reforms in banking

8/10/2019 reforms in banking

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Index / Content

Particulars Page No.

Executive Summary 02

Chapter 1: Introduction to the Study 04

Objective of the Project 06

Hypothesis 06

Research Methodology 06

Limitation of the study 07

Chapter 2: Introduction to Reforms in banking sector

History of Reforms in banking industries. 08-66

Chapter 3: Review of the Literature 67-69

Chapter 4: Analysis of the Project 70-80

Chapter 5: Findings 81

Chapter 6: Conclusion 82

Appendix

Brief background of Reforms in banking sector 84

Questionnaire 88

Bibliography 91


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EXECUTIVE SUMMARY

A retrospect of the events clearly indicates that the Indian banking sector has comefar away from the days of nationalization. The Narasimham Committee laid thefoundation for the reformation of the Indian bankingConstituted in 1991, the Committee submitted two reports , in1992 and 1998,which laid significant thrust on enhancing the efficiency and viability of the bankingsector. As the international standards became prevalent, banks had to unlearn theirtraditional operational methods of directed credit, directed investments and fixedinterest rates, all of which held to deterioration in the quality of loan portfolios,inadequacy of capital and the erosion of profitability. The recent internat ionalbanking system has veered around certain core themes. These are:effective risk management systems, adequate capital provision, soundpractices of supervi sion and regu lat ion, tran spar ency of operat ion , conductivepublic policy intervention and maintenance of macroeconomic stability in the economy.

Until recently, the lack of competitiveness vis--vis global standards, lowtechnological level in operations, over staffing, high NPAs and low levels of motivationhad shackled the performance of the banking industry.However, the banking sector reforms have provided the necessaryplatform for the In dian ban ks to ope rat e o n t he bas is of ope rat ion al flexibility and functional autonomy, thereby enhancing efficiency, productivity and profitability.

The reforms also include increase in the number of banks due to the entry of newprivate and foreign banks, increase in the transparency of the banks balancesheets through the introduction of prudential norms and increase in the role of themarket forces due to the deregulated interest rates. These have significantlyaffected the operational environment of the Indian banking sector. To encouragespeedy recovery of Non-performing assets, the Narasimham committee laiddirections to introduce Special Tribunals and also lead to the creation of an AssetReconstruction Fund. For revival of weak banks, the Verma CommitteerecommendationsLastly,to ma in ta in ma cr oe co no mi c st ab il i t y, RB I ha s i

n t r od u ced t h e A s se t Liability Management System.The East-Asian crisis has demonstrated the vital importance of financial institutionsin sustaining the momentum of growth and development. Iti sno longe r poss ib l e fo r deve lop ing coun t r i e s l i ke Ind ia t o de l ay th e introduction of these reforms of strong prudential and supervisory norms, in orderto make the financial system more competitive, more transparent and moreaccountable. The competitive environment created by financial sector reformshasnonetheless compelled the banks to gradually adopt modern technology tomaintain their market share.


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The developments, in general, have an emphasis on service and technology; forthe first time that Indian public sector banks are being challenged by the foreign banks andprivate sector banks.

The deregulation process has resulted in delivery of innovative financial products at

competitive rates; this has been proved by the increasing divergence of banksin retail banking for their development and survival.

In order to survive and maintain strong presence, mergers andacquisitions has beenthe most common development all around t he world. In order to ensure healthycompetition, giving customer the best of the services, the banking sector reformshave lead to the development of a diversifying portfolio in retail banking, andinsurance, trend of mergers for better stability and also the concept of virtual banking. TheNarasimham Committee has presented a detailed analysis of various problems andchallenges facing theIndian branging recommendations for improving.


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Meaning of Banking:-

A Bank is a financial institution that accepts deposits and channels those depositsinto lending activities. Banks primarily provide financial services to customers whileenriching investors. Government restrictions on financial activities by banks varyover time and location. Banks are important players in financial markets and offerservices such as investment funds and loans. In some countries such as Germanybanks have historically owned major stakes in industrial corporations while in othercountries such as the United States banks are prohibited from owning non-financialcompanies.

Chapter 1:- INTRODUCTION

Measured by share of deposits, 83 percent of the banking business in India is in the

hands of state or nationalized banks, which are banks that are owned by the

government, in some, increasingly less clear-cut way. Moreover, even the non-

nationalized banks are subject to extensive regulations on who they can lend to, in

addition to the more standard prudential regulations.

Government control over banks has always had its fans, ranging from Lenin to

Ger schenkon. While there are those who have emphasized the political importance

of public control over banking, most arguments for nationalizing banks are based on

the premise that profit maximizing lenders do not necessarily deliver credit where the

social returns are the highest. The Indian government, when nationalizing all the

larger Indian ba nks in 1969, argued that banking was inspired by a larger social

purpose and must sub serve national priorities and objectives such as rapid growth

in agriculture, small industry and exports.

There is now a body of direct and indirect evidence showing that credit

markets in developing countries often fail to deliver credit where its social product

might be the highest, and both agriculture and small industry are often mentioned as

sectors that do not get their fair share of credit. If nationalization succeeds in pushing


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credit into these sectors, as the Indian government claimed it would, it could indeed

raise both equity and efficiency.

The cross-country evidence on the impact of bank nationalization is not very

encouraging. For example, La Porte find in a cross-country setting that government

ownership of banks is negatively correlated with both financial development and

economic growth. They interpret this as support for their view, which holds that the

potential benefits of public ownership of banks, and public control over banks more

generally, are swamped by the costs that come from the agency problems it creates:

cronyism, leading to the deliberate misallocation of

Capital, bureaucratic lethargy, leading to less deliberate, but perhaps equally costly

errors in the allocation of capital, as well as inefficiency in the process of mobilizing

savings and transforming them into credit.

Unfortunately the interpretation of this type of cross-country analysis is never

easy, and never more so than the case of something like bank nationalization, which

typically occurs as part of a package of other policies. For example, Bertrand study a

1985 banking deregulation in France, which gave banks much greater freedom to

compete for clients. They find that deregulated banks respond more to profitability

when making lending decisions. After the reform, firms that suffer a negative shock

are much more likely to undertake restructuring measures, and there is more entry

and exit in bank-dependent industries.

Micro studies of the effect of bank nationalization are rare: an important

exception is Main who examines the privatization of a large public bank in Pakistan

in 1991. He finds that the privatized bank does a better job both at choosingprofitable clients and monitoring existing clients, than the commercial banks that

remained public.

This paper builds on the previous work with the aim of using that evidence and

evidence from other research by ourselves and others, to come to an assessment of

the appropriate role of the Indian government vice versa the banking sector.


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1.1 Objectives

To study and analyze of various financial reforms in banking sector duringpost liberalization period with respect to public and private sector banks.

To Study the legal and structural and financial status of banking sector prior tofinancial reforms period.

To study the changes in banking sector during post financial reform period.

1.2 HYPOTHESIS

The reform measures brought a paradigm shift in the banking industry andenhanced the overall performance of the banks.

Information technology in banking business has a visible impact on the qualityof customer service.

The performance of public sector banks is not as good as private sectorbanks in spite of their age size and image.

The introduction of prudential norms improved the financial health andcredibility of banks.

1.3 MethodologyThe study was conducted by the information given by them were directly

recorded on questionnaire. For the purpose of analyzing the data it is necessary tocollect the vital information. There are two types of data, this are-

PRIMARY DATA: - The data is collected from questionnaire. The questionnaire is

filled from customer through direct interviewing them . SECONDARY DATA: - Secondary data is collected from magazines, newspaper,etc. E.g. social networking sites, books, newspaper, etc.


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1.4 Limitations of the study

To understand the importance of banking sector.

To study the Indian bank scenario and its problem.

Long Term and Short Term Finances.

To study the role of bank in Indian Market.

Different types of services provided by the banks.

To study various bank, Corporate and Commercial.

To study the Indian bank scenario and its problem.


