Liberalization and Development of Financial Sector in Post-independence India

Abstract: 
The financial sector in India has changed drastically since late 1990s due to technological innovation, financial liberalization with the entry of new private and foreign banks, and regulatory changes in the corporate sector. The intense competition between these new entrants with the already existing public sector banks to cater to the needs of the same pie of consumers facilitated implementation of new ways in reducing costs, and at the same time attracting customers/business. Further liberalization of the financial sector facilitated development of capital markets; non-banking financial institutions that absorb current and potential borrowers and bank depositors, thereby, banks may face competition both in raising resources and in deploying them. In the current scenario, liberalization and deregulation have to go hand-in-hand with a greater emphasis on efficiency, consolidation, asset quality and profitability.
Main Article: 

1. Introduction

The financial sector in India has changed drastically since the late 1990s due to technological innovation, financial liberalization with the entry of new private and foreign banks, and regulatory changes in the corporate sector (Allahabad Bank, 2002). The intense competition between these new entrants with the already existing public sector banks to cater to the needs of same pie of consumers facilitated implementation of new ways in reducing costs, and at the same time attracting customers/business.  Further liberalization of the financial sector facilitated development of capital markets; non-banking financial institutions that absorb current and potential borrowers and bank depositors, thereby, banks may face competition both in raising resources and in deploying them. In the current scenario, liberalization and deregulation has to go hand-in-hand with a greater emphasis on efficiency, consolidation, asset quality and profitability (Jalan, 2002).

The developments in the banking sector such as technological advances in information technology and securitisation bill, reduction in employee strength through Voluntary Retirement Schemes (VRS) have greatly reduced costs and Non-Performing Assets (NPAs), thereby increased efficiency among Indian banks. What is equally important is that the intermediation process has improved even in Public Sector Banks (PSBs), as is evident from the ratio of net interest income (interest spreads) to total assets of PSBs has declined from 3.22 in 1990-91 to 2.84 in 2000-01, even though there was an improvement in mode of function of banks from one of mere intermediator to that of provider of quick, cost effective and efficient services (Bhide et al., 2002).

However, there is still a large gap to be filled in improving financial health and providing quality customer services, reducing NPAs, and improving corporate governance practices in banks in general, and PSBs in particular. Lower level of provisioning for NPAs, when compared to international standards is also a problem. For example, PSBs on average provide for 55 per cent of their NPAs, while provisioning by foreign banks is much higher at 70 percent whereas international banks provide up to 140 percent. It was recognized that restoration of health of the banking system required both a stock solution (i.e., restoration of net worth) and flow solution (i.e., an improvement in future profitability) (Joshi and Little, 1997). Recent interest rate deregulation exposes the banks to interest rate risk (market risk). Such interest rate risk has a potential impact on net interest income as well as on the market value of the fixed income securities held by the banks, which may affect bank risk exposure. The issue of capital adequacy and recapitalisation also require urgent attention (Jaikvoulle and Kauko, 2001). With the above background, the paper specifically reviews banking sector performance (especially scheduled commercial banks) and its determinants in developing countries' perspective, especially in the Indian context.

In analyzing the functions performed by commercial banks, Bergendhal (1998) mentions five fundamental goals of efficient bank management: profit maximization, risk management, service provision, intermediation and utility provision. To keep it simple, one can redefine the five goals into two by pooling the five goals, i.e., profit maximization (combining features of Bergendhal’s profit maximization and risk management) and interest spreads (combining service provision, intermediation and utility provision). By reducing interest spread, one can maximize utility of bank customers i.e., reduce intermediation cost in providing services to both depositors and borrowers.

