I Introduction

Role of Banking in the Current Growth Phase

What is the role of banks in general and bank credit in particular in the current growth phase of the economy? The question gains importance in the context of the recent exhortation by the finance minister to the public sector banks to raise bank credit as a percentage to GDP to a minimum of 50 per cent. Correspondingly, some of the banks have indeed increased their credit targets for the current financial year. Even though the ratio of bank credit to commercial sector as percentage to GDP at market prices is much lower compared to the developed world and some of the developing countries like China and Thailand, it has been increasing over the decades and stood at 41.2 per cent at the end of 2004-05.

Sectoral level data of bank credit might throw some further insight. The mid-term monetary policy of 2005-06 revealed that even though non-food credit grew by 29.3 per cent on year-onyear basis, credit towards medium and large industries grew at

22.2 per cent, which is below that of overall non-food credit growth. If credit to small-scale industries is also included, growth comes down to 21 per cent. Sectors which have witnessed higher than average growth are agriculture, housing and real estate, and the omnipresent “others”. Trends implicit in the 2005-06 third quarter review of the monetary policy are also along the same direction.

Why is it that credit to industries is growing at a lower pace than the rest of the economy? In particular, what is the behaviour of the Indian corporates towards bank credit as source of funds?

One of the most striking features of trends in sources of funds for non-financial firms is the increasing dependence of these firms

Economic and Political Weekly March 18, 2006

Figure 1: Quarterly GDP-Manufacturing and Net FII Inflows Figure 2: Sources of Funds of Non-Financial Firms

GDP Quarterly - manuf Net FII inflows 2000 1600 1200 800 400 0 5000 4000 3000 2000 1000 0 100 Incr Q-GDP in US $ millionNet FII Inflows in US $ million

Jan-Mar: 00 July-Sep: 00 Jan-Mar: 01 July-Sep: 01 Jan-Mar: 02 July-Sep: 02 Jan-Mar: 03 July-Sep: 03 Jan-Mar: 04 Jul-Sep: 04 Jan-Mar: 05 July-Sep: 05

70 60 50 40 30 20 In Per Cent Internal sources External sources

1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 Data Source: CMIE, December 2005.

Financial markets, such as the stock market or the bond market, give access to funds of savers directly to borrowers, whereas

Data source: CSO and SEBI websites.

on retained earnings rather than on borrowed funds. Based on CMIE data, nearly 59.7 per cent of the funds of industries in 1998-99 came from external sources, which came down to 44.7 per cent in 2004-05, indicating a growing dependence on retained earnings. Figure 2 shows that this reversal in the role of internal and external sources of funds is a recent phenomenon that began in 2002-03. Further, average dividend payouts grew at a rate of 26.5 per cent during the last three years, while average retained earnings grew at 70 per cent. Thus, non-financial firms have been retaining their profits at a much higher rate than rewarding the shareholders in the form of dividends. Higher rates of retained profits are also partly observed in the robust growth in net worth.

Not surprisingly, a similar picture is visible in the overall debt raised. The debt equity ratio has been declining. A recent RBI study (RBI Bulletin, November 2005) indicates a stagnant debt equity ratio during 1998-99 to 2002-03, while CMIE data indicates a clear decline in the ratio.

With regard to bank borrowings, both the share of working capital in total borrowings and bank borrowings as a percentage of total sources of funds have been stagnant, but with an upward bias. However, this upward bias is to be seen in the context of a declining share of the external sources of funds of firms.

In spite of a substantial decline in interest rates in the economy, why is the Indian corporate depending more on retained earnings than on external sources of funds in general and bank borrowings, in particular? What are the implications of this behaviour for banks? Most importantly, in response to the changing financial pattern of corporates, are banks readjusting their growth strategies to the new realities? Moreover, what is the role of the household sector in this jigsaw puzzle? The present article grew out of these questions, and we do not pretend to have all the answers. Rather, this is an exploration. Before we actually look at the micro and macro numbers, we present some of the important theoretical underpinnings of the ensuing discussion.

