CENTRE FOR NEW AND EMERGING MARKETS
Discussion Paper Series
Number 17
THE INDIAN BANKING INDUSTRY: A COMMENTARY
Sumon Kumar Bhaumik
London Business School
Paramita Mukherjee
ICRA Limited, Calcutta
July 2001
Contact details:
Anna M Malaczynska
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© London Business School, 2001
Abstract:
During the 1990s, the Indian banking sector witnessed more reforms than most other sectors
of the Indian economy. Interest rates have been deregulated, and entry into the banking sector
has been liberalized. The cash reserve ratio and the statutory liquidity ratio are at their historic
lows, thereby granting the banks control over a greater share of their deposit base. Banks are
now allowed to invest in hithertofore contraband assets like equity. Further, non-interest
income by way of fees and off-balance-sheet activities is increasingly becoming an important
part of banks' revenues. Finally, banks routinely take positions in the markets for complex
instruments like derivatives. At the same time, however, these financial intermediaries are
supposed to maintain capital adequacy ratio at the stipulated minimum level, mark assets to
market, classify assets to identify doubtful and loss loans, and make provisions for nonperforming assets. Despite the spate of reforms, the Indian banking industry continues to face
several problems: many banks, mostly in the public sector, continue to underperform in terms
of return to assets; the volume of non-performing assets continue to be at an alarmingly high
level; and the issue of deposit insurance remains hostage to the fact that about 80 percent of
the deposits in the country remain in the control of public sector banks. The paper takes a
close look at the issues and challenges facing the Indian banking industry. It concludes that
the evolution of the banking sector in India is likely to take the form of emergence of
universal or quasi-universal banks, and that, therefore, risk management and development of
an appropriate regulatory system remain the main challenges facing the banking industry in
the foreseeable future.
JEL Classifications: G21, G28, G38
2
Non-Technical Summary
Independent India inherited a weak financial system. Commercial banks mobilized household
savings through demand and term deposits, and disbursed credit primarily to large
corporations. Indeed, between the years 1951 and 1968, the proportion of credit going to
industry and trade increased from an already high 83 percent to 90 percent. This increase was
at the expense of some crucial segment of the economy like agriculture and the small scale
industrial sector. This lop-sided pattern of credit disbursal, and perhaps the spate of bank
failures during the sixties, forced the government to resort to nationalization of banks.
The main thrust of nationalization was social banking, with the stated objective of increasing
the geographical coverage of the banking system, and extension of credit to the priority
sectors. This phase of banking in India was characterized by administered interest rates, and
the government and/or Reserve Bank of India’s (RBI) intervention with respect to credit
disbursal. Further, a significant part of the banks’ deposit base was preempted to support
government expenditure through statutory measures like the cash reserve ratio (CRR) and the
statutory liquidity ratio (SLR). There is little doubt about the fact that the twin objectives of
nationalization had been met by the last decade of the twentieth century. The number of
branches of the nationalized banks increased by 55,505 between 1951 and 1990, and the
emergence of a large number of rural branches helped widen the delivery points for rural
credit.
However, despite the successes of bank nationalization in India, the banking sector remained
mired in problems, and was incompatible with the paradigm of the market economy which
was gradually emerging as the dominant economic paradigm worldwide. As late as 1990, the
interest rates were still being fixed by the RBI, directed credit was still in vogue, and
government ownership of 88.5 percent of the banking industry (measured in terms of deposit
base) created enormous moral hazard problems for the depositors and the banks’ management
alike. The crisis in the banking industry was manifested in the financial performance of the
banks: while the gross operating profit of scheduled commercial banks as a proportion of total
assets rose marginally from 0.8 percent in 1970s to 1.5 percent in 1990s, the net profit of
these banks declined.
3
With economic reform emerging as the primary agenda of the central government in 1990, the
banking-financial sector in India witnessed a significant degree of liberalization since the
early nineties. Between 1992 and 1997, interest rates were liberalized, and banks were
allowed to fix lending rates subject to a cap of 400 basis points over the prime lending rate
(PLR). Further, the CRR was reduced to 9.5 percent by 1997, and the SLR was reduced to 25
percent. Banks were further encouraged to increase the returns on their operating assets when,
in 1994-95, they were allowed to invest in equity. At the same time, in pursuance of the
recommendations of the first Narasimham Committee, entry of new banks and the expansion
of branching network of existing banks were deregulated. At the same time, banks were asked
to maintain risk weighted capital adequacy ratio of 8 percent, mark assets to market, identify
problem loans on their balance sheets, and make provisions for bad loans. This phase of
reforms was completed by March 31, 1998.
During this period, the competition unleashed among banks by way of the deregulation of
entry and branching norms was supplemented by competition from non-bank financial
companies (NBFC). The deposit base of NBFCs grew from Rs. 20,438.5 crore in 1991-92 to
Rs. 101,672.4 crore in 1995-96, a rise of 397.5 percent, the rise of the deposit base of
commercial banks during the same period being 88 percent (see Figure 2). The NBFCs, which
typically offered higher interest rates on deposits than commercial banks, gained
respectability with the introduction of prudential norms aimed at making them safe
depositories for savings. All registered NBFCs were required to achieve a minimum capital
adequacy norm of 6 percent by March 31, 1995, and 8 percent by March 31, 1996. Further,
they were required to obtain a rating from Indian credit rating agencies, and invest 10-15
percent of their deposits in liquid assets.
But while the increasing competition in the banking industry led to product innovation and
quality competition, major problems continued to persist. Profitability of nationalized banks
continued to be a problem, and the ratio of net profits to total assets of these banks remained
at 0.77 percent, lower than the corresponding ratio for domestic private (1.04 percent) and
foreign banks (0.97 percent). Even more worrying was the fact that the net non performing
assets (NPA) of scheduled commercial banks continued to rise, stood at Rs. 23,761 crore in
1997-98. The public sector banks contributed to about 89.4 percent of the net NPAs. The
problem is further complicated by the fact that the fear of accumulating NPAs and the
required provisioning for the same might have rendered banks unwilling to make loans to
non-blue chip companies. Finally, in order to meet their capital adequacy requirements, banks
4
raised tier II capital through bonds which were typically subscribed to by other banks, thereby
increasing the system wide downside potential of adverse shocks.
The paper examines the following issues concerning the Indian banking industry: (a) whether
public sector banks should be privatized, (b) how the banks can best deal with the NPAs that
have an adverse effect on their balance sheets, (c) how the banks can best deal with greater
competition and manage the new forms of risk, and (d) whether there should be deposit
insurance reform such that there is greater confidence in the banking system and yet reduction
of moral hazard on the part of stakeholders. It concludes that in the absence of any political
consensus about privatization of the public sector banks (and hence consolidation of the
banking sector), and given the policy and business trends in the financial sector in general, the
Indian banks are likely to opt for the universal banking route to risk diversification and
revenue generation. The challenge facing the Indian policy makers, therefore, is to design
policies that can regulate well the complex financial institutions that are poised to emerge in
the Indian market.