The banking system in India comprises the Reserve Bank of India (RBI), commercial banks, regional rural banks and the co-operative banks. In the recent past, private non-banking finance companies also have been active in the financial system, and are being regulated by the RBI. As of 2000, commercial banks (which include public sector banks, private sector banks and foreign banks) remain the most dominant with nearly 62 per cent of financial assets, followed by investment institutions (18.6%), term lending institutions (15.1%), and cooperative banks (2.6 per cent) (Aditya and Ghosh, 2001). The Indian banking sector has been characterized by the predominance of PSBs. The PSBs had 47,579 branches during 2001 with total assets of Rs. 10,298 billion, which accounted for 79.5% of assets of all Scheduled Commercial Banks (SCBs) in India. PSBs account for 81% of deposits, 79% of advances, 78% of income, and 90% of branches of all commercial banks during the year 2001. The private sector banks accounted for 12.6% of the total assets, and foreign banks accounted for 7.9% of the total assets of all SCBs. The primary activity of most foreign banks in India has been in the corporate segment, while public sector banks cater to the needs of wider mass of India. However, in recent years, some of the larger foreign banks have started making consumer financing. The recent increase in foreign direct investment cap in banks from 49 per cent to 74 percent is a significant development in liberalizing banking sector to foreign participation.

2. Performance of Indian Banking Sector

In a study that covers more recent period, Das (1999) compares performance among public sector banks for three years in the post-reform period, 1992, 1995 and 1998. He finds a certain convergence in performance. He also notes that while there is a welcome increase in emphasis on non-interest income, banks tend to exhibit risk-averse behaviour by opting for risk-free investments over risky loans.

Sarkar and Das (1997) compare the performance of public, private and foreign banks for the year 1994-95 by using measures of profitability, productivity and financial management. They find PSBs comparing poorly with the other two categories.

Bhattacharya et al. (1997) studied the impact of the limited liberalization initiated before the deregulation of the 1990s on the performance of the different categories of banks, using Data Envelopment Analysis. Their study covered 70 banks during the period 1986-91. They constructed one grand frontier for the entire period and measured technical efficiency of the banks under study. They found PSBs had the highest efficiency among the three categories, with foreign and private banks having much lower efficiencies. However, PSBs started showing a decline in efficiency after 1987, private banks showed no change, and foreign banks showed a sharp rise in efficiency. The main results accord with the general perception that in the nationalized era, public sector banks were successful in achieving their principal objectives of deposit and loan expansion. However, Das (1997), who analyzed overall efficiency – technical, allocative and scale efficiency of PSBs in 1990-96, found a decline in overall efficiency. This occurred because there was a decline in technical efficiency, which was not offset by an improvement in allocative efficiency. The study, however, pointed out that the deterioration in technical efficiency was mainly on account of four nationalized banks.

In a review of performance of banks, RBI (1999a) concluded that there has been a decline in spreads, a widely used measure of efficiency in banking and a tendency towards their convergence across all bank-groups except foreign banks. 2. Intermediation costs as a percentage of total assets have also declined especially for PSBs and new private sector banks, due largely to a decline in their wage costs. 3. Capital adequacy and asset quality (measured by the net NPAs as percentage of net advances) have both improved over the period 1995-96 to 1999-2000. 4. Median profit per employee of PSBs witnessed a significant rise from 1996-97 to 1999-2000. 5. Non-interest income to working funds rose modestly for the median PSBs. 6. The ratio of wage bill to total expenses remained at a high level for PSBs. 7. The cost to income ratio declined for PSBs. The RBI noted that, “Developments after 1996 indicate that a majority of the public sector banks have been able to progress considerably towards the direction of passing the acid test of achieving competitive efficiency.

The difference between the interest rate charged to borrowers and the interest rate paid to depositors, which reflects the cost of intermediation (interest spread), is an important indicator of efficiency. The main components of interest spread are non-interest income, overhead, taxes, and loan loss provisions and after-tax bank profits. The efficiency of the banking system as a whole, measured by declining spreads/total assets (3.22 in 1991-92 to 2.7 in 1999-2000), has improved, and the public sector banks have improved their performance in both absolute and relative terms (Ram, 2002). Contrary to that, Souza (2002) argued that the banking system as a whole has not become more efficient as measured by the interest spreads/working funds which have been rising (2.10 in 1990-91 to 2.73 in 1999-2000 for all banks) and not declining. However, some issues need to be addressed in PSBs, such as low provisioning to non-performing assets and low employee productivity compared to private and foreign banks. The turnover per employee in the private banks doubled relative to the public sector banks during the 1990s. The establishment expenses as percent of total expenses drastically declined in private and foreign banks as they have been able to contain their wage and salary expenditures compared to the public sector banks, however, private and foreign banks spend more on technology upgradation.

