriental Banking Corporation” was the first Anglo-Indian commercial bank to be set up in 1842 at Bombay with a Royal Charter. The bank, however, shifted its head office to London within three years. This was followed by the opening up of “The Chartered Bank of India, Australia and China” and “The Chartered Bank of Asia” in 1853 [Khandelwal 1965]. Though British initiated the process of setting up banks in India, banks from many other countries, viz, France, Germany, Japan, Holland and US actively followed. India offered ample scope for the banking business to flourish with a high profitability during that time. Panandikar (1966) observed that the profits of banking in India attracted the nationals of a number of countries having important trade relations with India.
Most of the present-day FBs were originally called as “Exchange Banks” as the exchange transactions relating to foreign trade, foreign exchange, etc, were the exclusive domain of FBs. The Indian Central Banking Enquiry Committee Report of 1931 observed that FBs engaged predominantly in the financing of foreign trade and the entire foreign exchange business was a virtual monopoly of these banks. Exchange banks, invested considerable funds in the discounting of foreign bills during the busy season [Rau 1930]. Incidentally, references state that the term “exchange bank” was used even in western countries, mainly referring to those banks that were dealing with the financing of trade of India and China, as these countries did not adhere to the gold standard and their exchange rates were subject to wider fluctuations. FBs also carried out the normal transactions, viz, financing internal trade [RBI 1970], albeit to a lesser extent, accepting deposits, lending to industry and so on. However, there was no trace of these banks financing agriculture and rural activities. Interestingly, even the Indian joint stock banks (IJSBs) played a negligible role in providing agricultural finance [RBI 1970]. However, there is considerable debate and disagreement in the literature regarding reference to all “FBs” as “exchange banks” as there were also FBs that did not exclusively deal in trade-related finance.
Though FBs played an important role in promoting the foreign exchange business, foreign trade-related financing and bills discounting, etc, they were always criticised to be more favourable to European traders at the cost of Indian business interest. For instance, the Indian traders unlike the European businessmen, were required to deposit 10 per cent to 15 per cent of the value of the merchandise with the FBs to open a confirmed letter of credit [Rau 1930].
Operational Status of Foreign Banks
As pointed out, by the Indian Central Banking Enquiry Committee, virtual monopoly in financing of foreign trade and the foreign exchange business was possible for FBs (exchange banks) for the reasons, inter alia, that they had an edge over the IJSBs in this area due to their long-drawn-out exposures in similar activities in their parent countries and other parts of the world. However, the presidency banks (later the Imperial Bank of India) were legally restricted, almost till 1935, on participating in the foreign exchange business [Khandelwal 1965; RBI 1970; Rau 1930]. Nevertheless, the role of the FBs in financing and promotion of India’s foreign trade had been substantial and important [Chandavarkar 1984].
Reliable data on the functioning of the FBs are available only since 1870 [RBI 1954], but not uniformly on all aspects of their business operations. There were only three banks in operation in 1870, with aggregate deposits of Rs 5.2 million, constituting
4.2 per cent of total banking deposits. In the early stages, FBs were primarily dependent on their home country for funds to meet any demand for additional finance, which did not augur well for the development of the domestic credit and money markets in India. However, later on the FBs became very active in mobilising deposits in the domestic market, competing with the IJSBs. The number of banks had increased to four in 1880 and the deposits rose to Rs 34.0 million. Though the number of banks increased very slowly, the deposits had increased rapidly. During the entire decade of 1890 only one bank was added while deposits accelerated to Rs 75.5 million (Table 1). Although international trade, one of the principal areas of financing by FBs, had slowed down between 1870 and 1890 [Chaudhari 1984], growth of deposits in respect of FBs was very rapid during this period [Goldsmith 1983]. It was in 1900 that the number of banks increased to eight and deposits multiplied to Rs 105.04 million. Though the decade of 1910 had to face the wrath of the first world war, that did not deter the FBs’ operations. On the contrary, there was appreciable growth of deposits among these banks during the war. For instance, a year before the first world war, during 1913, the deposits of 12 FBs had grown to as much as 70 per cent of that of the three presidency banks and to nearly one-third of the entire banking system. During the war, the number of banks declined to 9, but deposits surged manifold to Rs 533.8 million. The outbreak of war affected the operations of FBs only in terms of their need for high cash balances (63.21 per cent in 1917), reducing their turnover, though the war affected India’s foreign trade gravely. The low turnover was also largely due to a lower demand for credit as industrial production was hampered due to the government assigning greater priority to the production of war related materials [Khandelwal 1965]. The post-war period witnessed a spurt in the operations of the FBs reflected in the growth of number of banks as well as the deposits.
