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Rewriting the Rules for India's Banks

Rewriting the Rules for India's Banks

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Against the backdrop of India's 9% GDP growth and aspirations to become the world's third-largest economy, its banking industry represents an anachronism of sorts. India's public sector banks, which control more than 76% of nearly $700 billion in assets (as of the end of 2006), are shackled by excessive state regulation and protection, according to University of Chicago finance professor Raghuram Rajan, who served as chief economist of the International Monetary Fund.
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Against the backdrop of India's 9% GDP growth and aspirations to become the world's third-largest economy, its banking industry represents an anachronism of sorts. India's public sector banks, which control more than 76% of nearly $700 billion in assets (as of the end of 2006), are shackled by excessive state regulation and protection, according to University of Chicago finance professor Raghuram Rajan, who served as chief economist of the International Monetary Fund.
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Raghuram Rajan on Rewriting the Rules for India's
Banks
Published: November 15, 2007 in India Knowledge@Wharton

Against the backdrop of India's 9% GDP growth and aspirations to
become the world's third-largest economy, its banking industry
represents an anachronism of sorts. India's public sector banks,
which control more than 76% of nearly $700 billion in assets (as of
the end of 2006), are shackled by excessive state regulation and
protection, according to University of Chicago finance professor
Raghuram Rajan, who served as chief economist of the International
Monetary Fund from 2003 to 2007.

Rajan has been tapped by India's Planning Commission to
recommend reforms in the country's banking sector, due to be
finalized next March. A graduate of both the Indian Institute of
Technology and the Indian Institute of Management, Rajan received
his PhD from the Massachusetts Institute of Technology. Last week,
he spoke on "Reforming the Indian Banking System: Why It Is
Important and What Can Be Done" at the University of

Pennsylvania's Center for the Advanced Study of India, as part of its Nand and Jeet Khemka
Distinguished Lecture Series.
'Three Tensions'

Rajan said he sees the challenges facing India's banking industry against the backdrop of three forces, or
"tensions," in its socio-economic setting. The first tension is between the "haves" and the "have-nots."
This is not so much an urban-rural divide, he noted, but one that plays out as high income vs. low
income; well managed states vs. poorly managed states; good institutions vs. bad institutions; and upper
castes vs. lower castes. "There are lots of cleavages which reflect this [tension], but fundamentally it's an
economic divide," he said.

The second tension "is between the private sector and the public sector, or between the markets and the
state," Rajan continued. He pointed out that a common reading of this "clash" is that it represents the
rich-poor divide, where the markets are seen as favoring the rich and the state as fighting on behalf of
the poor. "This is where the wires get crossed in India," he said. "It is not necessarily [true] that currently
or going forward, the state is doing the right thing by the poor. In fact, what is happening is the state is
treating the poor miserably."

Rajan said the third clash is one "between the foreign and the domestic sectors," and that this is
compounded by the first two tensions. "These three tensions are all intertwined in the example of the
banking sector," he said.

To help India's public sector banks improve their financial health and promote growth and investment
without having to constantly look over their shoulder at the government, the rules need to be rewritten,
Rajan said. "If we don't do the right things, it is quite possible that the state will be hijacked by the
oligarchy and India will become a very different country from the [one] we know now. That is a danger.
I'm not sa

y
in
g
it is about to ha
p p
en or it's on the cards, but it is a
p
ossibilit
y
we have to kee
p
track of."
All materials copyright of the Wharton School of the University of Pennsylvania.
Page 1 of 4
Raghuram Rajan on Rewriting the Rules for India's Banks: India Knowledge@Wharton (http://www.ikw.in/)
A Dismal Record

Pointing to the track record of India's public sector banks (28 in all), Rajan argued that state control has
failed to meet the policy goals of providing credit access to the poor and the underserved sections of
society. Further, those goals have been thwarted by corruption, political meddling and largesse through
loan waivers, he noted, adding that the prevailing environment has also impeded technological progress
at India's public sector banks, and proven a drag on their debt recovery and eventually their financial
performance.

According to Rajan, the Indian central bank -- the Reserve Bank of India -- is also unhelpful, with its
directed lending policies and reserve requirements that favor banks' investments in government bonds or
state-approved securities. Currently, Indian banks are required to set aside 40% of their net credit at
below-market rates for the so-called "priority sectors," including the agricultural sector, small-scale
industries, retail trade and housing. Foreign banks have a lower requirement of 32% of net credit. "We
are now in a phase where we are protecting the public sector and that is impeding reforms," he said.

Cash and statutory liquidity reserve requirements for Indian banks take away another 32.5% of their
disposable credit, leaving limited elbow room for banks to improve profitability. Banks have little
incentive to stay financially healthy because of an unstated understanding that the government will bail
them out with capital infusions if ever they face the threat of collapse, Rajan said. He added that
compensation caps have hurt the ability of banks to attract professional managerial talent, and the
targeting of bank officers in cases of failed loans has instilled a deep-rooted culture of risk aversion.

"Everything started with bank nationalization in 1969," which included 14 large private banks, said
Rajan. A second round followed in 1979-80. The 1969 nationalization program had the stated rationale
that India, then a planned economy, was obligated to direct credit to the needy and underserved, and that
private banks preferred to serve private sector enterprises. Rajan pointed to another, unstated factor:
Indira Gandhi, then the country's prime minister, was "fighting the old guard in the Congress and trying
to establish her own unique brand, and this was her populist phase." Gandhi rode a campaign platform of
"Garibi Hatao (Banish Poverty)" to a landslide win in the 1971 national elections.

