The Hindu Business Line : Report on Trend and Progress of Banking 2003-04

THE latest report on Trend and Progress of Banking in India for 2003-04 follows the lines of its predecessors in presenting a workmanlike account of the health of the banking industry and its prospects. It tells, of course, a credible story of progress, thanks to improvements in macroeconomic conditions, better regulation, a strong approach to regulation and risk mitigation and, above all, better governance.

The RBI report makes a bow in the direction of the stock market by stressing the improvement in market valuations of various bank stocks in the recent period. This is a far cry from the time when bank equity was shunned by the market, except for a few privileged exemplars.

The RBI report is, indeed, clear in its exposition of the problems and challenges that face the banking sector, even as it details the litany of achievements in regard to various improvements.

The growth of credit in the Indian economy has been quite remarkable, although there is substantial scope for improvement in respect of access to credit by agriculture, small and medium industries.

During the year under review, 2003-04, what is important is that the growth of credit in retail and housing has driven the overall progress of banking.

In spite of this, the ratio of bank assets to GDP stands only at 71 per cent compared to a much higher figure in advanced countries and even developing countries like China, where it is well over 100 per cent. That there is scope for deepening and widening access to bank credit and resources is obvious.

The detailed analysis in the report shows that the growth of credit to large and medium industries was lower in 2003-04 than in 2002-03. This reflects a greater dependence of larger corporates on internal resources as well as alternative sources of external financing, like the market.

Credit to the infrastructure sector, however, increased by 41.6 per cent to a total Rs 10,927 crore. This compares with a growth of 35.3 per cent in the previous year. Significantly, bank lending to wholesale trade also recorded a growth of 10 per cent during the year.

Bank lending to non-bank finance companies, however, showed a decline in the year. Retail loans recorded a growth of 23.7 per cent, while housing showed an increase of 42 per cent.

Overall, housing loans as a percentage of non-food gross bank credit formed about 7.1 per cent at the end of March 2004. This was primarily due to various initiatives and incentives given to housing in the recent period.

The central bank points out that the housing needs of the low-income group and the poorer sections have remained largely unaddressed. About 90 per cent of the shortage in housing is experienced by the economically weaker sections.

One of the reasons for low financing to weaker sections is the use of margin, which is the proportion of loan brought in by the borrower. This clause is considered a constraining factor in the weaker sections getting housing loans.

The NHB is promoting a separate entity in its Mortgage Credit Guaranty Corporation, which will guarantee payment of principal and interest by the borrower to the lender. To what extent this mortgage guarantee device will succeed in mitigating risk without itself taking on too high a risk remains to be seen.

Regarding retail lending, one interesting factor mentioned in the report is that non-performing assets (NPAs), as a percentage of outstanding loans under this sector, which covers housing, consumer durable and credit cards, are only 2.8 per cent.

The fear that expansion of consumer lending will lead to non-performing loans seems to be misplaced for the present. Banks have, however, to tread cautiously in this sector.

One of the important aspects of banks' performance during the year has been the higher investments in government securities. As of end-March 2004, investments in such securities formed 41.3 per cent of the total net demand and time liabilities of the banks.

This, however, compares with the statutory requirement of only 25 per cent. Banks had invested substantially more in credit to government than required under the law. This is partly because of the zero risk weight attached to government securities and lower capital requirements.

The credit/deposit ratio is a widely used banking indicator, which shows how much of the deposit resources to banks are converted as loans and thus contribute to economic growth.

The credit/deposit ratio as at the end of March 2004 was 58.7 per cent. Even if we take into account the flow of resources in the form of investments in gilt-edged securities, such as bonds, banks contributed credit plus investment in the ratio of 66 per cent.

There have been widespread discussions in political circles about credit/deposit ratio being adverse in the backward regions of the country. This is partly because the capacity for absorbing credit in the shape of institutional infrastructure is inadequate in the very States that need credit the most.

In spite of much discussion and analysis, the problem of inadequate flow of credit to backward areas and States remains unsolved.

One of the indicators of bank performance is the ratio of NPAs that is overdue in interest and principal. The NPA provision of the scheduled commercial banks, net of provisions, as a whole decreased from 2.5 per cent of the total assets in 2001 to 1.2 per cent in 2004. This is a significant improvement.

The performance of the public sector banks in this respect has improved during the period. The gross NPAs have decreased from roughly Rs 28,000 crore to Rs 19,000 crore in the period. The ratio of net NPAs to total assets has fallen from 2.7 per cent to 1.3 per cent.

The old private sector banks, which had a legacy of a high ratio in the beginning with 3.5 per cent, have also brought it down to 1.8 per cent now.

It is creditable, however, that the new private sector banks have an NPA ratio of only 1.1 per cent. For obvious reasons, foreign banks based in India have a low NPA ratio of 0.7 per cent, reflecting their comparatively restricted exposure, primarily in the urban area.

Considerable improvement in the performance of banks in relation to NPAs has been partly due to the liberal provision, which they were able to make out of the high profits earned during the last year.

These profits, in turn, were due to higher valuation of their holdings of g-secs consequent on the declining rate of interest.

While the central bank has been commenting adversely on the excessive concentration of bank assets in gilt-edged securities, this excess has conferred an unintended benefit as a result of improved valuation. The RBI is right, however, in insisting that excess dependence on a low-interest environment is dangerous. It has rightly called on the banks to establish an investment fluctuation reserve.

While the report comments on the various policy developments, I would like to concentrate on the report referring to small industries. The Ganguly Committee has recommended, inter alia, that banks set up dedicated non-bank finance type of institutions to handle credit to clusters of small and tiny industries.

There is an implicit recognition that an NBFC-type operation is more efficient than that of a bank. This is in contrast to the RBI's reluctance to encourage NBFC operations, in general.

Whether the special purpose NBFC-type institution set up as a result of the Ganguly Committee's recommendation will suffer the same fate as the RRBs that are now proposed to be merged with the parent banks remains to be seen.

In my view, it is far better to improve the functioning of banks in regard to small industries than resort to banks setting up devices, like the one proposed by the Ganguly Committee.

In regard to financing infrastructure, there have been considerable advances in recent years. The report refers to the recommendation of the Special Group set up by the RBI in regard to the role of banks and financial institutions in infrastructure.

The criticality of credit enhancement to infrastructure projects by the Government has been mentioned in the report.

It rightly observes that credit enhancement should not be used as a substitute for due diligence. Reform of the regulatory regime and the structure for collection of user charges are both vital to induce more lending both from private and public sources.

Turning to the general proposals regarding banking shareholding and the RBI's permission, the report presents a rather strange view by the regulator as to who can be allowed to enter banking. Banking cannot be exempt from the general rule of management that stake-holders have proportionate share in governance.

The fact that the regulator is reserving the right to choose who is "fit and proper to own shares and control management in a bank" itself can impose a strain on the collective capabilities of the central bank.

How the central bank will discover the fitness and propriety of an individual or a corporate is difficult to discern.

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