Summary – Yojana – Banking Sector Reforms: Ensuring Regulation

BANKING SECTOR REFORMS: ENSURING REGULATION

Source: Yojana – January 2018

Author: Atisha Kumar, Economist at NITI Aayog

Banking sector is one of the most important sources of credit in India and is important for smooth functioning of the Indian economy.

Key challenges that the banking system faces:

  1. Low financial depth i.e. lesser outreach to people.
  2. High share of non-performing assets NPAs
  3. High Concentration of Public Sector Banks (PSBs)

These issues constrain industrial credit/bank credit and bank’s ability to meet international capital requirements (e.g. Basel III norms to be enforced in January 2019).

Three areas need to be focused upon to stimulate the banking sector:

  1. Improving governance of banks
  2. Enhancing competition in the banking sector
  3. Developing corporate bond markets as alternative source of lending.

History of Bank Reforms in India:

From the late 1960s to 1991, the government nationalised a large segment of the banking sector to the extent that 90% of the banks were controlled by the government. During this period, the geographical coverage of banks increased (number of bank branches grew significantly) and there was significant increase in deposit and credit growth.

However, by 1991, the Indian banks faced the following problems:

  1. Decline in efficiency and productivity;
  2. Poor Customer service quality;
  3. Low profitability.

1991 – To tackle these problems, post liberalisation of the Indian economy, the Committee on Financial Systems, chaired by Mr. M. Narasimham gave the following recommendations:

  1. Reduction in Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR).
  2. Relying on market forces to determine interest rates.
  3. Enhancing competition in the sector by implementing easier entry norms for private and foreign banks.
  4. Reducing substantially the number of PSBs.

 Many of these recommendations were implemented.

 1998 – Committee on Banking Sector Reforms also chaired by Mr. M. Narasimham recommended the following in addition to the legislative reforms and ensuring adequacy of capital:

  1. Greater technology use.
  2. Skills training.
  3. Professional management of banks.
  4. Merger of banks.

Recently in 2014, the Committee to Review Governance of Board of Banks in India (P.J. Nayak Committee) recommended the enhancement of governance and management of PSBs.

The Current Situation:

PSBs dominated India’s banking sector and account for over 70% of total assets. PSBs are the biggest contributors to NPAs contributing 88% of the stock as of March 2016 (Rs. 7.33 lakh crores in June 2017).

As a result, the Return on Assets (ROA) and Returns on Equity (ROE) ratios has been declining and turned negative for the first time in a decade in 2016.

Private Banks are also plagued by high share of NPAs. The gross NPAs of all scheduled commercial banks amounted to Rs. 6.1 Trillion in March 2016. As a result asset quality and profitability have been deteriorating.

On October 24, 2017, the government has undertaken the recapitalization of banks to the tune of Rs. 2.1 lakh crores under the Indradhanush Plan of 2015-16. This will help the PSBs in:

  1. Meet minimum capital requirements;
  2. Help PSBs clean up their balance sheets;
  3. Cover bank loans going forward.

In addition to recapitalisation of banks, the Indradhanush Plan provides seven points for wider banking reforms including:

  1. Creating a framework of accountability;
  2. Separating the roles of CEO and Chairman in PSBs;
  3. Creating a Bank Board Bureau (BBB) for appointment and governance reforms.

Additionally, to resolve the issues of NPAs, government has introduced Insolvency and Bankruptcy Code, 2016 (IBC), which ensures a time bound liquidation.

Global Competition:

Indian banks lag behind global counterparts in terms of financial depth. Financial depth is positively associated with economic growth and poverty reduction (especially in rural areas). India has low levels of private credit to GDP (India: 50.2%; China: 140%; Brazil: 71%) and credit to deposit ratio (India: 77%; China: 312%; Brazil: 119%) compared to other developing economies.

Looking Ahead:

The Indian banking sector should aim at a:

  1. More robust and well-capitalized banking system;
  2. Enhanced capacity to extend credit;
  3. Productive allocation of resources.

Remedial measures should include:

  1. Corporate governance reforms;
  2. Lower entry barriers for new entrant banks;
  3. Improved supervision of banks;
  4. Development of a dynamic corporate market;
  5. Efficient debt recovery mechanisms.

Three particular areas must be prioritized:

  1. Improving governance and strengthening PSBs: strengthening financial regulation and supervision, improving corporate governance and enhancing transparency. South Korea created a Financial Supervisory Service (FSS) to supervise its banks. On such lines, the Indradhanush Plan has suggested the creation of an independent Bank Board Bureau (BBB). There must be greater accountability to ensure that lending practices are in line with productive allocation of credit.
  2. Development of corporate debt markets: Bond markets can be an important source of finance and would enable firms to raise debt at low costs.
  3. Making banking sector more competitive: entry of private and foreign players must be encouraged to foster greater competition and innovation. Policies like ‘on-tap’ licensing of banks must be encouraged. Entry requirements could be relaxed further. However, for the entry of foreign banks, a subsidiary structure must be advocated to limit exposure to global shocks.

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