Corrective Steps towards Sound Banking

The Indian economy is facing some serious macroeconomic problems due to rapidly rising inflation and interest rates, a growing trade deficit and an uncertain global environment, which involves risks of sudden adjustments in the currency value and corrections in financial markets. In this situation, questions about the banking sector's ability to respond effectively to the unwinding of macroeconomic imbalances remain. This paper suggests some necessary short- and medium-term corrective measures to stabilise and improve the soundness of the Indian banking sector to face these challenges.

Corrective Steps towards Sound Banking

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Economic and Political WeeklyMarch 31, 20071220direct investment. As warned by the Economist (February 1,2007), India is highly vulnerable to rising interest rates if thereis a sharp reversal in the appetite for risk in global financialmarkets.Another area of serious macro-economic concern is govern-ment finances. General government debt remains high over 80per cent of GDP reflecting both budget deficits and off-budgetsubsidies for oil and food. The recently announced Union Budgetfor 2007-08 has targeted a central government deficit at 3.4 percent of GDP as against the actual estimate of 3.7 per cent ofGDP in 2006-07. However, in the year 2006-07, continuedbuoyancy in revenue especially from taxes has helped the gov-ernment to a large extent. This may not be so in the coming yeargiven the trends in inflation and interest rates. Moreover, thereare ongoing spending pressures related to public investment,social and rural sectors, etc. Given the fact that 2007-08 is anelection year, there is a strong likelihood of derailment in fiscalconsolidation this year due to heavy spending on populist schemes(see Standard and Poor’s report on India post the announcementof Union Budget 2007-08).With rising inflationary pressures and consequent monetarytightening, an upward bias is set in, in the interest rates’ structure.This has increased the probability of further widening of thedeficit, as “market borrowings” is the single largest source offunding the gross fiscal deficit in India. According to MorganStanley estimates, the off-budget items such as power and oilsubsidies amount to 1.8 per cent of GDP. If this is added to totaldeficit, it comes to the level of 8.0 per cent of GDP – the highestamongst the main emerging economies. India’s precarious publicfinances have reduced its government’s ability to spend ad-equately on infrastructure, health and education to supporteconomic growth on a higher trajectory.Implications of Macroeconomic Concernsfor Banking SectorRising inflationary pressures and consequent tightening ofmonetary policy combined with higher public debt and highdemand for bank credit (due to booming industrial activity) haveput tremendous upward pressure on the overall structure ofinterest rates – deposit rates, lending rates and yields ongovernment securities in the government bond market.Deposit rates offered by scheduled commercial banks (SCBs)on various maturities have gone up several times (at least eightto nine times) during the past one year. Deposit rates, which hadincreased by 25-175 basis points in October over April 2006,particularly for the longer end, rose further by 25-50 basis pointsin December over October 2006, and by 25-150 basis points inMarch 2007 across various maturities. In addition, higher interestrates have been offered on special deposit schemes of specifiedmaturities in terms of number of days, with attractive featuressuch as put options for depositors and in schemes specificallymeant for senior citizens. This reflects the banks’ desperateattempts to create enough “liquidity” to support their expandingloan books.On the lending side, most SCBs increased their benchmarkprime lending rates by 100-300 basis points between April 2006and February 2007. The benchmark prime lending rates of publicsector banks (PSBs) and private sector banks increased toarangeof 11.75-12.50 per cent and 11.75-15.50 per cent from10.25-11.25 per cent and 11-14 per cent, respectively, duringthe same period.The same trend is witnessed in home loan rates as well. Thefloating home loan rate of ICICI bank has moved up from 7.75per cent in November 2003 to 11.75 per cent in February 2007.Similarly, the fixed home loan rate of HDFC has moved up from8 per cent in 2004-05 to 11 per cent in January 2007.In the government securities market also, the yield on 10-yearbenchmark paper (8.07 per cent GoI 2017) has increased by 75basis points in a year’s time.Inherently weak government finances have been putting furtherpressure on interest rates that are already upward bound,jeopardising the growth momentum being generated by privateexpenditures.Moreover, the fiscal situation has been constraining publicinfrastructure investment and crowding out private investment.A large government deficit has emerged as the major barrier toreforms in the banking sector as the government is alwaysconcerned about finding buyers for its debt [FRBSF EconomicLetter, July 2006].As of today, the net non-performing assets (NPAs) of IndianPSBs (which account for around three-fourths of the total assetsof Indian banking industry) are as low as 1.6 per cent and grossNPAs are at 3.5 per cent. However, once there