1

INDIAN INSTITUTE OF SOCIAL WELFARE AND BUSINESS MANAGEMENT DISSERTATION ON AN ECONOMETRIC MODEL OF BANKING IN INDIA --AN ANALYSIS OF THE FACTORS THAT INFLUENECE THE TOTAL CREDIT FLOW

BY
SAMPRIKTA DE MBA (DAY), 2ND YEAR SESSION- 2009-11 MAJOR: FINANCE MINOR: MARKETING ROLL NO: 107/MBA/100034 REGISTRATION NO: 003218 OF 2003-04

ACKNOWLEDGEMENT
I am indebted to my institute, Indian Institute of Social Welfare and Business Management, Kolkata, for giving me an opportunity to work on this dissertation through which I have learnt to apply my limited knowledge in areas of finance and economics; imparted to me by my learned professors here. I owe a very significant debt to my respected professor, Dr. K. K. Roy, HoD, MBA Department, IISWBM . Without his valuable guidance and suggestions at every step of my inexperienced endeavour, it would have been difficult for me to complete this dissertation. His encouragement and suggestions have helped me to go forth with my work. The library staffs at IISWBM deserve a special mention for providing me with the required infrastructure and reading materials as and when required. My friends, who provided valuable inputs while I was working on this dissertation, must not be forgotten. Miss Pritha Banerjee and Mr. Shovon Sengupta have always been a commendable source of academic information and mental support. For them, a thank you is not enough. My classmate at IISWBM, Mr. Sabyasachi Barma also helped me immensely while completing this work. Last but not the least, I wish to acknowledge my wonderful familymy father, my mother and my sister & my grandmother for their support and encouragement, & especially my grandfather, who is no longer with us. His wishes and blessings will always remain as a source of strength and inspiration.

Signature: Date:

ABSTRACT

Since 1951, the country has had a series of Five Year Plans whose objective has been to promote a balanced pattern of investment in the economy. The ability of the financial system in its present structure to make available investible resources to the potential investors in the forms and tenors that will be required by them in the coming years, that is, as equity, long term debt and medium and short-term debt would be critical to the achievement of plan objectives. Commercial banks for long have been one of the most important financial intermediaries which help to transfer resources from the savers to the borrowers for productive purposes. In what follows, a detailed study has been undertaken on the factors that influence the total credit flow to the various sectors in the economy in any given period. As a point of reference, Econometric Model of Banking in India (Khusro A.M .& Siddharthan N.S. , 1996) was used. The first section introduces the issue, whereas the second section discusses the econometric methods used and the nature of the data. The third section deals with the empirical testing of the model and the fourth section discusses the further improvements that may be included in the model to get a better idea in the current economic and financial scenario. The fifth section contains the concluding remarks that are based on the findings of the regression analysis and a word on the future landscape of Indian Banking.

INTRODUCTION
The Indian financial industry underwent rapid transformation post liberalization in the early 90s, resulting in greater inflow of investments from FII's into the capital market. Despite the foray of foreign banks in the country, nationalized banks continue to be the biggest lenders in the country, primarily due to their size and penetration of networks. In fact, Industry estimates indicate that over 80% of commercial banks in India are in the public sector and of the 50-odd private banks, less than half are foreign banks. The financial sector reforms ushered in the year 1991 have been well calibrated and timed to ensure a smooth transition of the system from a highly regulated regime to a market economy. The first phase of reforms focused on modification in the policy framework, improvement in financial health through introduction of various prudential norms and creation of a competitive environment. The second phase of reforms started in the latter half of 90s, targeted strengthening the foundation of banking system, streamlining procedures, upgrading technology and human resources development and further structural changes. The financial sector reforms carried out so far have made the balance sheets of banks look healthier and helped them move towards achieving global benchmarks in terms of prudential norms and best practices. One of the basic issues in India today is in the realm of monetary and banking economics is: how can the monetary authorities the Reserve Bank of India (RBI) and the Government-effectively promote plans of investment and output without inflation on one hand and credit bottleneck on the other. Since 1951, the country has had a series of Five Year Plans whose objective has been to promote a balanced pattern of investment in the economy. Given the capital-output ratios, rates of savings and other relevant variables in different sectors, certain volumes of output are likely to emerge from such investment activities. While plans may exist for investment and output in different sectors, it is not a foregone conclusion that money supply in the aggregate and credit availability will necessarily be consistent with investment and output plans. The ability of the financial system in its present structure to make available investible resources to the potential investors in the forms and tenors that will be required by

