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Friday, Nov 14, 2003

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Is it time for financial disintermediation?

Madan Sabnavis

THE level of non-performing assets (NPAs) in banks inspires a debate on the usefulness of financial intermediaries. Economic theory says that financial intermediaries are necessary to bridge the gap of asymmetric information between ultimate lenders and borrowers. They are supposed to protect the interests of deposit-holders by judiciously deploying funds, as most investors have little knowledge about the borrower.

While Indian banks put their gross NPAs at around 10 per cent of total advances (for 2001-02), CRISIL almost doubles the figure to 19 per cent. In value terms, this works out to Rs 70,000-1,30,000 crore. And if one considers the Reserve Bank of India's new NPA classification norm of three months, which is to be used in the current year, the figures can be scary. In fact, most of the international rating organisations would tend to go with CRISIL's figure given the extent of ever-greening in the system.

Thus, it is hardly reassuring when one reads that all commercial banks have performed well in 2002-03 and that there are no longer any weak banks in the system. Almost all banks are close to meeting the BIS norms and the RBI has quite adeptly guided the system towards the global regulatory norms. But this is only one part of the story, banking practices and the crucial issue of NPAs are ignored. Is there, therefore, some kind of large-scale camouflage that is yet to be spotted?

Commonsense says disintermediation is welcome, as there are no brokers involved between borrowers and lenders; the lender (deposit-holder) gets better returns while the borrower can also cut costs by paying a lower rate. This happens when one buys shares or enters into a real-estate deal. If the capital market were efficient, it would have had a role to play; savers would invest in the IPOs, debentures and bonds of the companies which come to banks for loans. This way, as in most developed markets, investors would earn better returns. Also, they would not be at the mercy of banks which keep lowering deposit rates.

But there is a moral hazard issue here. Not much is known about the company one is lending to. Also, one does not have access to information such as funds flow of the company and cannot evaluate critical financial ratios. So it more like the toss of a coin, where there is an even chance of betting on the wrong company. What happened in the 1990s, when a number of NBFCs (non-banking finance companies) and infotech companies vanished with the deposit monies of unsuspecting public, may not have been forgotten. Therefore, there is need for specialists, such as banks and other financial intermediaries, to evaluate these proposals and ensure that our money is safe.

But the issue is whether banks are doing a good job or not on this front. There are two aspects to this. First, their high NPA levels could be interpreted to mean they are falling short. If the 20 per cent ratio is correct, then banks are only slightly better than individuals in their risk evaluation, for even individuals go by parameters such as credit rating before choosing to invest in debentures and bonds, and may not end up with such lemons.

The second issue is whether banks use their resources efficiently or not. This would mean checking whether they are operating efficiently with respect to intermediation costs and their profit levels. Higher operating costs and profits would mean that the true benefit is going elsewhere. This would, in the case of private banks, mean rewarding their managements and shareholders well but ignoring the main source of funds, that is, deposit-holders, who contribute to 78 per cent of the total funds.

The RBI data for 2001-02 presents a clearer picture. Banks earn 9 per cent as interest on their average working funds (that is, the balance-sheet total). This denominator has been used to normalise all ratios, as it represents the total funds with which banks operate, of which, deposits are the primary source. These funds are deployed essentially in advances and investments, with the former earning 10.2 per cent and the latter, 10.7 per cent. On the funds that are available, return on fee income is 1 per cent while that on treasury income is 0.7 per cent.

On the cost front, interest costs are 6.2 per cent of total funds utilised by banks; the average cost of deposits, 7.14 per cent; and intermediation costs, a horrendously high 2.4 per cent of total working funds, about 40 per cent of the cost of deposits.

Globally, banks operate with margins of 50-75 bps. J P Morgan Chase and CitiBank, for instance, operate on an intermediation cost of a mere 0.30 per cent. Banks at home make a provision of 0.7 per cent (of total working funds) for bad debts, meaning adding to the already high NPAs. Net profits are around 0.9 per cent of average working funds. While profits could be said to be a claim of the shareholders, deposit-holders do have a right to question the evolution of these provisions, as it is precisely for this reason that households put money in a bank.

From the standpoint of intermediation, while deposit-holders receive 7.14 per cent, banks charge borrowers 10.2 per cent. Surely, a spread of 300 bps shows there is a high level of inefficiency in their operations. If the two parties could transact directly with each other, they could well reach a midway point at, say, 9 per cent, where both are better off.

In sum, it could be argued that, with such rapidly declining interest rates, the case for financial disintermediation is bound to catch the saver's attention. As there is little incentive to put money in a bank for a return of 5-6 per cent, corporate bonds, which offer a higher return of at least 150-200 bps, are, prima facie, a viable option.

Further, a revival of the capital market would encourage households to turn to equity, while despair may make them opt for the secondary market notwithstanding the risks involved.

(The author is an economist with L&T, Mumbai.)

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