The decade ending 1920 saw the number of banks and the deposits increasing to 15 and Rs 748 million, respectively. But, towards the end of 1920s the global depression had an adverse effect on India’s foreign trade [RBI 1970]. The entire banking system, including FBs, was affected. Consequently, by 1930s the deposits of the FBs decelerated to Rs 681.1 million, with the number of banks at 18. The 1930s were prone to many economic and political upheavals, such as recession, decline in foreign trade and the outbreak of the second world war towards the end of the decade. All these developments had an adverse effect on the banking system in India. The reliability of the data of the 1940s up to 1946 has been questioned by many, including Chaudhari (1984), as the period was reeling under heavy inflation. Coterminously, during this period the FBs also performed better in terms of total deposits reaching Rs 1,812.8 million in 1946, which constituted nearly one-third of the total deposits of the commercial banking system in India at that point of time, despite the number of foreign banks dropping to 15. The data relating to deposits is bloated due to wartime inflation. Nevertheless, FBs in India could hold up the confidence of the public even during a period of wartime uncertainties.
FBs maintained around one-third of the business of the banking system more or less throughout the period under analysis, and untill the early 1940s. Their deposits remained high between 1880
Table 1: Foreign Banks in Colonial India
| Year | No of Banks | Deposits (Rs million) |
|---|---|---|
| 1870 | 3 | 5.2 |
| 1880 | 4 | 34.0 |
| 1890 | 5 | 75.4 |
| 1900 | 8 | 105.1 |
| 1910 | 11 | 247.9 |
| 1920 | 15 | 748.1 |
| 1930 | 18 | 681.1 |
| 1940 | 20 | 853.3 |
| 1946 | 15 | 1,812.8 |
Source: RBI: Banking and Monetary Statistics, various volumes.
and 1940. Contemporaneously, the operations of the IJSBs also expanded rapidly during the period 1895 to 1946. However, the impact of their growth seemed to have affected, by and large, only the presidency banks, rather than the FBs. This is mirrored in the apparent shift in the proportion of deposits among and between the domestic banks, the relative share of deposits in respect of IJSBs increased from as little as 1 per cent to as high as 62 per cent, while the relative share of deposits in respect of presidency banks sharply came down from as high as 95 per cent in 1870 to around 23 per cent in 1946. Thus, there was more competition among and between the domestic banks rather than between foreign and domestic banks. After all, the FBs were located mostly in the port towns and major cities and they established patronage of a “niche clientele”. They were thus somewhat insulated from the competition of domestic banks. The upcoming IJSBs were mostly located in the interior of the country and in the suburban centres, seeking new clients, in places where the presence of FBs was either non-existent or very negligible.
While both the FBs and the presidency banks always maintained relatively low cash balances, except during the war, the IJSBs almost always maintained shoddy cash balances. This could as well be one of the strong reasons for the frequent bank failures among the IJSBs, though the stronger and bigger banks continued in business and new banks continued to enter. The Indian Central Banking Enquiry Committee Report also highlighted a number of reasons for such failures, which inter alia, were insufficient capital and reserves, inadequate assets, payment of exorbitant interest rates to attract deposits, injudicious lendings, speculative investments and dishonest and incompetent management. Referring mainly to IJSBs, J M Keynes expressed apprehension that “in the case of smaller banks, the cash balances seem to be hopelessly inadequate and it is hard to doubt that in the next bad time they go down like nine pins”.
The FBs held as much as 28.4 per cent of the total credit (total credit includes both bills discounting/purchasing and loans/ advances) of the banking system in 1935. This, however, plummeted to 12.4 per cent in 1946, despite an increase in absolute terms to Rs 675.9 million. The growth rates increased from (-) 3.9 per cent in 1940 to 12.06 per cent in 1945, reflecting the immediate post-war recovery. However, growth decelerated again, in 1946 to 8.86 per cent. As against this, the Imperial Bank’s share that was placed at 20.75 per cent of total credit in 1935, had come down to 17.1 per cent in 1946, while the IJSBs were growing faster. The latter’s share had increased steadily from 50.9 per cent in 1935 to as high as 71.9 per cent in 1945, though it declined marginally to 70.6 per cent in 1946. Interestingly, despite their faster growth, the IJSBs were unable to make much headway in the exchange/foreign trade-related finance business and their share in those areas continued to be marginal. IJSBs were by and large specialised in short-term credit to trade and industry. Both foreign banks and IJSBs were not financing agriculture and other allied rural activities, as pointed out by the Indian Central Banking Enquiry Committee Report. Similar was the case with the presidency banks.