them in the coming years, that is, as equity, long term debt and medium and short-term debt would be critical to the achievement of plan objectives. The gap in demand and supply of resources in different segments of the financial markets has to be met and for this, smooth flow of funds between various types of financial institutions and instruments would need to be facilitated. Commercial banks for long have been one of the most important financial intermediaries which help to transfer resources from the savers to the borrowers for productive purposes. Therefore, they have either been given targets of loans and advances by the RBI or have been told to work out themselves enhanced magnitudes of credit disbursement. To meet the rising demands of real investments and real outputs, increased bank credit supplies are envisaged in almost every sector of the economy. Though the Indian finance and banking industry did suffer significantly during the past 2 years, it was relatively sheltered from the triggers of the global melt-down, suffering instead due to monies from FIIs drying up, falling interest rates, rapidly rising inflation and poor investor confidence. Annual reports suggest that most of the larger Banks have begun to pick up from where they left off, albeit with more caution, and most industry pundits are optimistic about the current fiscal year.
OBJECTIVE OF THE STUDY

In what follows, a detailed study has been undertaken on the factors that influence the total credit flow to the various sectors in the economy in any given period. This, above all, helps to generate profit and improve the bottom line for the banks which are the most important financial intermediaries in the Indian financial system Therefore, keeping the future in mind, it is of primary importance that attentions be paid to the factors that influence the total credit flow.
LITERATURE SURVEY

As a point of reference, Econometric Model of Banking in India (Khusro A.M .& Siddharthan N.S. , 1996) was used. This model looks at both the demand side and the supply side factors which determine bank credit. Certain implications of this model holds true in the context of Indian banking even today.

This study focuses on the supply side factors only. The empirical testing of the model was carried out using the latest available data. However, the current financial and economic scenario captured by the IIP data was introduced in the model later. Accordingly, policy implications are discussed.

METHODOLOGY AND DATA

The study is essentially divided into two parts: The first part deals with the empirical testing of the model and the second part discusses the further improvements that may be included in the model to get a better idea in the current economic and financial scenario. Nature of the data: The time series data has been collected for a period of 10 years from 2000-2001 to 2009-2010. In order to smoothen out the fluctuations in the time series data, the method of exponential smoothing has been used for every series in question. Exponential smoothing is a technique that can be applied to time series data, either to produce smoothed data for presentation, or to make forecasts. The time series data themselves are a sequence of observations. The observed phenomenon may be an essentially random process, or it may be an orderly, but noisy, process. Whereas in the simple moving average the past observations are weighted equally, exponential smoothing assigns exponentially decreasing weights over time. Exponential smoothing is commonly applied to financial market and economic data, but it can be used with any discrete set of repeated measurements. The raw data sequence is often represented by {xt}, and the output of the exponential smoothing algorithm is commonly written as {st}, which may be regarded as a best estimate of what the next value of x will be. When the sequence of observations begins at time t = 0, the simplest form of exponential smoothing is given by the formula:

where is the smoothing factor, and 0 < < 1. In order to carry out the empirical testing of the model and to analyse the data further, the technique of regression analysis has been used.

