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Abstract
Financial sector in India is changed over the past decade due to technological
innovation, deregulation of financial services, external financial liberalization and
organizational changes in the corporate. Competition among financial institutions
further increased due to emphasis on market-based outcomes and resultant deregulation
of interest rates on deposits as well as on the advances. Technological advances in
information technology and securitization bill, reduction in employee strength through
voluntary retirement schemes has greatly reduced costs and non-performing assets
thereby increased profits, productivity and efficiency among Indian banks with
simultaneous increase in costumer services with competitive costs. There was a
convergence of performance among public, private and foreign banks in recent years due
to adoption of technology. There was an increasing importance of non-interest income in
recent years for all banks. Even though PSBs comparing poorly with the other two
categories in terms of profit, PSBs had the highest efficiency in deposit mobilization. And
foreign and private banks are efficient in value added services. There has been a decline
in spreads and intermediation costs widely used measures of efficiency in banking and a
tendency towards their convergence across all bank-groups. While most of the studies
emphasized market related financial efficiency measures to boost banking sector, equally
good number of studies emphasized the importance of prudential and regulatory
measures to increase financial health and stability of banking sector. Only cost effective,
costumer focused, technology driven, capital strengthen banks which follow prudential
regulations can only sustain in attracting depositors and borrowers in the current
competitive environment. The individual banks have to be competitive on the one hand
and the regulator should ensure that the prudential norms should ensure needed stability
and financial health of banks without jeopardizing the proper incentives to banks.
1
BANKING SECTOR PERFORMANCE DURING LIBERALIZATION IN INDIA-
A REVIEW
1. Introduction
Financial sector in India is changed drastically since late 1990s due to technological
innovation, financial liberalization with entry of new private and foreign banks, and
regulatory changes in the corporate sector. (Allahabad Bank, 2002). The intense
competition between these new entrances with the already existing public sector banks to
cater needs of same pie of consumers facilitated implementation of new ways in reduce
costs at the same time attracting customers/business. Further liberalization of financial
sector facilitated development of capital markets; non-banking financial institutions that
absorb current and potential borrowers and bank depositor thereby banks may face
competition both in raising resources and in deploying them. In the current scenario,
liberalization and deregulation has to go hand in hand with a greater emphasis on
efficiency, consolidation, asset quality and profitability (Jalan 2002).
However there is still a large gap to be filled in improving financial health and providing
quality customer services, reducing NPAs, and improving corporate governance practices
in banks in general, and in PSBs in particular. Lower level of provisioning for NPAs
when compared to international standards is also a problem. For example, PSBs on
average provide for 55 per cent of their NPAs, while provisioning by foreign banks is
much higher at 70 per cent whereas international banks provide up to 140 percent. It was
2
recognised that restoration of health of the banking system required both a stock solution
(i.e., restoration of net worth) and flow solution (i.e., an improvement in future
profitability) (Joshi and little 1997). Recent interest rate deregulation exposes the banks
to interest rate risk (market risk). Such interest rate risk has a potential impact on net
interest income as well as on the market value of the fixed income securities held by the
banks, which may affect bank risk exposure. The issue of capital adequacy and
recapitalisation also require urgent attention (Jaikvoulle and Kauko 2001). With the
above background the paper specifically reviews banking sector performance (especially
scheduled commercial banks) and its determinants in developing countries perspective
especially in Indian context.
The banking system in India comprises the Reserve Bank of India (RBI), commercial
banks, regional rural banks and the co-operative banks. In the recent past, private non-
banking finance companies also have been active in the financial system, and are being
regulated by the RBI. As in 2000, commercial banks (which include public sector banks,
private sector banks and foreign banks) remains the most dominant with nearly 62 per
cent of financial assets, followed by investment institutions (18.6%), term lending
institutions (15.1%) and cooperative banks (2.6 per cent) (Aditya and Ghosh 2001).
