Banking sector wobbly even after reforms

Finance Minister Nirmala Sitharaman has announced some major banking sector reforms in her growth-oriented Budget 2021-22. The first is the setting up of a ‘Bad Bank’, in which banks can offload their non-performing assets (NPAs). The second is the much-awaited DFI (Development Finance Institution) for infrastructure financing, which will be set up with ₹27,000-crore equity and run by experts. And, third, is the privatisation of a couple of public sector banks (PSBs).

Economist are divided over the benefits of these reform measures. That said, the decision to set up DFIs, both in the public and private sectors, deserves to be applauded.

Looking back

The nearly two-centuries-old Indian financial system is a pot-pourri of cooperative banks, domestic financing institutions, scheduled commercial banks, regional rural banks, pre-reform traditional private sector banks, tech-savvy private banks, and foreign banks. And among the newer entities are small finance banks, payments banks, and large number of mobile applications.

While India’s banking sector has expanded, the major reforms suggested by the Narasimham Committee three decades have only been partially implemented. The suggested reforms include: (a) merge banks and close weak and unviable ones; (b) have two or three banks to serve as international banks and a larger number of domestic banks, including RRBs; (c) integrate NBFC activities with banks; and (d) review major banking laws.

Banks including PSBs were merged all right, but weak and unviable banks have not been closed. The call for privatisation is a sort of rewinding the clock to pre-nationalisation days, but in a different economic climate. Merged banks are yet to show up on their balance sheets.

Review of major banking laws is still unfinished agenda. The Negotiable Instruments Act needs amendment, particularly in the context of the inroads technology has made into banking. Frauds in value terms have risen to thousands of crores of rupees, and cyber risks are on the rise.

NBFCs have grabbed the space vacated by commercial banks. The suggestion to integrate NBFC activities with banks appears to have cast its shadow in the January 20, 2021, Discussion Paper of the RBI on NBFC regulation. While the jury is still out, the regulatory web is cast.

The underlying philosophy of post-liberalisation reforms was to make the banking system more responsive to changes in the market environment and, to that end, engendered a shift in the role of the RBI from micro-management of banks to macro governance.

The reforms sought to improve bank profitability by lowering pre-emptions (through reduction in the cash reserve ratio from 14 per cent in 1994 to 3 per cent in 2020-21, and the statutory liquidity ratio from 34.25 per cent to 18 per cent) and to strengthen the banking system through 9 per cent capital adequacy norms, in addition to prudential norms of income recognition, asset classification and provisioning. And competition encouraged entry of tech-savvy private and foreign banks.

The top 100 banking entities account for 23.3 per cent of the branches, 64 per cent of deposits and 75.1 per cent of credit. This indicates the risk intensity of the Indian financial system and the business concentration of the economy.

Coming to agricultural credit, 82 per cent is accounted for by 10 States. Similarly, a little over 65 per cent of SME investments are in 10 States.

The Monetary Policy that was being announced at half-yearly intervals, coinciding with the crop seasons, moved to annual intervals and then became more dynamic and flexible with quarterly reviews to absorb some of the global economic changes.

PSBs that constitute over 88 per cent of the total banking system have moved from routine banking to universal banking and their revenue share from sale of third-party products has reached around 20 per cent of the total and this proved the bane of banking. The preference for sale of third-party assets, rather than in core banking activities of deposit-taking and credit disbursal, are enhancing the risk levels in the banking system.

As for human resource, tech-savvy employees and executives have been consigned to various machines. Skills in monitoring and supervision have fallen drastically, reflecting in the unabated growth in NPAs in all sectors, rising to as high as 15.2 per cent of total loans by March 2021 under “very severe stressed scenario” after stress-testing 53 SCBs.

Then came Covid, casting its shadow on bank balance-sheets making historical data irrelevant and the risk models, built on ‘expected loss given default data’.

Financial stability, therefore, is at crossroads. The setting up of a Bad Bank may not be a good idea as it would encourage PSBs to indulge in reckless lending.

The writer is a retired senior banker, and an economist

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