II Theoretical Framework

The financial system provides channels to transfer funds from individuals and firms who save money to those who want to borrow money. Savers supply funds whereas borrowers demand funds for either producing goods or for consuming goods and services. Savers and borrowers can be households, firms or the governments.

financial institutions, mainly the banks, act as intermediaries by accepting deposits from savers and providing loans to borrowers. Figure 3 details the financial system channels from savers to borrowers.

The savers have two options – to directly invest their funds or to route them through financial intermediaries. By lending directly to the borrowers, the savers can bypass the costs of intermediation. Yet they prefer financial intermediation. There are three strong reasons for it – risk sharing, liquidity and information.

The intermediaries pool the savings of many small savers to lend money to many borrowers. The lending may be retail or corporate. In the case of retail, it is mainly for the purpose of consumer durables and housing. In the case of corporate, the lending is for production purposes. The firms have two sources of finance – internal and external. The profits made out of the business are partly distributed to equity holders in the form of dividends and partly retained to provide internal sources of funds. A firm sources external funds either directly from the market, through equity issue or borrows. The borrowing can be from public, other firms and banks.

The decisions of lending by banks and borrowing by firms may depend on various factors. There have been several theories to explain the behaviour of bank lending and corporate borrowing.

Figure 3: Schematic Representation of a TypicalFigure 4: Loanable Funds ModelFinancial System

Returns Financial Markets Returns Households, Firms and Governments Funds Funds Savers Returns Financial Intermediaries Returns Funds Funds Households, Firms and Governments Borrowers

r

r*

Supply of loanable funds Demand for loanable funds

L* L

particular set of expected cash flows and when the firm chooses the proportion of debt and equity to finance its assets, it is actually dividing up the cash flows among investors. It is assumed that both firms and investors have equal access to financial markets; that an investor can create any leverage that she wants and can get rid of any leverage that the firm has taken. As a result, the leverage of the firm has no effect on the market value of the firm.

There are two fundamentally different types of capital structure irrelevance propositions. As per the classic arbitrage based irrelevance propositions, the value of the firm is kept independent of its leverage due to arbitrage by investors. The second type of irrelevance proposition is associated with multiple equilibria. As per these propositions, aggregate quantities of debt and equity in the market are determined by equilibrium conditions. Both personal and corporate tax rates play a major role in determining the economy-level leverage ratio.

Several theories have been proposed since then to explain the choices of firms to finance their operations. Myers (1984) compares and contrasts two competing perspectives. One of them is the trade-off theory and the other, the pecking order theory. According to the first hypothesis, called trade-off theory, firms balance tax savings from debt against deadweight bankruptcy costs. The second hypothesis, called the pecking order theory, states that firms first look to retained earnings, then to debt and only in extreme circumstances to equity for financing.

A firm is said to follow the static trade-off theory if the firm’s leverage is determined by a single period trade-off between the tax benefits of debt and the deadweight costs of bankruptcy and it is said to exhibit target adjustment behaviour (dynamic tradeoff) if it has a target level of leverage and the deviations, if any from the target, get removed gradually over a period of time.

A firm is said to follow a pecking order if it prefers internal to external financing and debt to equity if external financing is used. The pecking order theory can be explained by either adverse selection considerations or agency considerations. Myers and Majluf (1984) attribute adverse selection to be the most common motivation for the pecking order. The owner-manager of a firm knows the true value of the firm’s assets and growth opportunities. Outside investors can only guess these values. If the manager offers to sell equity, then the outside investors must ask why the manager is willing to do so. In many cases the manager of an overvalued firm will be happy to sell equity, while the manager of an undervalued firm will not. Thus, internal sourcing gets preference over external sources. Myers (1984) argues intuitively that if debt were available, then it ought to fall somewhere between retained earnings and equity thus creating the pecking order.

