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Reforming the Banking Sector

The committee on financial sector reforms highlights several concerns on the Indian banking sector - about financial deepening, inadequate competition, lack of scale, high spreads banking, the low usage of new technologies, the decline in market share of public sector banks, etc. These concerns are either valid only up to a point or are misplaced when viewed against the totality of the Indian banking situation. Concern is also expressed about social obligations, delinking the government from banks and greater freedom to private banks - these too are not valid concerns. Indian banking is in a reasonably healthy state and is evolving in the right direction. It needs incremental, not sweeping, changes.

DRAFT RAGHURAM RAJAN COMMITTEE REPORTaugust 9, 2008 EPW Economic & Political Weekly28Reforming the Banking Sector T T Ram MohanThe committee on financial sector reforms highlights several concerns on the Indian banking sector – about financial deepening, inadequate competition, lack of scale, high spreads banking, the low usage of new technologies, the decline in market share of public sector banks, etc. These concerns are either valid only up to a point or are misplaced when viewed against the totality of the Indian banking situation. Concern is also expressed about social obligations, delinking the government from banks and greater freedom to private banks – these too are not valid concerns.Indianbanking is in a reasonably healthy state and is evolving in the right direction. It needs incremental, not sweeping, changes.The Committee on Mumbai as an International Financial Centre sub-mitted its report last year. The com-mittee had been given a fairly limited re-mit, namely, the development of bond, currency and derivatives markets. It pro-ceeded instead to enlarge the scope of its work to a point where virtually no important aspect of the economy was left untouched. The outcome is that, in attempting to implement its recommendations, policy-makers would not know where to begin. It is to the credit of the Raghuram Rajan Committee (the Committee on Financial Sector Reforms) that it is more focused in its approach. It also shows a keen aware-ness in various places of what is feasible in political and even economic terms. But it is in the nature of any committee tasked with reviewing a system to propose sweep-ing changes; not to do so would give the impression that the committee was bereft of ideas or did not take its job seriously. The Rajan Committee is no exception as revealed in its draft report. One cannot resist the feeling that many of its proposals have been made because they are theoreti-cally appealing. One lacks the conviction that the facts on the ground warrant such proposals. This article will confine itself to proposals related to banking sector reform and contained in the chapter titled, ‘Levelling the Playing Field’. It does not address issues related to the regulatory architecture, the regulatory environment and the conduct and performance of the regulator, which are addressed in separate chapters. State of Banking SectorIt is best to begin with the observed facts about the Indian banking system. What prescription is required depends on the condition of the patient. If there is a trend towards improvement, we are doing some-thing right. If there is worsening, we must be doing something wrong and we need to drastically change the medicine. The committee notes that growth inIndian banking has come without “significant instability”. This is an under-statement in respect of the post-reform period – one has to only look at well docu-mented studies on economies that have gone through bank deregulation. If we are anoutlier when it comes to the degree of government ownership in banking, as the committee notes elsewhere, we are also an outlier when it comes to banking stability. The committee also notes that in terms of return on assets, the Indian banking system is among the better performers in the world. What are some of the committee’s concerns and how valid are these? One, India’s banking system is relatively under-developed going by the ratio of commercial loans to the gross domestic product (GDP). This ratio is over 50 per cent at the mo-ment. It is true the ratio is lower than some other developing countries (although it is higher than that of Brazil with which India is often grouped). The key question is: what is the present trend? The ratio has been rising rapidly thanks to loan growth of 30 per cent in recent years and it will continue to do given projected loan growth of 20-25 per cent. It is only a matter of time before we catch up. Two, Indian banks are small relative to some banks in other economies – China, for example. So what? China’s banks do not compare with ours in profitability. As the committee itself notes, the size of banks is not disproportionate to those of Indian companies. As the Indian economy grows and as corporates grow, so will Indian banks. Some will try to leapfrog the process through mergers. True, to the extent that banks lack scale, they will miss out on some large loan re-quirements of the top corporates. But, in general, banks must accept that the top corporates will not need them as they can access capital markets. Isn’t that what dis-intermediation is all about? Banks must reinvent themselves so that they can make a viable market out of the middle and low corporates. Viewed thus, the issue for Indian banks is not so much scale as the ability to judge and price credit risk.Three, India’s banking market is ex-tremely competitive if we look at the share of the top three banks in total assets. The committee, however, says that if we view public sector banks (PSBs) as one group, T T Ram Mohan ( is with the Indian Institute of Management, Ahmedabad.
DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200829then one type of owner has 70 per cent of all assets. If the suggestion is that there is lack of competition, that is incorrect.PSBs are competing with each other, they do not behave as they are all part of one happy family.Four, the report states that India’s inter-mediation costs are high going by the spread – the difference between lending and borrowing rates of bank – of over 5per cent. This spread, the report notes, is offset by priority sector and statutory li-quidity ratio (SLR) requirements. It could also be that the spread is warranted by the riskiness of certain types of credit. It could be warranted by higher intermediation costs arising from the huge network of branches and the number of people involved. The committee believes that the burden of a high spread in banking falls on the Indian saver. The presumption here is that if some of the social obligations were to be removed, the benefits would accrue to savers and not to shareholders. This may not be true. In the post-reform period, yields on loans have fallen but yields on deposits have fallen even more, resulting in a net benefit to bank shareholders, not to savers. An important reason for the banking system enjoying a high spread is the over-whelming preference among savers for bank deposits. It is only when there is a big flight of savings to other savings instru-ments that banks will start offering higher returns to savers. So, merely removing so-cial obligations for banks may not help savers – it could simply mean fatter profits for banks on top of the very high returns they enjoy today.Five, the committee points to the low usage of technology to reduce transaction costs in India – for instance, the number of ATMs per million of population is lower in India than elsewhere. But this overlooks two aspects of the use of such techno-logies. First, banks elsewhere and also the newer banks in India have opted for such technologies as a way to avoid the bigger investment in branches. However, where a huge branch network has been created at historical cost, as in India, the compulsion to reach out through ATMs and other technologies is commensurately lower. In branch coverage, India ranks at the top along with theUS.Secondly, there has been asea-changein banks’ own perception of the importance of these technologies. Whereas some years ago,ATMs or online banking were seen as a substitute for branches, today they are seen as comple-ments to brick and mortar. Branches are essential for customer acquisition; ATMs and the rest are essential for customer re-tention. Coverage of ATMs and otherchan-nels in India is increasing. But the lowcov-erage of new technologies is not a weak-ness because the Indian banking system has inherent strengths in the branch net-work created after bank nationalisation. Six, the committee makes too much of PSBs’ decline in market from over 80 per cent to 72 per cent of assets and the smaller rate of growth of their balance sheets rela-tive to private banks. Partly this reflects the lower base from which private banks started off. The critical variables are growth in commercial credit and in profits or earnings. In respect of these variables, PSBs never had it so good. People IntensiveIt is also not appropriate to compare PSBs with other groups on profit per employee, as the committee has done. These figures will necessarily be lower forPSBs because they use a people-intensive business model. Private banks may incur huge costs on other elements crucial to their business model. It is the overall cost to income ratio and total factor productivity that must be compared if we are to arrive at meaningful conclusions. Lastly, the report points out how the comparable levels of profitability of PSBs and new private banks mask fundamental differences about the sources of profit. The latter have superior organisational capabilities (one is not as sure about sales and distribution channels or risk manage-ment, dimensions on which the commit-tee rates them superior) and are better placed to tap the affluent segments. This is indeed true.PSBs lag behind new private banks and foreign banks in wealth management and fee income generally. Private banks do a much better job of catering to affluent customers thanPSBs. These differences show up in higher market valuations for new private banks. (It is worth pointing out, however, that the State Bank of India does not suffer much in comparison.) But how big a problem is this? It could well be that, over time, we see a clear segmentation among banks – PSBs do “mass banking” while private banks cater to a more select clientele. Each could be viable in itself. For PSBs, the challenge may well be to make a commercial success of the mass market instead of trying to mimic their counterparts in the private sector. The report highlights howPSBs are big losers from the “grand bargain” inflicted on them, having to incur various social obligations in exchange for certain bene-fits that go with public ownership. Doing away with these would impose a cost, namely, higher rates on savings deposits due to deregulation. There would be bene-fits ifSLR and priority sector obligations were dispensed with. The report cites a McKinsey estimate of the net benefit – about 20-30 per cent of net operating profit – or, say, 15-20 per cent of net profit. The computation deserves careful scru-tiny. It is well known that not all of the pri-ority sector requirement constitutes a bur-den. Some of it, such as housing loans up to a certain value and vehicle loans in ru-ral areas, are indeed commercially attrac-tive and have been included in the priority sector computation only to make it easier for banks to meet the 40 per cent target. (This may explain why private banks have of late exceeded the overall priority target while falling short in respect of agriculture and having low exposure to small-scale industry.) So, if the benefit to banks is computed on the assumption that all of the 40 per cent is at present at non-commercial rates, we would have an overestimate. On SLR too, it must not be presumed that all of the mandated 25 per cent is a burden. There have been periods when banks have, on their own, invested way beyond the 25 per cent limit – at one point, such investment was over 40 per cent. In light of the sub-prime crisis, Indian banks’ holding a reasonably high proportion of liquid, government securities does appear as a strength, just as the low levels of such securities with banks abroad comes as something of a shock. If we accept that anSLR requirement is not such a bad thing – and that it is bound to go down over time – the presumed benefits of liberating banks from this requirement would not be large. In other