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CHAPTER 2

Reforms in Banking Sector

2.1 HISTORY OF BANKING IN INDIA

Banking in India has a very old origin. It started in the Vedic period whereliterature shows the giving of loans to others on interest. The interest rates

ranged from two to five percent per month. The payment of debt wasmade pious obligation on the heir of the dead person. Modern banking in Indiabegan with the rise of power of the British. To raise the resources for theattaining the power the East India Company on 2 nd June 1806 promoted theBan k of Cal cut ta. In the me an whi le two other banks Bank of Bombay andBank of Madras were started on 15 April 1840and 1July, 1843 respectively. In 1862the right to issue the notes was takena w a y f r o m t h e p r e s i d e n c y b a n k s . T h e g o v e r n m e n t a l s o w i t h d r e w th e nominee directors from these banks. The bank of Bombay collapsed in 1867andwas put under the voluntary liquidation in 1868 and was finally wound up in 1872.The bank was however able to meet the liability of public in full. A new bank called

new Bank of Bombay was started in 1867.On 27th

January 1921 all the threepresidency banks were merged together to form the Imperial Bank by passingthe Imperial Bank of India Act, 1920.The bank did not have the right to issue thenotes but had the permission to manage the clearing house and hold Governmentbalances. In 1934, Reserve Bank of India came into being which was made theCentral Bank and had power to issue the notes and was also the banker tothe Government. The Imperial Bank was given right to act as the agent of theReserve Bank of India and represent the bank where it had no braches. In 1955by passing the State Bank of India 1955, the Imperial Bank was takenover and assets were vested in a new bank, the State Bank of India.

Bank Nationalization:

After the independence the major historical event in banking sector was thenationalization of 14 major banks on 19 th July 1969. The nationalization wasdeemed as a major step in achieving the socialistic pattern of society.In1980 six more banks were nationalized taking the total nationalized banks totwenty.


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STRUTURE OF SCHEDULED COMMERCIAL BANKS

The composition of the board of directors of a scheduled commercialbank s h a l l c o n s i s t o f w h o l e t i m e c h a i r m a n . S e c t i o n 1 0 A o f t h eb a n k i n g Regulation Act, 1949 provides that not less than fifty-one per cent, of thetotal number of members of the Board of directors of a bankingcompanyshall consist of pe rsons, who shal l have special knowledge or practicalexperience in respect of one or more of the matters including accountancy,agriculture and rural economy, banking, co-operation, economics, finance, law,small-scale industry, or any other matter the special knowledge of, and practicalexperience in, which would, in the opinion of the Reserve Bank, be useful to thebanking company. Out of the aforesaid numberofdirectors, notless than two shall be persons having special knowledge or practicalexperience in respect of agriculture and rural economy, cooperating or small-scaleindustry. Besides the above the board of the scheduled bank shallconsist of the directors representing workmen and officer employees. TheReserve Bank of India and the Central Government also has right to appoint theirnominees into the board of the banks.

PRESENT SCENARIO OF BANKS IN INDIA

Banks are extremely useful and indispensable in the modern community. Thebanks create the purchasing power in the form of bank notes,cheques b i l l s , d r a f t s e t c , t r ans fe r s fun ds b r ing bo r row s and l e nde r s together, encourage the habit of saving among people. The banks have

played substant ial role in the growth of Indian economy. From the meagre startin 1860 the banks have come to long way. At presenting India there are 19nationalized banks, State bank of India and its seven Associate banks, 21 oldprivate sector banks and 8 new private sectorbanks.B e s i d e s t h e m t h e r e a r e m o r e t h a n 3 0 f o r e i g n b a n k s e i t he r o p e r a t i n g themselves or having their branches in India.

WAVE OF BANKING SECTOR REFORMS IN 1991

In 1991, the country was caught into a deep crisis. The government atthis j unc tu re dec ided to i n t ro duce co mprehens i ve econ omic r e f o rms t h e banking sector reforms were part of this package. The main objectiveof b a n k i n g s e c t o r r e f o r m s w a s t o p r o m o t e a d i v e r s i f i e d , e f f i c ie n t a n d c o m p e t i t i v e f i n a n c i a l s y s t e m w i t h t h e u l t i m a t e g o a l o f i m pr o v in g t he allocative efficiency of resources through operational flexibility,improved financial viability and institutional strengthening. Many of the regulatoryand supervisory norms were initiated first for the commercial banksand were later extended to other types of financial intermediaries.

Whilenudgingthe Indian banking system to better health through the introduction of international best practices in prudential regulation and supervision early in the reform

process, the main idea was to increase competition in thesystemgradually. The reforms have focused on removing financial repressionthroug


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h reductions in statutory pre-emption, while stepping up prudential regulationsat the same time. Furthermore, interest rates on both deposits and lending of bankshad been progressively deregulated.

In August 1991, the Government appointed a committee under the chairmanship of

M.Narasimham which worked for the liberalization of banking practices.The aim of this Committee was to bring aboutoperational flexibility and functional autonomy so as to enhanceefficiency, productivity and profitability of banks.

CHARACTERISTICS OF BANKING REFORMS

1.Financial sector reform was undertaken early in the reform-cyclein India.

2.The financial sector was not driven by any crisis and the reforms havenot been an outcome of multilateral aid.

3 . T h e d e s i g n a n d d e t a i l o f t h e r e f o r m w e r e e v o l v e d b yd om es t i c expertise, though international experience is always kept in view.

4 . T h e G o v e r n m e n t p r e f e r r e d t h a t p u b l i c s e c t o r b a n k s m a n a g e t h eover-hang problems of the past rather than cleanup the balance sheetswith support of the Government.


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2.2 The Committee submitted its report in November, 1991 andrecommended

1. Reduction in CRR to 8.5 percent and SLR to 25 percent over a periodof about five years.

2. Deregulation of interest rates structure and decreasing the emphasis laidon directed credit and phasing out the concessional rates of interest to prioritysector.

3. To raise fresh capital through public issue by the profi t making banks.4. Transparency in Balance sheets.

5. Establishment of Special Tribunals to speed up the process of debtsrecovery.

6. Establishment of an Assets Reconstruction Fund with special powerof recovery.

7.Bank restructuring through evolving a system of a broad pattern consistingof 3 or 4 large banks including SBI, 8-10 national Banks engaged in Universal Banking with a network of branches, local banks confined to a specific region andRRBs confined to the rural areas engaged in financing of agriculture and alliedactivities.

8. Abolishment of branch licensing and leaving the matter of opening and

closing of branches to the commercial judgment of individual banks.

9. Progressive reduction in pre-emptive reserves.

10.Introduction of prudential norms to ensure capital adequacy norms, properincome recognition, more stringent recognition of NPAs, classification of assetsbased on their quality and provisioning against bad and doubtful debts byconstituting the special debt recovery tribunals.

11. Introduction of greater competition by entry of private sector banks and foreignbanks and permitting them to access capital market.

12. Partial deviation from directed lending.

13. Strengthening the supervisory mechanism by creating a separate Board forBanking and Financial supervision.

14. up gradation of technology through the introduction of computerized system inbanks.

15. Freedom to appoint chief executive and officers of the banks and changes in theconstitutions of the board.

16. Bringing NBFC S under the ambit of regulatory framework.


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The Government also appointed another committee on banking sector r eforms under the Chairmanship of M. Narasimham which submitted itsreport in April 1998. The committee focused on bringing about structuralchanges so as to strengthen the foundations of the banking system to make it

more stable.

The majo r recommend ations of Narasimha m Commit tee II were-

1. In case of capital adequacy, strengthening the banking system through anincrease in the minimum capital adequacy ratio (CRAR) from 8 percent to 10 percentby 2002, 100 percent of fixed income portfolio marked-to-market by 2001 (up from70 percent), 5 percent market risk weight for fixed income securities andopen foreign exchange positions limits (no market risks weights previously) and 100percent commercial risks weight to Government-Guaranteed advances (previouslytreated as risk free).

2. To bring down net NPAs below 5 percent by 2000 and to 3 percentby2002.

Reducing the minimum stipulated holding of the Government or RBI in the equity ofnationalized banks or SBI to 33 percent.

1. Merging financ ially st rong insti tutions and giving a revival packageto the weak banks.

2. Strengthening the operation of rural financial institutions in terms ofappraisal, supervision and follow-up, loan recovery strategies and development ofbank-client relationships in view of higher NPAs in public sector banks dueto directed lending.

3. Amendment to RBI Act and Banking Regulation Act4 .

The Government focused on competition enhancing measures by way of grantingoperational autonomy to public sector banks, reduction of public ownership in publicsector banks by allowing them to raise capital from equity market up to 49 percent ofpaid-up capital; setting of transparent norms for entry of Indian private sector, foreigninsurance companies, giving permission for foreign investment in thefinancial sectoras portfolio investment, giving permission to banks to diversify product portfolio andbusiness activities, to prepare a road map for presence of foreign banks and

guidelines for mergers and amalgamation of private sector banks, public sectorbanks and NBFCs, and providing guidelines on ownership and governance in privatesectorbanks.Government focused through reform process on enhancing the role ofmarket forces by making sharp reduction in pre-emption throughreserverequirement, market determined pricing for government securities,disbanding of administered interest rates with a few exceptions andenhanced transparency anddisclosure norms to facilitate market discipline; introduction of pure inter-bank callmoney market, auction basedrepos-reverse repos for short-term liquidity management, facilitation of improved payments and settlement mechanism, and requirement of significant advancement in dematerialization andmarkets for security zed assets are being developed.