They argue that what matters is not supply of savings, but supply of credit. Banks play a pivotal role in determining the credit that flows to finance investment of firms and consumption of households. There may be large changes in the supply of credit over the business cycle. The decrease in the supply in a recession may well outpace the decrease in the demand for funds, thereby exacerbating the downturn. The funds may not be flowing to households and firms; they may be going to government or even outside the country.

Credit markets are not like goods and services markets. In case of goods and services markets, it does not really matter who buys and who purchases them. But in the case of credit, the borrower matters. Supplying credit to a highly rated borrower is not the same as supplying credit to not so well rated borrower and to a badly rated borrower. There are two sets of information that are taken into consideration. A set of information is general, like the industry to which the borrower belongs. Another set of information is very specific to the borrower. Each bank, based on its experience, in dealing with the borrower, builds its own information base on individual borrowers.

The quantum of credit a bank is willing to extend to a borrower depends on its information base. It does not depend on the available funds, but on the assessment of the borrower by the bank. It leads to the concept of credit rationing. Banks may not extend loans to certain segments of borrowers. This leads to complications in determination of interest rates.

In the case of not so highly rated borrowers, banks need to charge higher interest rates in view of the higher risk associated with such lending. But higher interest rates may lead to bankruptcy and non-performing loans. The higher interest rates instead of giving higher returns may reduce profits due to accumulation of bad debts. In the presence of credit rationing, the relationship between changing economic conditions and the interest rates is not clear. In fact, different effects may predominate. Further it is shown that there is a systematic force leading to an increase in the interest rates charged as the economy goes into a recession.

It is generally accepted that the modern theoretical framework has its origin in the capital structure irrelevance proposition of Modigliani and Miller (1958). According to them, a firm has a

Economic and Political Weekly March 18, 2006

Figure 5: Quarterly Return on Advances andFigure 6: Return on Advances and InterestIndicative Interest Rate Payments by Non-Financial Firms

13

12

11

4 4 5 5 6 6 7 Return on advances Yield on 5 year paper Return on advances in per cent (annualised)10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 7.0 6.5 6.0 5.5 5.0 4.5 4.0 YTM on 5 year paper in per cent

10

9

8

7

1997-98

1998-99

1999-2000

2000-01

2001-02

2002-03

2003-042004-05

Oct-Dec: 02 Jan-Mar: 03 Apr-Jun: 03 Jul-Sep: 03 Oct-Dec: 03 Jan-Mar: 04 Apr-Jun: 04 Jul-Sep: 04 Oct-Dec: 04 Jan-Mar: 05 Apr-Jun: 05 July-Sep:05

Interest payments by non-financial firms – – Return on advancess of SCBs

Sources: Return on advances is computed from the quarterly results of

29 listed banks with advances figures interpolated from annual

balance sheets. YTM are for government paper with five years of

residual maturity.

Agency considerations also explain pecking order. The argument in favour of internal sources to external is based on the managers’ reluctance to reveal the details of projects to outside investors. Traditionally, outside financing requires managers to explain the project details and expose themselves to monitoring. Therefore, the managers show a preference for retained earnings. Jensen and Meckling (1976) develop agency theory based on these ideas. Here again, the arguments placing debt over equity in the order of preference are intuitive.

III Helicopter Tour

nearly 41.1 per cent, which is the largest block as a sector. Thus, with some minor caveats, it may be safe to assume that the return on advances is more or less representative of the interest received by banks from industry. This means that Indian corporates are paying higher interest rates to non-banks. Even though the gap between the two has narrowed, especially during the last three years, there indeed exists a gap.

This implies that there is an unmet demand for credit by nonfinancial firms which is actually met by non-banks. Perhaps the levels of risks as perceived by banks in the unmet demand are beyond the return offered on such credits. This might be forcing firms to tap other options for meeting their credit requirements. This is indeed a reflection of credit rationing in the market.