Though the FBs witnessed a good growth performance in terms of deposits and credit, their relative share in aggregate deposits and credit in the banking system was getting thinner, and was overwhelmingly being taken over by the domestic banks even before the country’s independence. During the war, the flurry of banking activities was high, which induced the entry of a larger number of weak IJSBs than FBs.
III Foreign Banks in Post-Independent India
Key Legislative Developments
The banking system left behind by the British at independence metamorphosed in size, stature, scope and nature of operations. Independent India witnessed many “landmark events” in the financial system in general and the banking system in particular, which affected the functioning of FBs in India, both directly and indirectly. Some of the key policy and legislative measures such as the nationalisation of the Reserve Bank of India, the passing of the Banking Companies Act, 1949, introduction of five-year economic plans, conversion of the Imperial Bank of India into the State Bank of India, takeover of the princely state owned banks and their conversion into subsidiaries of SBI, introduction of deposit insurance, etc, left an indelible mark on the banking scene in India. Among these, the passing of Banking Companies Act, 1949 (presently Banking Regulation Act2) was considered to be the “single most vital legislative initiative”, as this was very instrumental to repaint the whole banking canvas including the position and functioning of the FBs operating in India during the successive years of free India.
Regulation of Foreign Banks in India
The Indian Central Banking Enquiry Committee recommended as early as in 1931 a comprehensive legislation for banking companies. This legislation encountered many hurdles, but with the RBI’s initiative, ultimately took the shape of the Banking Companies Act, 1949. One key aspect of the Act was that it brought both foreign and domestic banks on an equal footing. Until then, it was alleged that the FBs were privileged, as there were neither Indian nor British legislations to govern and regulate their functioning and ensure transparency in their operations. FBs were not required to furnish any detailed information regarding their state of affairs to the Reserve Bank, which was the regulator, excepting a weekly statement under Section 42 of the RBI Act, 1934 and a copy of their consolidated balance sheet [RBI 1970]. This information was far too insufficient for the regulator to assess the precise position of a foreign bank’s operations in India. Among the FBs, British banks had always enjoyed greater privileges, despite lot of criticism from various quarters.
The Banking Regulation Act, 1949 was amended on number of occasions to accord adequate authority to RBI, the regulator and supervisor of the banking system. It was only in 1958 that the RBI decided to inspect each bank once a year, although the practice of inspecting the banks, on a restricted scale, began way back in 1940, in consultation with the government [GOI 1972]. The power to inspect FBs, however, came in for the first time, by amendment to Banking Regulation Act in 1959. The act thus, became a powerful tool in the hands of the regulator to steer the entire banking system, including the FBs along a prudentially desired trajectory. The act prescribed the minimum capital for all banks functioning in India. For banks incorporated elsewhere, the aggregate minimum value of paid up capital and reserves was Rs 15 lakh and Rs 20 lakh, respectively, if the banks were located in Bombay and Calcutta. These amounts were revised from time to time3 . Such amount was deposited with the RBI either in terms of cash or in approved securities. The Act empowered the RBI to mould and re-mould their lending policies or even stop any particular type of business activity that is deemed to be detrimental to the public/depositors in India. Further, the Act contains several vital provisions relating to issue, cancellation and forfeit of licence, closure of existing banks/branches, calling for returns, reports, inspection, regulation and supervision and empowers the RBI to issue directives to FBs to maintain certain portion of assets and liabilities in India. These developments impacted on the style of functioning, orientation and relative status of FBs in the banking system.
Review of Operations, 1947-1969
FBs, which were in the commanding heights of Indian banking before the country’s freedom, showed signs of decline towards the end of the colonial period itself, and this continued almost steadily thereafter. In 1947, the number of FBs was 15, with a business share of 14.2 per cent and 17.3 per cent in terms of deposits and credit, respectively. There was a sharp decline in their overall position in terms of their share of aggregate deposits and credit over the period (Table 2).
Except in 1950, their share of deposits in the banking system has progressively declined, reaching 9.3 per cent in 1968. The period also saw a sharp decline in the number of domestic joint stock banks, more specifically, the non-scheduled banks, during the late 1950s and 1960s, either due to merger and consolidation or liquidation. The “Bank Award of 1950” accelerated this process, due to strong implications for the operational cost of banks, and consequently, several uneconomic banks were forced out. The momentum of weeding out substandard and non-viable banks had further picked up with the report of the Travancore-Cochin Banking Inquiry Commission. The process was accelerated further with the enforcement of the Banking Companies (Amendment) Act, 1960. Thus, a conspicuous feature of the Indian banking scene during the 1950s and 1960ss until the nationalisation of major commercial banks was the progressive expansion of the healthier banks coterminous with the large-scale amalgamation/consolidation or liquidation of smaller and unviable banks. These developments impacted on the size, stature and style of functioning of FBs. The FBs continued to operate with a relatively lower “cash balance” without hindrance. For instance, their cash balance had progressively descended from 16.6 per cent to 5.8 per cent of their deposits during the period. The exceptional level of cooperation among and between FBs helped them overcome any liquidity problem. FBs operated almost always in seclusion from the domestic banks. They had a business share of more than 17.3 per cent of the aggregate credit of the banking sector in 1947, slightly more than the Imperial Bank’s share, which declined to 11.5 per cent in 1968. A similar trend was observed in the case of deposits. On nationalisation of the Imperial Bank and its conversion to the State Bank of India, and its subsidiaries, the growth of domestic banking was significantly stepped up.