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2.3 DISCLOSURE NORMS

Banks should disclose in balance sheets maturity pattern of advances,deposits, investments and borrowings. Apart from this, banks are also required togive details of their exposure to foreign currency assets and liabilities andmovement of bad loans. These disclosures were to be made for the year endingMarch 2000.

In fact, the banks must be forced to make public the nature ofNPAs being written off. This should be done to ensure that the taxpayersmoney given to the banks as capital is not used to write off privateloan s wi thou t adequate efforts and punishment of defaulters.

# A C l o s e l o o k

For the future, the banks will have to tighten their credit evaluationprocess to prevent this scale of sub-standard and loss assets. The presentevaluation process in several banks is burdened with a bureaucratic exercise,sometimes involving up to 18 different officials, most of whom do not add any value(information or judgment) to the evaluation. But whether this government andits successors will continue to play with bank funds remains to beseen. Perhaps even the loan waivers and loan"m ela s" wh icha re of te nd e c r i e d b y b a n k e r s f o r m o n l y a s m a l l p o r t i o n o f t h e t o t a l N PA s .

A lot therefore depends upon the seriousness with which anewreg ime o f r egu la t ion i s pu r sued by RBI and the newly fo rmedBoard for Financial Supervision.


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2.4 RBI norms for consolidated PSU bank accounts

The Reserve Bank of India (RBI) has moved to get public sector banks toconsolidate their accounts with those of their subsidiaries and otheroutfits Where they hold substantial stakes. Towards this end, RBI has set up aworking group recently under its Department of Banking Operations andDevelopment to come out with necessary guidelines on consolidated accounts forbanks. Those ova is aimed at providing the investor with a better insight intoviewinga bank's performance in totality,including all its branches and subsidiaries, and not as isolated entities.

According to a banker, earlier subsidiaries werefloatedas external independent entities wherein the accounting details were notincor porated in the parent bank's balance sheet, but at the same time it was assumed that

the problems will be dealt with by the parent. This will be a path-breaking changeto the existing norms wherein each bank conducts its accounts without taking intoconsideration the disclosures of its subsidiaries and other divisions fordisclosure.

Resul t :

This will require the banks to have a stricter monitoring system of not only their ownbank, but also the other subsidiaries in other sectors like mutual funds, merchantbanking, housing finance and others. This is all the more important inthe context of the recent announcements made by some major publicsector banks where they have said they would hive off or close down some oftheir underperforming subsidiaries.

The Investors Adv antage

Getting all these accounts consolidated with that of the parent bank will provide the

investor a better understanding of the banks' performances while deciding ontheir exposures. More so, since a number of public sector banks are nowlisted entities whose stocks are traded on the stock exchanges.Some public sector banks are even preparing their accounts in line with US GAAP

norms in anticipation of a US listing. These norms will therefore be inline with the future plans of these banks as well. The working group was set upfollowing the need to bring about transparency on the lines of internationalnorms through better disclosures. These new norms will necessitate not only thatthe problems are handled by the parent, but investors are also aware of what exactlythe problems are and how they affect the bottom lines of the parent banks.Now, und er the new guidelines, this will no longer be an external disclosure

to the parent banks' books of accounts.


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2.5 RATIONALISATION OF FOREIGN OPERATIONSIN INDIA

Entry of New B anks in the Pr ivate Sector

As per the guidelines for licensing of new banks in the private sector issued inJanuary 1993, RBI had granted licenses to 10 banks. Based on are view ofexperience gained on the functioning of new private sectorprovisions/requirements are listed below: -

Initial minimum paid -up capital shall be Rs. 200crore; this will be raised to Rs.300crore within three years of commencement of business.

Promoters contribution shall be a minimum of 40 per cent of the paid -upcapital of the bank at any point of time; their contribution of 40 per cents hallbe locked in for 5 years from the date of l icensing of the bank andexcess stake above 40 per cent shall be diluted after one year ofbanks operations.

Initial capital other than promoters contribution could be raisedthrough public issue or private placement.

While augmenting capital to Rs. 300crore within three years, promotersneed to bring in at least 40 percent of the fresh capital, which will also be

locked in for 5 years. The remaining portion of fresh capital could be raised throughpublic issue or private placement.

NRI participation in the primary equity of the new bank shall be to themaximum extent of 40 per cent. In the case of a foreign banking companyor f i n a n c e c o m p a n y ( i n c l u d i n g m u l t i l a t e r a l i n s t i t u t i o n s ) a s a t e c h n ica l collaborator or a co-promoter, equity participation shall be limited to 20 per centwithin the 40 per cent ceiling. Shortfall in NRI contribution toforeigne q u i t y c a n b e m e t t h r o u g h c o n t r i b u t i o n b y d e s i g n a t e d multilateral institutions.

No large industrial house can promote a new bank. Individual companiesconnected with large industrial houses can, however, contribute up to 10 per ce n to f t h e e q u i t y o f a n e w b a n k , w h i c h w i l l m a i n t a i n a n a r m sle ng th relationship with companies in the promoter group and the individualcompany/ies investing in equity. No credit facilities shall be extended tothem.

NBFCs with good track record can become banks, subject to specifiedcriteria

A minimum capital adequacy ratio of 10 per cent shal l be maintained on acontinuous basis from commencement of operations.


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Priority sector lending target is 40 per cent of net bank credit, as in the case ofother domestic banks; i t is also necessary to open 25 per cent ofthe branches in rural/semi-urban areas."Our industry did not oppose the entry ofprivate bankers because we knew they will not be able to reach out tothe rural markets s tates, G.M. Bhakey, president of the State Bank of India

Officers Association. "Even after privatisation not more than 10 per cent of theIndian population can afford to open accounts in private banks."The newgeneration private sector banks have made strongpresenceinthe most lucrative business areas in the country because of techn o l o gyupgradation. While, their operating expenses have been falling as comparedto the PSU banks, their efficiency ratios (employees productivity and profitabilityratios) have also improved significantly. The new private sector banks haveperformed very well in the FY2000.Most of these banks have registeredan increase in net profits of over 50%.

They have been able to make significant inroads in the retail market ofthe public sector and the old private sector banks. During the year, the twoleading banks in this sector had set a new trend in the Indian banking sector.

HDFC Bank, as a part of its expansion plans had taken over Times Bank. ICICIBank became the first bank in the country to list its shares on NYSE. The ReserveBank of India had advised the promoters of these banks to bring their stake to40% over a time period. As a result, most of these banks hade foreign capitalinfusion and some of the other banks have already initiated talks about astrategic alliance with a foreign partner.

The main problems concerning the nationalized / state sector banks are as follows:

A. Large number of unprofi table branches.

B. Excess staffing of serious magnitude.

C.Non Performing Assets on account of polit ically directed lending andindustrial recession in last few years.

D. Lack of computerization leading to low service delivery levels, non-reconciliation of accounts, inability to control, misuse and fraud etc.

E.Inabili tyto introduces profitable new consumer oriented products l ikecredit cards, ATMs etc.

The privates edge

Technology- The private banks have used technology to provide quality service throughlower cost delivery mechanisms. The implementation of new technology hasbeen going on at very rapid pace in the private sector, while PSU banks are laggingbehind in the race.


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Declining interest rates- In the present scenario of declining interest rates, some of the new private banks arebetter able to manage the maturity mix.PSU Banks by and large take relatively long-term deposits at fixed ratestol e n d f o r w o r k i n g c a p i t a l p u r p o s e s a t v a r i a b l e r a t e s . I t t h e r ef o r e i s negatively affected when interest rates decline as it takes time toreduce interest rates on deposits when lending has to be done at lowerinterest rates due to competitive pressures. NPAs- The new banks are growing faster, are more profitable and have cleanerloans. Reforms among public sector banks are slow, as politician sari reluctant tosurrender their grip over the deployment of huge amounts of public money.


