BANKING SECTOR REFORM SINCE 1991

BANKING SECTOR REFORM SINCE 1991 Banking sector reforms were an important part of the broader agenda of structural economic reforms introduced in India in 1991. The first stage of reforms was shaped by the recommendations of the Committee on the Financial System (Narasimham Committee), which submitted its report in December 1991, suggesting reforms in banking, the government debt market, the stock markets, and in insurance, all aimed at producing a more efficient financial sector. Subsequently, the East Asian crisis in 1997 led to a heightened appreciation of the importance of a strong banking system, not just for efficient financial intermediation but also as an essential condition for macroeconomic stability. Recognizing this, the government appointed a Committee on Banking Sector Reforms to review the progress of reforms in banking and to consider further steps to strengthen the banking system in light of changes taking place in international financial markets and the experience of other developing countries. The two reports provided a road map that has guided the broad direction of reforms in this sector.

Pre-reform Situation

India's commercial banking system in 1991 had many of the problems typical of unreformed banking systems in many developing countries. There was extensive financial repression, reflected in detailed controls on interest rates, and large preemption of bank resources to finance the government deficit through the imposition of high statutory liquidity ratio (SLR), which prescribed investment in government securities at low interest rates. The system was also dominated by public sector banks, which accounted for 90 percent of total banking sector assets, reflecting the impact of two rounds of nationalization of private sector banks above a certain size, first in 1969 and again in 1983. These banks were nationalized because of the perception that it was necessary to impose social control over banking to give it a developmental thrust, with a special emphasis on extending banking in rural areas. The system suffered from inadequate prudential regulations, and nontransparent accounting practices. Supervision by the Reserve Bank of India (RBI) was also weak.

Broad Approach to Reform

The strategy for banking reforms was broadly similar to that followed in other countries, but with some important differences. It was similar to the extent that it focused on imposing prudential norms and improving regulatory supervision to meet Basel I standards (standards that were formulated by the committee of the Bank of International Settlement, or BIS, based in Basel, Switzerland), and it aimed at increasing competition to promote greater efficiency. However, there were two important differences compared with reforms in other countries. First, the reforms in banking were much more gradualist than in most countries, a course of action that was in line with the general strategy of reforms in India, made possible by the fact that the reforms were not introduced in the midst of a banking sector crisis, which might have entailed greater urgency. Second, unlike the case in many other countries, there was never any intention to privatize public sector banks. It was clearly recognized that competition was desirable, and this implied that both private sector banks and foreign banks should be allowed to expand their market share if they could. However, the government also declared its intention to strengthen public sector banks and enable them to meet competition.

There was also a great deal of progress in introducing prudential norms for income recognition, asset classification, and capital adequacy in a phased manner. As a consequence of this gradualist process, income recognition norms and capital adequacy norms have been fully aligned with Basel I standards, while asset recognition norms, though still falling short of international best practice, are now close to existing international standards.

Decontrol of Interest Rates and Credit

There has been a significant liberalization of interest rate and credit controls on commercial banks. Earlier, there were detailed restrictions on interest rates that could be paid on different types of deposits and rates that were charged to various categories of customers. These have been extensively liberalized. On the deposit side, interest rates paid on term deposits have been decontrolled, except that the RBI prescribes a maximum interest rate on short-term (15-day) deposits and also prescribes the interest rate on savings deposits. On the lending side, the detailed structure of interest rates prescribed for different types of borrowers and for different sizes of loans has been abolished; the RBI prescribes only the interest rate to be paid under the differential rate of interest scheme a very small window for loans to individuals below the poverty line. For the rest, individual banks fix lending rates with reference to the prime lending rate fixed by the bank. The reforms also abolished the requirement that banks needed to obtain RBI approval for individual credit limits fixed for large customers. With these changes, decisions on the cost of credit and the volume of credit to be extended have been left to bank management, subject to internal guidelines and procedures for credit approval and general prudential limits on single borrower and single project exposure.