Another indicator of bank efficiency is the quality of assets (NPAs). As of March 31, 2002, the gross NPAs of scheduled commercial banks stood at Rs. 71,000 crores. Although the net NPAs of the commercial banks in India have witnessed a decline over the past several years, they are still high in comparison to developed country standards of around 2 per cent. Some argue that the high level of NPAs in PSBs was due to higher proportion of NPAs in priority sector advances by PSBs, which was attributed to the directed and pre-approved nature of loans sanctioned under government sponsored programs, the absence of any security, lack of effective follow-up due to large number of accounts, legal recovery measures being considered not cost-effective, vitiation of repayment culture consequent to loan waiver schemes, etc (Nachane, 1999; RBI, 1999b). However, all but three banks have met RBIs capital adequacy norm of 9 per cent in 2002. Performance measured by gross and net return on average assets worsens and liquidity (measured by cash over assets) declines for weak banks.

The commercial banking system in the country has become quite apprehensive of exposing itself to lending risks and has developed an unhealthy appetite for government securities. The pace at which the commercial banks invested in government securities far exceeded those in both deposit mobilization and credit disbursal (Nair, 2000), as in the low interest rate regime trading profits very high for government securities (Rakesh, 2002).

A cross-bank study for India Sarkar et al. (1998) regresses two profitability and four efficiency measures on pooled data for two years 1993-94 and 1994-95, for a total of 73 banks, using single equation OLS estimation for each.  They found that after controlling for total assets, the proportion of government securities to total assets, proportion of priority sector loans, share of rural banking, non-interest income to total income, foreign ownership showed positive association with profitability and efficiency. Ajit and Bangar (1998) present a tabulation of the performance of private sector banks vis-a-vis public sector banks over the period 1996-1997, using a number of indicators: profitability ratio, interest spread, capital adequacy ratio and the net NPA. The conclusion is that the Indian private banks out-perform the public sector banks. The study also found that Indian private banks have higher returns to assets in spite of lower spreads.

Rajaraman et al. (1999) show that bank-specific characteristics such as ownership or adherence to prudential norms do not suffice to explain inter-bank variability in NPAs. The study argued that banks functioning in less developed areas like Bihar were having high NPAs, while banks functioning in developed regions such as Delhi, Punjab were having less NPAs.

As Indian banking system is predominantly a public sector one, the incentive structure differs significantly from those prevailing under private sector banking. In the changed scenario of liberalization, banks will have to bring about an overall improvement in their working, covering human resource management, technology upgradation and integrated risk management (Jalan, 2001).

3. International Experience

Interest Spreads and Profitability

The financial systems in developing countries typically exhibit significantly high and persistent spreads as cost of poor quality loans is shifted to bank customers through higher spreads (Barajas et al., 2000). Similarly, Brock and Suarez (2000) also find significant evidence of a positive relation between spreads and wages or non-financial costs. Non-financial costs reflect variations in physical capital costs, employment and wage levels. While studying bank restructure policies of 11 transition countries during 1991-98, Zoli (2001) stated that an increase in interest spreads may indicate that banks are facing riskier borrowers and, hence, charging higher rates or that banks need to cover larger expenses due to loan losses. So, a decline in the spread is interpreted as an improvement in efficiency. Undercapitalized banks faced distorted incentives in extending new loans and were prone to excessive risk-taking and high spreads. The excess risk-taking was also encouraged by the government by retaining a controlling stake in major banks that creates the expectations of future bailout.

Intermediation margins are positively related to market power in the Columbian banking system (Barajas et al., 1999). A study by Asli and Harry (1998) while studying bank performance that takes interest spread and bank profitability as dependent variables and bank specific variables (size, leverage, type of business, foreign ownership), country specific variables (macro-economic, legal and institutional environment) as explanatory variables, concluded that foreign banks are better in terms of net profits with high interest spread and low NPAs. The study found that higher interest spread could indicate greater banking efficiency under segmented or imperfectly competitive markets.