Regression analysis is concerned with the study of the dependence of one variable, the dependent variable, on one or more other variables, the explanatory variables, with a view to understand the relationship between them. This analysis may also be used for prediction or estimation purposes. Multivariate regression analysis is used for the purpose of data analysis. As mentioned earlier, the study is broadly divided into two parts: The first part deals with the empirical testing of the model and the second part discusses a few other factors that may be included in the model to get a broader idea in the context of the study. The study aims to find out the factors that influence the total credit flow to the various sectors of the economy. Therefore, total credit flow is taken as the dependent variable for both the models. For empirical testing of the said model, the factors that influence the total credit flow are: The advance rate of interest. For the sake of simplicity, the interest rate of SBI, the largest bank in India has been considered throughout. The reserve money outstanding. The demand deposits.

In the next section, further analysis has been carried out and another important factor emerged. The IIP data, which is taken as an indicator of the organised business scenario in the country. These are the explanatory variables for the models. They have been explained in greater details in the forthcoming sections. In both cases, we aim to test:

The statistical significance of the individual partial regression coefficients using the t-statistic. Here, the NULL HYPOTHESIS to be tested isthe corresponding partial regression coefficient is zero against the ALTERNATIVE HYPOTHESIS that it is not zero. If the observed value of the t-statistic, at the chosen level of significance

and degrees of freedom (d.f.), is greater than the tabulated values of t, then we reject the null hypothesis at the chosen level of significance.

The overall significance of the regression using the F-statistic. Here, the NULL HYPOTHESIS to be tested is- all partial regression coefficients are simultaneously zero against the ALTERNATIVE HYPOTHESIS that they are not simultaneously zero. If the observed value of the F-statistic, at the given level of significance and degrees of freedom (d.f.) , is greater than the tabulated values of F, then we reject the null hypothesis at the chosen level of significance.

AN ECONOMETRIC MODEL OF BANKING IN INDIA

The model of banking developed by A.M. Khusro and N.S. Siddharthan in 1996 serves as a reference point in analysing the factors that affect the total flow of credit to various sectors of the economy. In essence, it is a macroeconomic view which best describes the factors that affect the supply of credit as a whole. The term advances in this model refers to the bank credit, i.e., to loans and advances and bills purchased and discounted by the banks. Also, it may be noted that the original model discussed both the demand and the supply side factors; in this case, we have taken a look at the supply side factors only. THE MODEL: The supply of advances is positively related to the interest rate on advances. With an increase in advance rates, the bankers are expected to increase their supply of advances to maximize their returns on their earning assets. Further, an increase in bank reserves would prompt the bankers to advance more credit. However, the bank advances could increase only if deposits increase too, as increased advances can generally be made only out of increased deposits. If deposits fail to increase, the effect of increase in advances can only be to reduce the cash and liquidity ratios of the banks. When these ratios eventually hit the prescribed minimum, banks would find themselves unable to advance or extend bank credit further. Advances, then, could be a function of deposits and the hypothesis set up is that the supply of advances (or total credit flow), A, is a function of interest rate on advances, r, bank reserves, R, and aggregate deposits, D. A= A( r, R, D) s.t. (dA/dr > 0, dA/dR> 0, dA/dD>0)

The supply of advances was expressed as a linear function of interest rate on advances, bank reserves and aggregate deposits. A= a+ b1 r+b2 R+ b3 D+ e; Where ; b1, b2, b3 represents the coefficients of r, R and D respectively; e represents the error term which follows the assumptions of Classical Linear Regression Model; a denotes the intercept term.