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2.6 ASSET LIABILITY MANAGEMENT SYSTEM

T h e c r i t i c a l r o l e o f m a n a g i n g r i s k s h a s n o w c o m e i n t o t h e o pe n specially against the experience of the recent East Asian crisis, where marketsfell precipitously because banks and corporate did not accurately measure the risk

spread that should have been reflected in their lending activities. Nor didthey manage such risks or provide for them in their balance sheets.

In India,theReserve Bank has recently issued comprehensive guidelines to banks for putting in place an asset-liability management system. The emergenceof this concept can be traced to the mid 1970s in the US whenderegulation of the interest rates compelled the banks to undertake activeplanning for the structure of the balance sheet. The uncertainty of interest ratemovements gave rise to interest rate risk thereby causing banks to look forprocesses to manage their risk . In the wake of inte rest rate ris k,came liq uidi ty risk and cred it ris k as inherent components of risk forbanks. The recognition of these risks brought Asset Liability Management tothe centre-stage of financial intermediation.

The Necess i ty

The asset-liability management in the Indian banks is still in its nascentstage. With the freedom obtained through reform process, the Indian banks havereached greater horizons by exploring new avenues. The government ownership ofmost banks resulted in a carefree attitude towards risk management. Thiscomplacent behaviour of banks forced the Reserve Bank to use regulatorytacticsto ensu re th e impl ementatio n of the AL M. Als o, the post-reform bankingscenario is marked by interest rate deregulation, entry of newprivate banks, and gamut of new products and greater use of information technology.To cope with these pressures banks were required to evolve strategies rather thanad hoc fire fighting solutions. Imprudent liquidity management can put banks'earnings andReputation at great risk. These pressures call for structured and comprehensivemeasures and not just action. The Management of banks has to base theirbusiness decisions on a dynamic and integrated risk management system andprocess, driven by corporate strategy. Banks are exposed to several major ri sk s in

the course of their business - credit risk, interest rate risk, foreignexchange risk, equity / commodity price risk, liquidity risk and operationalrisk.It is, therefore, important that banks introduce effective risk managementsystems that address the issues related to interest rate, currency andliquidity risks.

Imp lementat ion of asset l iabi l i ty management (ALM) system

RBI has issued guidelines regarding ALM by which the banks have to ensurecoverage of at least 60% of their assets and liabilities by Apr 99. This willprovide information on banks position as to whether the bank is long

or short. The banks are expected to cover fully their assets and liabilities by April2000.


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ALM framework rests on three pillars.ALM Organisation :

The ALCO consisting of the banks senior management including CEO should beresponsible for adhering to the limits set by the board as well as for deciding thebusiness strategy of the bank in line with the banks budget and decidedrisk management objecti ves. AL CO is a decis ion-making unit responsible for balance sheet planning from a risk return perspect ive inc luding s t ra teg icmana geme nt of in t e res t a nd l iqu id i t y r isk . Co n s i de r t he p r oce d ur e f o r sanctioning a loan. The borrower, whoapproaches the bank, is apprised by the credit department on variousparameters like industry prospects,operationalefficiency, financial efficiency, management evaluation andothers which influence the working of the client company. On the basis of thisappraisal the borrower is charged certain rate of interest to cover the credit risk. Forexample, a client with credit appraisal AAA will be charged PLR. While somebodywith BBB rating will be charged PLR + 2.5 %, say. Naturally, there willbe certain cut-off for credit appraisal, below which the bank will not lend e.g.Bank, will not like to lend to D rated client even at a higher rate of interest. Theguide lines for the loan sanctioning procedure are decided in the ALCOmeet ings wi th targets set and goals established.

ALM Information System

ALM Information System is used for the collection of information accurately,

adequately and expeditiously. Information is the key to the ALM process. Agood information system gives the bank management a complete picture ofthe bank's balance sheet.

ALM Process

The basic ALM process involves identification, measurement and management ofrisk parameters. The RBI in i ts guidelines has asked Indian banks tousetraditional techniques l ike Gap Analysis for monitoring interest rate an dl i q u i d i t y r i s k . H o w e v e r R B I i s e x p e c t i n g I n d i a n b a n k s t o m o v e t o wa r d s sophisticated techniques like Duration, Simulation, and Vary in the future.Keeping in view the level of computerisation and the current MISin banks, adoption of a uniform ALM System for all banks may not befeasible. The final guidelines have been formulated to serve as a benchmarkfor those banks which lack a formal ALM System.Banks that have already adoptedmoresophisticated systems may continue their existing systems but they shouldensure to fine-tune their current information and reporting system so as tobe in line with the ALM System suggested in the Guidelines.


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2.7 SPECIAL TRIBUNALS AND ASSETRECONSTRUCTION FUND

Setting up of special tribunals to speed up the process of recoveryof loans and setting up of Asset Reconstruction Funds (ARFs) to take overfrom banks a portion of their bad and doubtful advances at a discount was one ofthe crucial recommendations of the Narasimham Committee.

To e x p e d i t e a d j u d i c a t i o n a n d r e c o v e r y o f d e b t s d u e t o b a n k s a n d f inancial insti tutions (FIs) at the instance of the Tiwari Committee(1984),appointed by the Reserve Bank of India (RBI), the governmentenacted the Debt Recovery Tribunal Act, 1993 (DRT). Accordingly, DRTsand Appellate DRTs have been established at different places in thecountry. The act was amended in January 2000 to tackle some problems withthe old act.

DRTs - - a com puls ion

One of the main factors responsible for mounting non-performing assets(NPAs) inthe financial sector has been the inability of banks/FIs to enforce the security held bythem on loans gone sour. Prior to the passage of the DRT Act, the only recourseavailable to banks/FIs to cover their dues from recalcitrant borrowers, when allelse failed, was to file a suit in a civil court. The result was that by the late 80s,banks had a huge portfol io of accounts where cases were pending in civilcourts. It was quite common for cases to drag on interminably. In the interim,borrowers, more often than not, stripped their premises of all assets so thatthat by the time the final verdict came, there was nothing left of the security

that had been pledged to the bank.DRTs, it was felt, would do away with the costly, time-consuming civil courtprocedures that stymied recovery procedures since they followa summary procedure that expedites disposal of suits filed by banks/FIs.Following the passage of the Act in August 1993, DRTs were set up atCalcutta,De lh i ,Banga lo re , J a ipu r and Ahmedabad a long wi th an Appe l l a t eT r i bu n a l a t Mumbai.However, DRTs soon ran into rough weather. Theconstitutional validity of the Act itself was questioned. It was only in March1996, that the Supreme Court modified its earlier order staying theoperation of the Delhi High Court order quashing the constitution of the

DRT for Delhi to allow the setting up of three more DRTs in Chennai,Guwahati and Patna. Subsequently, many more DRTs and ADRTs have beenset up.

CURRENT STATUS

Unfortunately, as a consequence of the numerous lacunae in the act and the hugebacklog of past cases where suits had been filed, DRTs failed to make a significantdent. For instance, the tribunals did not have powers of attachment before

judgment, for appointment of receivers or for ordering preservationof property. Thus, legal infrastructure for the recovery of non-performing loans stilldoes not exist. The functioning of debt recovery tribunals has beenhampered considerably by litigation in various high courts. Complains Bank of


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Baroda's Kannan: "Of the Rs 45,000-crore worth of gross NPAs, over Rs12,000crore is locked up in the courts." So, the only solution to the problem ofhigh NPAs is ruthless provisioning. Till date, the banking system has provided forabout Rs20, 000crore, which means it is still stuck with net NPAs worthRs 25,000crore. Even that is an under estimate as it does not include advances

coveredbygove rnmen t gua ran tees , wh ich have tu rned s t i cky. Nor does i t in c l u d e

Allowances for "ever greening"--the practice of extending fresh advancestodefaulting corporates so that the prospective defaulter can make interest payments, thus enabling the asset to escape the non-performing loan tag.Warns K.R. Maheshwari, 60, Managing Director, Inducing Bank: "NPA levelsare going to go up for all the banks." And so will provisions.

Recent Developments

The recent amendment (Jan 2000) to the DRT Act addresses many of the lacunaein the original act. I t empowers DRTs to attach the property onthe borrower filing a complaint of default. It also empowers the presiding officer toexecute the decree of the official receiver based on the certificate issued by theDRT. Transfer of cases from one DRT to another has also been madeeasier.More r ecen t l y, t he Supreme Cour t ha s ru l ed tha t t he DRT Act will take precedence over the Companies Act in the recovery of debt, putting torest all doubts on that score.

