The Hindu Business Line : Strengths and weaknesses of Indian banking

Indian banks have done quite well, especially in terms of efficiency and non-performing loans. But there is still a long way to go before they can catch up with their peers in the US, the UK, Germany or China. S. VENKITARAMANAN hopes the RBI is alive to this, and suggests that it can take cues from its own Deputy Governor, Dr Rakesh Mohan's analysis.

The Reserve Bank of India Deputy Governeor, Dr Rakesh Mohan, placed all of us in his debt by speaking exhaustively and authoritatively on certain efficiency issues related to Indian banks, in a lecture he delivered in Islamabad, at a conference of the Pakistan Society of Development Economists on December 21, 2005. He dealt with the subject with his characteristic professionalism. The address, published in RBI Bulletin of March 2006, deserves wide publicity, considering the light it throws on various aspects of Indian banks' working, particularly in relation to their peers in the world.

At the outset, Dr Mohan calls attention to the intuitively obvious fact that research has provided robust evidence that financial development contributes to economic growth.

Cross-country studies confirm that domestic credit to private sector, stock market capitalisation and financial sector assets are found to be positively related to economic growth. Dr Rakesh Mohan cites figures to show that the financial ratio — total issues/total national income in India — has increased from 0.2 in 1970-71 to 1974-75 to 0.5 in 1995-96.

That there has been a specific deepening of financial intermediation in the reform period is obvious.

CHANGED ORIENTATION

Following the rapid growth of stock markets since the 1990s, the role of market-based finance has also been on the rise. Market capitalisation in relation to bank assets gives a measure of this change in system orientation. This ratio has changed from about 21.3 in December 1970 to 72.1 in March 2005. Obviously, the ratio cannot be depended on too much as it is subject to the vagaries of the stock market. In contrast to this, the growth in bank loans/GDP ratio is much more regular and informative.

Particularly impressive are figures given by Dr Rakesh Mohan, in his lecture, in regard to the efficiency and productivity indicators of the Indian banking system. An impressive figure is that of non-performing loans to total advances, which has declined from 24.8 per cent in 1994 to 3.5 per cent in 2005 in respect of public sector banks. For foreign banks, the ratio is significantly lower (2.8 per cent) and in new private banks (3.6 per cent), both for 2004. The corresponding figures for China in 2004 stood at 15.6 per cent, Indonesia at 13.4 per cent, South Korea at 1.7 per cent, the US at 0.8 per cent, the UK at 2.2 per cent and Japan at 2.9 per cent.

We have a long way to go to catch up with the best. There is no denying, however, the considerable step up in performance of the Indian banks in respect of non-performing loans over the period, particularly after reforms began.

LOWER OPERATING EXPENSES

An interesting table in Dr Mohan's lecture shows the break-up of operating expenses of Indian banks in relation to their various components over the years. The operating expenses as a proportion of earning assets declined from a level of 2.08 per cent in 1992 to 1.78 per cent in 2004. In the same way, labour costs as a proportion of earning assets came down from 1.4 per cent to 1.08 per cent in the same period reflecting greater labour productivity. Non-labour costs to earning costs, however, increased from 0.68 per cent to 0.71 per cent, perhaps reflecting investments in technology and related costs.

Operating expenses as a ratio of total business came down from 3.42 to 2.61. Labour costs as a proportion of total business declined from 2.30 per cent to 1.58 per cent. These are significant improvements.

The cost-income ratio of Indian banks also shows similar picture of improvement over the years. The cost to income ratio of public sector banks declined from 58.4 per cent in 1992 to 45 per cent in 2004. For all scheduled commercial banks taken together, the decline was from 55.3 per cent to 45.1 per cent. Foreign banks, however, showed an increase in the ratio from 30.9 per cent to 42.8 per cent.

The productivity indicators of Indian banks show a similar pattern over the reform period. Business per employee calculated at 1993-94 price increased from Rs.5.4 million to 16.3 million in the period 1992 to 2004. Profit per employee similarly increased from Rs 0.02 million to Rs 0,15 million in this period. In spite of branch expansion, business per branch expanded from Rs 109 million to Rs 254 million. All these are, no doubt, impressive advances. But the gnawing question remains whether they will survive increasing regulatory rigour!

A comparison with banks in major Asian countries, however, gives a slightly less flattering picture. Intermediation costs (operating expenses as percentage of assets shows a range from 1.01 in China to 2.19 in India in 2004, Indonesia at 2.94, the Philippines at 3 are worse than India. While India's figures have declined from 2.77 in 1996 to the current level of 2.19, China had a head-start with a low figure of 1.23 in 1996, showing a lower level of operating expenses in general.

CONTRARIAN CHINA

The table showing the net profit of banks in the Asian region also gives an informative picture. China has a contrarian scenario showing a net profit ratio to assets of 0.29 in 1996 declining to 0.12 in 2003. Korea has a spotty record rising from 0.17 in 1996 to 0.84 in 1997, declining to 0.15 in 2003. India has shown a consistent increase over the years from 0.71 in 1996 to 1.14 in 2004. The net profit figure as a ratio of assets is a confluence of operating efficiency plus the occurrence of non-performing loans. India has performed better than most of its peers in the period.

What is more important than those indicators of profitability and efficiency is what bank credit contributes directly to growth of GDP. Dr Mohan does not give specific figure on the subject of credit-GDP ratio. Related figures are available in the RBI's Report On Currency and Finance for the year 2003-04.

As Dr Mohan pointed out in his Islamabad address, the ratio of bank credit to private sector to GDP is an important measure of bank contribution to economic development. The Table shows the performance of Indian banks against those in other countries.

These figures tell their own story. India comes at almost the bottom of the scale. China with a ratio of credit to private sector above 100 per cent of GDP almost matches advanced economies, such as Germany, the UK and the US. All the talk of increased efficiency and better performance in respect of NPAs should not blind us to the distance we have to travel before we can claim our banks to be equal to their peers in the rest of the world, be it China, the UK, the US or Germany.

We have, no doubt, a difficult task on our hands. The latest Credit Policy, necessarily combining a brake and an accelerator, does not help our banks too much to achieve the goals of inclusive of credit distribution. Much more needs to be done. Hopefully, the RBI listened to the story told by Dr Rakesh Mohan's own analysis as well as its own Currency and Finance Report. We cannot afford to be complacent. Our banks are doing well. But they do need to do far better.