Implicit taxes such as Cash Reserve Ratios (CRR), Statutory Liquidity Ratio (SLR) and priority sector lending are at higher level in developing countries, which is also a cause for higher spreads. There is a positive and significant relationship between spreads and liquidity reserves in the Columbian banking system (Barajas et al., 1999). Despite high wages, overhead as a share of total assets appears to be lowest at around 1 per cent for banks in high-income countries. Large banks tend to have smaller overheads.

The above studies provide contradictory evidences about interest spread as bank efficiency indicator in the perspective of developing countries, such as in India. In the long run, the banking system should be stable and efficient to enhance overall development of the country. Stability clearly requires sufficient banking profitability, while economic efficiency requires bank spreads that are not too large. A prerequisite to formulating effective banking policies is thus to understand the determinants of bank profitability and interest margin (Asli and Harry, 1999).

Deposit Rates

One instrument to increase profitability and spread was lowering deposit rates, which lowers cost of funds to banks. Abdourahmane (2000), by using United States data, concluded that the ability of commercial banks to lower deposit interest rates diminishes when their deposits become closer substitutes to non-bank liabilities requiring greater interest rate competition (for example, ceiling rate for non-bank financial companies were around 11 per cent compared to average bank deposit rate of about 6 to 7 per cent). Deposits can be inputs for the production of bank loans (an intermediation service) or safekeeping services output provided to depositors (a non-intermediation service). The same deposits may also be inputs to the provision of payment services (checking services). The framework shows that the input-output nature of banking deposits may be such that banks use their market power on deposits to subsidize non-intermediation service fees as deposit raising strategy. Therefore, reduction of deposit interest rate does not mean a lack of competition, but an increase in competition by using another means. Banks would lower deposit interest rate provided they have market power on deposits and non-intermediation services. Given the low-income levels in developing countries, small savers and demand depositors may be less sensitive to the deposit interest rate, but more responsive to the convenience of bank branches and payments services for savings, safekeeping and transactions. The public sector commercial banks have advantage in competing via branch banking that may be good for financial deepening. While foreign banks are competing via providing non-intermediation banking services, which ultimately may increase domestic banks' efficiency and foster domestic financial deepening (Bernado and Douglous, 2001).

Prudential Regulations and Banking Restructuring

While most of the studies emphasized market related financial efficiency measures (spread and profitability) to boost the banking sector, equally good number of studies emphasized the importance of prudential and regulatory measures to increase financial health and stability of the banking sector. Prudential tightening covers exposure and disclosure norms, guidelines on investment, risk management, asset classification and provisioning. A study of the Croatian banking system argued that fundamental determinant of profitability is probably good management, which succeeds both in cutting costs and managing risk prudently. It is good prudential management rather than cost efficiency that explains the survival of more cost-efficient banks in turbulent waters of transition banking (Evan  et al., 2002).

While discussing the consequences of weak prudential regulation upon the Russian banking system, Gidadhubli (2001) stated that due to the low minimum capital requirements, a large number of small banks were set up. Most of these banks engaged in utilizing their resources for speculative activities such as exchanging rubles into dollars or vice versa to earn quick profits. It was reported that a few banks even used money borrowed from the government and the central bank of Russia for transactions, due to the inefficient regulations. In line with this, David and Vlad (2002) found that tighter minimum capital adequacy ratios seem to be associated with improved revenue generating capacity and more aggressive deposit-taking behaviour. Well-capitalised banks face lower expected bankruptcy costs, thereby reducing their cost of funding.

In a study of crisis and restructuring of Indonesian banking system, Mari and Manggi (2002) listed causes for banking crisis as: Firstly, a rapid expansion of the banking sector without necessary strengthening of prudential regulations and central bank supervision. Secondly, the high concentration of ownership in the banking sector led to weak corporate governance of banks. An even more serious problem was the lack of ability to enforce prudential regulations because of the weak capacity and capability of central bank supervisors, widespread corruption and political interference. Further, it was believed that banks would be bailed out in case of bank failure by the government and there was no effective exit mechanism for failed banks.