Some More Issues

As things stand, the DRT Act supersedes all acts other than TheSick Industrial Companies Act (SICA). This means that recovery procedures canstill be stalled by companies declaring themselves sick under SICA. Once the factof their sickness has prima facie been accepted by the Board for Industrialand Financial Reconstruction (BIFR), there is nothing a DRT can do till such time asthe case is disposed of by the BIFR. This lacuna too must be addressedif DRTs are to live up to their promise. The amendments would ensure speedyrecovery of dues, iron out delay sat the DRT end, as well as ensure thatpromoters do not have the time and opportunity to bleed their companiesbefore they go into winding up.

Yet the number of cases pending before DRTs and courts make a tellingcommentary on the inability of lenders to make good their threat. They alsoreflect the ability of borrowers to dodge the lenders. The main culprit for all this is thelaw. Existing recovery processes in the country are aimed at recovering lenders'dues after a company has gone sick and not nipping sickness in the bud.Since sickness is defined in law as the erosion of capital of a companyfor three consecutive years, there is little to recover from a sick company afterit has been referred to the Board of Industrial and Financial Revival (BIFR).What'shurting banks now is the fact that these new issues have cropped up even as theyhave been (unsuccessfully) wrestling with their NPAs which, together, tot upto a staggering Rs 60,000crore. The stratagem of using Debt Recovery

Tribunals has failed.


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2.8 REDUCTION OF GOVERNMENT STAKE IN PSBS

This is what the finance minister said in his budget speech on February29,2000:

" In recen t year s , RBI has been p resc r ib ing p rud en t ia l norms fo r banks b road lycon sis tent wi th in ternat ional pract ice . To meet the min imu m capi ta l adequacynorms se t by the RBI and to enablethebanks to expand thei r operat ions , pub l ic- sector bank s wi l l need mor e capi tal . With the Government bu dget und er sever e s t ra in , suc h cap i ta l has to b e ra ised f rom the pu bl ic w hich wi l l resul t inreduct ion in government shareholding. To faci l i ta te th is process theGovernment has dec ided to accep t the r ecommenda t ions o fthe Naras imham Com mi t t ee on Bank ing Sec to r Reforms fo r r educ ing the requ i r ement o f min imu m sh areho ld ing by go vernment inna t iona l i sed banks to 33 pe r cent . This wi l l be don e wi thout chang ing the pu bl ic-sector character of bank sand wh i le ensur ing tha t fr e sh i s sue o f sha res i s wide ly he ld by the pub l i c ."

Banking is a business and not an extension of government. Banks must beself-reliant, lean and competitive. The best way to achieve this is to privatisethe banks and make the managements accountable to real shareholder

s. If "privatisation" is a still a dirty word, a good starting point for us is torestrict government stake to 33 per cent.

During the winter session of the Parliament, on 16 November 2000,theU n i o n C a b i n e t h a s t a k e n c e r t a i n d e c i s i o n s , w h i c h h a v e f a r r e a c h i n g consequences for the future of the Indian banking sector clearedamendmentof the Banking Companies (Acquisitions and Transfer of Undertakings)

Act 970/1980 for facilitating the dilution of governments equity to 33 percentGovernments action programme has expressed clearly its programme for the

d i l u t i o n o f i t s s t a k e i n b a n k e q u i t y. T h e C a b i n e t h a d t a k e n t h i s d ecision, immediately on the next day after the bank employees went on strike, is aclear indication of Government of Indias determination to amend theconcerned Acts, to pave the way for the reduction in its stake. The proposalhad beentor e d u c e t h e m i n i m u m s h a r e h o l d i n g f r o m 5 1 p e r c e n t t o 3 3 p e r c ent, withadequate safeguards for ensuring its control on the operations ofthe banks.H o w e v e r, i t i s n o t w i l l i n g t o g i v e a w a y t h e m a n a g e m e n t c o n t r o l i n t he nationalised banks. As a result public sector banks may find it very difficult toattract strategic investors.


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SALIENT FEATURES of the pr opo sed amend ments

Government would retain its control over the banks by stipulating that theVo t i n g r i g h t s o f a n y i n v e s t o r w o u l d b e r e s t r i c t e d t o o n e p e r c en t , irrespective of the equity holdings.

T h e g o v e r n m e n t w o u l d c o n t i n u e t o h a v e t h e Prerogative of theappointment of the chief executives and the directors of thenationalised banks . There has been considerable delay in the past in fillingup the posts of the chairman and executive director of some banks. It is not clearas to how this aspect would be taken care of in future. It is said that the proposedamendment to the Act would also give the board of banks greater autonomy andflexibility.

I t h a s b e e n d e c i d e d t o Discontinue the mandatory practice ofnominating the representatives of the government of India and the ReserveBank in the boards of nationalised banks . This decision is in tune with therecommendation of Narasimham committee. However, the government would retainthe right to nominate i ts representative in the boards and strangelyn o m i n e e o f t h e g o v e r n m e n t c a n b e i n m o r e t h a n o n e b a n k

Af ter the amendment.

The number of whole t ime directors would be raised to four asagainst the present position of two, the chairman and managingdirector and the executive director. While conceptually it is desirable to decentralise power, operationally it may bedifficult to share power at peer level. In quite a few cases, it was observed that interpersonal relations were not cordial among the two at the top. It has to be seen as tohow the four full time directors would function in unison.

It is proposed to amend the provisions in the Banking Companies( A c q u i s i t i o n a n d T r a n s f e r o f U n d e r t a k i n g s ) A c t t o e n a b l e t h ebank shareholders to discuss, adopt and approve the annual accounts andadopt the same at the annual general meetings. Paid-up capital of nationalisedbanks can now fall below 25 per cent of the authorised capital.

Amendment will also enable the sett ing up of bank -specific FinancialRestructuring Authority (FRA). Authority will be empowered to take over themanagement of the weak banks. Members of FRA will comprise of expertsfrom various fields & will be appointed by the government; on the adviceof Reserve Bank of India.

The measures seen in totali ty are clearly aimed at enabling banks toaccess the capital markets and raise funds for their operations. The Governmentseems to have no plans to reduce its control over these banks. The Act willalso permit it to transfer its stake if the need ar ises, apart from grantingbanks the freedom to restructure their equity.


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2.9 DEREGULATION ON INTEREST RATES

The interest rate regime has also undergone a significant change.For long, an administered structure of interest rate has been in vogue in India.The1998 Narasimham Reforms suggested deregulation of interest rates onterm deposits beyond a period of 15 days. At present, the Reserve Bankprescribes only two lending rates for small borrowers. Banks are free todetermine the interest rate on deposits and lending rates on all landings aboveRs. 200,000.

In the last couple of years there has been a clear downward trend ininterest rates. Initially lending rates came down, leading to a decline in yieldson advances and investments.

I n t e r e s t r a t e s i n t h e b a n k i n g s y s t e m h a v e b e e n l i b e r a l i s e d ve r y substantially compared to the situation prevailing before 1991, when theReserve Bank of India controlled the rates payable on deposits ofdifferent maturities. The rationale for liberalising interest rates in the bankingsystem was to allow banks greater flexibility and encourage competition. Banks wereable to vary rates charged to borrowers according to their cost of funds andalso to reflect the credit worthiness of different borrowers.

With effect from October 97 interest rates on all time deposits, including15-daydeposits, have been freed. Only the rate on savings deposits remains

controlled by RBI. Lending rates were similarly freed in a series of steps. TheReserve Bank now directly controls only the interest rate charged for exportcredit, which accounts for about 10% of commercial advances. Interest rates on timedeposits were decontrolled in a sequence of steps beginning with longer-termdeposits and the liberalisation was progressively extended to depositsof shorter maturity.

Interest rates on loans up to Rs 2,00,000, which account for 25% of totaladvances, is not fixed at a level set by the RBI, but is now aligned withthe Prime Lending Rate (PLR) which is determined by the boards ofindividual Banks.

Earlier interest rates on loans below Rs 2,00,000 were fixed at a highlyconcessional level. The new arrangement sets a ceiling on these rates at thePLR, which reduces the degree of concessionality but does not eliminate it. Cooperative Banks were freed from all controls on lending rates in 1996 andthis freedom was extended to Regional Rural Banks and private localarea banks in 1997. RBI also considers removal of existing controls on lending ratesin other Commercial Banks as the Indian economy gets used to higher interest rateregime on shorter loan duration.