Indian banking sector has been characterized by the predominance of PSBs. The PSBs
had 47,579 branches during 2001 with total assets of Rs. 10,298 billion, which accounted
for 79.5% of assets of all Scheduled Commercial Banks (SCBs) in India. PSBs account
for 81% of deposits, 79% of advances, 78% of income, and 90% of branches of all
3
commercial banks during the year 2001. Private sector banks accounted for 12.6% of the
total assets and foreign banks accounted for 7.9% of the total assets of all SCBs. The
primary activity of most foreign banks in India has been in the corporate segment, while
public sector banks cater to the needs of wider mass of India. However, in recent years,
some of the larger foreign banks have started making consumer financing. The recent
increase in foreign direct investment cap in banks from 49 per cent to 74 percent is a
significant development in liberaizing banking sector to foreign participation.
In a study that covers more recent period, Das (1999) compares performance among
public sector banks for three years in the post-reform period, 1992, 1995 and 1998. He
finds a certain convergence in performance. He also notes that while there is a welcome
increase in emphasis on non-interest income, banks have tend to show risk-averse
behavior by opting for risk-free investments over risky loans.
Sarkar and Das (1997) compare performance of public, private and foreign banks for the
year 1994-95 by using measures of profitability, productivity and financial management.
They find PSBs comparing poorly with the other two categories.
Bhattacharya et al., (1997) studied the impact of the limited liberalization initiated before
the deregulation of the nineties on the performance of the different categories of banks,
using Data Envelopment Analysis. Their study covered 70 banks in the period 1986-91.
They constructed one grand frontier for the entire period and measured technical
efficiency of the banks under study. They found PSBs had the highest efficiency among
the three categories, with foreign and private banks having much lower efficiencies.
However, PSBs started showing a decline in efficiency after 1987, private banks showed
no change and foreign banks showed a sharp rise in efficiency. The main results accord
with the general perception that in the nationalized era, public sector banks were
successful in achieving their principal objectives of deposit and loan expansion.
However, Das (1997), which analysed overall efficiency –technical, allocative and scale
efficiency of PSBs in the period 1990-96, found a decline in overall efficiency. This
4
occurred because there was a decline in technical efficiency, which was not offset by an
improvement in allocative efficiency. The study, however, pointed out that the
deterioration in technical efficiency was mainly on account of four nationalized banks.
In a review of performance of banks, RBI (1999a) concluded that 1. There has been a
decline in spreads a widely used measure of efficiency in banking and a tendency towards
their convergence across all bank-groups except foreign banks. 2. Intermediation costs as
a percentage of total assets have also declined especially for PSBs and new private sector
banks, due largely to a decline in their wage costs. 3. Capital adequacy and asset quality
(measured by the net NPAs as percentage of net advances) have both improved over the
period 1995-96 to 1999-2000. 4. Median profit per employee of PSBs witnessed a
significant rise from 1996-97 to 1999-2000. 5. Non-interest income to working funds rose
modestly for the median PSBs. 6. The ratio wage bill to total expenses remained at a high
level for PSBs. 7. The cost to income ratio declined for PSBs. The RBI noted that,
“Developments after 1996 indicate that a majority of the public sector banks have been
able to progress considerably towards the direction of passing the acid test of achieving
competitive efficiency.
The difference between the interest rate charged to borrower and the interest rate paid to
depositors, which reflects the cost of intermediation (interest spread), is an important
indicator of efficiency. The main components of interest spread are non-interest income,
overhead, taxes, and loan loss provisions and after tax bank profits. The efficiency of the
banking system as a whole, measured by declining spreads/total assets (3.22 in 1991-92
to 2.7 in 1999-2000), has improved, and public sector banks have improved their
performance in both absolute and relative terms (Ram, 2002). In contrary to that Souza
(2002) argued that banking system as a whole has not become more efficient as measured
by the interest spreads/working funds which have been rising (2.10 in 1990-91 to 2.73 in
1999-2000 for all banks) and not declining. However, there are some issues need to be
addressed in PSBs such as low provisioning to non-performing assets and low employee
productivity compared to private and foreign banks. The turnover per employee in the
private banks doubled relative to the public sector banks during the 1990s. The
establishment expenses as percent of total expenses drastically declined in private and
5
foreign banks due to these banks have been able to contain their wages and salaries
expenditures compared to the public sector banks however private and foreign banks
spend more on technology up gradation.