Directed Credit

Reducing directed credit requirements is a common feature of banking reforms, and this was the case in India as well. A major directed credit requirement was constituted by the high levels of the SLR, which preempted bank resources to finance the government deficit at low interest rates. Preemption of credit by the government also occurred indirectly because the RBI followed a practice of automatically issuing ad hoc Treasury bills to meet any shortfalls in the government's balances with the RBI. Since this implied a mechanical transmission of fiscal expansion to the monetary side, it was offset by imposing a high cash reserve ratio (CRR) in the commercial banks, thus effectively crowding out private sector credit.

At one stage, prior to the reforms, the combined effect of the high CRR and the SLR was such that only 35 percent of the increment in bank deposits was actually available for commercial advances, the rest being either impounded by the RBI in the form of cash reserve deposits or absorbed by the government. The practice of automatic monetization was abandoned in 1994, and both the CRR and the SLR were reduced over time from 15 percent and 38.5 percent, respectively, before the reforms to 5 percent and 25 percent by 2005. The fiscal deficit is now financed through the auction of government securities conducted by the RBI, and in that sense, the interest rate on government borrowing is market-determined. However, it is interesting to note that, despite the reduction in the SLR from 38.5 percent to 25 percent, the proportion of government securities held by the banks to their total assets has actually increased from 30.4 percent at the end of March 1994 to 34.5 percent at the end of March 2004. This has occurred because of the combined effect of the inability to reduce the fiscal deficit—a key weakness of the reforms to date—and the fact that the prudential norms give sovereign debt a very low risk weight. In other words, while statutory preemption of bank resources was steadily reduced in the 1990s, the banks' appetite for government debt has remained high because the prudential norms contain a built-in regulatory bias in favor of government debt in preference to commercial credit.

The other major form of directed credit was the requirement that 40 percent of commercial credit has to be extended to the priority sector, which includes agriculture, small-scale industry, small transport operators, artisans, and so on. It applies to Indian commercial banks but not to foreign banks because the latter do not operate in rural areas and therefore cannot engage in agricultural lending. In their case, the requirement is that 15 percent of advances must be for exports and for the small-scale sector. These provisions have not been altered by the reforms. However, although the priority sector target for Indian banks has not been changed, the provision has been liberalized indirectly to some extent by definitional changes that expand the range of borrowers that are eligible. It is also worth noting that while banks are subject to sectoral direction of credit, they are not required to lend to particular borrowers; the credit decision of lending to a particular borrower is left to the bank on the basis of normal credit-worthiness analysis.

Banking Supervision

Improved prudential regulation must be supported by strong supervision, and several steps have been taken in this area since 1991. A Board of Financial Supervision, with an advisory council and an independent department of supervision, was established in the RBI. Traditional on-site supervision was supplemented by a system of offsite supervision, which allows a closer and more continuous monitoring of asset quality. A new supervisory reporting system was introduced in 1995, using the CAMELs approach (capital adequacy, asset quality, management, earnings, liquidity, and system for risk assessment) to assess the financial position of banks. More recently, the RBI has moved from the Basel I risk-based approach to a system of risk-based assessment for selected public sector banks.

In 2003 the RBI introduced a framework of prompt corrective action under which banks falling short of predetermined critical levels of capital adequacy, percentage of nonperforming assets (NPAs), and return on assets would automatically trigger some mandatory corrective action and possibly also further nonmandatory actions. Properly implemented, this should ensure that banks falling below a certain standard would be forced to correct their market share. An effective framework for corrective action is particularly important in the Indian context, where there are a number of weak public sector banks, and in which corrective action is the best way of preventing regulatory forbearance.

Increasing Competition

Increasing competition within the banking sector was an integral part of the reforms as a means of promoting efficiency in the sector, and important steps were taken in this direction. New banking licenses for Indian private sector banks, which had not been granted for many years before the reforms, were granted, and several new Indian private sector banks were established in the 1990s. While some have fared poorly, others have prospered. Some of the best Indian private sector banks have modernized their banking operations commendably and have developed electronic banking capability fully comparable with foreign banks. They have also expanded their market share. Foreign banks, which were earlier subjected to a very restrictive policy, were allowed more liberal expansion opportunities. New foreign banks were licensed to enter the market, and existing banks were allowed to expand branches more liberally.

