Performances of LABs So far

As at end of 2002, the LABs have opened only 25 branches and of these only 7 were in rural areas. They are mostly operating in the already banked centers. The total volume of business handled was Rs. 153 crores as on 31st March 2002, and the bulk of the business was emanating from the district head-quarters, where the head offices of these banks were located. It is obvious that LABs have not made any impact on the local communities amongst whom they are functioning in terms of any of the significant indicators such as deposit mobilization, number of depositors, number of borrowal accounts and amounts lent, number of rural branches and number of poor people helped. LABs as now constituted and with their present capital base are unlikely to make themselves felt on the rural scene as any significant purveyors of credit in the foreseeable future.

In this context the Review Group has commented as under:

"In examining the working of the existing LABs, we cannot refrain from drawing attention to certain fundamental issues relating to the very concept of an LAB. We are strongly of the view that whether it is rural banking or any other segment of the financial sector, size, whether in terms of capital base or totality of operations as reflected in the balance sheets, is of critical importance. It is size which inspires and retains the confidence of depositors and borrowers alike. It is size of capital which enables a financial entity to cope with unexpected adverse trends in its business and overcome threats to its survival from any panic reaction on the part of its investors. LABs in our view fail to pass this critical test. Their initial capital being only Rs. 5 crores and the capital adequacy requirement being set at 8% , they are handicapped ab initio by the severe restrictions being imposed on their growth. They thus suffer from an inherent inability to absorb the losses which were bound to arise in the course of their business. We should remember that LABs have been mandated to lend to agriculture, priority sector and also weaker sections in the rural areas. The credit portfolio of an LAB will thus tend to be more risk prone than that of other banking institutions. In view of their size and location, they will not also be able to diversify and derisk their business model. Their inability to undertake other activities will also expose them to the risks of concentration. Further, since LABs depend on loan portfolio for their income and do not have diversified income stream, they have to necessarily expand their loan portfolio for generating income. This exposes them to the risk of adverse selection. It is true that none of the LABs has so far posted any non-performing assets. But this is no matter for comfort. The absence of non-performing assets is solely due to the fact that LABs are of recent origin and are not matured sufficiently. Even so, we noticed that stressed accounts are emerging in the books of one of the LABs. This LAB is also engaged in trading in securities income from which outstrips its net profit. Thus if its stressed assets become non-performing and the bank is unable to earn substantial income on its securities portfolio, there will be the worrisome prospect of the bank incurring losses. Given its narrow capital base, it will not take much time for the concerned bank to become weak and sick. There are thus fundamental weaknesses inherent in the business model of the LAB. These need to be addressed without delay. The irregularities noticed in the functioning of the existing LABs need to be dealt with quickly while initiating simultaneously measures to enable them grow on healthy lines and attain viability within a reasonable time frame. Keeping these objectives in view we make some recommendations in the following paragraphs."

The Review Group recommended a number of measures that "have to be undertaken to strengthen them and new norms of capital and capital adequacy have to be laid down if the few banks which have come into existence are to survive and grow." The summary of the recommendations of the group are as under:

1. Licensing of new LABs- Since the current LABs have only recently commenced functioning, some more time needs to be given to observe their performance and help given to overcome their weaknesses. We would urge that till these measures to strengthen the existing LABs are put through and the existing LABs are placed on a sound basis there should be no licensing of new LABs.

2. Capital base- LABs with their present capital base cannot become viable institutions. The existing LABs should be asked to reach net worth of at least Rs.25 crore over a period of five years.

3. Capital adequacy- LABs should also be enjoined to maintain a minimum capital adequacy of 15%. This should not be a problem for the present. A higher capital adequacy norm is being proposed because as pointed out earlier LABs carry an inherently high-risk portfolio and do not have derisking possibilities. The matrix proposed by us - a net worth of Rs. 25 crore and capital adequacy norm of 15% would enable LAB to build an asset base of about Rs.150 crore - a level at which their operations would become viable. Every one of the existing LABs should be asked to submit a suitable road map for achieving the twin objectives of higher capital base and enhanced capital adequacy norm (Para 3.18).

4. Trading in securities- Considering the risks involved, LABs should be prohibited from trading in Government securities and other papers during their formative years, say for a period of five years.

5. Engagement of agents- LABs should not be permitted to engage the services of agents and quasi agents for achieving their business outreach.

6. Arms length relationship- In view of the inherent weaknesses of LABs, great care has to be taken to ensure that no "Holding out" is done by the sponsoring agency and an arms length relationship is maintained with other group entities by the LAB.

7. Scheduling of LABs- It is too early to confer on LABs the status of a scheduled bank. Scheduling of LABs may be considered after they have reached higher capital and capital adequacy and after watching their performance for sometime.

8. Refinance- The absence of refinancing facility places the LABs under a serious handicap both in managing maturity mismatch and in their ability to lend at finer rates .We therefore suggest that though an LAB may not be "scheduled," it should not be denied access to refinance for its term lendings from NABARD and SIDBI. However, as a precautionary measure we suggest that refinance should be permitted only in respect of such loans where at least one instalment repayable has been recovered by the LAB. Such a proviso would hopefully inculcate credit discipline among the LABs in the sanction of term loans and the refinance facility will not end up as a mere liquidity support.

9. Branch licensing- LABs should be treated on par with Cooperative Banks in the matter of opening of branches falling within their charter. Other restrictions should be waived and the opening of a branch should be subject only to the granting of a licence by the Reserve Bank of India.

10. Branch expansion- To enable LABs to expand their business and attain viability we recommend that after LABs have opened a certain minimum rural /semi urban branches, they could be licensed to open more urban branches. A ratio of one urban branch to 10 rural/ semi urban branches will perhaps be appropriate. While the first urban branch may be allowed to be opened at any time, the second urban branch should be permitted to be opened only after 20 rural/semi urban branches have been opened by the LAB concerned.

11. Regulation & Supervision- LABs need to be treated like any other commercial bank and therefore, regulation and supervision should be entrusted to the same wing of the Reserve Bank which is responsible for Regulation and Supervision of the commercial banks. The RPCD should be relieved of its responsibility of regulating LABs.