The credit deposit ratio was higher for the FBs, in range of
55.8 per cent in 1947 to 87.06 per cent in 1960 (Table 2), while the same for the domestic banks hardly crossed 70 per cent, including the Imperial Bank of India. This signified proactive credit expansion, despite their limitation of concentrated location and wholesale banking. In the absence of data specific to foreign bills/foreign trade-related business, it was not possible to say whether the predominate position of FBs in this area was impaired with the adoption of various legislative and other deliberate policy measures giving a greater and freer role to domestic banks during this period. However, in the overall, the relative importance of FBs had declined over the years in the post-independence period, vis-à-vis domestic banks. As the Report of the Banking Commission (1972) noted: “…the relative importance of FBs in the banking system declined…”
IV Modes of Operation of Foreign Banks
Globally, FBs have been permitted by the host country to function either in one or the other of the models described below, and at times, in more than one form, depending upon various factors. Practically, all countries including the most laissez-faire, adopt the following restrictions: permitting only a particular format, a limit on the number of branches/offices, requirement of very high capital infusion upon entry in terms of forex, type of business and fixing a limit for acquiring an interest in domestic banks, etc.
The various types of representation of FBs in the global context are as follows:
(iii) Affiliate bank: Here the FB/entity holds an equity interest in a local bank in the host country, which however is not large enough to permit the FB to control the activities of the local bank.
Table 2: Foreign Banks in India, 1947-68
| Year | No of | Assets/ | Cash | Deposits | Total Credit* | Credit- |
|---|---|---|---|---|---|---|
| Banks | Liabilities Balances | (Per Cent | (Per Cent | Deposit | ||
| (Rs Million) | (Per | Share in | Share in | Ratio | ||
| Cent of | Total | Total | (Per | |||
| Deposits) | Banking) | Banking) | Cent) | |||
| 1947 | 15 | 1,636.7 | 16.61 | 14.19 | 17.27 | 55.86 |
| 1950 | 14 | 2,346.0 | 10.90 | 17.22 | 23.04 | 78.25 |
| 1955 | 17 | 3,319.2 | 10.45 | 16.95 | 23.86 | 85.49 |
| 1960 | 16 | 3,752.2 | 9.05 | 12.00 | 16.57 | 87.06 |
| 1965 | 15 | 4,918.1 | 6.32 | 10.67 | 12.47 | 77.58 |
| 1968 | 13 | 6,484.4 | 5.83 | 9.28 | 11.51 | 84.98 |
Note: * Includes advances and bills discounted/purchased. Source:RBI: Statistical Tables Relating to Banks in India, various volumes.
(vi) Foreign bank branch: Other than location in the host country, the foreign branch of a bank is just another branch of a commercial bank.
The choice of a particular archetype in a host country is influenced by the host country’s government/supervisory authorities. It could also partly be the result of the legacies of the past. In case, a country is a member of a regional bloc, viz, the European Union, ASEAN, etc, the choice of the type of representation may depend on the treaty signed by the member countries. In the emerging scenario, agreements under the auspices of the World Trade Organisation could play a stronger role.
Modes of Operation in India
In India, historically there does not seem to have been any regulatory restrictions on FBs for their operations. Some of the larger banks, in exist for more than a century, are the legacy of the past. Since independence, and especially after the banking laws, FBs had been permitted to operate in the following formats only: as an agency office, a representative office or as a branch office. Since 1984, the FBs have been permitted to establish an agency arrangement/tie-up with the local entity, subject to the prescribed terms and conditions specified by the RBI. Until recently, FBs had been explicitly prohibited from functioning as a subsidiary in India. As part of financial liberalisation and globalisation, in February 2005, RBI permitted the FBs to have their wholly owned subsidiaries (WOS), by acquisition of holding in domestic private sector banks identified for restructuring. In India, the choice of a particular structure for operation, apart from historical reasons, takes into account the planned strategy of rebalancing efficiency and stability in the financial system [Reddy 2005]. Accordingly, several key parameters, viz, country-wise diversification, overall presence in India, international standing of the bank and its global status, trade relations, the political, economic and financial relations between India and the respective banks’ country of origin, overall benefits accruing to the country in allowing such banks to operate in India, the policy of reciprocity followed by the other country whose bank seeks permission in India, etc, are being given due consideration while permitting a FB to enter the Indian market.
