The Hindu Business Line : RBI's Report on Currency and Finance 2004-05 — Banks must compete, consolidate and converge

The RBI Report on Currency and Finance 2004-05 highlights the challenges facing the banking sector, which requires infusion of new technologies, better processes of credit and risk appraisal, product diversification, robust internal controls and corporate governance, and efficient human resource management. Competition, consolidation and convergence will be the key drivers of the sector in the years to come, says S. D. Naik.

ROBUST macroeconomic performance continued to underpin the business and financial performance of scheduled commercial banks (SCBs) in 2004-05. The Report on Currency and Finance 2004-05, released by the Reserve Bank of India (RBI) on November 24, points out that bank credit exhibited robust growth during the year. Moreover, the credit offtake was also broad-based with agriculture and industry joining the housing and retail segments in driving up the demand for credit.

Surge in credit growth

The credit extended by the SCBs registered a 26 per cent growth during the year compared to 15.3 per cent in the previous year. The growth in non-food credit was 26.5 per cent (net of conversion) compared to 18.4 per cent in 2003-04. Credit flows to agriculture and industry picked up significantly even and to housing, small road transport operators and retail loans continued to remain strong.

The credit flow to agriculture almost doubled over the last three years (from end-March 2002 to end-March 2005). It registered a growth of 35.2 per cent in 2004-05 against 23.2 per cent in 2003-04. According to the Report , rural credit has emerged as an important growth opportunity. Several new areas such as agri-clinics, contract farming and rural housing are fast becoming viable revenue propositions for banks. "Although rural credit witnessed higher growth during the year, there is still need to further enhance credit to these emerging areas of economic activity in rural areas," the report added.

The credit flow to industry also picked up significantly on the back of strong industrial recovery; credit to industry (medium and large) registered a healthy growth of 17.4 per cent during 2004-05 against just 5.1 per cent in the preceding year. A heartening development is a sharp pick up in credit to infrastructure sector.

Incidentally, banks are now expected to have greater funding opportunities in the area of project finance, especially in the infrastructure sector, given the conversion of two major financial institutions into banks. Banks have now been focussing mainly on syndication of debt to ensure wider participation in project finance and wholesale lending segment. The RBI has allowed banks to raise long-term bonds to finance infrastructure investments and reduce the asset liability mismatch.

However, lending to small and medium enterprises (SMEs) has continued to stagnate despite a surge in credit to agriculture and large enterprises. Attributing this possibly to the perception of higher levels of risks in the sector, the RBI report says, financing the growth of the healthy SME sector is essential for the future sustained growth of the economy.

Retail advances continued to grow at a brisk pace increasing by 41.2 per cent (Rs 77,947 crore) in 2004-05 compared to a growth of 27.9 per cent in the overall growth of loans and advances of SCBs). In this segment, housing finance registered the highest growth (50.5 per cent), followed by `other personal loans' (comprising auto loans, loans to professionals and educational loans) and credit card receivables. Loans for consumer durables, however, declined.

Efficiency indicators

Various efficiency indicators have shown a marked improvement. For instance, the credit-deposit ratio (in terms of outstandings) of the SCBs, which fell from 55 per cent in 1995-96 to 48 per cent by 1998-99, rose sharply to touch a high level of 60 per cent at end-March 2005 due to a sharp increase in credit growth during the year. The growth in C-D ratio implies greater credit orientation of banks and is used as a credit efficiency indicator for analysing the role of banks in promoting productive sectors and contributing to economic growth.

More important, the sharp rise in credit growth was accompanied by a steady improvement in asset quality. Following the trend of the previous year, the reduction in non-performing assets (NPAs) for the SCBs outpaced additions to NPAs in 2004-05. This trend was observed across all bank groups, barring new private sector ones. The gross NPAs-to-advances ratio declined to 5.2 per cent at end-March 2005 from 7.2 per cent at end-March 2004.