There are two issues closely related to credit rationing. On the one hand, the economy has seen a substantial decline in levels of NPAs since 1997-98. The pressure on banks to reduce NPAs seems to have resulted in a cautious approach towards lending policies and the levels of risks taken by banks. On the other hand, since many banks are preparing themselves for higher capital requirement in the emerging era of Basel II, this added burden of capital requirement cannot be met simultaneously with the additional provisions necessary for more risky projects.

These reasons put together may provide an explanation for the current stress by banks on pushing retails products. While commercial real estate projects are perceived as high risk category, housing loans for salaried class and professionals are treated as low in risk. Moreover, the housing requirement itself is still highly unsaturated. The earlier period of high interest rates could not attract enough takers for housing loans from middle and lower middle income groups. Attractively low interest rates (as compared to earlier years and captured through indicative interest rate in Figure 5) and more disposable income in the pockets of middle class have resulted in a very competitive housing mortgage market in the country. Banks and other housing finance agencies are targeting the insatiated aspirations of the growing middle income group, and naturally so. Growth in other real estate loans seems to be partly triggered from the boom in the residential property market.

Reduction in the household savings reported by RBI [RBI Monthly Bulletin, September 2005] bolsters this argument. Perhaps a part of the household saving is used to create real assets like housing. The third quarter review of monetary policy for 200506 further reveals that some industrial sectors like petroleum products, rubber, transport equipment, gems and jewellery and construction, showed higher than average credit growth. In addition, infrastructure too received much needed higher than average credit support from banks.

In order to understand the pattern of credit flow to industry in general, it is necessary to look at the behavioural pattern of credit requirements of industry. As already indicated, the sources of funds of industry have been witnessing subtle change. The debt-equity ratio, dividend payouts, retention ratios and growth in net worth over the last three years are pointing towards the higher earning capacity of firms. As evident from Figure 2, industry is now more dependent on internal sources of funds rather than external sources.

Further, it is intriguing that a booming stock market has not witnessed a substantial increase in money raised by firms from the capital market. As revealed by the third quarter review of the monetary policy, total capital issues raised during the first half of 2005-06 was Rs 6,231 crore as compared to Rs 4,757 crore during the same period of the previous year, while the average BSE Sensex increased to 8,272 points in September 2005 as compared to 5,423 points in September 2004. Thus, the increase in new capital issues raised grew at a far lower rate (31 per cent) than the BSE Sensex (52.5 per cent). To reinforce this argument further, new capital issues raised in the market during the first three quarters of the current financial year grew by only 10 per cent over the same period of the previous year, while average BSE Sensex grew by nearly 40 per cent.

To summarise the jigsaw puzzle, even the regime of low interest rates and sub-PLR lending rates and, more intriguingly, even in the phase of a booming stock market, firms have a clear preference for retained earnings over external sources of finance, including the capital market.

Why is it so? This question leads to the main objective of the present article. Is it possible to explain the financial behaviour of Indian corporates in terms of the existing theories of capital structure of firms? As discussed above, in addition to the capital irrelevance theory of Modigliani-Miller, there are two broad theories trying to explain financial behaviour of firms. The tradeoff theory says that firms try to optimise their capital structure towards an optimal level which balances tax shield from debt and cost of bankruptcy. Even though firms often move away from the optimal capital structure in terms of debt and equity, mean reversal effects bring the firm back to the optimal structure by timing the market. The second theory states that there is a pecking order in which firms tend to meet their financial requirements.

While applying any theory to Indian corporates, one needs to consider the Indian realities. Even though the Indian capital market itself has a long history, there have been innumerable constraints faced by Indian corporates in the form of licensing, labour laws, constraints faced by banks and financial institutions in financing corporate requirements, the ability to expand beyond the geographical boundaries of the country, or even funding political parties, and corruption in the executive machinery. Liberalisation has seen the walls of constraints crumbling down. This may have given more vitality to firms in achieving optimal capital structure, if such a thing exists.