5
Introduction
The last three decades of the twentieth century witnessed the emergence of a number of issues
that spurred debates and discussions among economists. During the seventies, economists
grappled with the breakdown of the Bretton Woods system and the emergence of stagflation
in the aftermath of the OPEC induced oil shock. Later, during the eighties, debates raged
about the supply side tax cuts of Ronald Reagan and the emergence of mergers and
acquisitions and junk bonds as major corporate-financial phenomena. Finally, in the nineties
economists split hair about the “new” economy and the “taming” of business cycles.
However, while the world quickly adjusted to flexible exchange rates, and while wild
gyrations in the equity prices of technology related companies do not make headlines any
more, one phenomenon continues to haunt economists through the decades: fragility of the
banking system.
From Sweden to Brazil, and from the United States of America (USA) to Japan, banks seem
to “go bad” with monotonic regularity. The South East Asian currency crisis of 1997 brought
to the fore the fact that while such a crisis may not be triggered by bad banks per se, the
extent of the crisis and the ability of a country to emerge out of the crisis fast enough depends
crucially on the soundness of its banking system. To make matters worse, the banking
industry itself is evolving rapidly, thereby forcing economists and policymakers to look at the
industry through the proverbial crystal ball, rather than in retrospect. In sum, it is more
difficult than ever to discuss the economic prospects of a country without taking a look at the
problems and prospects of its banking system.
Independent India inherited a weak financial system. Commercial banks mobilized household
savings through demand and term deposits, and disbursed credit primarily to large
corporations.1 Indeed, between the years 1951 and 1968, the proportion of credit going to
industry and trade increased from an already high 83 percent to 90 percent. This increase was
at the expense of some crucial segment of the economy like agriculture and the small scale
industrial sector. This lop-sided pattern of credit disbursal, and perhaps the spate of bank
failures during the sixties2, forced the government to resort to nationalization of banks.
1
This was due to the fact that the commercial banks were controlled by a handful of people
through interlocking of directorships, and these people were entrenched in the corporate sector (Ghosh,
1988).
2
Bank failures and mergers led to a decline in the number of banks from 566 in 1951 to 90 in
1968 (India Banking Yearbook, 1995).
6
The main thrust of nationalization was social banking, with the stated objective of increasing
the geographical coverage of the banking system, and extension of credit to the priority
sectors. This phase of banking in India was characterized by administered interest rates, and
the government and/or Reserve Bank of India’s (RBI) intervention with respect to credit
disbursal. Further, a significant part of the banks’ deposit base was preempted to support
government expenditure through statutory measures like the cash reserve ratio (CRR) and the
statutory liquidity ratio (SLR).3 There is little doubt about the fact that the twin objectives of
nationalization had been met by the last decade of the twentieth century. The number of
branches of the nationalized banks increased by 55,505 between 1951 and 1990, and the
emergence of a large number of rural branches helped widen the delivery points for rural
credit (Sarkar, 1997).
However, despite the successes of bank nationalization in India, the banking sector remained
mired in problems, and was incompatible with the paradigm of the market economy which
was gradually emerging as the dominant economic paradigm worldwide. As late as 1990, the
interest rates were still being fixed by the RBI, directed credit was still in vogue, and
government ownership of 88.5 percent of the banking industry (measured in terms of deposit
base) created enormous moral hazard problems for the depositors and the banks’ management
alike. The crisis in the banking industry was manifested in the financial performance of the
banks: while the gross operating profit of scheduled commercial banks as a proportion of total
assets rose marginally from 0.8 percent in 1970s to 1.5 percent in 1990s, the net profit of
these banks declined.
With economic reform emerging as the primary agenda of the central government in 1990, the
banking-financial sector in India witnessed a significant degree of liberalization since the
early nineties. Between 1992 and 1997, interest rates were liberalized, and banks were
allowed to fix lending rates subject to a cap of 400 basis points over the prime lending rate
(PLR). Further, the CRR was reduced to 9.5 percent by 1997, and the SLR was reduced to 25
percent. Banks were further encouraged to increase the returns on their operating assets when,
in 1994-95, they were allowed to invest in equity. At the same time, in pursuance of the
recommendations of the first Narasimham Committee, entry of new banks and the expansion
3
The CRR requires banks to maintain a specified fraction of their total time and demand
deposits as cash balances with the RBI. The SLR, on the other hand, requires them to invest a specified
proportion of time and demand deposits in government securities and quasi-government securities like
bonds issued by the Industrial Development Bank of India (IDBI). As late as 1991, the magnitudes of
CRR and SLR were 15 percent and 38.5 percent respectively.
7
of branching network of existing banks were deregulated.4 At the same time, banks were
asked to maintain risk weighted capital adequacy ratio of 8 percent, mark assets to market,
identify problem loans on their balance sheets, and make provisions for bad loans. This phase
of reforms was completed by March 31, 1998.5
During this period, the competition unleashed among banks by way of the deregulation of
entry and branching norms was supplemented by competition from non-bank financial
companies (NBFC). The deposit base of NBFCs grew from Rs. 20,438.5 crore in 1991-92 to
Rs. 101,672.4 crore in 1995-96, a rise of 397.5 percent, the rise of the deposit base of
commercial banks during the same period being 88 percent (see Figure 2). The NBFCs, which
typically offered higher interest rates on deposits than commercial banks, gained
respectability with the introduction of prudential norms aimed at making them safe
depositories for savings. All registered NBFCs were required to achieve a minimum capital
adequacy norm of 6 percent by March 31, 1995, and 8 percent by March 31, 1996. Further,
they were required to obtain a rating from Indian credit rating agencies, and invest 10-15
percent of their deposits in liquid assets.6
But while the increasing competition in the banking industry led to product innovation and
quality competition, major problems continued to persist.7 Profitability of nationalized banks
continued to be a problem, and the ratio of net profits to total assets of these banks remained
at 0.77 percent, lower than the corresponding ratio for domestic private (1.04 percent) and
foreign banks (0.97 percent). Even more worrying was the fact that the net non performing
assets (NPA) of scheduled commercial banks continued to rise, stood at Rs. 23,761 crore in
1997-98.8 The public sector banks contributed to about 89.4 percent of the net NPAs. The
problem is further complicated by the fact that the fear of accumulating NPAs and the
required provisioning for the same might have rendered banks unwilling to make loans to
non-blue chip companies. Finally, in order to meet their capital adequacy requirements, banks
raised tier II capital through bonds which were typically subscribed to by other banks, thereby
increasing the system wide downside potential of adverse shocks. In view of these
4
Between 1991-92 and 1996-97, the number of domestic private banks and foreign banks rose
from 23 to 34, and from 23 to 39 respectively. Between June 1993 and March 1997, the number of
branches of domestic private and foreign banks rose from 3,887 to 4,535, and from 141 to 181
respectively.