The line to control is the cost of funds, since the markets determine asset yields.The opportunity to improve yields on the corporate side tends to belimited if banks dont want to increase the risk profile of the portfolio. Banks income


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will depend on the interest rate structure and the pricing policy for the deposits andthe credit. With the deregulation of the interest rates banks are given thefreedom to price their assets and liabilities effectively and also plan for aproper maturity pattern to avoid asset-liability mismatches. Nevertheless, with theincrease in the number of players, competition for the funds and the other

banking services rose.

The consequential impact is being felt on the income profile of the banksespecially due to the fact that the interestincomecomponent of the total income is significantly larger than the non-interestincome component. As far as the interest costs are concerned, theprevailing interest rate structure will be a major deciding factor for the rates.But what influences both the interest costs and the intermediation costs is the timefactor as it is directly related to costs. The solution for these two influencingfactors lies predominantly on technology. In this regard, the new private banks andthe foreign banks, which are equipped with the latest technology, have a better edgeover the nationalized banks, which are yet to be automated at the branch level.


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2.10 Income and Expenses Profile of Banks

Interest Income

Interest/discount on advances/bills Interest on investments Interest on balances with RBI and other interbank funds Others

Interest Expenses

Interest on deposits Interest on Refinance/interbank borrowings Others

Other Income

Commission, Exchange and Brokerage Profit on sale of investments Profit on revaluation of investments Profit on sale of land, building and other assets Profit on exchange transactions Income earned by way of dividends, etc. Miscellaneous

Operating Expenses

Payments to and provisions for employees Rent, taxes and lighting Printing and stationery Advertisement and publicity Depreciation on Banks property Director/Auditors fees and expenses Law charges, Postage, etc. Repairs and Maintenance,

Insurance. Other expenses


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2.11 VOLUNTARY RETIREMENT SCHEMES

Public Sector Banks which together (there are 27 of them) account for 77.34per cent of the bank deposits in India. The most ambitious downsizingexercise undertaken by the PSBs has set them back by close to Rs 7,490crore.Voluntary Retirement Scheme in Banks was formally taken up by theGovernment in November 1999. According to Finance Ministry on the basisof business per employee (BPE) of Rs. 100 lakhs, there were 59,338 excessemployees in 12 nationalised banks, while based on a BPE of Rs. 125lakhs,the number shot up to 1, 77,405.

Government had cleared a uniform VRS for the banking sector, giving publicsector banks a seven-month time frame. The IBA has been allowed tocirculate the scheme among the public sector banks for adoption. The

scheme was to remain open till March 31, 2001. It would becomeope rat ion al af ter adoption by the respective bank board of directors. Noconcession had been made to weak banks under the scheme. The scheme isenvisaged to assist banks in their efforts to optimise use of human resourceand achieve a balanced age and skills profile in tune with their businessstrategies.

As per estimates the average outgo per employee under the banking VRS sch e m ew o u l d r a n g e b e t w e e n R s . 3 l a k h s a n d R s . 4 l a k h s . H o w e v e r, t h eaggregate burden on the banking industry is difficult to work out. To minimise the

immediate impact on banks, the scheme has allowed them the staggerthe payments in two instalments, with a minimum of 50 per cent of the amount to bepaid in cash immediately. The remaining payment can be paid within sixmonths either in cash or in the form of bonds. The total burden of the VRS on thebanking industry is about Rs 8,000crore, and union activists feel that it will adverselyaffect the profitability and capital adequacy of the banks. In fact, out of this Rs8,000crore, nearly Rs 2,200crore will be borne by State Bank of India, thelargest public sector bank.

Sal ient Features of Volun tary Ret irement Schem e of Banks

Eligibility

All permanent employees with 15 years of service or 40 years of age are eligible.Employees not eligible for this scheme include:

Specialists officers/employees, who have executed service bond sand havenot completed it, employees/officers serving abroad under specialarrangements/bonds, will not be eligible for VRS. The Directors may however waivethis, subject to fulfilment of the bond & other requirements.


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Employees against whom Disciplinary Proceedings arecontemplated/pendingor are under suspension.

Employees appointed on contract basis.

Any other category of employees as may be specified by the Board.

Amount of Ex-gratia 60 days salary (pay plus stagnation increments plus special allowance plusdearness relief) for each completed year of service or the salary for the number ofmonths service is left, whichever is less.

Other Benefits

Gratuity as per Gratuity Act/Service Gratuity, as the case maybe.

P e n s i o n s ( i n c l u d i n g c o m m u t e d v a l u e o f p e n s i o n ) / b a n k s contribution towards PF, as the case may be.

Leave encashment as per rules.

Other Features It will be the prerogative of the banks management either to accept a request forVRS or to reject the same depending upon the requirement of the bank.

Care will have to be taken to ensure that highly skilled and qualified workers and

staff are not given the option.

There will be no recruitment against vacancies arising due to VRS.

Before introducing VRS banks must complete their manpower planning and identifythe number of officers/employees who can be considered under the scheme.

Sanction of VRS and any new recruitment should only be in accordance with themanpower plan.

Funding of the Scheme

Coinciding with their financial position and cash flow, banks may decide paymentpartly in cash and partly in bonds or in instalments, but minimum 50 percent of thecash instantly and in remaining 50 percent after a stipulated period. Funding of thescheme will be made by the banks themselves either from their own funds or bytaking loans from other banks/financialinstitutions or any other source.

Periodicity

The scheme may be kept open up to 31.3.2001


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Sabbatical

An emplo yee / off icer who may not be in t e re s ted to take voluntaryretirement immediately can avail the facility of sabbatical for five years, which can befurther extended by another term of five year. After the period of sabbatical is overhe may re-join the bank on the same post and at the same stage of pay where hewas at the time of taking sabbatical. The period of sabbatical will not beconsidered for increments or qualifying service for person, leave, etc.

Current Sta tus

The VRS, as on July 2001, which bankers rushed to grab, has become a drag on thebottom line of the State-owned banking segment.

Heavy provisioning made towards VRS has pushed the combined net profitof PSU banks down 16 per cent to Rs 4,315.70crore in 2000-01, from Rs5,116crore in the previous year.

In the banking sector close to 1, 26,000 employees opted for the VRS in00 -01.

The total benefits received by these employees has been close toRs15, 000crore


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2.12Quality of Intermediation

Under-lending.

Identifying under-lending

A firm is getting too little credit if the marginal product of capital in the firm is higher

than the rate of interest the firm is paying on its marginal rupee of borrowing. Under-

lending therefore is a characteristic of the entire financial system: the firm has not

been able to raise enough capital from the market as a whole. In other words, while

we will focus on the clients of a public sector bank, if these firms are getting too little

credit from that bank, they should in theory have the option of going elsewhere formore credit. If they do not or cannot exercise this option, the market cannot be doing

what, in its idealized form, we would have expected it to do. However, we know that

the Indian financial system does not function as the ideal credit market might. Most

small or medium firms have a relationship with one bank, which they have built up

over some time they cannot expect to walk into another bank and get as much credit

as they want. For that reason, their ability to finance investments they need to make

does depend on the willingness of that one bank to finance them. In this sense the

results we report below might very well reflect the specificities of the public sector

banks, or even the one bank that was kind enough to share its data with us, though

given that it is seen as one of the best public sector banks, it seems unlikely that we

would find much better results in other banks in its category. On the other hand we

do not have comparable data from any private bank and therefore cannot tell

whether under-lending is as much of a problem for private banks. We will, however,

later report some results on the relative performance of public and private banks in

terms of overall credit delivery.

Our identification of credit constrained firms is based on the following simple

observation: if a firm that is not credit constrained is offered some extra credit at a

rate below what it is paying on the market, then the best way to make use of the new

loan must be to pay down the firms current market borrowing, rather than to invest

more. This is because, by the definition of not being credit constrained, any

additional investment will drive the marginal product of capital below what the firm is


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paying on its market borrowing. It follows that a firm that is not facing any credit

constraint will expand its investment in response to additional subsidized credit

becoming available, only if it has no more market borrowing. By contrast, a firm that

is credit constrained will always expand its investment to some extent.

A corollary to this prediction is that for unconstrained firms, growth in revenue should

be slower than the growth in subsidized credit. This is a direct consequence of the

fact that firms are substituting subsidized credit for market borrowing. Therefore, if

we do not see a gap in these growth rates, the firm must be credit constrained. Of

course, revenue could increase slower than credit even for non-constrained firms, if

the technology has declining marginal return to capital.