EMPIRICAL TESTING OF THE MODEL

The result of the regression analysis is detailed below: Dependent Variable : Total Credit flow in period t R2 Adjusted R2 : 0.996 :0.994

No. of observations :10 F : 498.06*** Coefficient -536360.4 0.936 0.559 20449.37 t-statistic (d.f.= 9) -1.416 0.981 2.396*** 0.544

Explanatory variable Intercept Reserve money outstanding Demand deposits Advance rate of interest

Although the R squared is very high, but most of the explanatory variables are statistically insignificant. This points out to the existence of the problem of multicollinearity in the data. This means that one or more of the explanatory variables are correlated with each other. When the explanatory variables are highly intercorrelated, it becomes difficult to disentangle the separate effects of each of the explanatory variables on the dependent variable. One of the ways of correcting the multicollinearity problem is to drop the related variable from the analysis. Subsequently, it was found that the reserve money outstanding was highly correlated with demand deposits with the value of the

10

correlation coefficient being at a moderate high of 0.564. Therefore, although the data set is very limited, reserve money outstanding was dropped from the analysis. Also, since the model yielded a better fit without the intercept term, the intercept term was also dropped. Therefore, the model effectively became: A= b1 r+ b2 D+ e; Where ; b1 and b2 represents the coefficients of r and D respectively; e represents the error term which follows the assumptions of Classical Linear Regression Model. REGRESSION ANALYSIS Dependent Variable : Total Credit flow in period t R2 Adjusted R2 : 0.998 :0.855

No. of observations :10 F : 498.06*** Coefficient 0.843 -30299.44 t-statistic (d.f.= 9) 33.87*** -6.51***

Explanatory variable Demand deposits Advance rate of interest In this case, we see that

The total credit flow has a positive relationship with demand deposits. This is in accordance with the theory.

The advance rate of interest has a negative relationship with the total credit flow. This of course, is an anomaly and different from our theoretical pre-conception.

However, the regression results may be considered satisfactory as the value of R2 is very high and most the t-statistic(s) is statistically significant at 1% level of significance. This

11

shows that the explanatory variables are successful in explaining the factors that influence the dependent variable, total credit flow in any given periodt. It is worth mentioning that the results of the empirical tests with the recent data are almost similar to the results that were obtained when the model was tested by Khusro in 1996.

TAKING THE MODEL FURTHER

The business environment of the country has changed significantly in the past few years. Therefore, it is of primary importance that this factor be considered while studying the determinants of bank credit. This is because the maximum portion of bank credit flows to the organised business sector of the economy. IIP data is a simple index which provides information about the growth of different sectors of our economy like mining, electricity, Manufacturing & General. The IIP index reflects the growth in Indias industrial activity and excludes all kinds of services. The base year for the index over the period of the analysis is 1993-94. In order to include the perception about the business activity in the country, IIP data was taken as an explanatory variable, along with demand deposits and interest rate. The model now becomes: Total credit flow in period t= C+ a1 IIP data+a2 demand deposits+ a3 interest rate+ E Where E follows the standard assumptions of the Classical Linear Regression Model. C denotes the intercept term; a1, a2, a3 denotes the coefficients of IIP data, demand deposits and interest rate respectively. Also, all the variables have been taken in their logarithmic form as this enables the coefficients to represent the elasticity of the explanatory variable concerned with respect to the total credit flow. Essentially, the log-linear form of the model looks like: Log( total credit flow in periodt)= C+ a1 log (IIP data)+ a2 log( demand deposits)+ a3 log( interest rate) + E; Where E follows the standard assumptions of the Classical Linear Regression Model. C denotes the intercept term; a1, a2, a3 denotes the coefficients of the logarithmic form of IIP data, demand deposits and interest rate respectively.

12

REGRESSION ANALYSIS Dependent Variable : Total Credit flow in period t R2 Adjusted R2 : 0.998 :0.997