5
The fiscal and financial years in India run from April 1 to March 31 of the following year.
6
Despite the regulatory measures, uncertainty about the asset portfolios and business practices
of NBFCs subsequently affected the growth of NBFCs. Their deposit base on March 31, 1999 stood at
Rs. 20,428.93 crore.
7
The average PLR of banks declined by about 200 basis points between 1991-92 and 1997-98,
but the cheap money policy followed by the RBI have been responsible for it than price competition
among banks.
8
developments, between 1997 and 2000, the central government and the RBI set up two
different committees to provide guidelines for the second generation reforms for the banking
sector: the second Narasimham Committee to provide guidelines for the second generation
reforms of the banking sector, and the Varma Committee to provide guidelines about
treatment of weak public sector banks.
Second generation banking reforms
The second Narasimham Committee undertook its evaluation of the Indian banking sector at a
crucial point of time: the currency-banking crisis in South East Asia, and the assertion by the
Tarapore Committee that the banking sector of the country should be strengthened to meet
international standards before the rupee is made fully convertible on the capital account of the
balance of payments. The report of the committee, submitted in 1998, focussed on
strengthening the foundations of the banking system, as well as on issues like upgradation of
technology and human resource development.
The report stressed two aspects of banking regulation: capital adequacy, and asset
classification and resolution of the NPA-related problem. 9 It recommended that the capital
adequacy ratio be increased to 9 percent by 2000 and further to 10 percent by 2002. It also
suggested that measures of capital adequacy should take into account market risk of the
banks’ assets,10 including the exchange rate risk of foreign currency held by the banks.
Further, it proposed that the entire portfolio of government securities with banks be marked to
market within a 3-year period. Finally, the committee suggested that an asset should be
classified as “doubtful” if it is in the substandard category for 18 months to begin with, and
that this period be reduced to 12 months over time.11
In order to reduce the moral hazard associated with government ownership, the committee
suggested that banks should not be recapitalized using government funds. However, it
acknowledged the fact that the government might have to play a role in the removal of NPAs
from the banks’ balance sheets by way of asset reconstruction companies (ARCs).
Specifically, the government might have to guarantee the bonds issued by the ARCs, the
proceeds from which would be used to buy the bad assets of the banks at a discount.
8
The volume of gross NPAs has been estimated to be double the volume of net NPAs.
The committee proposed that the average level of net NPAs as a fraction of credit outstanding
for all banks be reduced to 5 percent or less by 2000 and to 3 percent by 2002. For banks with
international presence, the corresponding targets for gross and net NPAs were proposed to be 5 percent
and 3 percent, and 3 percent and 0 percent respectively.
10
In conjunction with this, the banks were encouraged to undertake risk management by way of
value at risk (VaR) modelling.
9
9
Implicitly linking ownership with performance, the second Narasimham Committee
suggested a reduction in the minimum stipulated holdings of the government in the equity of
public sector banks to 33 percent.12 It also favored separation of monetary policy and bank
supervision, and suggested that a supervisory body for banks be formed in line with the
Financial Services Authority (FSA) of United Kingdom.
While the second Narasimham Committee proposed reforms which were indubitably good in
so far as the health of the banking system is concerned, it stopped short of proposing closure
of public sector banks like United Bank of India, United Commercial Bank and Indian Bank
which were clearly underperforming even by the modest standards of the public sector banks.
The unenviable task of formulating a policy to deal with weak public sector banks was,
instead, left for the Varma Committee.
The Varma Committee concluded that the public sector banks were under pressure because of
the prudential norms regarding asset classification and provisioning for NPAs, and because of
the intensification of competition subsequent to the first phase of banking sector reforms.
However, the committee pointed out that the dismal performance of the weak public sector
banks were not merely on account of exogenous shocks, but rather that internal problems like
limited number of products, poor risk management systems and mediocre service had also
contributed to the weak performance. It concluded that mergers and narrow banking are
unlikely to resolve the problem of weak banks, and while privatization is perhaps the best
course of action it would be difficult to attract private bids for public sector banks the cost of
restructuring which would be prohibitively high.
The committee identified persistence of the large volume of NPAs as the biggest challenge
facing the weak public sector banks, and proposed that ARCs be used as the vehicle for
alleviating this problem. Importantly, the committee categorically stated that the weak banks
would have to reduce cost of operation by way of reduction in staff strength, an economically
sound proposition that has been difficult to implement in light of the Indian political
economy.13 It proposed that the staff strength of weak public sector banks be reduced by 25
percent. Moreover, it argued that if VRS fails to reduce the operations cost of these banks,
11
The committee suggested that the banks be asked to adopt the international standard with
respect to income recognition, thereby reducing the relevant time period from 180 days to 90 days.
12
The central government is attempting to effect such a reduction with the help of appropriate
legislation, but the proposal has met with significant resistance from the opposition parties.
10
there should be across-the-board wage cuts for their employees.14 Once again, given the
political economy of the Indian banking industry, this was a radical proposal.
While the various committees have accurately identified the malaise (adversely) affecting the
evolution of the Indian banking system into an efficient and globally competitive industry,
and have paved the way for many a reform, trade unionism, lack of political will to take hard
decisions, moral hazard and sheer inefficiency continue to haunt this critical component of the
Indian financial system. While any commentary about the industry cannot divorce itself from
positive analysis, thereby taking into consideration the political economic realities, it is also
imperative to touch upon normative aspects of policy making without which there cannot be a
vision about the way forward. Attaining a balanced mix of the positive and the normative
would be the challenge that has been addressed in the subsequent analysis.
Issues facing the Indian banking system
The issues facing the Indian banking system today are, ironically, very similar to the issues
that were raised nearly a decade ago. The liberalization of the banking industry and the
introduction of prudential norms have opened the door for greater competition on the one
hand, and have reduced the vulnerability of the banking system on the other. However, the
bane of the Indian banking sector continue to be a clutch of banks with weak balance sheets
and weaker prospects of improving asset quality and profitability simultaneously. Further, the
large yet weak banks are in the public sector. As a consequence, the policy debate about
banks continues to encompass the following issues: (a) whether public sector banks should be
privatized, (b) how the banks can best deal with the NPAs that have an adverse effect on their
balance sheets, (c) how the banks can best deal with greater competition and manage the new
forms of risk, and (d) whether there should be deposit insurance reform such that there is
greater confidence in the banking system and yet reduction of moral hazard on the part of
stakeholders.
Privatization
There seems to be general agreement about the hypothesis that public sector banks (PSBs)
underperform vis a vis the domestic privately owned banks (PvSBs) and the foreign banks
(FBs). This view is usually based on analysis of the profitability of the banks, and the quality
of their balance sheets; public sector banks, on average, are less profitable and have larger
13
However, a generous voluntary retirement scheme (VRS) offered by the State Bank of India
and some other banks in the recent past was successful in the sense that more people opted for VRS
than was originally envisaged.
