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Banking and Financial Policy: An Independent View

The Independent Commission on Banking and Financial Policy has produced an excellent report that puts the banking and financial policies of India under a microscope. The analysis is not always on the mark but the report needs to be studied and debated in detail.

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Banking and Financial Policy: An Independent View

Sof the “establishment”. The establishment selects experts, and constitutes a committee to advise it on selected issues.

Economic and Political WeeklyMarch 31, 20071197is, however, also a fact, which any insider must agree, that inthe pre-non-performing asset (NPA) days, 18 or 10 per cent oftargeted credit in many cases was achieved by allowing theoverdues to accumulate to increase the outstanding level toimprove the required ratios without making much fresh lending.The ICBFP again agrees with the post-bank nationalisationpolicies of directing credit to the weaker sections for reducingpoverty and unemployment. This implicitly tried to transformany poor person to a business person generating income, surplusesand employment. This was perhaps the greatest mistake of thepost-nationalisation policy. Whatever be the level of business,it requires management skill. All do not possess these traits. Thepoor people require wage and microcredit, which is basically forlife cycle needs, not any investment credit. Also “credit plus”is more important than credit for these people. These were neverthought of during the pre-reform period.The ICBFP is, however, correct to point out that because of thepost-nationalisation policies the rural deposit share increased to15.5 per cent and rural credit share to 97 per cent of the total. Thebranch network improved substantially in north-eastern, easternand central regions, which were highly unbanked areas earlier.There has definitely been a “decisive shift in credit deploymentin favour of (the) agricultural sector”. But one must note that,not much penetration had taken place among small and marginalfarmers in the pre-reform period; a section of big farmers misutilisedbank loans by lending informally to others at usurious rate ofinterest.Secondly, agricultural credit, in the form of farm mechanisationcredit and less as crop loan encouraged tractorisation reducingthe demand of labour in a labour-surplus economy. Lastly, therehad indeed been a phenomenal increase in the small borrowalaccounts. But one must be cautious in terming it a great achievement.This was mainly the outcome of “loan melas”. The loanees weremerepassengers; they never became permanent customers of the bank.The ICBFP then moves to banking sector reform and makesa critical evaluation. The main elements of reform according toit are: (i) freeing of interest rates, (ii) enhancing the credit creatingcapacity of banks by reducing the Cash Reserve Ratio (CRR)and Statutory Liquid Ratio (SLR), (iii) increasing competitionthrough structural changes, (iv) diluting control on the entry ofnew private banks and allowing the public sector banks to sellequity to the private investor, and (v) giving greater freedom tothe banks in determining their asset portfolio, subject to newcapital adequacy norms and prescribed guidelines for accountingand provisioning for bad debts.The ICBFP’s first grievance is that the credit-deposit (CD) ratiodeclined to 55.9 per cent in 2003-04. However, the report’s owntable shows that it increased to 62.9 per cent in 2004-05.Today, in fact, banks are facing a liquidity crunch. In this regardthe ICBFP’s contention that the CD ratio declined only in BIMARU(Bihar, MP, Rajasthan, UP) states is not correct. It was a nationalphenomenon. Again, the assumption that backward districts havesuffered more may not be universally true as Andhra Pradeshdata does not corroborate this. As the ICBFP itself admits, theincrease of loanable funds because of a reduction of CRR andSLR, meant that the absolute amount of credit did not perhapscome down drastically. The ICBFP then complains about themove towards the risk-free portfolio of government securities.This stood at 40 per cent in 2003-04 and 37.2 per cent in 2004-05. Ironically, this kind of allocation prevailed in the pre-reformperiod too. Unfortunately, that was called “SLR”, which wasmandatory. However, at that time bankers refused to admit that“SLR” was a better portfolio choices and consistently complainedagainst the high target set up by the government.The problem of NPAs in the form of “overdues”, and “realisationof interest income in cash” existed in the pre-reform period too.But because of the concept of “accrual income”, they couldwindow dress their profit and loss account. The point is how longcould that be