No. of observations :10 F : 1169.36*** Explanatory variable Intercept IIP data Demand deposits Advance rate of interest In this case we see that, The IIP data is highly significant when it comes to explaining the total credit flow. A 1% rise in IIP data results in a 3.5% rise in total credit flow. The demand deposits turn out to be insignificant. This, of course, is an anomaly, as the theoretical importance of demand deposits in explaining total credit flow is unquestionable. The interest rate also turns out to be highly significant. However, empirical testing shows a negative relationship between advance rate of interest and the credit flow. The sign of the coefficient is different from that of our theoretical pre-conception. This, too, is an anomaly and what is important is the statistical significance of this variable. However, the regression results may be considered satisfactory as the value of R2 is very high and most the t-statistic(s) is statistically significant at 5% level of significance. This shows that the explanatory variables are successful in explaining the factors that influence the dependent variable, total credit flow in any given periodt. Coefficient -1.0533 2.2962 0.3394 -0.3117 t-statistic (d.f.= 9) -3.459** 3.501** 1.228 -1.838**

13

LIMITATIONS OF THE ANALYSIS

The analysis takes into account only a period of 10 years beginning from 2000-2001 to 20092010. This may not be sufficient to capture every possible aspect of the massive changes that have occurred in the banking sector of India. Also, as noted earlier, the original model has taken into account both the supply as well as the demand side of the credit flow aspect. Supply side factors were explored in greater details and as the scope is limited, the demand side factors were not explored in this study. The usual tests of stationarity for the time series data like the Durbin-Watson test or the Engel-Granger test could not be carried out due to unavailability of such options in MSExcel. However, to smooth out the fluctuations in the data, the technique of exponential smoothing has been used. Total credit flow also depends on the risk perception of the country. This could not be included in the analysis as the quantification of country risk at a macro-level is beyond the scope of the current study. However, the study provides a broad idea on the factors that influence the total credit flow to the various sectors of the economy.

14

CONCLUDING REMARKS
The regression results point out that the factors crucial to the total credit flow are: The organised business environment in the country as depicted by the IIP data. The advance rate of interests.

By and large, the results indicate the importance of having an environment conducive to organised business in the country. The total credit flow depends on the IIP data which, in effect, is influenced by the macro conditions of the country. Only when the business environment is conducive, we can have a strong credit flow mechanism catering to the various sectors of the economy. This, of course, follows from the last C of the 5 Cs model of credit standardCONDITIONS. This denotes the macro-economic factors that govern the finance and economic scenario of the nation. Therefore, the government and the central bank must take appropriate steps to build a strong financial system which enables the building of a sound business environment free from red-tapes or corruption. In this context, it is worth mentioning that the Union Budget for the financial year 2011-2012 has laid down ambitious plans for the infrastructure sector of the nation. This fuels economic growth and thereby, benefits the organised business environment. Although the demand deposits turn out to be statistically insignificant, yet the importance of this variable as a policy parameter should not be undermined. Also, the importance of interest rates as a policy variable has been established. For example, in a policy of deposit mobilization, instead of relying mostly on administrative measures, the banks could perhaps additionally use the interest rate weapon. Since the shift from the BPLR to the Base rate, it has been envisaged that the base rate system will increase transparency in credit pricing and address the shortcomings of the BPLR system. Large banks that have higher percentage of low cost deposits and better operating

15

efficiency will have a lower base rate and thus they will be able to price their loan products competitively. This will help to increase the total credit flow to the various sectors of the economy. The future landscape of Indian Banking: Liberalization and de-regulation process started in 1991-92 has made a sea change in the banking system. From a totally regulated environment, we have gradually moved into a market driven competitive system. Our move towards global benchmarks has been, by and large, calibrated and regulator driven. The pace of changes gained momentum in the last few years. Globalization would gain greater speed in the coming years particularly on account of expected opening up of financial services under WTO. Four trends change the banking industry world over, viz. 1) Consolidation of players through mergers and acquisitions, 2) Globalisation of operations, and 3) Development of new technology. With technology acting as a catalyst, great changes in the banking scene are expected in the coming years. Therefore, keeping the future in mind, it is of primary importance that attentions be paid to the factors that influence the total credit flow. This, above all, helps to generate profit and improve the bottom line for the banks which are the most important financial intermediaries in the Indian financial system. This translates into building blocks of a stronger and more resilient financial system, based on sound logic and principles.