What ails the Indian Banking Sector

Introduction
The Indian banking sector is broadly classified into scheduled and non-scheduled banks. The
scheduled banks are those included under the 2nd Schedule of the Reserve Bank of India Act,
1934. The scheduled banks are further classified into: nationalized banks; State Bank of India
and its associates; Regional Rural Banks (RRBs); foreign banks; and other Indian private sector
banks. The term commercial banks refers to both scheduled and non-scheduled commercial
banks regulated under the Banking Regulation Act, 1949.

The Indian banking system consists of 27 public sector banks, 21 private sector banks, 49 foreign
banks, 56 regional rural banks, 1,562 urban cooperative banks and 94,384 rural cooperative
banks, in addition to cooperative credit institutions (FY17 data). In FY07-18, total lending
increased at a CAGR of 10.94 per cent and total deposits increased at a CAGR of 11.66 per cent.
India’s retail credit market is the fourth largest in the emerging countries. It increased to US$
281 billion on December 2017 from US$ 181 billion on December 2014.

Investments/developments
Key investments and developments in India’s banking industry include:

 As of September 2018, the Government of India launched India Post Payments Bank
(IPPB) and has opened branches across 650 districts to achieve the objective of financial
inclusion.
 The total value of mergers and acquisition during 2017 in NBFC diversified financial
services and banking was US$ 2,564 billion, US$ 103 million and US$ 79 million
respectively.
 The biggest merger deal of FY17 was in the microfinance segment of IndusInd Bank
Limited and Bharat Financial Inclusion Limited of US$ 2.4 billion.
 In May 2018, total equity funding's of microfinance sector grew at the rate of 39.88 to Rs
96.31 billion (Rs 4.49 billion) in 2017-18 from Rs 68.85 billion (US$ 1.03 billion).
 In April 2019, Vijaya Bank and Dena Bank were merged with Bank of Baroda.
 On 30 August 2019, Union Finance Minister Nirmala Sitharaman announced merger of
six public sector banks (PSBs) with four better performing anchor banks in order to
streamline their operation and size, two banks were amalgamated to strengthen national
presence and four were amalgamated to strengthen regional focuses. Subsequently, the
 number of public sector bank has been reduced to 12 from 27.This new amalgamation
will be effective from 1 April 2020.

Trends in Indian Banking Sector from 2005-06 to 2012-13

Table 1 : Trends in Bank Group Wise Return on Asset (ROA) During 2005 to 2013.

Bank Group Wise 2005-06 2006-07 2007-08 2007-09 2009-10 2010-11 2011-12 2012-13 CAGR(%)

Nationalized Banks 0.89 0.94 1.01 1.03 1.00 1.03 0.88 0.74 -2.28

Sbi & Associates 0.87 0.86 0.97 1.02 0.91 0.79 0.89 0.88 0.14

Public Sector Banks 0.88 0.92 1.00 1.03 0.97 0.96 0.88 0.78   -1.50

Old Private Sector Banks 0.64 0.78 1.14 1.15 0.95 1.12 1.20 1.26 8.84

New Private Sector Banks 1.22 1.09 1.13 1.12 1.38 1.51 1.63 1.74 4.54

Private Sector Banks 1.07 1.02 1.13 1.13 1.28 1.43 1.53 1.63 5.40

Scheduled Commercial Banks 1.01 1.05 1.12 1.13 1.05 1.10 1.08 1.03 0.25

In the above table we can see the data related to return on assets (ROA) of public, private, and
foreign banks during the period of 2005-2013.

The ROA is a functional indicator of bank’s profitability. ROA reflects bank’s management
ability to utilize the bank’s financial and real investment resources to generate profits. Here,
private banks have high ROA than public banks, which means they are using their assets
efficiently.

Table 2 : Trends in Bank Group Wise CRAR During 2005 to 2013.

Bank Group Wise 2005 -06 2006 -07 2007 -08 2007 -09 2009 -10 2010 -11 2011 -12 2012 -13 CAGR(%)

Nationalized Banks 12.27 12.37 12.13 13.24 13.18 13.47 13.03 12.26 -0.01

Sbi & Associates 11.95 12.30 13.21 13.96 13.46 12.25 13.70 12.67 0.73

Public Sector Banks 12.17 12.36 12.51 13.49 13.27 13.08 13.23 12.38 0.21

Old Private Sector Banks 11.69 12.08 14.08 14.74 14.85 14.55 14.12 13.73 2.03

New Private Sector Banks 12.60 11.99 14.39 15.33 18.03 16.87 16.66 17.52 4.21

Private Sector Banks 12.42 12.10 14.34 15.23 17.43 16.46 16.21 16.84 3.88

Scheduled Commercial Banks 12.32 12.28 13.01 13.97 14.54 14.19 14.24 13.88 1.50

Capital adequacy ratio is a measure of a bank’s financial health and it measures the performance
of a bank’s capital. It reflects the soundness of a financial institution. It is expressed as a
percentage of a bank’s risk weighted credit exposures.