V Foreign Banks in the Post-Reform Period
Changing Dimensions
Post-Nationalisation and Pre-Reforms Period
FBs operations have continued to be confined to the select major cities and metros. The relative share of FBs in terms of total assets has drastically reduced from 8.6 per cent at end-March 1971 to just around 3 per cent at end-March 1991, the remaining 97 per cent constituted by the domestic banks. Similar has been the trend in respect of deposits and credits, as the domestic banks have expanded both in terms of business and branch spread. The relative size of deposits of the FBs dropped to a miniscule level (Table 3). This compelled them to resort to large-scale borrowings from the inter-bank markets in money and foreign exchange. Nevertheless, due to their long standing experience and worldwide exposure, FBs had an edge over domestic banks in the creation and deepening of these markets, in terms of both volumes and multiplicity of products. However, as FBs had to resort to large-scale borrowings in the call money markets, disproportionate to their asset base, there was the possibility of distortion of rates. Unlike in the past, only in select areas of business did FBs enjoy a domineering position over domestic banks, by creating a niche around them. FBs became highly specialised in a few select areas, viz, extending foreign currency loans or arranging foreign currency loans through loan syndications, investment banking, consultancy relating to investment activities, portfolio management, and in general capital market-related and derivative market-related areas.
In retail banking they were confined to the elite clientele or high net worth customers. Wholesale banking had become the order of their style. FBs offered their expertise to the Indian corporate sector to access foreign currency resources with the help of their overseas presence. This did help the Indian corporate sector to raise much needed foreign capital, especially when the country was in distress with a precarious level of forex reserves during the early 1990s. FBs had become highly mechanised and computerised, placing themselves a cut above the domestic banks in espousing banking products/services based on information and communication technology. These developments eventually trickled down to domestic banks through the demonstration effect in the 1980s. The profitability (measured in terms of RoA) of FBs has always been far ahead of the domestic banks. For instance, the RoA for the year ending March 1971 was 1.61 per cent, which was as high as 2.54 per cent for the year ending March 1975, reduced to less than 1 per cent for the year ending March 1991, and yet, far above the banking system’s average. It has been pointed out that the higher profitability was purely the result of higher efficiency among FBs vis-à-vis domestic banks [Battacharyya 1997]. Efficiency criteria, however, needs to be evaluated against a set of wider objectives [Shetty 1978]. It is important to take into cognisance the fact that the domestic banks, particularly the PSBs, were given the onerous responsibility of branch expansion, not based on commercial prospects alone. The mandated goal for domestic banks was “branch expansion” rather than “financial profit”. On that count, PSBs performed exceptionally well, placing India at the top of the league as the world’s
Table 3: Bank Group-wise Share in the Banking System, 1971-91
(In per cent)
Total Deposits# Advances and Loans# Total Assets# PSBs Private FBs PSBs Private FBs PSBs Private FBs Banks Banks Banks
1971 84.65 7.02 8.32 84.62 6.82 8.56 84.62 6.82 8.56 1975 84.93 9.36 5.71 86.38 8.17 5.44 86.38 8.17 5.44 1980 91.91 5.15 2.94 92.30 4.57 3.13 92.30 4.57 3.13 1985 92.57 4.58 2.85 93.04 4.14 2.82 93.04 4.14 2.82 1990 92.53 3.94 3.53 94.13 3.35 2.52 94.13 3.35 2.52 1991 92.11 4.16 3.73 93.72 3.44 2.84 93.72 3.44 2.84
Interest Income* Other Income* Return on Assets@
1971 60.20 61.42 54.19 39.80 38.58 45.81 0.73 0.63 1.61 1975 58.46 58.95 51.84 41.54 41.05 48.16 0.79 0.59 2.54 1980 58.44 62.97 50.16 41.56 37.03 49.84 0.66 0.59 2.37 1985 57.23 59.37 41.55 42.77 40.63 58.45 0.74 0.73 1.92 1990 90.92 90.24 82.59 9.08 9.76 17.41 0.14 0.23 1.20 1991 90.45 89.85 82.58 9.55 10.15 17.42 0.16 0.32 0.94
Notes: #Refers to the percentage share in total of commercial banking system only.
* Refers to percentage share in the total income of the respective group. @Refers to net profit as a proportion to their own total assets.