The commercial banking system in the country has become quite apprehensive of
exposing itself to lending risk and has developed an unhealthy appetite for government
securities. The pace at which the commercial banks invested in government securities far
exceeded those in both deposit mobilization and credit disbursal (Nair, 2000) as in the
low interest rate regime trading profits very high for government securities (Rakesh,
2002).
In a cross-bank study for India Sarkar et al., (1998) regresses two profitability and four
efficiency measures on pooled data for two years 1993-94 and 1994-95, for a total of 73
banks, using single equation OLS estimation for each. They found that after controlling
for total assets, proportion of government securities to total assets, proportion of priority
sector loans, share of rural banking, non-interest income to total income, foreign
ownership showed positive association with profitability and efficiency. Ajit and Bangar
(1998) present a tabulation of the performance of private sector banks vis-à-vis public
6
sector banks over the period 1996-1997, using a number of indicators: profitability ratio,
interest spread, capital adequacy ratio and the net NPA. The conclusion is that Indian
private banks out perform public sector banks. The study also found that Indian private
banks have higher returns to assets in spite of lower spreads.
As Indian banking system is predominantly a public sector one, the incentive structure
differs significantly from those prevailing under private sector banking. In the changed
scenario of liberalization, banks will have to bring about an overall improvement in their
working covering human resource management, technology up gradation and integrated
risk management (Jalan 2001).
3. International Experience
7
excess risk taking was also encouraged by the government by retaining a controlling
stake in major banks that creates the expectations of future bailout.
Intermediation margins are positively related to market power in the Columbian banking
system (Barajas et al., 1999). A study by Asli and Harry (1998) while studying bank
performance that taken interest spread and bank profitability as dependent variables and
bank specific variables (size, leverage, type of business, foreign ownership), country
specific variables (macro-economic, legal and institutional environment) as explanatory
variables concluded that foreign banks are better in terms of net profits with high interest
spread and low NPAs. The study found that higher interest spread could indicate greater
banking efficiency under segmented or imperfectly competitive markets.
Implicit taxes such as Cash Reserve Ratios (CRR), Statutory Liquidity Ratio (SLR) and
priority sector lending are at higher level in developing countries, which is also a cause
for higher spreads. There is a positive and significant relationship between spreads and
liquidity reserves in the Columbian banking system (Barajas et al., 1999). Despite high
wages, overhead as a share of total assets appears to be lowest at around 1 per cent for
banks in high-income countries. Large banks tend to have smaller overheads.
The above studies are providing contradictory evidence about interest spread as bank
efficiency indicator in developing countries perspective such as in India. In the long run
banking system should be stable and efficient to enhance overall development of the
country. Stability clearly requires sufficient banking profitability, while economic
efficiency requires banking spreads that are not too large. A prerequisite to formulating
effective banking policies is thus to understand the determinants of bank profitability and
interest margin ( Asli and Harry 1999).
One instrument to increase profitability and spread was lowering deposit rates, which
lowers cost of funds to banks. Abdourahmane (2000) by using United States data
concluded that, commercial banks ability to lower deposit interest rates diminishes when
their deposits become closer substitutes to non-bank liabilities requiring greater interest
8
rate competition (for example ceiling rate for non-bank financial companies were around
11 percent compared to average bank deposit rate of about 6 to 7 percent). Deposits can
be inputs for the production of bank loans (an intermediation service) or safekeeping
services output provided to depositors (a non-intermediation service). The same deposits
may also be inputs to the provision of payment services (checking services). The
framework shows that the input-output nature of banking deposits may be such that banks
to use their market power on deposits to subsidize non-intermediation service fees as
deposit raising strategy. Therefore reduction of deposit interest rate does not mean a lack
of competition but an increase in competition by using another means. Banks would
lower deposit interest rate provided they have market power on deposits and non-
intermediation services. Given the low-income levels in developing countries, small
savers and demand depositors may be less sensitive to the deposit interest rate and more
responsive to the convenience of bank branches and payments services for savings,
safekeeping and transactions. The public sector commercial banks are having advantage
in competing via branch banking that may be good for financial deepening. While foreign
banks are competing via providing non-intermediation banking services, which ultimately
may increase domestic banks efficiency and foster domestic financial deepening
(Bernado and Douglous, 2001).