It is shown in the Table 2 that the CAGR of private sector banks is 3.88% as compared to public
sector banks where it is 0.21 respectively. The Capital to Risk weighted Assets Ratio (CRAR)
profile of SCBs remains comfortable and much above the minimum regulatory requirements of
9%. The decline in the capitalization level of the nationalized banks, is attributable largely to
strong credit growth.

Table 3 : Trends in Bank Group Wise Non-Performing Assets (NPA) During 2005 to 2013.

Bank Group Wise 2005-06 2006-07 2007-08 2007-09 2009-10 2010-11 2011-12 2012-13 CAGR(%)

Nationalized Banks 1.16 0.94 0.77 0.68 0.91 0.92 1.44 2.00 7.05

Sbi & Associates 1.63 1.32 1.43 1.47 1.50 1.49 1.76 2.04 2.84

Public Sector Banks 1.32 1.06 0.99 0.94 1.10 1.09 1.53 2.02 5.46

Old Private Sector Banks 1.66 0.96 0.66 0.90 0.82 0.53 0.58 0.77 -9.16

New Private Sector Banks 0.78 0.97 1.21 1.40 1.09 0.56 0.42 0.45 -6.64

Private Sector Banks 1.01 0.97 1.09 1.29 1.04 0.56 0.46 0.52 -7.96

Scheduled Commercial Banks 1.22 1.02 1.00 1.05 1.12 0.97 1.28 1.68 4.08
Table 3 is demonstrating the data related to NPA to advances during the period of 2005-2013.
Comparison of bank group wise performance in terms of NPA reflects the profitability of loan
portfolios of banks since less NPA contributes to higher interest income.

Here, public sector banks have high ratio than other banks which means the asset quality of
public banks is poor among other scheduled commercial banks. The nationalized banks are more
exposed to high potential losses in case of defaults.

The deterioration in asset quality of Indian banks, especially PSBs, can be traced to the credit
boom of 2006-2011 when bank lending grew at an average rate of over 20 per cent. Other factors
that contributed to the deterioration in asset quality were lax credit appraisal and post-sanction
monitoring standards; project delays and cost overruns; and absence of a strong bankruptcy
regime until May 2016.

During 2017-18, the GNPA ratio reached 14.6 per cent for PSBs due to restructured advances
slipping into NPAs and better NPA recognition. For PVBs, it remained at a much lower level but
rose during the year. The asset quality of FBs improved marginally (Chart IV.15).

The Problem
India’s banking sector has been going through a rough patch for the last five years. The number
of non-performing assets (NPAs) has sky-rocketed. At its peak, the gross NPA to advances ratio
exceeded 11 per cent. Until the NPA crisis hit, banks contributed more than 90 per cent of the
economy’s commercial credit. As a result, any impairment of banking has a deep and long-
lasting impact on the economy.

As of March 31, 2018, provisional estimates suggest that the total volume of gross NPAs in the
economy stands at Rs 10.35 lakh crore. About 85% of these NPAs are from loans and advances
of public sector banks. For instance, NPAs in the State Bank of India are worth Rs 2.23 lakh
crore.

In the last few years, gross NPAs of banks (as a percentage of total loans) have increased from
2.3% of total loans in 2008 to 9.3% in 2017 (Figure 1). This indicates that an increasing
proportion of a bank’s assets have ceased to generate income for the bank, lowering the bank’s
profitability and its ability to grant further credit.

Banks have witnessed a decline in their profitability in the last few years (Figure 2), making
them vulnerable to adverse economic shocks and consequently putting consumer deposits at risk.

The government had to re-capitalize the banks. The total amount of capital infused by the
government in PSBs since 2008–09 is Rs 3 trillion (US$42 billion) — 2 per cent of India’s GDP.
For a government that is committed to fiscal consolidation, this is a serious fiscal drag.

The Indian government has recently taken steps to merge PSBs. This reduces the number of
PSBs and makes governance easier. But it does not address the institutional decay that requires
more radical reforms — such as privatization. The NPA problem is less severe in the private
sector banks compared to the PSBs.

There is certainly urgency in finding a solution to the current NPA problem, but diagnosing the
cause(s) and putting correctives in place is perhaps even more important. Unfortunately, the
entire discourse around this issue appears to have boiled down to the governance practices in
public sector banks (PSBs), particularly political interference and crony capitalism. The
solutions, therefore, have more or less polarized around two ideologically colored views – (a)
privatisation of PSBs; or (b) strengthening independence and capacity of PSBs. While this is a
perfectly legitimate debate and may well lead to a part of the solution, it should not forestall the
search for other causes, which may be just as important.