sustained? The ICBFP is silent on this aspect. Itfeels that “increased risk aversion of banks following the adoptionof Basel I has also adversely affected credit to agriculture andsmall-scale industries”. The ICBFP, however, does not discussthe demand side of credit. In the pre-reform period, the bankswere never encouraged to develop an attitude of considering themas viable and important sectors; instead the loan was politicallythrust through a plethora of unviable and unrealistic governmentsponsored schemes; and a universal loan waiver scheme wasimplemented from time to time. On the top of it, when the bankswere found “violating priority sector norms”, the Reserve Bankof India (RBI) diluted the definition in such a way that achievingthe target of 40 per cent was no problem for the banks. However,the re-definition was against the interest of the weaker sections.Priority Sector BankingAlthough the ICBFP’s viewpoints with regard to priority sector,which are “diluting the norms” and “overlooking the shortfall”,are acceptable, what is not acceptable is the ICBFP’s lament overthe collapse of the Integrated Rural Development Programme(IRDP) scheme. There is hardly any study, which reports ad-equate income or employment generation through the IRDP. Thegovernment has substituted IRDP by the Swarnjayanti GramSwarozgar Yojna (SGSY), which too does not show better results.The inherent problem is both in the concept and implementation.There is no doubt that, agricultural growth decelerated in 1990s.It is, however, risky to argue that this deceleration was becauseof a limited availability of agricultural credit alone. The reporteddata on agricultural credit need to be analysed with care. Theoutstanding credit is cumulative disbursement plus overduesminus repayment. As argued earlier, in the pre-reform period,the outstanding level did not reflect real status of lending. That’swhy, the banks had huge problems in the beginning of the reformperiod in maintaining the ratio of 18 per cent as a good amountof NPA was knocked out of the outstanding level. Agriculturalgrowth, in fact, has been halted because of unconducive marketconditions and lack of public sector investment. The flow of creditto the agricultural sector declined because (i) the formal sectorhad not reached out to small and marginal farmers significantlyfarmers who needed credit much more, even in the pre-reformperiod; (ii) the credit need of other farmers declined because therewas not much market incentive to make more investment; (iii)a new consciousness of transaction cost had surfaced; and (iv)the credit risk arising out of uncertain and unfriendly marketconditions and expectations of a loan waiver increased.What must be an urgent agenda item is agricultural sectorreform which (i) respects market principles, (ii) take cognisanceof the fact that for a huge segment of population, agriculture isthe only source of income, and (iii) realises that agriculturalproduction is a highly risky business, yet it is the foundation forthe industrialisation process. And if this sector thrives, even thesupercilious banker would rush there.Not that the ICBFP does not recognise the role of marketfactors, it overemphasises the credit aspect, and that too throughformal banks. It does not consider microfinance institutions(MFIs) as an alternative; it also does not endorse the higherinterest rate charged by the MFIs, although it recognises that“banking for the poor” is a high-risk activity. In this regard one
Economic and Political WeeklyMarch 31, 20071198must accept that cost must be covered for sustainability; andnormal profit is necessary for doing business. Altruism can worktemporarily, and it depends upon the depth of the pocket. TheMFIs’ interest rate includes (i) the cost of funds, (ii) risk cost,(iii) transaction cost of lender, (iv) transaction cost of borrower(doorstep service), and (v) other service charges (in case of someMFIs). Bank’s interest rate includes only the first three components.Some MFIs may be adopting wrong practices. While these defi-nitelyneed to be corrected, there is, however, nothing wrong,if self-help groups of mostly women help the banks or MFIs ingetting the repayment from their wilful defaulter husbands or others.These women are not powerful political entities but empoweredpoor citizens who understand the value of credit. Secondly, if someof the MFIs are engaging in unethical practices, this is becauseof the absence of any control over them. There is an urgent needfor legislation on MFIs. Only MFIs can penetrate into the ruraland deprived markets. The MFIs however, need access to cheaperfinancial resources of formal institutions. The price is bound togo up if there is scarcity of loanable funds. On the other hand,competition must be encouraged and maintained