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Wednesday, October 25, 2006

Future of Banking in India – Changing Imperatives

A healthy financial system is crucial for any economy thriving to achieve high growth and yet remain stable in an increasing global capital markets. The Indian banking sector has witnessed several reforms in the era of liberalization. Government did a commendable job to ease regulations and attract foreign investments. Confidence in banking sector increased not only among consumers but also in capital market. Indeed Indian banking sector has come far from the economic instability to a period of growth opportunities. However, a closer inspection reveals that tight government control is undermining India’s overall economic performance. India’s banking sector is studied over several areas of concern and findings are quite disappointing.

If we regress few years, in year 2001, Indian banking system was creaking. Non-performing loans were reported to be as high as 10 % of the loans of banking institutions. A resource-strapped Indian government was evaluating foreign direct investment, recapitalization and capital markets to set about strengthening the sector and encouraging structural change. It critically assessed that the recapitalization would not be possible given a high fiscal deficit (6.1 percent of GDP of 2000). Also it observed that capital markets will not come forward to rescue, as even after six years, banks had only raised $1.6 billion and capital markets did not show any interest in most government-owned and private banks because of their weak performance. In short, government had to look for private domestic and foreign investor to revive the sector. India did a good job to get over the time of instability, however much is required to done to propel further transformations. The transformation can be achieved by focusing on the areas identified below.

Savings of the people
Astonishing levels of savings and investments occur outside the formal financial system. Even though the country’s households save about 28 percent of their disposable income, but invest only half of these savings in bank deposits and other financial assets. The other half is invested in housing and machinery to support household businesses characterized with low-levels of productivity. These businesses lack technology and business know-how and are below efficient scale. India would demonstrate a much faster growth if these savings could be channeled through banking sector and allocated to more productive enterprises. Government needs to take initiative outside the banking sector to squelch these businesses with low-productivity. Though there is political pressure as some believe that it will result in losses of jobs for millions, however losses in jobs would be compensated by job creation in higher productivity businesses. Banking sector needs to play an instrumental role to allow this transformation to happen smoothly.

Liquidating Gold
Indians are the world’s largest consumer of gold. Indian banks attract none of the $200 billion savings that Indians have keep tied up in the gold. A large portion of it is in rural areas, which is effectively outside the reach of current banking penetration. Building more countryside branches, as most state-owned banks have done, is not sufficient. Key is to understand rural household needs and offer products that would allow cash against gold deposits. Government should give incentives banks to launch gold-deposit schemes to attract more of the value of consumer gold into financial system through banking. This would allow more formal control over a large asset, which could be directed to fund newer opportunities and thus get a higher rate of return.

Cost of bank Intermediation
Indian banking sector suffers from very high cost of intermediation, 5.6 percent in 2004 compared to 2.4 percent in United Kingdom and 1.8 percent in US. It is high mainly because state-owned banks, whose productivity levels is 10 percent of US levels, control 75 percent of bank assets. To improve the situation government needs to encourage consolidation among state-owned banks and improve corporate governance of bank by making them independent and accountable to stakeholders. The cost of intermediation is detrimental to financial system, as because of it savers get too less a return while borrowers need to pay a high cost of capital. This motivates people to create informal market places where borrowers and savers could transact without government taxation and regulations.

Increasing Productivity using Technology
Public sector banks currently function at productivity levels far below of the best Indian banks. India’s IT sector on one side leads the technology initiatives to make American banks increasingly more productive, India’s banking sector shy away from heavy technology investments to remain least productive. India needs to ensure comprehensive adoption of proposed internet, mobile and electronic technologies by creating incentive for banks to make initial investment to revamp their underlying business processes.

Private Banks
Retail-banking customers in India are very loyal to their domestic banks. According to McKinsey’s study 69 percent would stay with their current banks even if competitor’s offered lower cost of transactions. However there are certain customer segments which are willing to try foreign banks. Multinational banks should leverage their ability to deliver quality service and a sophisticated portfolio of financial products to create willingness among consumers to shift their assets to private banks and capture a share of India’s large retail-banking market. Increased participation by private banks will not only improve the productivity of the sector but also allow a more efficient capital allocation.

Government Regulation
Government regulations oblige banks to direct a high proportion of their funding to the government and its priority investments. Banks are required to hold 25 percent of their assets in government bonds. And to exasperate the situation, state-owned banks, that control the 75 percent of total assets, hold a much larger percent of their assets in government bonds. Further banks must direct 36 percent of their loans to household businesses, agriculture and priority sectors characterized with low-levels of productivity. Directed loans have high default rates, which restricts banks to achieve higher lending levels to avoid higher risk-exposure. This diversion of funds not only takes away investment from higher productive opportunities but also contains lending levels. Government essentially is financing its budget deficit through these regulations to follow a flawed approach to achieve social welfare objectives.

Competing with China
India aims to achieve growth rate comparable to its neighbor China. A detailed inspection of the numbers can show that India needs to vitalize its banking sector to increase capital investment rate resulting in higher GDP growth. Deposits in India represent 60 percent of its GDP compared to 142 percent for China. India’s saving rate, though respectable, is only half of the China’s rate. India’s financial depth, a measure of country’s financial stock with its GDP, is just 160 percent compared to 330 percent of China. Given above figures, India can still achieve its target mainly because the allocation of capital is better in India compared to China due to increased participation by private sector banks. Non-performing loan levels as percentage of assets, though high, are only a fraction of that of China. However to expedite the process India needs to fix some basic levers and put the banking sector on right track.

To conclude, government has always approached reforms in a reactive manner starting from the liberalization in 1991 forced by the economic crisis of balance of payment deficit. India’s banking sector needs a proactive approach to allow its participation in strengthening country’s financial system. By building a strong financial system and financial asset management, India will not only achieve its current target of growth but is likely to surpass them. However, no sound financial system can be imagined without an efficient and productive banking sector, and thus India needs rejuvenate its reform initiatives and extend them beyond foreign investments.