The Hindu Business Line : Myths, old and new, of Indian banking

A number of propositions about the banking sector have failed the empirical test. Myths abound about the sector, and Asuri Vasudevan examines a few of them, both in the pre- and post-nationalisation eras.

A NUMBER of propositions about banking have turned out to be myths when they were empirically tested. This is also true of Indian banking. We shall here examine a few of such propositions with one qualification, namely the need to classify the myths into two periods.

The basis for periodisation was the nationalisation in 1969 of major Indian banks that marked a watershed in Indian economic history. Till then, there were at least three myths about Indian banking. The first was that commercial banking was inherently unstable when left free from external controls and that monetary authorities should, therefore, be armed with regulatory provisions.

This framework formed the critical reasoning behind the Reserve Bank of India and the Banking Regulation Acts. While this led to considerable increase in central banking powers, many of the regulations were prudential in nature and in the interest of depositors.

Some of the regulations were intended to save banks from the volatilities of the bond and stock markets. The powers of the central bank also helped bring about mergers and amalgamations of unviable small banks and a reduction in the number of non-scheduled commercial banks in the 1960s.

Yet, the fact that a number of private commercial banks had grown over years under the astute leadership of their managements (as for example Punjab National Bank, Canara Bank, Central Bank of India, Bank of India, and Indian Bank) shows that commercial banking in India was not inherently unstable.

The performance and soundness of banks depended essentially on the quality and commitment of managements.

The second of the myths was that commercial banks tend to charge usurious interest rates, contrary to the principle of public good or social welfare. The corollary was that farmers or persons in areas where bank presence was negligible did not get bank loans at reasonable rates of interest.

In reality, however, banks charged much less on their loans than other intermediaries especially those in the unorganised sector such as the moneylenders and indigenous bankers. In any case, interest rate flexibility did not exist either in theory or practice during this period.

Finally, effective economic policy was said to be not possible without government control over banks. This was often interpreted to mean that as private sector banks were managed by industrial/business houses or traders with interests of their own, they would not financially support productive activities other than their own.

The fact, however, was that commercial banks were confined to cities and port towns while rural credit needs were to be taken care of by cooperative credit institutions.

Though State Bank of India was to cast its net wide into the rural areas, the active official policy was to encourage the cooperative credit structure with the result that commercial banks had no incentive to lend to agriculture and allied activities.

The last two myths led first to the short-lived experiment of social control over banks and eventually to nationalisation of major Indian banks.

Bank nationalisation in 1969 and again in 1980, however, resulted in a broadened and impressive geographical as well as functional coverage of Indian banks. Branch expansion was strong and lending to priority sectors — agriculture, small-scale industries and small artisans and other weaker sections — had increased substantially. Priority sectors were to get credit up to a given proportion of net advances, without any concession in rates.

By the early 1990s, however, these positives were nullified by the huge non-recoverable loans, and by a large wedge between the average rates at which resources are mobilised and that at which they are lent and invested. In the process, new myths have emerged. They have persisted notwithstanding the banking reforms undertaken since about 1992-93.

One of the new myths is that public sector banks are inefficient compared with their private sector counterparts, in particular the new private sector and foreign outfits.

Derived from the above is the proposition is that new private sector banks are efficient compared with old private banks and can perhaps be only tad less efficient than the major foreign banks.

Very few have noticed that this myth has been laid to rest by the Report on Trend and Progress of Banking in India, 2002-03.

The Report showed that by 2002-03, public sector banks performed as well as the other bank categories — old private sector banks, new private sector banks and foreign banks — in terms of operating profits, cost of funds, rates of return on advances and on investments and reduction in non-performing assets. The incremental net non-performing assets had in fact declined due to large provisions made by public sector banks.

One proposition that has gained immense popularity is that banks hardly give loans and bankers are `lazy' because investments in government securities are attractive and less expensive in terms of transaction costs. The term lazy banking, associated with a former Deputy Governor of the Reserve Bank, has been picked up by many central bankers and academics elsewhere. This term seems to have been used in the context of the situation evolving in 2002-03. But is this justified?

To answer this question, one needs to know whether the Indian banker has deviated in his behaviour towards the overall portfolio management over time.

The data given in the latest Handbook of Statistics on the Indian Economy, 2003-04 for the years 1991-92 to 2003-04 provide no evidence of deviation: bankers' behaviour, on the other hand, was incredibly stable. The annual mean growth rates in the following categories provide a snapshot picture. The growth in investments in government securities by banks was 100 basis points higher on the average in the recent period than that in 1991-92 to 1996-97.

Bank credit too showed a similar trend. On the other hand, banks' investment in Government securities as percentage of gross government borrowings was lower at less than 50 per cent in the recent period, than that in the preceding period. Bank credit showed higher growth in the recent period despite deceleration in manufacturing output and decline in agricultural output.

The Table is undoubtedly a simplification. It does not reveal yearly or within the year trends. For example, in 2002-03, investment in government securities and bank credit increased respectively by 27.3 per cent and 23.7 per cent as against 20.9 per cent and 15.3 per cent in 2001-02. The high growth in investment in government securities based on the position of 2002-03 cannot be used to support the proposition. Investment in government securities had been volatile and had increased more sharply by 33.3 per cent in 1993-94 — the year in which bank credit growth was only 8 per cent. No one called the bankers lazy then!

There are many more propositions such as these and we shall take here only one of them for want of space. Indian bankers are said to be blissfully ignorant about their customers, both present and potential. Impliedly, the Indian bankers seem to have forgotten the `know your customer' (KYC) principle.

Historically though, sound small banks in India had sufficiently good information about their customers. If `KYC' is now forgotten, it could be because banks nowadays are big in terms of the size of operations by design, the design being one that is meant to give good capital base and to exploit the economies of scale and scope. Or, is it because of narrow specialisation of banking personnel? To test the validity of this proposition, one needs to adopt interdisciplinary skills, for herein lies the probable relevance of the phenomenon of asymmetric information in the Indian case.

(The author, a former Executive Director of the Reserve Bank of India, can be accessed on asurivasudevan@hotmail.com)