In response to the crisis, Indonesian Bank Restructuring Agency (IBRA) was set up to supervise and restructure the banking sector. The IBRAs mandate was to close, merge or take over and recapitalise troubled banks. The banking reforms also included steps to intensify the supervision of a number of the largest private banks, rehabilitation and surveillance plans for a number of smaller private banks and mergers of state-owned banks. The IBRA recommended a change in the management of some banks, reducing the number of banks to consolidate and increase scale and scope of economies that would increase performance and profitability.  It also recommended higher capital requirements for banks, as Indonesian banks need to operate in riskier environment. The high capital requirement is widely practiced in high-risk environment such as community banks in United States. It also recommended efficient deposit insurance scheme by providing incentives to better performing banks by linking the annual premium payments to their risk profile.

Asli et al. (2000) stated that during crisis the rate of growth of real deposits falls significantly, in fact, banks lose other sources of funding  (such as inter-bank credit, foreign loans, commercial paper or equity) more rapidly than deposits, as witnessed by significant increase in the ratio of deposits to assets. On the assets side, real credit slows down and NPAs increase significantly, banks shift their portfolio away from loans to safer assets to economize on regulatory capital. The drop in the sources of funds calls for an effective management of liquidity in times of crisis.

4. Reforms and Restructuring of Banking System in India

In the above backdrop, there was a need for further reforms and prudential regulations to be placed for adjustment with the technological advances and economic conditions. The economist’s case for justifying prudential regulation in the field of banking is due to the existence of two types of market imperfections i.e., externalities-social cost of failure of banking system far exceeds private costs and information failures-as small depositors/clients do not have the capacity to evaluate financial contracts and safety with banks (Souza, 2000). However, the approach to achieve the above objectives should be market-friendly and cost-effective with greater reliance on incentives, and less on supervision.

Institutional restructuring encompasses reforms of the legal framework, prudential regulations, accounting standards and banking supervision. Operational restructuring deals with the flow problems caused by sizable non-performing loans and high operating costs, and aims at improving corporate governance.

The Working Group of RBI, under the chairmanship of  M.S.Verma, identified three weak banks, which fell short of every competitive benchmark in every business segment, in cost, productivity and profitability, in technology and systems support, in internal control and risk management procedures, in their mode of operation and servicing of customers. The restructuring plan has been prepared for these banks, and suggested seven parameters covering three major areas i. Solvency (capital adequacy ratio and coverage ratio), ii. Earning capacity (return on assets and net interest margin) and iii. Profitability (include operating profit to average working funds, cost to income and staff cost to net interest income plus other income), The core of the strategy to restructure weak banks suggested by Verma Committee comprises five components, as follows:

  1. Shed the load of non-performing assets by creating an Asset Reconstruction Fund (ARF) to clean the balance sheet of large Non-Performing Assets (NPAs).
  2. Shed excess manpower by introducing a voluntary retirement scheme (VRS) or a 25 per cent reduction in salary, in case of failure to do so.
  3. Install a credible and effective governance model at the board and the top management level.
  4. Review and change the core processes in each of the banks, principally those pertaining to technology, customer service and human resources, and
  5. Establish a Financial Restructuring Authority (FRA) with statutory banking to oversee the restructuring process of the three weak banks.

In stage one, focus will be on operational, organizational and financial restructuring of the units involved, which aims at restoring their competitive efficiency. In stage two of restructuring, after investor attention, privatization or mergers will then assume relevance. In line with the above recommendations, during 2001-02, RBI took many policy measures in the context of the banking sector, which were guided by the objective of strengthening the banking sector through rigorous operational, prudential and accounting norms set to gradually converge to international standards (basal capital standards). Banks were encouraged to prepare themselves to follow international practices with respect to assigning capital for market risk. Initiatives in the direction of redefining the regulatory oversight of the Reserve Bank such as mitigating the potential conflict of interest regarding issues of ownership, risk-based supervision, consolidated accounting and supervision, off-site monitoring and inspection are underway. Policy attention was also drawn to issues in management of NPAs and related supervisory initiatives, including the setting up of Asset Reconstruction Company and the revival of weak public sector banks. New avenues of banking activity were created in insurance and the access of the banking sector to foreign direct investment was enhanced during 2001-02 (RBI, 2002).