Banks have been successful in containing their NPAs, despite adoption of 90-day delinquency norm and the problem of overhang that was there. Net NPAs of the banking sector have now fallen to about just two per cent of net advances. They have been able to achieve this by using treasury profits during the last few years.

The setting up of the Asset Reconstruction Corporation of India (ARCIL) has provided a major boost to banks' efforts to recover their NPAs. In 2004-05, several banks and certain FIs sold their NPAs to the ARCIL to the extent of Rs 15,343 crore.

Profit earnings

However, despite the sharp rise in credit off-take and improvement in efficiency indicators, operating profits of the SCBs in 2004-05 declined by 3.1 per cent as against an increase of 29.3 per cent in the previous year. Net profits declined by 7 per cent during the year against 30.4 per cent in the previous year. This reflects largely the impact of a sharp decline in non-interest income.

A little reflection will show that this dip in profit is not surprising. As the earlier RBI Report on Trend and Progress of Banking 2002-03 had pointed out, the declining interest rates over the past few years had increased the valuations of the government securities held by banks. These holdings were far in excess of the statutory requirements. By trading in these securities as also by selling gilts back to government under its buyback scheme, banks had earned some windfall profits. Such profits were no longer available during 2004-05. What is significant is that the net interest income of banks rose sharply during the year, alleviating, to a large extent, the impact of sharp decline in non-interest income. Thus, banks, in general, were successful in weathering the impact of an upturn in interest rate cycle. By maintaining a broad-based growth in credit, it should be possible for banks to maintain its profit growth. The RBI report points out that profitability of the sector has improved in recent years, with return on asset trending at around one per cent, which is comparable with international levels.

Basel II and risk management

The RBI has been trying to facilitate gradual convergence of prudential norms for the banking sector with international best practices by resorting to suitable country-specific adaptations. In India, capital adequacy norms were adopted in 1992 following Basel Accord 1988. Commercial banks in India will start implementing Basel II with effect from March 31, 2007. In the interim, banks have been advised to create an investment fluctuations reserve of 5 per cent of the investment portfolio, both in ASF and HFT categories, plus a 2.5 per cent risk weight on the entire investment portfolio to address the market risk. It is pointed out that as the implementation of Basel II gathers force and banks capture operational risk appropriately and provide for capital charge for market risk, several of them may need additional capital. With the expected high growth of the economy, banks' lending operations are also likely to expand, requiring more capital.

In this context, the country's public sector banks (PSBs) are confronted with a peculiar problem. They cannot raise additional equity from the market if it meant that the government's shareholding would go below 51 per cent. The Left parties supporting the Government from outside are opposed to the move. A large number of PSBs have already reached close to 51 per cent government holding after their public issues. Earlier, the Government had decided to dilute its holding in PSBs to 33 per cent. The subsequent decision to abandon the move is clearly a setback to the ongoing reform process in the banking sector.

Some challenges

Referring to the new challenges, the RBI report says, there are several challenges in future which may require new technologies, better processes of credit and risk appraisal, product diversification, robust internal controls and corporate governance, and efficient human resource management. Competition, consolidation and convergence are emerging as key drivers of the banking sector in the year to come.Meanwhile, there is a need to strengthen the regional rural banks (RRBs) and co-operative banks. Their performance continues to remain poor even as the rest of the banking sector made considerable progress. The liabilities of RRBs to the banking sector registered a sharp increase. Of the 196 RRBs, 29 incurred losses in 2004-05. On September 12, 2005, the Government of India notified amalgamation of 28 RRBs into nine new RRBs in six states — Bihar Gujarat, Karnataka, Maharashtra, Punjab and Uttar Pradesh. The consolidation process should continue to make the RRBs viable.

They can play a crucial role in rural development. The co-operative banking sector has hardly shown any improvement. While urban co-operative banks managed status quo in asset quality, the asset quality of rural co-operative banks has actually worsened. The high NPAs of co-operative banks remain a major cause for concern.

The rural co-operative banks, which can play an important role in providing credit to rural areas, are beset with several problems. There is a need to rationalise this segment through early restructuring and recapitalisation.

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