The Hindu Business Line : Banking on creditable lines

The RBI has to take steps to see that banking progressively becomes more concentrated on lending instead of investing in securities, says S. VENKITARAMANAN.

The public placing deposits will always make a beeline to banks in preference to NBFCs.

The Report on the Trend and Progress of Banking in India for 2007-08 has presented a credible and commendable story of improvement in banking indicators in the country. In the context of various international developments in which the banking and financial systems of the advanced countries such as the US, the UK and Europe have faced serious problems, the story of relative stability and progress in the Indian banking system is definitely creditable.

A recent review of the banking situation in India, in an article in The New York Times, pays well-deserved compliments to the soundness of the regulatory system of Indian banks and also to the Reddy factor. I think it is only fair to say that the combination of the supervisory system along with the contributions of Dr Y.V. Reddy, has led to a situation in which India can hold its head high. In fact, there are lessons that India can offer the rest of the world.

All this does not mean that there are no serious problems in the Indian banking system. In a perceptive passage in the report, the RBI acknowledges the need for balance between regulation and preserving a role for innovation. Too tight a regulation, the report concedes, may lead to a lack of development of financial products, which will cater to greater flexibility in the financial system. But, by and large, the Indian system has erred rightly on the side of caution. It has not encouraged too much of securitisation, which led, in the American example, to a crisis in the credit market and also to failure of financial institutions.

The performance pattern

The broad pattern of performance of the Indian banking system is on creditable lines. Non-performing Assets (NPAs) of the Scheduled Commercial Banks (SCBs) remained at a level of 0.9 per cent in 2005 and had declined to 0.6 per cent in 2008. Amongst the scheduled banks, public sector banks have NPA/assets ratio ranging from 1.0 per cent in 2005 to 0.6 per cent in 2008.

Old private sector banks have had a ratio declining from 1.4 per cent in 2005 to 0.9 per cent in 2006 and progressively to 0.4 per cent in 2008. New private sector banks have a better performance. Their ratio ranges over the same period from 0.8 per cent to 0.7 per cent. Foreign banks with a lower exposure to rural sector have a ratio ranging from 0.4 per cent to 0.3 per cent.

In respect of capital adequacy ratio, the position is quite comfortable. All SCBs together have a capital adequacy ratio of 13 per cent as at the end of 2007-08 as compared to the mandatory norm of 9 per cent. Amongst the SCBs, public sector banks have a capital adequacy ratio of 12.5 per cent. Nationalised banks have a ratio of 12.1 per cent. The State Bank Group has a capital assets ratio of 13.2 per cent. The old private sector banks have a higher capital adequacy ratio of 14 per cent. The same is the case with new private sector banks. Foreign banks make do with an adequacy ratio of 13.1 per cent.

The important point to note is that high capital adequacy ratio means inefficient use of capital. Banks should be able to do their business with just so much capital as required by their norms. Having too much capital means profitability will be affected. Perhaps, this is an attempt to insure banks against volatility of returns.

Focus more on lending

The question before us is whether the RBI’s actions in regulating and supervising the banking system are adequate and whether it will provide the growth impulse necessary in the current crisis.

In response to the declining inflation, the RBI also tried to reduce interest rates, especially the benchmark rates by which it indicates to markets that the low interest rate regime is to come.

In spite of persuasion and pressure by the Government, especially by the former Finance Minister, P. Chidambaram, the low interest rates do not seem to have percolated to the various categories of borrowers. The point at issue is whether the interest rate reduction will be sufficient to induce increased access of borrowers to credit at low interest. Banks have to translate the benchmark rate of the RBI to lending rates.

A point raised in regard to this relates to the tendency of banks to invest in securities and bonds in preference to lending. Lending involves risk that a business may default. Usually, such risks are not so apparent in respect of bonds and debentures. Further, in a declining interest rate regime, banks may be able to get marked to market advantages, in the sense that the securities will gain in value and as a result their profits will improve.

A situation might arise when lazy banking becomes the order of the day, banks preferring to invest in securities instead of their real business — lending to individuals and corporates. The RBI has to take steps to see that banking progressively becomes more concentrated on lending instead of investing in securities.

Role of NBFCs

I turn to another issue, viz, the role of NBFCs. The RBI’s report under reference gives adequate information to justify the inference that NBFCs do not have access to resources other than borrowings from the banks. This is a result of the RBI’s own restrictions, which impose impediments on NBFCs raising deposits.

While there is some merit in the argument that the NBFCs tend to offer higher rates of interest and divert deposits from banks, there is a great deal of justification in the feeling that banks are a class by themselves.

The public placing deposits will always make a beeline to banks in preference to NBFCs because of their feeling that banks have better protection in terms of deposit insurance and have bigger asset base.

It is also to be realised that NBFCs perform a useful role in the Indian financial system, in the sense they cater to unserved areas, such as transport sector, which cannot be serviced by banks efficiently.

There has been some talk that NBFCs can become banks and in that case can offer the same facilities as banks do. As against this, banks have the disadvantage that they have more reserve requirements. The RBI needs to devise a better model for encouraging the expansion of the NBFCs.

One option could be what the Americans have tried now insisting on all non-banks to become banks. But that requires modification in some of the reserve requirements, as NBFCs will find it difficult to raise resources to fund their reserves. This will be a challenge for the RBI in the coming years.

There is yet another obvious difficulty that the RBI has to overcome in the coming years. In view of the slowdown in the US and the corresponding slowdown in demand for products and services from India, there may be increasing difficulties faced by corporates, especially in the small and medium industries.

This might increase defaults unless the lender takes care to monitor and to encourage the borrowing entities. It is important that the RBI evolves a suitable mechanism to cope with the problem of increasing delinquencies that might arise in the downside of the business cycle.

( blfeedback@thehindu.co.in)

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