14
In harmony with the proposal to reduce operating cost and staff strength, the Varma
Committee proposed that the branch network of the weak banks be rationalised.
11
NPA to asset ratio than the domestic private banks and the foreign banks (see Figures 3
through 7).15 Interestingly, however, there has been only one systematic empirical study
attempting to test the aforementioned hypothesis. The econometric analysis of Sarkar, Sarkar
and Bhaumik (1998) reported that, as of 1994, the profitability of the private nontraded banks
and that of the public sector banks were not significantly different. Further, there was
practically no distinction between private domestic and public sector banks in terms of cost
efficiency.
The study is six years old and the data does not reflect the full impact of the process of
liberalization that was initiated in the aftermath of the formulation of the first Narasimham
Committee. However, even this limited study raises the possibility that profitability, and to an
extent cost efficiency, of banks is significantly determined by the extent of market discipline
to which the banks’ management are subjected. This proposition finds further support from a
casual comparison of the performances of the new domestic private sector banks (NPvSBs)
whose shares are publicly traded, old domestic private banks (OPvSBs) whose shares are
publicly traded, and old domestic private banks which are still closely held.16
Pragmatic policy making cannot divorce itself from the political economy, and an essential
part of pragmatism in the Indian context is that public sector banks are unlikely to be
privatized in the foreseeable future.17 It has sometimes been suggested that, as an intermediate
step, it would perhaps be prudent to corporatize all public sector banks that are not already
listed at stock exchanges, sell at least 26 percent (and perhaps a higher proportion) of the
banks’ equity to private investors, and list the banks at the Bombay and National stock
exchanges. However, in such an event, the government would continue to be the majority
shareholder and, therefore, the banks would remain open to political suasion while the
management remain steeped in moral hazard. Hence, while, in principle, the presence of other
stakeholders with a voice would increase the probity of the banks, and pave the way for some
15
As of March 31, 2000, the return on assets (ROA) for public sector banks was 0.15 percent
while that of old private sector banks, new private banks and foreign banks were 0.2 percent, 0.08
percent and 0.49 percent respectively. On the same day, the net NPA to asset ratio of public sector
banks stood at 2.9 percent, the ratio being 2.3 percent for domestic private banks and 1 percent for
foreign banks.
16
See Tables 1 and 2 in the Appendix. They control for ownership/majority stake, and highlights
the difference between the performance between listed and non-listed banks. The average ROA for the
closely held private banks should be taken into account after omitting Ganesh Bank which is clearly an
outlier. Similar, the ROA of public sector banks should be taken into account after omitting Indian
Bank and UCO Bank.
17
In any event, privatization of state owned banks may not be easy because an examination of a
bank’s book provides very imperfect information about the possibility of loans/assets turning bad in the
future. Hence, a private investor would insist on thorough due diligence that might make the process of
privatization very costly. Alternatively, he would insist on a steep discount over any valuation, thereby
making the process of privatization politically infeasible.
12
form of market discipline, however weak, the probability of offloading minority shares of
public sector banks to private investors remain low.
In other words, in order to effectively sell shares of public sector banks to minority
shareholders, the government would have to signal that it as the owner it encourages
maximization of profits and shareholder value. Hence, the first stage of the process of
restructuring has to involve an improvement in the quality of the banks’ balance sheets.18 This
process would have to involve a resolution of the banks’ problems with respect to NPAs, and
the introduction of measures and institutions that allow banks to take a reasonable amount
risk to augment their returns while providing options to manage and hedge against these risks
adequately.
Non Performing Assets
Perhaps the biggest concern of the weaker banks in India, most of which are state owned, is
that they have significant amounts of NPAs on their balance sheets. As of March 31, 2000,
the volume of net NPAs in the Indian banking system was Rs. 30,152 crore, of which the
“contribution” of the public sector banks was Rs. 26,188 crore. This problem was brought
into focus by the first Narasimham Committee, and has subsequently been addressed by the
second Narasimham Committee and the Varma Committee. The general consensus seems to
be that the NPAs of banks should be offloaded to ARCs. Such a move would take the NPAs
off the balance sheets of the banks, and thereby improve their profitability by way of lower
provisioning requirement. At the same time, it is expected, the ARCs would be able to
recover more bad loans (and perhaps at a faster pace) because they would be dedicated
towards loan recovery.
The use of ARCs has been an integral part of banking sector restructuring in a number of
countries (Hawkins and Turner, 1999). In many transition economies of eastern and central
Europe, banks saddled with large volumes of NPAs were split into “good” banks and “bad”
banks whereby the latter effectively functioned as ARCs.19 The good bank-bad bank policy
paradigm also saw the light of the day in Australia (State Bank of South Australia), Brazil
(Bamerindus, Bank of Rio de Janeiro), Finland (Savings Bank of Finland, STS Bank),
Sweden (Nordbanken, Gota Bank) and Thailand (Bangkok Bank of Commerce) among
others. In many other economies like those of the Japan, Malaysia and South Korea, bad loans
18
This would indeed be a tall order. The fact that the shares of public sector banks are being
traded below their issue price at the stock exchanges indicate that the private investors have little faith
in the ability of the government to turn the banks around with hard and politically difficult measures.
19
Of course, the extent of loan recovery in central and eastern European countries was minimal
and much of these bad loans eventually had to be written off.
13
of banks were passed onto ARCs. Typically, ARCs purchase the bad loans from the banks at
a discount after raising money with the help of government backed bonds.
But how easy is it for ARCs to recover bad loans from the defaulting borrowers? In the Indian
context, it has proved difficult to close down and foreclose the assets of a defaulting
company, especially if the company has a large number of employees. Notwithstanding the
reforms of the rigid laws governing labor and exit policy that have been drafted in the Budget
for the fiscal year 2001-02, the opposition to the reforms by trade unions and mainstream
political parties indicate that actual implementation of these reforms would be difficult at
best.
It is also difficult to envisage defaulter-ARC interaction on lines of a Chapter 11 bankruptcy
proceeding. In a Chapter 11 type proceeding, the management of the defaulting company is
not ousted,20 and the company is allowed to continue operations, but it has to come up with a
clear and convincing plan that indicates how the creditors would be compensated. In a sense,
therefore, till the loan is eventually repaid, the company is bound by a commitment the terms
of which can be set by the ARC (or the bank). In India, since major defaulters include public
sector companies and large private sector companies that are often controlled by families or
tightly knit groups of people, the primacy of the ARC may not be acceptable nor practicable.
For the same reason, it may be difficult for the ARCs to implement, on a case-by-case basis,
debt-equity swaps, and later sell this equity of the defaulting companies at market clearing
prices to those who may want to take over the defaulting companies.21
The only two options facing a ARC, therefore, are to recover loans by way of the debt
recovery tribunals, and to sell the bad loans off to asset management companies which would
be interested in investment in these de facto junk “bonds.” Despite the claims of success made
by the banks, thus far only a small fraction of the total volume of bad loans have been
recovered with the help of the tribunals. But in the absence of an effective exit policy and
foreclosure law, it would be difficult for ARCs to persuade private investors to buy the bad
loans, and hence the use of tribunals may be the only viable option.