The evidence for under-lending

Data: The data we use were obtained from one of the better-performing Indian public

sector banks. We use data from the loan folders maintained by the bank on profit,

sales, credit lines and utilization, and interest rates. The loan folders also report all

numbe rs that the banker was required to calculate (e.g. his projection of the banks

future turnover, his calculation of the banks credit needs, etc.) in order to determine

the amount to be lent. We also record these, and will make use of them in the

analysis described in the next section. We have data on 253 firms (including 93

newly eligible firms). The data is available for the entire 1997 to 1999 period for 175

of these firms.

Specification Through much of this section we will estimate an equation of the form

with y taking the role of the various outcomes of interest (credit, revenue, profits,

etc.) and the dummy POST representing the post January 1998 period. We are in

effect comparing how the outcomes change for the big firms after 1998, with how

they change for the small firms. Since y is always a growth rate, this is, in effect, a

triple difference we can allow small firms and big firms to have different rates of

growth, and the rate of growth to differ from year to year, but we assume that there

would have been no differential changes in the rate of growth of small and large

firms in 1998, absent the change in the priority sector regulation.


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Using, respectively, the log of the credit limit and the log of next years sales (or

profit) in place of y in equation 1, we obtain the first stage and the reduced form of a

regression of sales on credit, using the interaction BIG POST as an instrument for

credit. We will present the corresponding instrumental variable regressions.

Results: The change in the regulation certainly had an impact on who got priority

sector credit. The credit limit granted to firms below Rs. 6.5 million in plant and

machinery (henceforth, small firms) grew by 11.1 percent during 1999, while that

granted to firms between Rs.6.5 million and Rs. 30 million (henceforth, big firms),

grew by 5.4 percent. In 2002, after the change in rules, small firms had 7.6 percent

growth while the big firms had 11.3 percent growth. In 2005, both big and small firms

had about the same growth.

Bank Ownership and Sectoral Allocation of Credit

As mentioned above, an important rationale for the Indian bank nationalizations was

to direct credit towards sectors the government thought were underserved, including

small scale industry, as well as agriculture and backward areas. Ownership was not

the only means of directing credit: the Reserve Bank of India issued guidelines in

1974, indicating that both public and private sector banks must provide at least one-

third of their aggregate advances to the priority sector by March 1979. In 1980, it was

announced that this quota would be increased to 40percent by March 1985. Sub-

targets were also specified for lending to agriculture and weaker sectors within the

priority sector. Since public and private banks faced the same regulation, in this

section we focus on how ownership affected credit allocation. The comparison of

nationalized and private banks is never easy: banks that fail are often merged with


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healthy nationalized banks, which makes the comparison of nationalized banks and

non-nationalized banks close to meaningless. The Indian nationalization experience

of 1980 represents a unique chance to learn about the relationship between bank

ownership and bank lending behaviour. The 1980 nationalization took place

according to a strict policy rule: all private banks whose deposits were above certain

cut off were nationalized.18 After 1980, the nationalized banks remained corporate

entities, retaining most of their staff, though the board of directors was replaced by

nominees of the Government of India. Both the banks that got nationalized under this

rule and the banks that missed being nationalized, continued to operate in the same

environment, and face the same regulations and therefore ought to be directly

comparable.

Even this comparison between banks just nationalized and just not nationalized may

be invalid, because policy rule means that banks nationalized in 1980 are larger than

the banks that remained private. The differences between the nationalized and

private banks seem to have decreased over time: in the 2005 data, the point

estimate on agricultural lending drops from 8 to 5 points, on rural lending from 7 to 3

points, and on trade and transport and finance from -11 to -6 percentage points.

In sum, bank ownership does seem to have had a limited impact on the

governments ability to direct credit to specific sectors. Through the early 1990s, the

credit environment in India was very tightly regulated. The government set interest

rates, required both public and private banks to issue 40 percent of credit to the

priority sector, and to meet specific sub-targets within the priority sector.

Nevertheless, banks controlled by the government provided substantially more credit

to agriculture, rural areas, and the government, at the expense of credit to trade,

transport, and finance. Though, surprisingly, there was no effect on credit to smallscale industry. Lending differences shrunk over the 1990s, and in 2000 were about

half of what they were in the early 1990s. This might reflect the increasing dynamism

of the private sector banks in the liberalized environment of the 1990s or the

loosening grip of the government on the nationalized banks.


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Bank Ownership and Speed of Financial Development

To determine whether public ownership of banks inhibits financial intermediation, we

again compare banks just above and just below the 1980 nationalization cut-off,using data from the Reserve Bank of India, for the period 1969 to 2000. We include

the six above, which were nationalized, and the nine largest below, which were not.

Since we have data from both the pre and post period, we adopt a difference-in-

differences approach. Specifically, we regress the annual change in bank deposits,

credit, and number of bank branches on a dummy for post nationalization (Post=1 if

year (1980 1991)), and a dummy for post-nationalization in a liberalized

environment (Nineteen = 1 if year (1992 2000)). We break the post-nationalization

analysis up into two periods (1980-1991 and 1991-2000) because the former period

was characterized by continued financial repression, while substantial liberalization

measures were implemented in the beginning of the 1990s. Public and private banks

could well behave differently before and after liberalization.


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2.13Bank Ownership and the Quality of Intermediation

Limitations on Public Sector Banks

Official Lending Policies

While public sector banks in India are nominally independent entities, they are

subject to intense regulation by the Reserve Bank of India (RBI). This includes rules

about how much a bank should lend to individual borrowers the so- called maximum

permissible bank finance. Until 1997, the rule was based on the working capital gap,defined as the difference between the current assets of the firm and its total current

liabilities excluding bank finance (other current liabilities). The presumption is that the

current assets are illiquid in the very short run and therefore the firm needs to

finance them. Trade credit is one source of finance, and what the firm cannot finance

in this way constitutes the working capital gap. Firms were supposed to cover a part

of this financing need, corresponding to no less than 25 percent of the current

assets, from equity. The maximum permissible bank finance under this method was

thus: CURRENT ASSETS OTHER CURRENT LIABILITIES

The sum of all loans from the banking system was supposed not to exceed this

amount. This definition of the maximum permissible bank finance applied to loans

above Rs. 20 million. For loans below Rs.20 million, banks were supposed to

calculate the limit based on the projected turnover of the firm. Projected turnover was

to be determined by a loan officer in consultation with the client. The firms financing

need was estimated to be 25 percent of the projected turnover and the bank was

allowed to finance up to 80 percent of what the firm needs, i.e. up to 20 percent of

the firms projected turnover. The rest, amounting to at least 5 percent of the

projected turnover has again to be financed by long term resources available to the

firm. In the middle of 1997, following the recommendation of the committee on

financing of the small scale industries (the Nyack committee), the RBI decided to

give each bank the flexibility to evolve its own lending policy, under the condition that


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it be made explicit. Moreover the Nyack committee recommended that the turnover

rule be used to calculate the lending limit for all loans under Rs. 40 millions.

Given the freedom to choose the rule, different banks went for slightly different

strategies. The bank we studied adopted a policy which was, in effect, a mix

between the now recommended turnover-based rule and the older rule based on the

firms asset position. First the limit on turnover basis was calculated as: min(0.20

Projected turnover, 0.25 Projected turnover available margin)

The available margin here is the financing available to the firm from long term

sources (such as equity), and is calculated as Current Assets Current Liabilities

from the current balance sheet. In other words the presumption is that the firm has

somehow managed to finance this gap in the current period and therefore should be

able to do so in the future. Therefore the bank only needs to finance the remaining

amount. Note that if the firm had previously managed to get the bank to follow the

turnover based rule exactly, its available margin would be precisely 5 percent of

turnover and the two amounts in 6 would be equal.

In India the venture capital industry is still nascent and it will be a while before it can

play the role that we expect of its US equivalent. Therefore banks may have to be

more pro-active in promoting promising firms. Following a rule that does not put any

weight on profits may not be the way to favour the most promising firms: while the

projected turnover calculation does favour faster growing firms, the loan officer is not

allowed to project a growth rate greater than 15 percent. This may be enough to

meet the needs of a mature firm, but a small firm that is growing fast clearly needs

much more than 15 percent. It is important that the rules encourage the loan officers

to lend more to companies on the basis of promise.

Actual Lending PolicyThe lending policy statements give us the outside limits on what the banks can lend.