to bring downthe cost of production and delivery. Whatever is the institutionalmechanism, no government or political institution should beinvolved in the process of financial intermediation. They may,however, use the Right to Information (RTI) Act to modify policies.While discussing Regional Rural Banks (RRBs), the reportoutlines four major policy changes of the reform period:(i)rationalisation of branch network including relocation andmerger of loss-making branches, (ii) permission to lend to othertarget groups and deregulation of interest rates, (iii) recapitalisation,and (iv) introduction of prudential norms.According to the ICBFP, because of the above policy changes(i) there has been a decline in (a) the share of the rural branch networkand rural credit outstanding, (b) share of priority sector lending,(c) share of small borrowal accounts, and (d) the credit growth rate;(ii) an increase in the investment portfolio presumably indicatinga reverse flow of funds from the rural to urban areas; (iii) awidening of regional disparity; and (iv) an increase in interest rates.The above facts need not be denied. But the cost aspect cannotbe overlooked. A branch network is not necessary to serve ruralinteriors. Also, the small demands of small borrowers cannot beserviced by high cost scheduled commercial banks directly. AnMFI like BASIX has shown how to use mobile vans, agents,information technology and reward based compensationpackages to take financial services effectively to the poor. AnRRB or for that matter even public sector banks have miserablyfailed in microfinance not because of reform policies but pre-reform inaction. The RRBs were never professionalised, but thecompensation package was linked to that in the sponsor banks.Chairmen from sponsor banks did not take up the assignment asachallenge, but as punishment. Five different bosses: (i) the centralgovernment, (ii) the state government (iii) the RBI, (iv)theNational Bank for Agriculture and Rural Development (NABARD),and (v) the sponsor bank controlled the management. Politicalinterference by state governments and corruption at the grassrootlevel dictated business decisions. As a result the outstanding levelhad increased, but not the “credit utilisation” and repayment level.The situation worsened so much that thedeposit amount wasbeing utilised for establishment cost in some cases.However, now that a majority of the RRBs have started earningprofits, although the accumulated loss still continues to exist, theICBFP is definitely right to argue that the government must nowinitiate new policies to motivate RRBs to deliver productseffectivelyas per the original agenda.The ICBFP then discusses the health of the financial systemitself. It is admitted that post-reform profitability has increased,NPAs have declined and the gap between public sector and otherbanks has reduced. However, it does not seem to be fair for ICBFPto lament that the taxpayer’s money is utilised for bailing out thefinancial institutions, and yet feel sorry that the banks are nowgeared towards profit making. But the ICBFP is right to observethatafter legislating the Securitisation and Reconstruction of FinancialAssets and Enforcement of Security Interest (SARFAESI) Act,the government has yielded a bit to the pressure of the industryassociations, and the “message that has gone to the private sectoris that the new powers with which the banks have been armedwould not be used across the board”. This is exactly the reasonwhy the government should be out of ownership as much aspossible so that the government as a guardian does not interfereinabusiness dispute, which can be taken care of by legal institutions.The issue of consolidation of Indian PSBs has attracted muchattention from many quarters. The pro-consolidation view is thatin the present international context, consolidation is the order ofthe day and the Indian PSBs have to become giants. Even the bigIndian banks like SBI and ICICI, are very small compared to biginternational banks in US, Japan, and even in China. A large sizeproduces economies of scale, and therefore is a must in the arenaof international competition which takes place between banksboth in India and outside the country. Sometimes it is also arguedthat a large size creates efficiency in banking, a proposition whichcan definitely be contested both theoretically and empirically.Empirical studies using the production function approaches donot necessarily support the proposition that the big banks are moreefficient than small banks in spite of the advantages of theeco-nomies of scale. On the other hand, bigger banks can under-cutsmall banks in competition and can lead to monopoly in banking.The output can be smaller and therefore can lead to less efficiency.Inany case, the aforesaid