20
In fact, the defaulting debtor may also get fresh loans but these loans enjoy seniority.
In Thailand, in a variation of this strategy, ownership of defaulting companies were handed
over to investors who did not want to make lump sum payments for the bad assets, but who entered
into profit-sharing agreements with the creditors.
21
14
Competition, Consolidation and Risk Taking
The Indian banking sector was introduced to competition when, in accordance with the
suggestions of the first Narasimham Committee, entry was deregulated and both domestic and
foreign banks were allowed to expand their branch networks. However, an early study by
Sarkar and Bhaumik (1998) indicated that the deregulation did not have a significant impact
on the extent of competition faced by the public sector banks, who controlled about 83.9
percent of the deposits in 1994.22 Since then, however, the share of deposits controlled by
these banks has declined to 79.3 percent, thereby indicating that the extent of competition
may have increased in the Indian banking industry. Much of the reduction of market share of
the public sector banks can be attributed to the emergence of the new domestic private sector
banks, who control about 5 percent of the deposits. In other words, there is prima facie
evidence that the Indian banking sector is becoming more competitive.
Economists have traditionally argued that competition is good because it improves the overall
efficiency of an industry by way of creative destruction. Stiroh (2000), for example, argued
that in the USA exit of weak banks and reallocation of the business of these banks among the
surviving stronger ones have significantly added to the efficiency of the country’s banking
sector. However, while the positive impact of competition on an industry’s efficiency cannot
be brought into question, competition may also precipitate major systemic crises. For
example, “price” competition among banks, as well as between banks and money market
mutual funds, in the USA during the early eighties, following the abandonment of Regulation
Q, led to asset-liability mismatch in many banks (Bhaumik, 1996).23 The consequence was an
increase in the exposure of the balance sheets of weak banks to real estate and junk bonds,
which precipitated the banking crisis in the USA during the late eighties.
In other words, if a bank fares poorly in the face of competition, there is a high probability
that it would take risks to either make up for poor net returns on traditional banking assets,
and/or to expand business to the point where it would be deemed too-big-to-fail. This would
be the consequence of the stylized agency problem that affects the relationship between
22
Since the ability of a bank to expand its business and increase its business depends on the
amount of deposits it controls, the share of deposits it controls is a fairly good proxy for the extent of
its market power, when market power of a firm itself is negatively related to the extent of competition
in the industry.
23
Banks had to compete for deposits with the money market mutual funds and hence once
Regulation Q was abolished banks increased their deposit rates. Hence the cost of funds of the banks
reflected the relatively high interest regime of the post oil shock period. At the same time, a significant
part of the banks’ assets were in the form of long term government bonds that had been issued during
the low inflation era prior to the OPEC induced oil shock. Hence, there was a severe mismatch of
returns on assets and liabilities.
15
managers and the other stakeholders of firms. Anecdotal evidence suggests that in India this
agency problem leads to the evergreening of de facto bad loans, largely because banks’
exposures to other assets are somewhat restricted. However, given the potential for adverse
selection in traditional banking activities, and given the low rates of return on loans made to
blue chip companies,24 banks are increasingly turning to high risk-high return lines of
business like credit card business and consumer lending, as well as fee-based off-balancesheet activities. While the downside potential of such businesses is as yet unknown, the
payments crisis at the Calcutta Stock Exchange highlighted the fact that the banks remain
vulnerable to negative shocks on account of their off-balance sheet exposures.25 The
experience of banks in developed financial markets suggests that this problem is likely to be
exacerbated as the banks increase their exposure to complex financial products like
derivatives (Peek and Rosengren, 1996).26
Exposure of banks to equities and real estate is reflected in their balance sheets and hence it
can easily be monitored. However, by their very nature the downside risk of off-balance-sheet
activities cannot be assessed until after they have a negative impact on the viability of banks.
Indeed the only way to estimate the exposure of banks to such risks is to effect continual onsite monitoring which can be prohibitively expensive. Hence, the need of the hour is to
provide options such that banks are able to cope with competition without imperiling the
health of the banking system.
For example, it has been shown that in India the ability of a bank to profitably involve itself in
banking activities significantly depends on the geographical distribution of its branches, and
banks located in weaker economic regions are inherently at a disadvantage vis a vis the other
banks (Rajaraman, Bhaumik and Bhatia, 1998). Hence, if weak banks in the economically
backward regions are asked to improve their profitability, and they are unable to do so by way
of traditional banking activities, they may have to expose themselves to high risk-high return
activities. At the same time, if the weakness of these banks stems also from relatively lower
24
Since it is risky to lend to non-blue chip companies, and given that addition of appropriate risk
premia to the PLR might result in averse selection, banks in India have often preferred to lend through
the commercial paper route than through traditional banking channels. Evidence abound that blue chip
companies with good credit ratings are able to raise money with commercial papers at yields that are
100 basis points or more lower than the PLR.
25
Brokers at the Calcutta Stock Exchange had provided bank guarantees against their equity
market exposures. In the aftermath of a rapid fall in the equity prices during March 2001, the brokers
were unable to meet their commitments and hence the stock exchange was forced to invoke the bank
guarantees.
26
As of now, Indian banks are required to match swaps and options back-to-back in the foreign
exchange market. The internal market for interest rate swaps is in its infancy, and equity options have
not yet been introduced. However, with further liberalization of the Indian financial sector, the banks
16
capability to assess and manage risks, the downside potential of the high risk-high return
activities could be significant. However, this impasse can be resolved by allowing banks to
trade loans among themselves (Demsetz, 1999); banks in more prosperous regions can make
“good” loans in excess of the capacity defined by their deposit base, and then bridge the gap
by selling the loans off to banks in the weaker regions who would have the money but few
“good” debtors.27
The geographical segmentation of the Indian loan market leads to one other important issue.
A strategy to cope with competition that has come into vogue in the banking industry
worldwide is mergers. Earlier, mergers among banking institutions were often limited to
smaller banks who merged to attain better economies of scale and to gain access to remote
markets. The rationale behind the more recent phenomenon of mergers among large banks too
goes beyond the logic of economies of scale28 and increased market power, and can be
associated with strategies aimed at gaining market access (especially in the context of crossborder merges) and strategies pertaining to repositioning of banks in their native markets
(ECB, 2000).29 While the evidence about the impact of mergers on profitability and efficiency
gains is mixed at best, it has been argued that gains accruing to the post-merger entity have
been underestimated in the economics literature, and that such gains can actually be
substantial (Kwan and Wilcox, 1999). Further, studies have concluded that while gains in
terms of cost efficiency is minimal subsequent to banks’ mergers, there can be significant
gains in profit efficiency on account of greater diversification of risks.