These changes had an impact on the banking system. At the end of March 1991, 90 percent of the assets of the banking system were accounted for by public sector banks, with the private Indian banks accounting for 3.7 percent and foreign banks 6.3 percent. By the end of March 2003, this had changed to 75 percent, 18.5 percent, and 6.9 percent, respectively. The major expansion in market share has been on the part of Indian private sector banks, though the extent of the increase is exaggerated because they include the effect of the merger of a major nongovernment development financing institution (ICICI) with its banking subsidiary to create a new bank, leading to the inclusion of its assets in the total for private bank assets.

The share of foreign banks has increased only marginally, despite a more liberal policy of branch expansion of this sector. This reflects the fact that these banks are focused primarily on high-end corporate clients, who are in any case moving away from bank financing, relying increasingly upon the capital markets to raise finance. The income-earning strategy of foreign banks is correspondingly oriented toward greater reliance upon feebased income.

Public Sector Banks

Unlike banking reforms in most developing countries, India's banking sector reforms abjured privatization; the strategy from the very outset was that public sector banks would remain publicly owned but would be made to improve their performance by a combination of better supervision and greater managerial autonomy.

While ruling out privatization, public sector banks were encouraged to raise capital from the market, which diluted government equity, a dilution that was allowed as long as the government share remained 51 percent. The induction of private shareholders was expected to help the banks meet capital adequacy requirements without putting a strain on the budget. It was also expected to create a more commercial environment and thereby also to condition the attitude of government, even though the government remained a majority shareholder. Twenty of the public sector banks were able to raise capital from the market, and by 2005 the private shareholding in these banks varied from 20 percent to 46 percent.

A number of steps were taken to improve the efficiency of public sector banks, including rationalizing the branch network and reducing the labor force through voluntary retirement plans. Productivity enhancement through information technology application was also pursued, though public sector banks were slower than others in introducing electronic banking. However, some of the better public sector banks now offer online banking facilities at a large number of their branches. The fact that public sector banks have to observe the public sector salary structure remains an important limitation, and this is likely to become more of a constraint as the size of the private banking sector expands. However, within this constraint, public sector banks have made efforts to improve recruitment and develop better human resource development policies.

Skeptics remain unconvinced that public sector banks can ever be managed in a way that distances government from individual banking decisions. The problem in India is not so much political intervention in individual credit decisions as the imposition of procedures that make it difficult for bank managers to take initiative in making commercial decisions without being accused of having extended undue favors. This is primarily because the law equates the employees of any entity in which the government has a 51 percent stake with civil servants, making them subject to the same standards of accountability for their actions. This places a great deal of emphasis on compliance with procedures, which forces bank management to be cautious and rule-bound rather than innovative.

Despite these constraints, the evidence suggests that public sector banks have improved their performance in the postreform period. Gross nonperforming loans of public sector banks declined from 17.8 percent at the end of March 1997 to 9.4 percent at the end of March 2003. Net nonperforming loans as a percentage of total assets declined from 3.6 percent to 1.9 percent over the same period. Net profit in public sector banks as a percentage of total assets increased from 0.6 percent in 1996–1997 to 1.0 percent in 2002–2003, and operating expenses as a percentage of total assets declined from 2.9 percent to 2.3 percent in the same period.

Banking System Performance

The impact of the reforms on the efficiency of the banking system in performing its twin roles of financial intermediation and resource allocation is not easy to evaluate. As far as the scale of bank intermediation is concerned, the ratio of total credit extended by the banking system to India's gross domestic product has increased, but it is still relatively low compared to countries such as China or some of the other East Asian countries. The ratio in India increased from 51.5 percent in 1990 to 53.4 percent in 2000, whereas in China it increased from 90 percent to 132.7 percent in the same period. The figures over the same period are also much higher for Malaysia (75.7% and 143.4%) and Thailand (91.1% and 121.7%), though many Latin American countries have figures closer to those of India.