Chart: Foreign Banks (Post Reforms Period)
(Percentage share in the banking system)
Ratio
30
20
10
0
-10
-20
-30
| 1993 | 1995 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 |
Years
Assets Deposits Advances Other Income Profits largest “branch banking system”, though this had its own flip side. This period could rightly be referred to as the “expansion period” in Indian banking.
Foreign Banks during the Post-Reforms Era,1993-2005
The operations of FBs received a considerable boost during the post-reforms period. The reforms included successive relaxations in various policy measures addressed to FBs, inter alia, permission to start WOS, relaxed branch expansion, voting rights, acquisition in domestic private sector banks up to 74 per cent, relaxation in the priority sector’s composition, including investment in the IBP to qualify, repatriation of profits, capital requirements, etc. These developments have had a tremendous impact on the overall functioning of the FBs. Consequently, there is divergence from the tradition of strict confinement to the “major towns and metro cities”, stretching out into relatively smaller but “commercially vibrant cities” in later years.
The number of offices of FBs increased sharply from 145 at end-March 1990 (before reforms) to as many as 245 offices by end-March 2005, while the number of Indian bank branches abroad remained more or less stagnant; only in end-March 2005 it reached to 97 offices. Moreover, all Indian bank offices abroad are not full-fledged branches. For instance in Singapore, though six Indian banks have an office each, SBI and ICICI bank offices have only a restricted licence, as the Asian Banking Union (ABU) authorises them to deal only in US dollar and none of the Indian bank offices are permitted in the retail banking business (Business Line, December 14, 2005), despite a large ethnic population of Indian origin, and regardless of WTO agreements and the principle of reciprocity. One of the most important aspects of continuity of FBs in India is their higher profitability ratio vis-àvis the banking system. Their percentage share in the total assets, (see the chart) hovered around 6.7 per cent. However, this is more than double their position during the pre-reforms period (less than 3 per cent) (Table 3). Deposits and investments hovered around 5 per cent during the post-reforms period. Significantly, the share of income from non-interest income sources was always higher, clearly reflecting higher dependence on the non-fund based activities, marking one more aspect of continuity.
FBs have increased their exposure to the off-balance sheet (OBS) operations, mainly because of their low deposit base. OBS exposures are as serious as the on-balance sheet exposure and have a number of risks, viz, market risks, credit risks, operational risks and liquidity risks, depending upon the composition of the OBS for each bank. An internal study by the RBI in 2005 concluded that, in general, the banking system’s exposures in OBS have increased tremendously in recent years; 78 per cent of banking system’s exposures in OBS are confined to 15 banks, all of which are FBs. Besides, FBs have the highest exposure of as much as 63.7 per cent in the derivatives market, with repercussions not only for the banks concerned, but for the banking system itself.
Should Domestic Banks Mimic FBs?
The current policy stance towards the operation and expansion of FBs in India are a great leap forward in the furtherance of unswerving overall banking reforms and financial openness. India’s overall approach of “globalisation” has been widely appreciated, including by, IMF and World Bank, for the “gradualist slant”, in the context of south-east Asian currency crisis. It is said that India’s approach to globalisation could as well be a “prototype” for the emerging market economies (EMEs). India’s recent policy approach towards FBs, in some aspects, appears to be scampering, at least insofar as the laissez-faire approach to FBs’ branch network, combined with the permission to establish WOS and the policy permitting the FBs to hold upto 74 per cent stake in domestic private banks in India.4 Reddy’s (2004) unequivocal statement reinforces the view that FBs enjoy more freedom in their operations in India than in many other developing countries and that India has been granting branch licences more liberally than is required under the commitments to the WTO. Contrary to this, practically every nation, including the most laissez-faire developed countries, have relatively more restrictive policy in place for FBs. This is, however, not to preach a relapse to a repressive policy regime, but only highlight its ramifications.
It must be emphasised that the policy document, however, is not rigid; it provides for denial, notwithstanding commitments to the WTO, of licences for new foreign bank branches “when the maximum share of both on- and off-balance sheet assets of FBs to total assets, both on- and off-balance sheet, of the banking system in India exceeds 15 per cent”. In the case of FBs, while their on-balance sheet exposures constituted to just around 7 per cent at end-March 2003, which came down to around 4 per cent by end-March 2005 (Table 4), the size of OBS exposures plays a critical role, for obvious reasons, in determining their overall size. Their OBS exposure was 4.8 times their balance sheet exposure at end-March 2003 and increased to 10.3 times their on-balance sheet exposure at end-March 2005. The total exposure
Table 4: Indian Banking System – On and Off-Balance SheetExposures
(Bank groupwise percentage share in the total of the banking system)
Bank-March 2003 March 2005 Group Off-B/S On-B/S Total Ratio Off-B/S On-B/S Total Ratio (Per (Per Share in of (Per (Per Share in of Cent) Cent) System 2 to 3 Cent) Cent) System 6 to 7 (Per Cent) (Per Cent) 1 2345678
PSBs 34.9 75.7 59.1 0.3 16.7 45.3 31.1 0.4 NPBs 14.2 11.3 18.2 0.9 13.3 7.9 10.6 1.7 OPBs 2.6 6.2 4.7 0.3 1.1 3.6 2.4 0.3 FBs 48.3 6.9 23.7 4.8 42.6 4.1 23.3 10.3 All SCBs 100 100 100 0.7 100 100 100 1.0
Note: On-B/S = On-Balance Sheet Exposure Off-B/S = Off-Balance Sheet Exposure.