While most of the studies emphasized market related financial efficiency measures
(spread and profitability) to boost banking sector, equally good number of studies
emphasized the importance of prudential and regulatory measures to increase financial
health and stability of banking sector. Prudential tightening covered exposure and
disclosure norms, guidelines on investment, risk management, asset classification and
provisioning. A study on Croatian banking system argued that fundamental determinant
of profitability is probably good management, which succeeds both in cutting costs and
managing risk prudently. It is the good prudential management rather than cost efficiency
explains the survival of more cost efficient banks in turbulent waters of transition
banking (Evan et al., 2002).
9
While discussing consequences of weak prudential regulation upon Russian banking
system Gidadhubli (2001) stated that due to the low minimum capital requirements a
large number of small banks were set up. Most of these banks engaged in utilizing their
resources for speculative activities such as exchanging rubles into dollars or vice versa to
earn quick profits. It was reported that a few banks even used money borrowed from
government and the central bank of Russia for transactions due to the inefficient
regulation. In line with this David and Vlad (2002) found that tighter minimum capital
adequacy ratios seem to be associated with improved revenue generating capacity and
more aggressive deposit taking behavior. Well-capitalised banks face lower expected
bankruptcy costs, thereby reducing their cost of funding.
In a study of crisis and restructuring of Indonesian banking system, Mari and Manggi
(2002) listed causes for banking crisis as Firstly, a rapid expansion of the banking sector
without necessary strengthening of prudential regulations and central bank supervision.
Secondly, the high concentration of ownership in the banking sector led to weak
corporate governance of banks. An even more serious problem was the lack of ability to
enforce prudential regulations because of the weak capacity and capability of central
bank supervisors, widespread corruption and political interference. Further it was
believed that banks would be bailed out in case of bank failure by the government and
there was no effective exit mechanism for failed banks.
10
incentive to better performing banks by linking the annual premium payments to their
risk profile.
Asli et al., (2000) stated that in crisis period rate of growth of real deposits falls
significantly, in fact banks lose other sources of funding (such as inter bank credit,
foreign loans, commercial paper or equity) more rapidly than deposits, as witnessed by
significant increase in the ratio of deposits to assets. On the assets side real credit slows
down and NPAs increased significantly, banks shifts their portfolio away from loans to
shift to safer assets to economize on regulatory capital. The drop in sources of funds calls
for an effective management of liquidity in times of crisis.
In the above backdrop there was a need for further reforms and prudential regulations to
be placed in adjust with the technological advances and economic conditions. The
economist’s case for justifying prudential regulation in the field of banking is due to the
existence of two types of market imperfections i.e., externalities-social cost of failure of
banking system far exceeds private costs and information failures-as small
depositors/clients does not have capacity to evaluate financial contracts and safety with
banks (Souza 2000). However the approach to achieve the above objectives should be
market friendly and cost effective with greater reliance should be placed on incentives
and less on supervision.
The Working Group of RBI under chairmanship of M.S.Verma while identifying three
weak banks, which fall short of every competitive benchmark. In every business segment,
in cost, productivity and profitability, in technology and systems support, in internal
control and risk management procedures, in their mode of operation and servicing of
customers. The restructuring plan has been prepared for these banks. And suggested
11
seven parameters covering three major areas i. Solvency (capital adequacy ratio and
coverage ratio), ii. Earning capacity (return on assets and net interest margin) and iii.
Profitability (include operating profit to average working funds, cost to income and staff
cost to net interest income plus other income), The core of the strategy to restructure
weak banks suggested by Verma Committee comprises five components.
12
The RBI has also initiated certain structured actions in respect of the banks now widely
known as Prompt Corrective Actions (PCA), based on trigger points in terms of CAR,
Net NPA and Return on Assets (ROA). The Reserve Bank, at its discretion, will resort to
additional actions (discretionary actions) as indicated under each of the trigger points. In
this process a high-risk bank will be subjected to enhanced supervisory focus through a
shorter supervisory cycle and greater use of various supervisory tools like targeted
inspections, intensive off-site surveillance, structured meetings with bank management,
commissioned audits etc. In addition to these above prudential norms, progressive
deregulation of interest rates, shaving of priority lending commitments and moderating
statutory liquidity and reserve norms have steadily oriented the banking sector towards
the market (Patel 2000).