There is evidence of significant improvement in several dimensions in recent years. Gross nonperforming assets (NPAs) as a percentage of total advances have fallen from 15.7 percent in 1996–1997 to 7.3 percent in 2003–2004. Gross NPAs as a percent of total assets are much lower because Indian banks typically have a large proportion of their assets in sovereign debt; this ratio has also declined from 7 percent in 1996–1997 to 4 percent in 2002–2003. More importantly, the financial strength of the banks is actually better than it appears from these ratios because Indian banks do not write off assets, even though large provisions have been made. Net nonperforming assets, calculated after taking account of provisioning, are 3 percent of total advances and only around 2 percent of total assets. There has been a general improvement in other financial indicators, such as net profit as a percentage of total assets, interest spread as a percentage of assets, and operating expenses as a percentage of total assets, for public sector banks, old private sector banks, new private sector banks, and foreign banks. The financial strength of the banks, as measured by the capital to risk adjusted assets ratio (CRAR), shows distinct improvement in the postreform period. The required CRAR was increased in phases, to 8 percent at first (which is the Basel I minimum) and then to 9 percent in 1999–2000. Initially, banks with insufficient capital had to be capitalized by the injection of government equity from the budget, but subsequently several banks were able to raise capital from the market, and this, combined with plowing back of profits, led to a substantial improvement in capital adequacy. At the end of March 2003, out of the 93 commercial banks operating in India, 91 were above 9 percent and as many as 87 were above 10 percent, compared with only 54 out of 92 banks above 9 percent and 42 above 10 percent at the end of March 1996.

It is noteworthy that the Indian banking system did not suffer from any contagion effect in the aftermath of the East Asian crisis. However, this is not so much due to the improvements brought about after 1991, as the fact that the capital account was not fully open. Banks were not allowed to undertake excessive foreign currency exposure, and external borrowing (especially short-term borrowing) was strictly controlled. This cautious policy helped insulate India from the severe reversals of external flows witnessed in many emerging market countries in the 1990s.

The Future Agenda

The agenda for banking reforms in the future involves the continuation of the process of aligning prudential norms and supervision systems to the best international practices. This is bound to be a moving target since the banking system internationally is shifting from Basel I to Basel II (standards formulated by the committee of the Bank of International Settlement, or BIS, based in Basel, Switzerland), which involves use of much more sophisticated and bank-specific methods of risk assessment. An immediate challenge facing the public sector banks relates to the case for merging some of the banks to create stronger banks with a larger capital base and therefore correspondingly larger capacity to finance large projects. Given the size of the economy and its projected growth, there is a case for having at least two banks at a scale comparable to the larger Asian banks.

A general problem affecting the banking system (both public sector and private sector banks) is the efficacy of the legal system in enforcing creditor rights. At present the legal procedure is dilatory, and there are difficulties associated with enforcing recovery through seizure and sale of collateral or through forced liquidation. Recent changes in the law enable banks to seize collateral, but the process of the sale of collateral remains difficult. Legislation was introduced in 2003, though not yet enacted, to make it easier to force liquidation in cases where bank debts are overdue and no agreement is reached between the creditor and the borrower on restructuring the debt. There is also a need for a credit information bureau that would enable banks to access information on the credit standing of prospective borrowers based on their status with other banks. The Credit Information Bureau of India was set up for this purpose in 2000, and the government has announced that it will introduce legislation to enable the bureau to obtain information from participatory banks with suitable safeguards protecting privacy. Improvements in the legal environment for recovery of bank dues and institutionalization of information sharing among banks will make a major contribution to increasing the efficiency of bank intermediation.

Montek S. Ahluwalia

See alsoCapital Market ; Commodity Markets ; Debt Markets ; Economic Reforms of 1991 ; Money and Foreign Exchange Markets

BIBLIOGRAPHY

Ahluwalia, Montek Singh. Annual Reports on Currency and Finance. Mumbai: Reserve Bank of India, 1992–2004.

——. Lessons from India's Economic Reforms in Development Challenges in the 1990s—Leading Policy-Makers Speak from Experience. Washington, D.C.: World Bank and Oxford University Press, 2005.

Report of the Committee on Banking Sector Reforms. New Delhi: Government of India, 1998.

Report of the Committee on Financial Systems. New Delhi: Government of India, 1991.