DRAFT RAGHURAM RAJAN COMMITTEE REPORTaugust 9, 2008 EPW Economic & Political Weekly30words, the addition to net profit of releas-ing PSBs from the “grand bargain”, correctly computed, could be more of the order of 5-10 per cent. Given their current profitability, this is not such a big deal. Or, to put it differently, social obligations may not constitute such a crushing burden.Proposals for ReformThe intention in making this dissection of the analysis of the Indian banking sector leading up to the committee’s prescrip-tions for levelling the playing field is to show that the concerns that underlie the committee’s reform proposals are neither as material nor as urgent as the report makes them out to be. Sure, there are umpteen things we could do by way of improving the Indian banking system. But both the nature of the improvements and the pace of change will be governed by our assessment of where things stand today. The committee looks at the glass and finds it half empty; some of us prefer to think it is half full.Let us now turn to the committee’s pro-posals for reform ofPSBs. The committee considered and rejected the option of pri-vatisation although the majority on the committee saw little reason for continued government ownership of banks. Privati-sation of all of the PSBs was not favoured because it was not considered a realistic option in the present environment. However, the committee favours selling some of the smaller, underperforming PSBs and seeing the results. This sounds like a pragmatic compromise. But the present statutes do not permit sale of government’s equity in PSBs, so these would have to be amended. An amendment would, however, open up the possibility of such a sale in PSBs across the board and would, therefore, be stoutly opposed by unions as well as some political parties. It does appear that selec-tive privatisation may be difficult.The committee is right in saying that whole-hogging privatisation poses a host of problems, quite apart from not being favoured by public sentiment. Selling large PSBs to private banks would raise issues of concentration. Selling them to large industrial houses would revive the ghost of related-party transactions. Selling to foreign banks is politically unacceptable, as the committee points out, but there are regulatory concerns as well. PSBs could be sold through a public offer as in the case of British privatisation, but this requires a greater degree of confidence in corporate governance than obtains at present. The practical course, then, is to effect improvements in governance inPSBs. The committee makes a number of proposals. Let us take up the key proposals.(i) Strengthening of Bank Boards: The committee points to dissatisfaction about government nominees who often lack knowledge of business or banking. It would like all directors to be appointed by an independent selection board. It is hard to see how any government will forgo the right to appoint its nominees – in private companies, all “independent” directors are selected by the promoters or management. The best we can do is ensure a minimum of competence in government nominees as well. We can do this by having the regulator prescribe “fit and proper” criteria for all directors on a board, be they government nominees or independent directors.There is already an appointments com-mittee, headed by the governor of the Reserve Bank of India (RBI), which selects top management of banks. Its scope could be extended to include appointment of in-dependent directors. A suitable composi-tion for the appointments committee can also be prescribed. It could include, say, a nominee of the chief justice of India, a dis-tinguished public figure and so on. There could be “fit and proper” criteria for the non-official members of the appointments committee as well.The committee would like to see repre-sentatives of non-government shareholders as well on bank boards. There is already a provision for such nominees but, as the committee notes, this only leads to directors proposed by management being voted in by shareholders. Widely dispersed ordinary shareholders, perhaps, cannot be expected to organise themselves to select their nominees. A better alternative would be for financial institutions, domestic and foreign, to take the lead in proposing non-government nominees. In all listed com-panies, public sector or private sector, we need to get financial institutions to bring in their nominees.The committee echoes the familiar clamour for “autonomy” of PSU boards, chiefly in relation to appointment and termination of CEOs. Since this has been demanded and not conceded for at least two decades now, it is hard to see the situ-ation changing. It cannot be that govern-ment is ultimately responsible for a PSU but does not have the right to appoint top management. We do not yet have a culture of govern-ance strong enough to ensure accountabil-ity of professionally-managed firms – and the experience with some of the best known financial institutions in the sub-prime crisis does little to enhance confi-dence. The best we can ask for, under the circumstances, is that top management appointments not be influenced by political considerations. The strengthening of the appointments committee along the lines suggested above is all we can hope for. (ii) Delinking Banks from Government: The proposal to delinkPSBs from govern-ment and from oversight by the central vigilance commissioner (CVC) and Parlia-ment also does not appear realistic. Having government indirectly own PSBs through holding companies or through other government-owned financial insti-tutions or reducing government stake to below 50 per cent to exempt them from PSU norms will not take us far either. The government is unlikely in any of these situations to cede full authority to an independent board. The problem withPSBs is not so much that the government appoints top man-agement. PSBs are different from other PSUs in that the appointment of top man-agement has been reduced to a game of musical chairs with managers jumping from one bank to another at the executive director and chairman and managing director levels. This has made nonsense of top management accountability and suc-cession planning. We do not have this syndrome in oil, power or insurance com-panies – somebody from within the organ-isation has a reasonable chance of getting the top job. It is for the appointments com-mittee to rectify this anomaly which is peculiar to the banking sector. Human resource development (HRD) should be the number one priority for PSBs

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