The RBI has also initiated certain structured actions with respect to the banks now widely known as Prompt Corrective Actions (PCA), based on trigger points in terms of CAR, Net NPA and Return on Assets (ROA). The Reserve Bank, at its discretion, will resort to additional actions (discretionary actions) as indicated under each of the trigger points. In this process, a high-risk bank will be subjected to enhanced supervisory focus through a shorter supervisory cycle and greater use of various supervisory tools like targeted inspections, intensive off-site surveillance, structured meetings with bank management, commissioned audits etc. In addition to the above prudential norms, progressive deregulation of interest rates, shaving of priority lending commitments and moderating statutory liquidity and reserve norms have steadily oriented the banking sector towards the market (Patel, 2000).

Although tightening prudential requirements may limit the flexibility and profitability of the banks in the short run, but doing so may encourage banks to look for new and innovative ways to invest, thereby expanding the production-possibility frontier. It is, therefore, essential for a policy maker to be able to identify and come up with the best (often the least-cost) policy response. However, one should be cautious about excessive or inappropriate regulation, as it can stifle efficiency and invite moral hazard problems and induce entities to move out of over-regulated business to less regulated ones (Reddy, 2001).

Conclusions

The financial sector in India has changed over the past decade due to technological innovation, deregulation of financial services, external financial liberalization and organizational changes in the corporate. Competition among financial institutions further increased due to emphasis on market-based outcomes and resultant deregulation of interest rates on deposits as well as on the advances.  Technological advances in information technology and securitisation bill, and reduction in employee strength through voluntary retirement schemes have greatly reduced costs and non-performing assets, thereby increased profits, productivity and efficiency among Indian banks, with a simultaneous enhancement of customer services with competitive costs. However, there is still a large void to be filled in improving financial health and providing quality customer services, reducing NPAs, and improving corporate governance practices in banks in general, and in PSBs in particular, compared to international standards.

There was a convergence of performance among public, private and foreign banks in recent years due to adoption of technology. There was an increasing importance of non-interest income in recent years for all banks. Even though PSBs compared poorly with the other two categories in terms of profit, they had the highest efficiency in deposit mobilization. The foreign and private banks are efficient in value-added services.

There has been a decline in spreads and intermediation costs, widely used measures of efficiency in banking, and a tendency towards their convergence across all bank groups. The establishment expenses as per cent of total expenses drastically declined in private and foreign banks as these banks have been able to contain their wages and salary expenditures compared to the public sector banks. However, the private and foreign banks spend more on technology up gradation. As a result, turnover per employee in the private banks doubled relative to the public sector banks during the 1990s.

Another indicator of bank efficiency is NPAs, although the net NPAs of the commercial banks in India have witnessed a decline over the past several years, they are still high. Some studies argued region of operation plays a greater role in the amount of problem loans than the type of ownership of banks, that is to say banks functioning in less developed regions had high NPAs compared to banks functioning in developed regions.

While most of the studies emphasized market-related financial efficiency measures to boost the banking sector, equally good number of studies emphasized the importance of prudential and regulatory measures to increase financial health and stability of the banking sector. It is good management rather than cost-efficiency that explains the survival of more cost-efficient banks in turbulent waters of transition banking. As for international experience, the Russian and Indonesian banking systems were good examples of inefficient central banks and prudential regulations. Due to low minimum capital requirements, a large number of small banks were set up which were weak, and led to banking crisis in later periods. International experience also shows that high concentration of ownership, weak corporate governance, lack of ability to enforce prudential regulations, weak central bank supervisors, widespread corruption and political interference are the major reasons for banking crisis in most of the developing countries.

According to the Varma committee of RBI, solvency, earning capacity and profitability were major thrust areas for banks to follow. The committee also recommended to shed the load of non-performing assets by creating an asset reconstruction fund, shed excess manpower by introducing a voluntary retirement scheme, establishment of a financial restructuring authority with statutory banking to oversee the restructuring process of the weak banks. The RBI has also initiated certain structured actions in respect to the banks, now widely known as prompt corrective actions, which have hit the trigger points in terms of capital adequacy ratio, non-performing assets and return on assets.

In short, only cost-effective, customer-focused, technology-driven, capital strengthened banks, which follow prudential regulations, can sustain in attracting depositors and borrowers in the current competitive environment. The individual banks have to be competitive while the regulator should make sure that the prudential norms would ensure the needed stability and financial health of banks, without jeopardizing the proper incentives to banks.

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