of FBs was 23.3 per cent of the banking system at end-March 2005 as against 23.7 per cent in end-March 2003, against the India’s commitment of 15 per cent ceiling. Our committed policy to WTO to continue with the branch expansion of 12 branches a year (for the existing as well as new banks), coupled with the more recent policy towards WOS, would impair the dynamism of the domestic banking system over time. Further, permitting the FBs to have a stake up to 74 per cent would strain the system and might even render futile the very purpose of the policy.
Historically, FBs took the lead in introducing the latest technology; the innovative products and services introduced gradually diffused in the Indian banking system. This trend has now changed. The domestic banks have responded to market demands by introducing more tailor-made and innovative products. Some of the domestic banks had been accredited to introduce new products, for instance Andhra Bank, for the “credit card business in India”, and the Kissan Credit Card by Dena Bank. Even in adopting the concept of “micro finance”, domestic banks took the lead; for instance, the Pigmy deposit scheme, started by Syndicate Bank in 1928. Therefore, even with respect to the trickling down of the innovative products of FBs as a result of their technological lead, they have lost ground. All the banks have now become technology savvy.
Even the case for granting greater freedom to FBs, thereby expecting that it would help domestic private banks in easily accessing the capital market, seems to have lost its fervour, as the need for foreign capital is no longer critical when India has sufficient forex reserves. Moreover, the present-day domestic banks have grown practically in all spheres of banking activities, such as, depository participatory services, investment banking, bancassurance and treasury operations. Above all, there has been a realisation and change in the mindset of the PSBs, in particular, of the need to align with the globalisation process. In fact, a number of domestic banks, have been seriously considering globalising their operations. Reddy (2005) believes that a few large domestic private sector banks have already attained world standards. In view of the above, there is no raison d’être to persist with promoting the aggressive expansion of FBs in India.
Foreign Banks in EMEs – Recent Experience
With the developed advanced economies reaching saturation point, the multinational banks are scrambling to foray into the EMEs in all possible spheres of banking and financial activities. The FBs have spread into a wide sphere of operations in the EMEs and have gained increasing permanence in the host countries. Moreover, the perception that these entities are a great source of stability and efficiency in the developing countries, which encounter frequent bank failures/crisis, has been defied by the BIS (2004). Besides, the committee on the Global Financial System of the BIS has pointed out that a substantial part of banking and financial sector was becoming foreign owned and that this was a source of heightened concern for the EMEs. Further, the entire financial system in the host country becomes increasingly vulnerable due to an enhanced exposure to international developments, making the host country’s supervisor’s job all the more complicated. Information about the whole gamut of operations of FBs is not available for the purpose of the host supervisory authority. In the extreme cases, the host country supervisor is constrained not only to maintain a constant surveillance of the operation of the branches of FBs, but even the more uphill and expensive task of shadowing the parent banks’ affairs when the EMEs lack an advanced supervisory system.
In the Indian context, no FB would invest in a domestic bank merely as a passive investor. Smaller but better performing domestic institutions might then fall prey to the hawkish tendency of multinational banks. Moreover, gaining control would become easier, given the fact that the shareholding pattern in a number of smaller domestic banks are widely scattered. Similarly, buying a stake in the best performing non-bank finance companies (NBFCs) would be easier than launching a new one, which would involve a lengthy process of obtaining a license.
A number of empirical studies, including by the RBI, during the post-reform period, have revealed that the domestic banking system has been increasingly exposed to competition in the pricing of products and in credit allocation. Ram Mohan (2004) has concluded that the expectation of superior performance of the private sector over the public sector has not been borne out in the Indian banking sector. Further, the expectation that deregulation would expose the inefficiencies inherent in public sector banks has not been borne out. Ahluwalia (2004) states that if China could grow faster despite the largest share of public sector banks, India could also achieve the same.