In India, mergers among banks is no longer a new phenomenon. But most of the mergers have
involved relatively small banks like ICICI Bank and UTI Bank for whom merger is a
convenient way to enjoy economies of scale and enhance distribution networks.30 However,
may be allowed to run options books and enter into other contingent claims contracts that would
increase their risk exposure significantly.
27
Note that the informational asymmetry between the banks in the prosperous and the weaker
regions, sellers and buyers respectively, would be significant. However, since the seller bank would
have to interact repeatedly with the buyer bank and other banks, it can be assumed that signalling
issues related to reputation would prevent the seller bank from systematically making and passing on
“bad” loans to the buyer bank.
28
Indeed, there is some degree of agreement among economists that mergers do not contribute
to scale economies, and that, in fact, there can even be scale efficiency losses in the aftermath of
mergers (Berger, Demsetz and Strahan, 1998).
29
Indeed, mergers among banks might reduce the number of banks within a country, but the
extent of competition is ever increasing. Technology has allowed banks to reach out “virtually” into
geographical areas where they have no physical presence. At the same time, non-bank financial
organisations like money market mutual funds are offering bank-type services like check writing
facilities. Hence, it is by no means certain that merger would augment the market power of two or more
banks.
30
Earlier attempts at merger involve merger of “good” and “bad” banks at the behest of the
government and the RBI. However, such mergers often do not work, and affect the viability of the
17
since many of the weak banks are in the public sector, merger is not always a viable option to
simulate creative destruction in the Indian context, and merger among the public sector banks
would be a farce in the absence of post-merger cost cutting measures that would certainly
involve large scale labor retrenchment. In sum, the use of mergers as a strategy to cope with
competition is somewhat limited in the Indian context, corporatization and privatization of all
the public sector banks have to precede mergers if its strategic potential is to be fully
realized.
Deposit Insurance
Deposit insurance has long been endorsed by economists as an important pillar of a robust
banking sector. It can help prevent bank runs (Diamond and Dybvig, 1984), and can also
make banking sector restructuring acceptable to deposit holders, thereby giving the regulators
the political support that is a necessary precondition for any successful reform process
(Hawkins and Turner, 1999). At the same time, the existence of deposit insurance schemes is
usually cited as the major source of moral hazard. Specifically, the deposit holders, who are
creditors to the banks, are less likely to monitor the activities of the management and the
equity holders if they believe or know that their deposits are insured. Hence, regulators have
to trade off the ability of deposit insurance schemes to prevent bank runs against its ability to
foster moral hazard. This problem came into focus sharply in the aftermath of the banking
crisis in the USA during the eighties. However, it has not emerged as a major policy issue in
the Indian context.
In India, an overwhelming proportion of the deposits lies with the public sector banks. Hence,
although India has in place an explicit deposit insurance system by way of which all
depositors are insured up to Rs. 100,000, the general view is that this cap on deposit insurance
is not credible. This view has found support from the government’s decision to infuse capital
into weak public sector banks at regular intervals, despite policy announcements to the
contrary. But the decision of the government to gradually make the returns on investments in
the flagship US-64 scheme of the Unit Trust of India (UTI) market related,31 as well the
recent thrust in the direction of structural reforms indicate that the fiscal crunch might make
the government and the RBI try to reduce the potential fiscal impact of bank failures and
good bank rather than enhancing the (joint!) profitability of the merged entity. A case in point is the
merger of Punjab National Bank with New Bank of India.
31
In 1998, the returns on the investments of UTI declined because of a decline in equity prices.
However, UTI had made a pre-commitment to pay its investors a reasonably high return on their US-64
investments, and the promised return was clearly not in harmony with the returns accruing to UTI. The
mutual fund honoured it commitments, but it was pressurized by the government to agree to link the
subsequent returns of their schemes to market returns.
18
closures to a minimum.32 In other words, the importance of an explicit and credible deposit
insurance scheme is on the rise. The importance of such a scheme has gained further
importance because the share of deposits controlled by domestic private sector banks and
foreign banks are on the rise and, as of March 31, 2000, these banks control 17.5 percent of
the deposits.
First of all, it should be understood that the clear theoretical case for moral hazard and its
potential impact on risk taking behavior of the banks notwithstanding, there is no strong
evidence to support the proposition that in the presence of a deposit insurance scheme a bank
would be more inclined to take risk (Gropp and Vesala, 2001). Indeed, any impact of deposit
insurance on risk taking behavior of banks can be counteracted by a bank’s desire to protect
its charter value, and by the presence of a significantly large number of creditors who are not
covered by deposit insurance.33 Hence, there can be no doubt about the fact that that the
deposit insurance scheme is a necessary component of a stable banking system. Indeed,
speculation, if any, should be about the nature of the deposit insurance scheme, and not as to
whether or not a banking system should include such a scheme.
Ideally, a deposit insurance scheme should attempt to prevent bank runs and, at the same
time, increase the willingness of the depositors to monitor the banks’ activities and
performance. Further, since the multitude of small deposit holders are unlikely to be able to
monitor banks effectively, the scheme should incorporate features that would encourage the
banks to be prudent in the context of risk taking. The experience of the banking industry in
the USA indicated that banks can be induced to be prudent about risk taking if the premia for
the deposit insurance are risk related, i.e., if it is not a flat amount.34 Further, the regulators
may lay down norms which the banks have to satisfy in order to be a part of the deposit
insurance system, the threat being that loss of insurance coverage would make it impossible
for a bank to raise deposits and carry on or expand its business.35 The depositors can be
induced to monitor the performance of the banks by restricting one claim per depositor
32
A RBI committee set up for evaluating and proposing changes to India’s deposit insurance
system suggested that the paid up capital for each of the deposit insurance funds, one for the
commercial and another for the cooperative banks, should be Rs. 500 crore. However, the aggregate
amount of savings deposits with scheduled commercial banks stood at Rs. 199,120 crore on March 31,
2000, and hence it is not obvious as to whether a Rs. 500 crore corpus would be enough to instil
confidence among depositors without invoking visions of implicit government guarantee.
33
An example of assets – from the creditors’ viewpoint – typically not covered by a deposit
insurance scheme is subordinated debt.
34
The optimal premium for any level of risk can be estimated using the methodology proposed
by Ronn and Varma (1986) which treats deposit insurance as a put option. The RBI committee
proposed that the banks be charged premia in accordance with the riskiness of their asset portfolios, as
indicated by their CAMEL ratings.
19
irrespective of the number of accounts held by him,36 making the deposits coinsured,37 and
paying out the insured amount in installments, thereby increasing the time cost of the
depositors.