propositions need further empirical studies.More relevant issues within India about consolidation, as rightlyfocused by the ICBFP, and its effects on employment, dislocationof staff and the standardisation of the product, where “relationshipbanking” and “retail banking” may lose their importance.Foreign Direct InvestmentRegarding the issue of foreign direct investment (FDI) inbanking, the RBI road map demarcates two phases for foreignbank presence. During the first phase between March 2005 andMarch 2009, permission for acquisition of shareholding in India’sprivate sector banks by eligible foreign banks will be limited tobanks identified by RBI for restructuring. The RBI may permitsuch acquisition subject to the overall investment limit of 74 percent of the paid up capital of the private bank. The investmentscan be by setting up a wholly owned banking subsidiary (WOS)or conversion of the existing branches into WOS. A clause onone-mode presence, i e, one form of banking presence, eitheras branches or as WOS or as a subsidiary with a foreign invest-ment in a private bank, has been added as the safeguard againstconcentration. The second phase will commence on April 2009,when greater freedom would be given to foreign banks in theform of national treatment to WOS, permit dilution of stake ofWOS and allow mergers and acquisitions with of any privatesector banks in India by a foreign bank, subject to an overallinvestment limit of 74 per cent. It is claimed by the RBI thatthe foregoing policies towards FDI in banking by India are alsoconsistent with India’s commitments to the World TradeOrganisation (WTO). But the RBI is well aware of the risks of
Economic and Political WeeklyMarch 31, 20071199concentrated ownership in banking whether they are of FDI ordomestic origin, and therefore a comprehensive set of policyguidelines on ownership of private banks was issued by the RBIin July 2004. Those guidelines stated, among other things, thatno single entity or group of related entities would be allowedto hold shares or exercise control, directly or indirectly in anyprivate sector bank in excess of 10 per cent of its paid-up capital.It had also clarified that 74 per cent means the aggregate fromall foreign sources, FDI, Foreign Institutional Inventors (FIIs),and non-resident Indians. Therefore, those guidelines issued byRBI in July 2004 put the FDI in banking in right perspectives.The ICBFP opposes the 74 per cent FDI in even private Indianbanksbased on the following lines: (a) This may focus on more net-profitoriented activities, as at present foreign banks with just 7.9 per centof total assets garner 14.7 per cent of aggregate net profits. Foreignbanks will do more fee earning activities. (b)The ICBFP quotesthe international experience of FDI in banking in countries likeLatin America, south-east Asia, Japan, etc; whereFDI has pur-chased domestic banks at very cheaper rates, when therehave beensteep devaluation. (c) Foreign banks usually focus on a select rangeof activities, like foreign currency loans, trade financing, wholesalebanking and focus on high net-worth individual accounts, etc.But there are other studies, which show that there are manypositive aspects related to FDI in banking. Peck and Rosengren(2000) in a widely quoted paper provide the theoretical expla-nation as to why foreign banks are not as sensitive to domesticshocks as local banks. As the portfolios of foreign banks are morediversified and global, banks have better access to internationalcapital markets, the impact of a domestic shock that could seriouslyaffect domestic banks would be easily absorbed by foreign banks.Also foreign banks have more ready access to foreign currencyduring a banking crisis because the lender of the last resortfunction of the foreign bank is the central bank in the bank’shome country rather than in the host country. There is anotherimportant study by Luc Laeven of the World Bank (2002) inwhich the author has studied the effects of the ownership basisof the banks on various risk categories of investment (high risk,medium risk and low risk) in south-east Asian countries. It wasfound that in widely held ownership banks, namely, state-ownedand foreign-owned banks, the propensity was to hold “low risk”assets, whereas in family and company held (narrow ownership)banks, the propensity was to hold “high risk” assets. From thisit is clear that the FDI in banking can supplement the state-ownedbanks in diversifying the risks as they are “widely held”. In thisregard, the Chinese experience of inviting FDI in banking cannotbe ignored as it has created a very positive impact. Finally, it shouldbe noted that the RBI has all the powers to stipulate guidelineslike priority sector lending to the foreign banks also. Their focuson fee-based activities can