Above all, in most of the developing countries, including India, while dealing with FBs, regulators do face the problem of lack of the sort of intimate knowledge that they have in the case of local banks [Reddy 2005], something that is absolutely essential at the time of crisis. Moreover, it is more difficult for the regulators to track the immensely complex system of transactions that the multinational banks deliberately undertake to circumvent the regulatory requirements. A recent study by Song and Inwon (2004) revealed, in greater detail, the special problems faced by the EMEs, which have not reached the “threshold” to be able to minimise the downside risks of the presence of FBs. Some of the key issues in the Indian context are (i) difficulties in managing systemic risks associated with cross-border banking operations and (ii) difficulty in tracking financial institutions that are involved in a variety of jurisdictions.
By and large, the multinational banks operate as “universal banks”, highly tilted towards non-traditional banking, or, more precisely, non-banking financial activities largely depended on non-fund based activity. Unlike domestic banks, whether private or public, who are more aligned with national welfare objectives, multinational banks cannot align their objectives even remotely with social objectives, adding to the extra-burden on the shoulder of domestic banks. In the emerging new Basel capital framework, the regulatory capital requirement would work out to be lower for the FBs, as revealed by the impact study conducted by the BIS, which would obviously place these banks in a better position in terms of fine tuning their pricing of the various products and services, vis-à-vis domestic banks. Some of the FBs even go to the extent of outsourcing such core banking activities as soliciting deposits, lending loans, cash loans, auto finance, housing finance, as also the credit card business. If a bank outsources the very basic function of opening an account and soliciting deposits, this has serious implications regarding flouting of important guidelines, i e, know your customers (KYC). Besides, outsourcing has its own risks [BIS 2005].
A cross country survey revealed that, many countries both developed and developing do not provide as liberal avenues as Indian policy does, despite the existence of WTO commitments, etc. It is fair to suggest, therefore, that the present level of penetration of FBs in India is adequate and coheres with the overall policy objectives.
VI Concluding Remarks
Seen through the historical prism, FBs were in the commanding heights right from the beginning of the modern banking era in India till as late as legislation of the key banking statutes in India. They were in a monopolistic position, in select areas, viz, foreign currency loans, foreign trade and trade bills related finance, etc. The supremacy of FBs in favoured European traders, and at times, at the cost of the Indian business interest. Even after the country’s independence, FBs were not subjected to any regulation and supervision, even after the regulator came on the banking scene and not until the enactment of the Banking Regulation Act, 1949.
In terms of the magnitude of their operations, FBs were loosing their predominant position even before the country’s independence. Their importance vis-à-vis their own past declined, this trend becoming more pronounced after independence. Nevertheless, their proactive role in the promotion of international trade and finance could not be undermined.
Now that the banking system is robust, with standards that are closely in conformity with international norms under the aegis of the RBI and buttressed with a fairly reformed legal system, the contemporary policy of openness and globalisation, giving greater access of FBs to Indian market will certainly hasten the process of globalising the Indian banking system. However, it is necessary that the policy takes due cognisance of the fact that they are already adequately represented in India and there is no exigency to exceed the WTO commitment on this count, which in itself is high. Any additional representation will not serve the intended purpose of enhancing competition, allocative efficiency, the adoption of new technology, and banking in un-banked areas, etc, as has been widely advocated. A fair degree of transparency, a roadmap and considerable flexibility to the supervisors to exercise judgment on several aspects of entry and presence of FBs appear to constitute the desirable components of an appropriate policy framework [Reddy 2005]. Domestic banks require greater encouragement and operational freedom to place themselves on par with foreign banks to meet the challenges of globalisation. Domestic banks, on their part, need to do a lot in select areas, viz, quality of customer services, investment in technology, strategic planning for the optimum use of human resources, investment in R&D to develop new products and services, and the best use of the latest available risk management techniques.
m Email: akarunagaran@rbi.org.in
Notes
[The author thanks Gunjeet Kaur for editorial suggestions. The views are those of the author and not of the institution to which he belongs. Typing assistance by S V Joshi is acknowledged with thanks.]
1 RBI guidelines, February 2005, available at www.rbi.org.in. 2 Banking Companies Act, 1949 was renamed as Banking Regulation Act,
1949 with the necessary amendments to the Act in 1966. 3 Since 1993, a foreign bank opening the first branch in India was required
to bring in US $ 10 million as an assigned capital, US $ 20 million for
a second branch and US $ 25 million for the third branch. This has been replaced with requirement of upfront US $ 25 million for opening the first branch, from September 8, 2005.
4 On March 5, 2004 government of India the FDI limit in private sector banks was raised up to 74 per cent under the automatic route, including investments made by FIIs.
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