The problem in the Indian context is that much of the aforementioned incentive related
strategies would not work for the public sector banks, may of whom are weak, simply because
the ownership of these banks would decrease the credibility of these strategies. For example,
so long as depositors believe that the government would rather violate any cap on the amount
of insurance than face a political backlash, they would not monitor the banks’ performance
effectively. The threat of elimination of insurance coverage for weak or imprudent banks too
would not be credible if they are owned by the government. In other words, as observed
implicitly in several other contexts, while privatization may not be a panacea for the Indian
banking industry, it may well be a necessary step towards improved efficiency and greater
viability. However, since it is unlikely to happen in the foreseeable future, a discussion about
privatization of public sector banks in India is moot.
Looking Ahead
The classical definition of banks suggests that they are intermediaries between savers and
investors. Subsequent developments in the economics literature explicitly took note of the fact
that banks are not merely intermediaries, rather they are institutions which manage risks on
behalf of the risk averse depositors. However, the view was that a bank manages risks by
diversifying its loan portfolio among competing projects with varying degrees of risk. In the
current scenario, the banks are consistently pushing the frontiers of risk management.
Compulsions arising out of increasing competition, as well as agency among between
management, owners and other stakeholders, are inducing the banks to look for avenues to
increase revenues. One manifestation of this is the increasing importance of fee-based
activities, and off-balance-sheet activities in a bank’s “life.”
More recently, as legislation like the Glass-Steagall Act have come under attack from
economists and banking sector professionals, banks are being exposed to activities that have
traditionally been outside the bounds of banking per se. Banks have emerged as fund
35
The RBI committee proposed that a bank’s deposits should not be covered unless it has a
minimum CAMEL rating of C, and it satisfies capital adequacy requirements as laid down by the RBI.
36
The RBI committee felt that the Indian deposit insurance system should continue to provide
coverage per deposit and not per depositor. However, it argued that certificates of deposits issued by
the banks, and deposits that were essentially cash collateral against bank loans should not be covered
by deposit insurance.
20
managers, brokers, underwriters of securities, and channels of distribution for insurance
products. In other words, universal banking, once a controversial organization, despite its
successful existence in countries like Germany and Switzerland, is increasingly becoming
acceptable and mainstream.38 The Indian banking industry too is catching up with this
international trend. Banks now routinely offer brokerage facilities to the depositors. The
recent tie-up between Standard Chartered Bank and Royal Sundaram insurance company,
whereby the former would act as a conduit for marketing the latter’s products, too is a step
towards the formation of universal banks. Futher, “development” financial institutions (DFIs)
like ICICI and IDBI now own significant amount of shares in commercial banks like ICICI
Bank and Federal Bank, and NBFCs like HDFC, thereby bringing closer together commercial
banks and financial institutions the nature of whose assets and liabilities are significantly
different from those of commercial banks.
The evidence about the scope efficiency of universal banks is fairly mixed (Berger, 2000).
There is agreement about the fact that universal banks can achieve revenue efficiency gains
through cross-selling and integration of the distribution channels of different types of
financial products. They can also gain through greater diversification of their risks which, in
turn, increases their ability to make high risk-high return investments, and increases the
credibility of the guarantees which they provide on behalf of customers against payment of
fees. However, scope inefficiencies can surface in the form of incompatibility among the
personnel associated with different divisions of the banks. Further, an universal bank might
face credibility problems if it is believed that it underprices its weaker products and makes up
for the revenue shortfall by overpricing the stronger products.39
However, while the expansion of scope through adoption of universal banking may be a
double edged sword for a bank, there is little evidence to suggest that amalgamation of
traditional banking products with insurance products, brokerage services etc. would increase
the riskiness of a bank’s portfolio. Indeed, Laderman (2000) argued that significant exposure
to underwriting of life insurance and casualty insurance products, and securities brokerage
37
The committee also suggested that deposits up to Rs. 90,000 should be insured completely,
but that any amount in excess of Rs. 90,000, and less than the cap of Rs. 100,000, should be insured to
the extent of 90 percent.
38
The regulators in the USA, for example, continue to distinguish between a commercial and an
investment bank. But it allows bank holding companies to own financial institutions of various types,
thereby allowing de facto existence of a weak form of universal banking.
39
In general, there can be conflict of interest arising out of the different functions of an universal
bank (RBI, undated). For example, in order to ensure that the investment banking division of the bank
does not suffer underwriting losses, and thereby loss of reputation, an universal bank may be tempted
to use part of its deposit base to prop up the prices of the pre-existing securities of a firm whose new
21
reduce the probability of bankruptcy among bank holding companies.40 In other words, so
long as a bank is able to reap economies of scope through appropriate organizational
structure, there is no compelling reason to stop the formation of universal banks through fiat
and regulation.
If the majority equity stake of the public sector banks, which account for 81.9 percent of the
Indian banking industry in terms of deposit base, remain in the hands of the government, the
industry is unlikely to witness consolidation and evolution in the form of strategic mergers.
Any merger among public sector banks is likely to be in the form of good bank-bad bank
merger which is typically not a harbinger of improved efficiency. The process of evolution,
therefore, is likely to involve emergence of universal banks. In recognition of this possibility,
the second Narasimham Committee and the Khan Committee, set up by the RBI, proposed
that the DFIs and commercial banks be allowed to tread into each other’s “territory.”
Specifically, the view was that banks should be allowed to make term loans, and the DFIs
should be allowed access to short term funds by way of deposit mobilization and access to the
money market.41 Further, the Khan Committee’s report suggests that the DFIs should be
allowed to convert themselves into banks or NBFCs over a period of time.
Thus far, the emphasis has been on the abolition of the distinction between DFIs and
banks/NBFCs on the basis of the maturity structure of their assets and liabilities. However,
an universal bank is not merely one which has both short and long term assets and liabilities
on their balance sheets. It is also one which is simultaneously engaged in many lines of
businesses ranging from traditional banking to investment banking and underwriting and
marketing of insurance products. The view of the RBI about this stage of evolution of
universal banking in India is as yet not apparent, even though the apex bank and the Insurance
Regulatory and Development Authority (IRDA) have allowed State Bank of India and Vysya
Bank to own, in part, insurance companies. What is certain is that if the Indian banking sector
does cross this threshold, there would be a significant increase in the complexity of the
products associated with the banking sector. In other words, a post-evolution (universal) bank
security the bank is underwriting. This would expose the depositors of the banks to risk for which they
may not receive the appropriate risk premium.
40
Laderman’s empirical analysis involving all possible combinations of bank holding companies
and nonbank financial companies in the USA indicated that the standard deviation of a bank holding
company’s return on assets declined with such exposure.