There is nothing in the policies that stops them from lending less, though bankers

are always enjoined to lend as much as possible in official documents.24 It is also

possible, given that it is not clear how these rules are enforced, that the banks

sometimes exceed the limits it is, for example, often alleged that loan officers in

public sector banks give out irresponsibly large loans to their friends and business


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associates. It is not even clear how one would necessarily know that banker had lent

too much given that he is given the task of estimating expected turnover.

Further, this is the case despite the fact that according to the banks own rules, the

limit could have gone up in 64 percent of the cases (note that getting a higher limit is

simply an option and does not cost the firm anything unless it uses the money).

Finally, this tendency seems to become more pronounced over time: in 1999, the

limit was equal to the previous granted limit 53 percent of the time. In 2001, it did not

change in 70 percent of the cases.

It is also conceivable that it is rational to ignore profit information in lending, if

the projected turnover calculated by the bank and included in the calculation of LTB,

already takes into account any useful information contained in the profits. To

examine this we looked at whether current profitability has any role in predicting

future profitability, delay in repayment and actual default, once we control for the

variables that seem to determine the level of lending past loans, LTB, LWC. As

reported in Bannered and Duffle, current profit is a good predictor of future profit, and

the variables that the bank uses (past loans, etc.) are not: the only good predictor of

future negative profit is current negative profit. Negative profits, in turn predict

default, while past loans, LTB and LWC do not.

This sub-section suggests an extremely simple prima facie explanation of why many

firms in India seem to be starved of credit. The nationalized banks, or at least the

one we study (but again, this is one of the best public banks) seem to be remarkably

reluctant to make fresh lending decisions: in two-thirds of the cases, there is no

change in the nominal loan amount from year to year. While the rules for lending areindeed fairly rigid, this inertia seems to go substantially beyond what the rules

dictate. Moreover the deviations from the rules do not seem to reflect informed

judgments, but rather a desire to do as little as possible.

Moreover, when they do take a decision to make a fresh loan the beneficiaries tend

to be firms whose turnover is growing, irrespective of profitability. This indifference to

profitability is entirely consistent with the rules that bankers work with: none of the

many calculations that bankers are supposed to do before they decide on the loanamount pay even lip service to the need to identify the most profitable borrowers. Yet


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current profits do a much better job of predicting future losses and therefore future

defaults, than the variables that do seem to influence the lending decision. In other

words, it seems plausible that a banker who made better use of profit information

would do a better job at avoiding defaults. Moreover, he might do a better job of

identifying the firms where the marginal product of capital is the highest. Lending

based on turnover, by contrast, may skew the lending process towards firms that

have been able to finance growth out of internal resources and therefore do not need

the capital nearly as much.

Need of under-lending.

Given that the rules for lending are quite rigid and largely indifferent to profitability, it

is perhaps not surprising that there are opportunities for profitable investment that

have not yet been exploited. What is surprising is that to the extent that there are

deviations from the rules, they tend to be in the direction of lending less.

One plausible reason for why this happens is that the loan officers in these banks

have no particular incentive to lend. They are government employees on a more or

less fixed salary and promotion schedule and the rewards are at best weakly tied to

their success in making imaginative lending decisions. On the other hand, failed

loans, as discussed below, can lead to investigations by the Central Vigilance

Commission, which is the body entrusted to investigate potential cases of fraud in

the public sector. They therefore have a lot to lose and little to gain from being brave

in lending. Not taking any new decisions may dominate any other course of action

and moreover, this is especially likely to be true if there are attractive alternatives to

lending (such as putting your money in government bonds). The next sub-section

examines the role that the fear of prosecution plays in discouraging lending. The

following sub-section asks whether the reluctance to lend is exacerbated when the

rewards from putting money in government bonds become relatively more attractive.


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Inertia and the fear of prosecution

Since public sector banks are owned by the government, employees of the bank are

treated by law as public servants, and thus subject to government anti-corruption

legislation. There is an impression among bankers that it is very easy to be chargedwith corruption, and that the law states that if any government functionary takes a

decision which results in direct financial gain to a third party, the individual is prima

facie guilty of corruption, and must prove her or his innocence.

The executive director of a large public sector bank was quoted saying Fe ar of

prosecution for corruption hangs over every loan officers head like the sword of

Damocles. The Economic Times of India has attributed slowdowns in lending

directly to vigilance activity working group on banking policy set up by the Reserve

Bank of India, and chaired by M.S.Verma, noted:

The [working group] observed that it has received representations from the

managements and the unions of the banks complaining about the diffidence in taking

credit decisions with which the banks are beset at present. This is due to

investigations by outside agencies on the accountability of staff in respect of some of

the Non Performing Assets. The group also noticed a marked reluctance at various

levels to take any credit decision.

In response to criticism from bankers, economists, and others, the Central Vigilance

Commission (henceforth CVC), which is the body entrusted to investigate potential

cases of fraud in the public sector, introduced in 1999 a special chapter of the

vigilance manual, on vigilance in public sector banks. While this new chapter was

meant to reassure bankers, the language would probably not reassure anyone with

experience working in a western bank. The manual reads, for example, that every

loss caused to the organization, either in pecuniary or non-pecuniary terms, need not

necessarily become the subject matter of a vigilance inquiry once a vigilance angle is

evident, it becomes necessary to determine through an impartial investigation as to

what went wrong and who is accountable for the same.

Interviews with public sector bankers revealed widespread concern: the legal

proceedings surrounding charges of corruption can drag on for years, leaving


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individuals charged with corruption in an uncertain state. Even if an individual is

exonerated, she may have been relieved of her duties, transferred, or passed over

for promotion during the time of investigation. In theory (as well as practice), even

one loan gone badly may be sufficient to start vigilance proceedings. The possible

penalties stand in stark contrast to rewards. While banks are constantly urged by the

Reserve Bank of India to lend as much as possible, there are no explicit incentives

for making good loans, or ways to penalize officers who make conservative

decisions. In effect, bankers are accountable to more than one authority the loan

officers boss is one of them but central vigilance may be another, and the press may

be yet another. In such circumstances, it may be very difficult to provide effective

incentives. If this were the case, loan officers would prefer not to take new decisions.

Simply renewing the loan without changing the amount is one easy way to avoid

responsibility, especially if the original decision was someone elses (loan officers

are frequently transferred) and when they do take a decision, making sure that they

did not deviate enormously from the precedent, is a way of covering themselves

against charges of wrong-doing or worse.

Lending to the government and the easy life

Lending to the government is the natural alternative to lending to firms and offers the

loan officers a secure vehicle for their money, with none of the legwork and

headaches associated with lending to firms. The ideal way to measure how

important high interest rates on government bonds might be in explaining under-

lending, would be to estimate the elasticity of bank lending to the private sector with

respect to the interest rate on government securities or the spread between the

interest rate on private loans and the interest rate on government securities. The

problem is that the part of the variation that comes from changes in the rate paid by

the government is the same for all banks and therefore is indistinguishable from any

other time varying effect on lending. The part that comes from the rates charged by

the banks does vary by bank, but cannot possibly be independent of demand

conditions in the bank and other unobserved time varying bank specific factors. One

cannot therefore hope to estimate the true elasticity of lending by regressing loans

on the spread.


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Our strategy is to focus on a more limited question which we may hope to answer

somewhat more convincingly: are banks more responsive to the central bank interest

rates in slow growing environments. We start by identifying the banks that are

particularly likely to be heavily invested in the easy life. These are banks that, for

historical reasons, have most of their branches in the states that are currently

growing slower than the rest. Our hypothesis is that it is these banks that have a

particularly strong reason to invest heavily in government securities, since in a slow-

growing environment it is harder to identify really promising clients. They also

probably have more marginal loans that they are willing to cut and reduce (or not

increase) when the interest rates paid to government bonds increases. It is therefore

these banks that should be particularly responsive to changes in the interest rate

paid by the government.

Data: The outcome we focus on is the in (Credit/Deposit Ratio), at the end of March

of each year, for 25 public sector and 20 private sector banks. Two minor public

sector banks were excluded due to lack of data, while the new private sector banks

were excluded for reasons of comparability. The data are from the Reserve Bank of

India.

Conclusion: The evidence seems to be consistent with the view that banks are

especially inclined towards the easy life in states where lending is hard. This

suggests that the opportunity for lending to the government tends to hurt the firms

that are relatively marginal from the point of view of the banks, such as firms in slow

growing states and smaller and less established firms.


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2.14 Commercial Ba

reforms in banking

Documents