is a slowdown inprivate expenditure and corporate earnings growth, companiesonthese banks’ books will not be in a position to clear their dues ontime and there is a strong likelihood of generation of new NPAs.There is also an apprehension whether Indian banks do havenecessary skill-sets to properly assess credit risk in increasinglyuncertain economic environment.With rising interest rates in the government bond market, thebanks’ treasury incomes have declined considerably. So goingforward, banks will not have enough profits to make provisionsfor NPAs. Pressures of heightened competition have forced manybanks to lend aggressively at unviable interest rates (especiallyto large corporates) in the past three to four years. Once theeconomic slowdown sets in, there is a strong likelihood that thesebanks will be saddled with new NPAs.Another concern relating to the health of the banking sectoris the aggressive retail loan growth (especially in real estate/mortgages, etc), which is likely to lead to serious asset qualityproblems. This is again a global phenomenon. World over, thespeculative deals in the real estate/mortgage sectors have goneup significantly in the last couple of years.In India also, the boom in real estate market is not showingsigns of abating despite the repetitive hikes in home loan ratesduring this period. As stated earlier, property prices have, in fact,appreciated two to three times in major cities since 2003.Over the past three years, Indian commercial banks’ non-foodcredit has grown at over 30 per cent and according to the RBIreports, banks’ lending to housing, commercial real estate andpersonal loans accounted for over a third of incremental creditin 2005-06. In several countries across the world, the housingboom is flattening out and this can set off a chain reaction interms of slowing down consumption and real wage growth.The RBI has given repetitive warnings to banks regarding theirover-exposure to certain retail segments. In response to thisconcern, it first increased the risk weights for advances tocommercial real estate from 100 per cent to 125 per cent in July2005and further to 150 per cent in April 2006. In addition to this,
Economic and Political WeeklyMarch 31, 20071221it also increased the provisioning requirements for standardadvances under commercial real estate and housing loans of Rs20lakh and above from 0.4 per cent to 1 per cent in April 2006.On January 31, 2007, it further increased the provisioningrequirement to 2 per cent for standard advances in real estatesector, credit card receivables, loans classifying as capital marketexposure and personal loans excluding housing loans.It also increased risk weight to 125 per cent for the banks’exposureto non-deposit taking non-bank finance companies (NBFCs) andprovisioning requirement to 2 per cent in banks’ standard ad-vances to these NBFCs, as it feels that the “money” thus givenis increasingly getting diverted to the property markets. Banksare now restrained from granting fresh loans, in excess of Rs20 lakh, against non-resident deposits and advised not to under-take artificial slicing of the loan amount to circumvent the ceiling.Leading indicators of distress have already emerged in the retailarena. India’s top three foreign banks – Standard Chartered Bank,Citibank and HSBC saw a rise in their respective net NPAs in2005-06. While the Standard Chartered Bank recorded an almost70 per cent increase in Net NPAs in 2005-06, the increase forHSBC was at 54 per cent and for Citibank at 29 per cent. Financialanalysts attributed this phenomenon to the hit these banks havetaken in some of the vulnerable retail segments. It is also becausethese banks are entering personal loan segments much moreaggressively.Another concern, of course, relates to the Indian bankingsystem’s high level of exposure to long-term government bonds.Although bonds have fallen to 28 per cent of the banking system’sassets – from nearly 40 per cent – this level is still high in absoluteterms. There is also a likelihood that this level may go up againgiven the widening fiscal gap of the government and its impli-cations for the market borrowings programme. This increases themarket risk for the banks as interest rates continue to rise.Also, the liquidity property of government securities (G-sec)depends upon the proper functioning of the G-sec market; duringa crisis, if everybody is on the same side (selling), then theliquidity property of the asset would be very much reduced[World Bank 2006].Corrective Steps towards Sound BankingThe Indian banking industry has come a long way since 1991-92,when the process of financial sector reforms began in the country.The thrust of the early reform measures was more on improvingthe productivity and efficiency of the sector.Once the desired results were achieved from the first phaseof reforms, the issues like improvements in management of riskand NPAs were addressed in the second phase of reforms throughthe issuance of comprehensive guidelines on credit, market and“operational risks” to banks, and through the implementation ofseveral regulatory changes. The changes in “supervision” in-cluded progress towards risk-based and consolidated supervision.Other structural reforms – ranging from branch and manpowerrationalisation to foreclosure and asset-reconstruction legislationhave been very effective in consolidating