41
Note that if banks are allowed to make term loans, they would not face asset-liability
mismatch problem because they already have long term liabilities like term deposits on their balance
sheets. Indeed, if banks are allowed to make long terms loans, as in the current regime, it would
provide them with an alternative to holding illiquid long term government bonds to effect asset-liability
mismatch. However, if DFIs are allowed to tap short term funds, they would also have to be allowed to
22
would have to put into place an efficient risk management system that can not only predict
future movements in fundamental economic and financial variables like interest rates, but can
also understand and appreciate the correlation among the prices of various assets.42
If the banks are subjected to increasing competitive pressure, they are likely to adapt
themselves to the situation, and move up the learning curve, however steep. But agency
problems will prevail, and government ownership might aggravate moral hazard problems
among the public sector banks. Hence, the health of the system would ultimately depend on
the ability of the regulating agency, the RBI or an independent regulatory agency on lines of
the FSA, to monitor the banks effectively and to proactively mitigate problems with the
banks’ portfolios. Strengthening of the regulatory set up, such that it is capable of preventing
catastrophes without inhibiting the evolution of banking practices and products in response to
competition, is the main challenge facing the Indian banking sector in the foreseeable future.
make short term loans and own other short term assets so that they are able to avoid the aforementioned
mismatch.
42
The Khan Committee’s report recognized the importance of risk management in a complex
financial organization, and emphasized the need to mandate extensive in-house risk management
capabilities for the post-evolution DFIs.
23
References
Berger, A. N., “The integration of the financial services industry: Where are the efficiencies?”
Board of Governors of the Federal Reserve System: Finance and Economics occasional
paper no. 2000-36, 2000.
Berger, A. N., R. S. Demsetz and P. E. Strahan, “The consolidation of the financial services
industry: Causes, consequences, and implications for the future,” Board of Governors of the
Federal Reserve System: Finance and Economics occasional paper no. 1998-46, 1998.
Bhaumik, S. K., “Liberalization vs regulation: Some lessons for financial restructuring,”
Journal of Transforming Economies and Societies, 3(2): 2-14, 1996.
Demsetz, R. S., “Bank loan sales: A new look at the motivations for secondary market
activity,” Federal Reserve Bank of New York: Staff Report no. 69, 1999.
Diamond, D. W. and R. H. Dybvig, “Bank runs, deposit insurance and liquidity,” Journal of
Political Economy, 91: 401-419, 1983.
European Central Bank, Mergers and acquisitions involving the EU banking industry: Facts
and implications, 2000.
Ghosh, D. N., “Banking: lessons from Indian experience,” SBI Monthly Review, 28: 531-543,
1988
Gropp, R. and J. Vesala, “Deposit insurance and moral hazard: Does the counterfactual
matter?” European Central Bank working paper no. 47, 2001.
Hawkins, J. and P. Turner, “Bank restructuring in practice: An overview,” Bank for
International Settlements: Policy Paper no. 6, 1999.
Kwan, S. H. and J. A. Wilcox, “Hidden cost reductions in bank mergers: Accounting for more
productive banks,” Federal Reserve Bank of San Francisco: Working Paper no. 99-10, 1999.
Laderman, E. S., “The potential diversification and failure reduction of bank expansion into
nonbanking activities,” Federal Reserve Bank of San Francisco: Working Paper no. 2000-01,
2000.
24
Peek, J. and E. S. Rosengren, “Derivatives activity at troubled banks,” Federal Reserve Bank
of Boston: Working Paper no. 96-3, 1996.
Rajaraman, I., S. K. Bhaumik and N. Bhatia, “NPA variations across Indian commercial
banks: Some findings,” Economic and Political Weekly, XXXIV(3-4), 1999.
Reserve Bank of India, Report of the working group on reforms in deposit insurance in India,
1999a.
______, Report of the working group on restructuring of weak public sector banks, 1999b.
______, Harmonising the role and effects of development financial institutions and banks,
1999c.
_______, Report of the Narasimham Committee on Banking Sector Reforms, 1998
______, Report of the Narasimham Committee on financial system, 1991.
______, Trends and progress in banking in India, several issues.
Ronn, E. and K. A. Varma, “Pricing risk-adjusted deposit insurance: An options based
model,” Journal of Finance, 41: 871-895, 1986.
Sarkar, J. and P. Agarwal, “Banking: The Challenges of Deregulation,” (in) K. Parikh (ed.)
India Development Report, Oxford University Press, 1997
Sarkar, J., S. Sarkar and S. K. Bhaumik, “Does ownership always matter? Evidence from the
Indian banking industry?” Journal of Comparative Economics, 26: 262-281, 1998.
Sarkar, J. and S. K. Bhaumik, “Deregulation and the limits to banking market competition:
Some insights from India,” International Journal of Development Banking, 16(2): 29-42,
1998.
Stiroh, K. J., “Compositional dynamics and the performance of the US banking industry,”
Federal Reserve Bank of New York: Staff Report no. 98, 2000.
25
APPENDIX
Table 1
26
Table 2
27
Percentage listed at stock exchanges
120.0
Percent
100.0
80.0
60.0
40.0
20.0
0.0
1994-95
1995-96
1996-97
1997-98
Financial year
PSB
OPvSB
Figure 1
28
NPvSB
1998-99
1999-00
85.0
84.0
83.0
82.0
81.0
10.0
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
80.0
79.0
78.0
77.0
76.0
Percent
Percent
Share of deposit base
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00
Financial year
OPvSB
NPvSB
FB
NBFC (% of bank deposits)
Figure 2
Note: The share of deposits of PSBs is being measured on the secondary axis.
29
PSB
Percent
Return on total assets
0.60
0.50
0.40
0.30
0.20
0.10
0.00
-0.10
-0.20
-0.30
-0.40
1993-94
1994-95 1995-96
1996-97
1997-98 1998-99
Financial year
PSB
OPvSB
Figure 3
30
NPvSB
FB
1999-00
Figure 4
Percent
Net interest margin as percent of total assets
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
Financial year
PSB
OPvSB
31
NPvSB
FB
1999-00
Figure 5
Operating cost as percent of total assets
4.00
3.50
Percent
3.00
2.50
2.00
1.50
1.00
0.50
0.00
1993-94
1994-95 1995-96
1996-97
1997-98 1998-99
Financial year
PSB
OPvSB
32
NPvSB
FB
1999-00
Figure 6
Intermediation cost as percent of total assets
4
3.5
Percent
3
2.5
2
1.5
1
0.5
0
1991-92
1996-97
1997-98
1998-99
Financial year
PSB
PvSB
33
FB
1999-00
Figure 7
3000
30000
2500
25000
2000
20000
1500
15000
1000
10000
500
5000
0
0
1994-95 1995-96 1996-97 1997-98 1998-99 1999-00
Financial year
OPvSB
NPvSB
FB
NBFC
PSB
Note: The volume of NPAs of PSBs is being measured on the secondary axis.
34
Rupee crore
Rupee crore
Net non-performing assets
Figure 8
Non performing assets of public sector banks
Number of banks
30
25
20
15
10
5
0
1994
1998
1999
Financial year
MT20
Note:
MT20 :
10-TO-20 :
LT10 :
10-TO-20
more than 20 percent
10 – 20 percent
less than 10 percent
35
LT10
2000