The Cause
The NPA problem has arisen from four features that characterized bank loans for fixed capital
formation:

Banks did not, and even today do not, have the capacity to assess the long-term credit-worthiness
of borrowers. They rely almost exclusively on assessments made by credit-rating agencies.
Unfortunately, the credit-rating agencies provide ratings only when the company concerned
intends to raise debt capital directly from the market. Therefore, in cases where the company has
not issued long-term bonds, there is no real basis to judge the viability of the company.

Banks have no capacity to monitor the use of the long-term loans by the borrower. This is
particularly egregious for project loans, especially when it is without recourse. The consequence
of this inability is that the parent company can use the funds for purposes other than for which
they were borrowed without the banks being any the wiser. As a result, whatever little appraisal
was done initially becomes seriously vitiated.

Since winding up petitions, especially with multiple lenders, was a complex legal process, which
frequently took 7-10 years in the courts, with promoters using every possible trick to stall
proceedings, banks faced the alarming prospect of making large loan loss provisions which
would stay on the books for many years with very little recovery at the end. It is no wonder that
bank managements have allowed these potential NPAs to simply accumulate over the years
through myriad forms of “ever-greening”. Reserve Bank of India’s (RBI) forced recognition of
these NPAs has now brought the problem to light.

Finally, there was gross mispricing of loans by the banks. In practically all banks, the yield curve
is almost parallel to, and sometimes even latter than, the yield curve on government securities.

The Origin
This high exposure to companies in fixed assets, especially in project finance, did not happen by
itself, but at the behest of successive governments. It really begins with a decision taken by the
government in 1997 to stop issuance of tax-free bonds by the Development Finance Institutions
(DFIs), which were the main source of term finance for corporates. This closed the only source
of relatively low-cost funds for these institutions and was instrumental in some of them
converting to commercial banks and others shutting down.

Consequently, Indian commercial banks were forced to the vacuum and, in effect, convert
themselves to “universal banks”. The problem escalated due to the government’s focus on
infrastructure during the 2002 to 2009 period, especially with the efforts made in promoting
‘public-private partnerships’.

This led to a rapid increase in project financing to private infrastructure rms. The global financial
crisis in 2008-09 again required the banks to take substantial further exposures in long-term
loans as external loans taken by Indian corporates simply dried up.

Therefore, to pin all the blame on poor governance in PSBs, especially by government
interlocutors, appears gratuitous.

The Solution
The most important solution to the NPA problem is to provide for rapid resolution of defaults. It
should be remembered that something similar used to happen earlier with working capital loans
as well. This was taken care of by the promulgation of the Securitization and Reconstruction of
Financial Assets and Enforcement of Security Interest (SARFAESI) Act in 2002, which resulted
in gross NPAs being reduced from 19% in 2002 to 6% by 2006. However, the SARFAESI Act is
of consequence only in cases where the collaterals are moveable assets, and especially where
there is a single claim-holder. It is simply not appropriate for fixed capital loans.

The need for a Bankruptcy Act was anticipated and recommended in the Tenth Five Year Plan as
far back as 2002. After much delay, the Insolvency and Bankruptcy Code (IBC) was eventually
passed in 2016, which has now made it much easier for banks to effect recovery through
liquidation of fixed assets. As the IBC institutions and processes are strengthened, it should take
care of the existing NPAs and, up to a point, the need for banks to do ever-greening. However, it
does not in itself address the other issues associated with long-term loans, especially that of
mispricing.

The key change is that countries which have a universal banking model, such as Europe and
Japan, permit banks to issue bonds for financing term loans. Our Banking (Regulation) Act 1949
does not do so. Banks can issue bonds only for raising their own capital. The only way to correct
this problem would be to amend the Banking Act to permit issuance of bonds by banks for on-
lending.

Finally, and perhaps most importantly, since banks would have to get themselves periodically
rated, the yield curve of individual banks would reflect the strength of their loan portfolios. As a
result, banks with weaker balance sheets will have to offer higher interest rates on their bonds,
which will get rejected in higher interest rates that they will have to charge to the same potential
client. This should have the effect of introducing a self-correcting mechanism in the lending
behavior of banks well before they run into serious problems.

Conclusion
India needs a well-defined framework for resolving failed financial firms. Such a framework was
proposed by the draft Financial Resolution and Deposit Insurance bill but has been withdrawn by
the government. Over and above privatization of PSBs, issues in the Indian banking sector need
to be resolved through comprehensive governance and banking regulation reforms.

Thus, the choice facing the government is clear: either revert to the status quo ante where banks
eschew lending for fixed capital formation; or amend the banking laws to reflect the new reality.
Sitting on ones hands and berating the banks is not an option.
References

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indias-economy/
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