the process.Today Indian commercial banks including the PSBs are muchbetter off in terms of key financial indicators like profitability,asset quality and capital adequacy.Despite this, banking distress in India is quite significant. TheWorld Bank attributed this to weak credit culture, poor riskassessment, weak regulation of a highly politicised bankingsystem and inefficient management of banks exacerbated by thelack of commercial incentives [World Bank 2006].These weaknesses of the Indian banking system certainly raiseconcerns about its ability to respond effectively to unwindingof underlying economic imbalances that are built up in the courseof last two to three years.The most recent report on Indian banking sector by the FitchRatings Agency (February 2007) gives a “cautiously optimistic”outlook for Indian banks. According to the report, rapid creditgrowth and rising asset prices have made Indian banks highlyvulnerable. It feels that Indian banks’ profitability could be hitby rising loan loss provisions, given the increasing portion ofunsecured consumer lending and the seasoning of rapidlygrowing retail loan portfolio. According to the ratings agency,risk management systems in many Indian banks are stillnascentin terms of estimating probability of default througheconomic cycles.To stabilise and improve the soundness of Indian banking sectorand to prepare it to face the challenges created by growing macro-economic imbalances, the following corrective steps need to beundertaken without much delay of time.Corrective Steps in the Short TermOf the foremost importance is the role of policy-makers inproviding an honest and realistic assessment of the economicsituation. (Also, as indicated by the BIS Annual Report 2006,policy-makers need to look beyond a near-term forecast horizon).Policy-makers in India may like to give appropriate signals tobanks, rating agencies and market players based on the realisticassessment of growing economic imbalances and concerns in thesystem.Policy-makers should make a proactive effort to sensitisemarket participants and corporate borrowers about sustainedupward pressures on interest rates as a result of both domesticand global factors so that banks (especially PSBs) are not undulypressurised to keep lending rates on hold at the expense ofprofitability.Policy-makers should actively regulate banks’ lending port-folios to ensure that their effective rates of lending are closelyaligned to their benchmark prime lending rate (BPLR) so thatthey do not indulge excessively in undercutting lending rates.These practices have resulted in unhealthy lending practices thatwill eventually jeopardise the sector as a whole. At present morethan 90 per cent of the loans given by Indian banks are at thesub-BPLR level.As a result of certain legislative changes, the RBI was notpaying any interest on the CRR balances from the fortnightbeginning June 24, 2006. Earlier it was paying interest at therate of 3.5 per cent on CRR balances above 3.0 per cent. Thiscombined with repetitive hikes in CRR, the banks have lost ahuge amount that it would have potentially earned from the RBIin the year 2006-07. Towards the end of the year 2006-07, theRBI has decided to pay interest on CRR balances again but ina graded fashion. This has helped banks recover their losses onlyin partial fashion. As growing economic imbalances have alreadystarted impacting the banks’ profitability adversely in FY07,partial payment of interest on CRR balances has definitely createda burden for the banks. The RBI should either lower the CRR
Economic and Political WeeklyMarch 31, 20071222or completely restore payment of interest on CRR balances, whichis acting as a tax on intermediation.Corrective Steps in the Medium TermPolicy-makers have been addressing current macroeconomicconcerns with an extremely short-term focus and perspective. Inorder to rein in inflationary pressures, a series of fiscal measureshave been taken in desperation by the government such as thebanning of exports of basic consumption items like sugar, wheat,milk powder, onions and lowering of import tariffs on key rawmaterials and capital goods. But this move is contradicting RBIintervention in the foreign exchange market to prevent a sharpappreciation of the rupee and erosion of the competitiveness ofexports. If a widening trade deficit is a serious concern, is it aright step on the part of policy-makers to discourage exports ofexportables and encourage imports of raw materials and capitalgoods? Rather, at this stage policy-makers need to look closelyat the factors responsible for creating shortages of these com-modities in the domestic market and address the problem byundertaking suitable measures to improve the productivity of theagriculture sector. This alone can boost sustainable growth.The time has come for the Indian economy to align its domesticfuel price level to international oil prices. There should be a moveto the regime of full pass-through of international oil priceswithout much delay – with focused targeted support for the poor– which would help limit fiscal and quasi-fiscal losses (wheninternational prices are rising) and provide incentives for moreefficient energy use, thus aiding competitiveness in the mediumterm. Recently the government cut the petrol prices by Rs 2 perlitre and diesel prices by Rs 1 per litre to control rising