be controlled by the central bank.Coming to the issue of expanding the horizon of the privatesector banks through the creation of the new private sector banksby industrial houses in India, and a corresponding envisageddecline of the public sector banks, a vision shared by the TaraporeCommittee in its second capital account committee report – anissue which is not dealt with by the ICBFP – we have the viewthat it would lead to a highly risky structure of assets, whichis caused by the narrowly-held ownership of private industrialhouse banks and would cause “related lending” and a bankingstructure which was prevalent just before the south-east Asiancrisis and was existent before nationalisation of commercial banksin India. On the other hand, the creation of private sector banks,which are widely held, and not created by any particular industrialhouse, can be encouraged, along with a strong sector of publicsector banks and a little larger FDI in banking. The latter typeof banking structure was adopted in the south-east Asian countriesafter their 1997 crisis. In this context, we are happy to note thatthe State Bank of India’s shares which were held by the RBI,and subsequently unloaded by the RBI, are to be purchased bythe government of India and the opposite advice givenbyTaraporeCommittee is to be discarded by the government.To put it briefly, it is felt that FDI should be encouraged inIndian banking. But at the same time there is a merit in the ICBFP’scontention that diversified ownership is very important. We sharethe ICBFP’s concern that the RBI in its February 28, 2005 pressrelease has not retained the earlier provision of a 10 per centlimit to a single entity. The consolidation of the banking sectorin the domestic context is an issue which needs further obser-vation and study rather than jumping to the conclusion thatconsolidation will increase efficiency or the opposite conclusionthat consolidation will eliminate competition and will lead to thestandardised products and reduce the “relationship banking”. Afew empirical studies are immediately needed in the Indian context.The ICBFP’s concern about the financial fragility and the roleof “credit derivatives”, etc, should be put in perspective. Financialinnovations through derivative markets help to transfer risk to thepeople who can bear it at a price, and also add to the liquidityanddepth of the financial markets. However, the ICBFP’s views that suchderivative products can mask systemic risks are also to be consideredfor an adequate understanding of the risks of the financial markets.But that needs further research, and it is unwise to take a standagainst financial innovations including derivative markets. Moreliquidity and depth in financial markets will attract more fundsto the financial markets. Ultimately it should help the economicgrowth and development through greater “financial inclusion”.The “financial inclusive growth” idea lead us to look at theICBFP’s views on monetary and fiscal policy. The ICBFP arguesthat “monetary policy and fiscal policy should be so designedas to make available resources for development and social bankingand guarantee the risk implicit in activities with substantial socialreturns and benefit”. We broadly agree with that but withoutquestioning the need for independence for the RBI in formulatingits monetary and exchange rate and inflation-targeting objectives.There is another area where the ICBFP has rightly taken someefforts: human resources management and training issues at thepublic sector banks. The earlier regime had somehow createdan impression that the public sector banks have to be disbandedor their staff had to be retired. That had created great demoralisationamong the employees and many took voluntary retirements, andthereafter effectively no recruitments have taken place. But every-body had forgotten that the public sector banks had indeed playedan important role in the financial and economic development ofthe country, and, whatever are the shortcomings, they shouldcontinue to play an important role. Even the training and researchinstitutions were asked to generate funds through commercialmeans.Unfortunately that was also a time when a lot of studies were neededabout the banking policies and the banking markets. Trainingin banking is a public good in nature and therefore institutionsof banking policy studies have to play an important role.Alternative Banking PolicyFinally, the ICBFP comes out with its “Blue Print for anAlternative Banking Policy”. These include: (i) continuation ofpublic ownership of a major share and limiting any single ownershipto 10 per cent of paid-up capital, (ii) discouragement of theconsolidation process, (iii) stopping banks to trade in commodities
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