The newly nationalized banks were compelled to expand their branch network in rural areas; they were
required to open four rural branches for every urban branch license. In the first couple of years after
nationalization, rural India witnessed a dramatic jump in new branch openings and an explosion of credit
availability.

But the policy seemed not to make commercial sense for the banks, Rajan said: They sharply cut back
their rural expansion after the statute which mandated it was repealed a decade later. "The charitable
view of that was that there were enough rural branches; the uncharitable view is that they were no longer
forced by the government [to open rural branches]," he said.

While the rural binge did expand credit access, did it really achieve policy goals? Rajan said there exists "some evidence of poverty alleviation." But, he added, "if you throw money at anything, you are going to alleviate poverty a little bit." On the other hand, he said there is "very little evidence" that all the additional rural credit helped agricultural investment or growth to any meaningful degree -- the most likely reasons being that much of the bank credit was "misallocated" or not accompanied by sufficient public investment, leading to "a lot of wastage."

Bank lending programs were also hijacked by politicians in the post-nationalization years, said Rajan. "There was significant expansion of loans from banks around election times, especially in the marginal constituencies where the ruling party had some chance of losing the elections," he adds.

Price Tags on Loans
Rajan also faults the government for its successive rounds of the "uniquely Indian invention" of loan
melas (loan fairs). He said politicians summoned bank executives to these "loan fairs," where they were

told to whom they should lend. "This was without any credit evaluation and purely on the politician's word," he said. "Obviously, [the politician's] friends and relatives got the credit, and obviously they didn't bother to repay [the loans]."

All materials copyright of the Wharton School of the University of Pennsylvania.
Page 2 of 4
Raghuram Rajan on Rewriting the Rules for India's Banks: India Knowledge@Wharton (http://www.ikw.in/)

"The problem is, rural India needs credit," said Rajan. "With the attraction of a highly subsidized rate, do
people with the best credit get the loan? The guy who has bribed the most gets the loan." He cited
household surveys where respondents reported paying bribes of up to 43% of their loan amounts to
secure their loans. He said the beneficiary has no intention of paying back the loan, "because that is the
only way he can justify the bribe."

Rajan cited other studies that show the average time to get a loan from public sector banks is 33 weeks, and that banks don't necessarily step forward with credit in times of rural distress. He said private sector banks have extended more agricultural credit than their public sector counterparts in times of drought and in good times, whereas public sector banks tended to focus on "consumption credit," or non-emergency financing. "The theory of nationalization would have it that in times of drought, the public sector banks would do far more in making loans; that's not happening in terms of social insurance," he said.

Advent of Reforms

With the economic liberalization and reforms of the 1990s came "two extremely far-sighted reports,"
said Rajan, referring to bank sector reforms suggested by a committee headed by M. Narasimham, a
former governor of the Reserve Bank of India. "Essentially, they laid out steps the government could
take: lift interest rate controls; reduce the amount the government absorbs from the banking sector;
de-politicize lending; professionalize bank managements; don't force them to open branches in areas
where they don't want to go; get competition by allowing new private banks to be opened; allow foreign
banks to come in and expand," he said.

According to Rajan, one of the key Narasimham committee recommendations the government did not act
upon was to reduce the level of state ownership in banks. He gave an example of how state ownership
typically interferes with prudent management at a public sector bank: "If the market is having a really,
really bad day, you may get a call from the government to put [in] some money and prop it up." Such
interference, along with the loanmelas and waivers end up saddling public sector banks with low asset
quality portfolios, he said.

In the 1990s, reforms and modernization worked well in another sector -- the stock markets, simply
because "neither the government nor politicians had any stake in the [incumbent] Bombay Stock
Exchange," which was eventually overtaken by the more modern and technologically advanced National
Stock Exchange of India.

Rajan explained why the success with stock market reforms did not occur with the banks: "The upper
middle class and the rich had migrated away from the nationalized banking system towards foreign
banks and the private banks, so the two important constituencies to push for reforms had been taken out
of the equation. The nationalized banks are serving more and more clientele that don't have as much of
an economic voice."

However, the Narasimham committee reforms did yield gains on several fronts, said Rajan. Banks
brought down their non-performing assets, shortened debt recovery periods and used that to expand
credit availability for growth. Further, the industry saw increased competition with the entry of private
banks and newer foreign banks, money market mutual funds and insurance companies, alongside a
booming stock market.

Among the priorities Rajan sees for India's public sector banks is a removal of the unspoken government guarantee of a bailout if any of them faces the threat of bankruptcy. "Bank capital means that if you grow a hole in your balance sheet, you get cut off and you go down the tube or somebody takes you over," he said. "If the government is going to come in and recapitalize you at that point, what does it mean?" He also would like directed lending to be done "at the minimum level," and earmarked for "areas that have social benefits."

Finally, Rajan dismisses the often-repeated contention that Indian banks must be doing something right because the country has so far not faced a single major financial crisis. "The RBI beat its drums and said we had no crises," he said. "I wouldn't focus too much on the lack of crises. There is always a risk-return tradeoff." He recalls that Korea, at one time, had the same per capita GDP as India's, but today it is 16 times as big. "I would settle for a few crises on the way to grow to that level of per capita GDP," he said.

All materials copyright of the Wharton School of the University of Pennsylvania.
Page 3 of 4
Raghuram Rajan on Rewriting the Rules for India's Banks: India Knowledge@Wharton (http://www.ikw.in/)

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