Apparently, there are no comprehensive studies on the capital structure of firms in developing or evolving markets or markets wherein the shackles of controls are being slowly removed. For instance, Frank and Goyal (2005) report that the debt-equity ratio of US firms at aggregate level remained stationary at 0.32 for over half a century with minimal deviations from it. However, as already indicated earlier, this ratio has been declining in India for the last eight years and is still far above that of the US market. Is it because of an evolving market? Are capital structure and leverage ratios expected to be different due to various countryspecific issues? To cite one such peculiarity, for example, dividends are taxed in the hands of the shareholders in US market, but tax is paid by companies and not shareholders in India and this is likely to have implications on corporate decisions on dividend payout vis-à-vis retention ratio. Thus, the applicability of corporate finance theories to Indian conditions is not obvious. However, we neglect this caveat and offer interpretations which may shed some light into the financing pattern.

As we have already stressed, firms are opting for internal financing over external sources of funds. Further, as revealed by data on low levels of new capital issues, out of external sources of funds, equitysource is the last option. This pattern is clearly supportive

Economic and Political Weekly March 18, 2006 of the pecking order theory. Literature on capital structure theory tends to view the pecking order theory in more favourable terms over the trade-off theory [Frank and Goyal 2005].

Evolving Role of Financial Intermediaries

As discussed, the credit requirements of Indian corporates seem to be changing over a period of time, with a preference for internal financing over external financing. An RBI study [RBI Bulletin, November 2005] and CMIE data [CMIE 2005] reveal that, even though debt itself has been declining since 2002-03, the share of bank borrowings has been stable with an upward bias – but from a shrinking pie. Besides, as per CMIE data the ratio of working capital as a percentage of total borrowings has been increasing since 2002-03.

The growth of bank credit to industry vis-a-vis other sectors need to be perceived as a result of evolving a behavioural pattern of corporates, discussed in the previous section. Given their preference for internal financing, the slow pace of growth of bank credit to industry is not surprising. But the implications for banks are profound.

If the nature of preferences of Indian corporates continues in the near future, then the role of banks as channelling agencies of savings (mainly households) to the borrowers (mainly corporates and the government) may be reducing. This, read with the reduction in household savings, could mean that banks need to evolve new strategies for survival. The new reality is a twin-twister. On the one hand, availability of funds to banks will be falling, and, on the other hand, traditional borrowers are able to raise funds elsewhere. Thus, both assets side and liability sides of the balance sheet of banks may shrink. We mention a few points that banks may have to explore.

The return on advances of banks is lower than the interest payouts by corporates. This means that there are still projects which are not financed by banks. This unmet corporate demand needs to be identified and good projects financed which are within the risk parameters of banks.

In order to finance more risky projects, banks may even think of creating products similar to “junk bonds” and offering higher interest rates to depositors investing in such junk bonds. Funds so created may be exclusively used for financing venture capitals and firms with a poor credit rating. However, banks need to have a careful look at them from risk management and supervisory angles.

Banks also need to explore other avenues, especially within the rural areas of India. The current model of rural banking (wherein customers come to bank branches) may need to be altered into a more customer centric approach by taking banks to markets like ‘mandis’ and weekly markets, which are the real features of any village in India; some banks already have initiated this strategy. One of the major drawbacks of the current model is the substantial fixed costs incurred by banks in running rural branches. With the help of new technologies, like smart cards, and by taking banks to markets in rural areas, they may be able to restrategise and reposition their rural operations into profit centres. After all, India lives in villages and business opportunities lie where life thrives.

rr;

Email: asramasastri@rbi.org.in

[The second part of the title ‘A Helicopter Tour’, is borrowed from a seminal paper on unit roots by Sims and Uhlig (1991). All opinions expressed here are purely personal and not necessarily that of the organisation for which the authors are working.]