Although tightening prudential requirements may limit banks flexibility and profitability
in the short run, doing so may encourage banks to look for new and innovative ways to
invest, thereby expanding the production-possibility frontier. It is therefore essential for a
policy maker to be able to identify and come up with the best (often the least-cost) policy
response. However one cautious about excessive or inappropriate regulation, as it can
stifle efficiency and invite moral hazard problems and induce entities to move out of
over-regulated business to less regulated ones (Reddy 2001).
5. Conclusions
Financial sector in India is changed over the past decade due to technological innovation,
deregulation of financial services, external financial liberalization and organizational
changes in the corporate. Competition among financial institutions further increased due
to emphasis on market-based outcomes and resultant deregulation of interest rates on
deposits as well as on the advances. Technological advances in information technology
and securitisation bill, reduction in employee strength through voluntary retirement
schemes has greatly reduced costs and non-performing assets thereby increased profits,
productivity and efficiency among Indian banks with simultaneous increase in costumer
services with competitive costs. However there is still a large gap to be filled in
improving financial health and providing quality customer services, reducing NPAs, and
13
improving corporate governance practices in banks in general, and in PSBs in particular
compared to international standards. There was a convergence of performance among
public, private and foreign banks in recent years due to adoption of technology. There
was an increasing importance of non-interest income in recent years for all banks. Even
though PSBs comparing poorly with the other two categories in terms of profit, PSBs had
the highest efficiency in deposit mobilization. And foreign and private banks are efficient
in value added services.
There has been a decline in spreads and intermediation costs widely used measures of
efficiency in banking and a tendency towards their convergence across all bank-groups.
The establishment expenses as percent of total expenses drastically declined in private
and foreign banks due to these banks have been able to contain their wages and salary
expenditures compared to the public sector banks however private and foreign banks
spend more on technology up gradation. As a result turnover per employee in the private
banks doubled relative to the public sector banks during the 1990s. Another indicator of
bank efficiency is NPAs, although the net NPAs of the commercial banks in India have
witnessed a decline over the past several years, they are still high. Some studies argued
region of operation play a greater role in amount of problem loans than the type of
ownership of banks. That is banks functioning in less developed regions were having
high NPAs compared to banks functioning in developed regions.While most of the
studies emphasized market related financial efficiency measures to boost banking sector,
equally good number of studies emphasized the importance of prudential and regulatory
measures to increase financial health and stability of banking sector. It is the good
management rather than cost efficiency explains the survival of more cost efficient banks
in turbulent waters of transition banking. International experience Russian and
Indonesian banking systems were good examples of inefficient central banks and
prudential regulations. Due to low minimum capital requirements a large number of small
banks were set up which were weak, which lead to banking crisis in later periods.
International experience also shows that high concentration of ownership, weak corporate
governance, lack of ability to enforce prudential regulations, weak central bank
supervisors, widespread corruption and political interference are major reasons for
14
banking crisis in most of the developing countries. According to the Varma committee of
RBI, solvency, earning capacity and profitability were major thrust areas banks to follow.
The committee also recommended shed the load of non-performing assets by creating an
asset reconstruction fund, shed excess manpower by introducing a voluntary retirement
scheme, establishment of a financial restructuring authority with statutory banking to
oversee the restructuring process of the weak banks. The RBI has also initiated certain
structured actions in respect of the banks now widely known as prompt corrective
actions, which have hit the trigger points in terms of capital adequacy ratio, non-
performing assets and return on assets.
In short, only cost effective, costumer focused, technology driven, capital strengthen
banks which follow prudential regulations can only sustain in attracting depositors and
borrowers in the current competitive environment. The individual banks have to be
competitive on the one hand and the regulator should ensure that the prudential norms
should ensure needed stability and financial health of banks without jeopardizing the
proper incentives to banks.
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