inflation.But again in the process it has substantially reduced auto fuelmargins of oil marketing companies, the burden of which willeventually fall on the fiscal exchequer. It must be rememberedthat the control of economic imbalances in one direction resultsin the widening of imbalances in some other directions. In Indiaalso, the “subsidies” extended by the government to controlinflation have put a substantial burden on government finances.Fiscal consolidation is a prerequisite for more complete bankingsector development.As is the case at present, India’s monetary policy should remainfocused on keeping inflation pressures in check. The increasesinthe repo and/or reverse repo rates by the RBI in January, June,Julyand October 2006 and January 2007 and CRR hikes in December2006 and February 2007 were seen as appropriate by the inter-national community, signalling the RBI’s commitment to pricestability and helping the smoother adjustment to rising capitalcosts.The government ownership of banks in India is still very high.Despite regulatory reforms and increased private sector partici-pation in the banking sector, government banks still dominatethe sector. Most of the 27 PSBs are overstaffed and still behindtheir private sector peers in terms of computing and e-bankingfacilities. Their intermediation cost also is much higher by globalstandards. Research done at the Harvard Institute of EconomicResearch [La Porta 2002] based on the data on governmentownership of banks from 92 countries around the world showsthat such ownership is associated with slower subsequent bankingsector development and low levels of per capita incomes.As a first step, the government may like to give a concreteroad map to bring down its stake in PSBs to 33 per cent in duecourse to fulfil the promise that it had made to investors threeyears ago. It would also help in restoring the commercial characterof PSBs.The existing cap of 20 per cent as an upper limit for FIIinvestment in the equities of PSBs may be removed and a limitedFDI route be permitted in the PSBs. At present, many FIIs arewilling to increase their stakes in PSBs based on their assessmentof the financial strengths of these banks but are constrained dueto the existing restrictions. Removal of the cap on FII investmentin the equities of PSBs will significantly improve the marketdiscipline for these entities. Similarly, FDI is an important sourceof finance as it helps in technology transfer and in accessingforeign markets.The PSBs may be given more freedom in appointing morenumber of independent directors, professionals on their boards.These banks’ boards may be given enhanced freedom in –(i)operational decision-making including various issues relatedto information technology, human resources and other businessareas,and (ii) laying down the policies on accountabilityandresponsi-bility of bank officials in order to remove undue fear of outsideagencies like Central Bureau of Investigation/Central VigilanceCommission. This would result in the creation of level-playingfield between the PSBs and the private/foreign banks.The lack of full autonomy to the banking sector’s regulatorgives rise to problems like regular waiver of prescribed limits,forbearance and lifeboat scheme for non-viable institutions [Basu2002]. Full autonomy to the banking regulator is a preconditionfor the soundness of the banking sector. The problem of multipleregulators and lower degree of coordination among differentregulators create opportunities for regulatory arbitrage for smartplayers [Mor and Rege-Nitsure 2002].“Consolidation” in the banking field could be viewed as thenext step in Indian banking sector evolution. A look at theinternational scene suggests that size does matter. Major driversbehind the instinct to expand the “scale of operations” in Indiaare heightened competition and thinning spreads. It is felt thatgeographically well-spread banks are customarily less vulnerableto economic shocks (especially regional ones). Cost efficiencyand profit efficiency largely depend on the volumes of fundsdeployed. Also, size offers greater manoeuvrability in enhancingbusiness volumes and productivity. Diversification benefits couldbe reaped not only by reducing portfolio risks on the assets sidebut also by lowering the funding risk on the liability side as itspreads funding activities over a larger geographic area.In view of this, the policy-makers should take concrete stepsin near future to kick start the consolidation process as that alonewill force the PSBs to acquire scale from both the business andtechnology perspectives, in order to compete. However, assuggested by the Narasimham Committee, “mergers” in thebanking sector should be market-led and synergy-driven insteadof externally imposed. In the past, mergers were initiated byregulators to protect the interest of depositors of weak banks.This need not be the case in the future. The focus should be onachieving better segmentation in the market. Most mergers, suchas those of Nedungadi Bank with Punjab National Bank, LaxmiCommercial Bank with Canara Bank, Benaras State Bank withBank of Baroda, Sikkim Bank with Bank of India, Global TrustBank with Oriental Bank of Commerce and United Western Bankwith IDBI happened because of the precarious financial positionof the weaker institution.
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