A strong and efficient financial system, functionally diverse and geographically widespread, is critical to the attainment of our objectives of creating a market driven, productive and competitive economy and to support higher investment levels and accentuate growth. The creation of such a system has been the objective that has inspired the process of financial sector reform since 1992 as part of the broader programme of structural economic reform.
Reforms in Banking Sector
As part of this process, reform of the banking sector is now under way. The banking system is, by far, the most dominant segment of the financial sector, accounting as it does for over 80 per cent of the funds flowing through the financial sector and it is appropriate that reform measures taken in this area have followed the recommendations of the Committee on the Financial System (CFS), which reported in November 1991. That Report had made a number of recommendations aimed at improving the productivity, efficiency and profitability of the banking system on the one hand and providing it greater operational flexibility and functional autonomy in decision making on the other. It covered policy aspects, accounting practices institutional and structural issues and matters relating to organisational development. The report itself was conceived as a holistic exercise and its recommendations were accordingly symbolically related to each other.
Since the submission of the Report several measures have been instituted in line with its recommendations. Accounting practices have been prescribed more in consonance with internationally accepted standards in this regard with the major objective of enhancing transparency and credibility and ensuring accuracy of financial statements.
Asset classification criteria have been prescribed and principles governing income recognition have been laid down with the aims of removing subjectivity in this regard and providing for measurable objectivity. Prudential norms have also been prescribed, most importantly, with respect to provisioning for various categories of market related and substandard assets
Capital adequacy requirements have also been laid down, directed towards enhancing the inherent strength of banking institutions. With regard to policy measures, the significant changes that have been effected in line with the recommendations of the CFS have been the progressive reduction of the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR) requirements as an aspect of correcting the impact of the high proportion of directed investments on profitability and operational flexibility. Another major step has been as suggested by the CFS , the progressive deregulation of the bewilderingly complex and detailed administered interest rate structure and to move interest rates more closely to a market-determined basis and to restore to the Bank rate its function of being an anchor or reference rate.
These have been very major and significant changes but it would be observed that while the `arithmeticals' of the CFS recommendations in relation to various ratios, rates and accounting have been accepted and put through the same measure of progress has not been made with regard to structural and systemic aspects of the reform agenda outlined by the CFS. Even with regard to `arithmeticals', an important recommendations relating to directed credit has not been accepted. In some cases, as for instance in respect of the ways to handle the problem of non performing assets (NPAs), while the problem has been recognised the approach adopted has differed.
Even as these measures are making their impact there have been major changes in the macro economic environment and policy and institutional developments. These may call for an examination of the problem issues anew and possibly for a review of some of the recommendations made earlier to see whether they continue to have the same relevance in the changed context. The most important change in the domestic macro environment has been the greater focus or the containment of the fiscal deficit the subsidence of inflationary pressures and the restoration to monetary policy of its defining function of regulating money and credit in the pursuit of its central objectives of price and exchange rate stability. For monetary policy itself to be effective we need a well knit and integrated financial system and active money and capital markets. The greater reliance on market instruments of monetary regulation and especially on the interest rate has been implications for the banking system in terms of expanding the scope and range of the risk management function especially as marking assets to market prices comes, as it should increasingly into vogue. Apart from the traditional concerns with credit risk, banks will thus increasingly need to manage market and liquidity risks and to develop the skills for this. The other development has been the much greater flexibility now available to banks and financial institutions with respect to forego exchange transactions. Indian banks are participating in growing measure in the foreign exchange markets both in India abroad with all the opportunities and risks that this entails. We could also expect derivative trading to play an increasing role with appropriate forms of risk management.
These changes in the domestic economic and institutional scene have coincided with the movement towards global integration of financial services. Financial autonomy is not a viable or even a possible option. Global financial integration would call for a greater measure of competitive efficiency in our financial system if it is to be able to face successfully the challenge of increasing competition from abroad. This is more so in the context of our objective of moving in a phased manner towards a more liberal capital account regime. An open capital account would result in larger inflows and outflows with attendant implications for the management of the exchange rate and domestic liquidity. For the system to be able to handle such problems it would need to be strong and resilient. The recent developments in East and South East Asia have only underscored the importance of a strong domestic financial system. The experience has shown that despite strong economic fundamentals, such as high savings rate and prudent fiscal policies, weak banking policies and practices and the consequent fragility of the financial system can have a serious destabilising influence.
Recent developments have thus served to reinforce the point that a strong and efficient financial system is necessary both to strengthen the domestic economy and make it more efficient and also to enable it to meet the challenges posed by financial globalisation. Building such a system constitutes the unfinished agenda of banking and financial sector reform.
Action on strengthening the foundations of the system would necessarily involve improving the quality of bank assets. Nothing is more indicative of the quality of assets than the quantum and incidence of NPAs in relation to the total portfolio. The causes for a high proportion of NPAs are various. Poor credit decisions by bank managements, difficult recovery environment and changes both cyclical and structural in the larger economic environment represent some of the micro and macro aspects of this. This is not all. Often, as international experience has shown, a high incidence of NPAs could be traced to policies of directed credit, not to speak of cruder forms of behest lending. In our own country, the `contamination coefficient' of directed credit has been shown to have a value above unity as the figure of NPAs emanating from priority sector credit testify. There is nothing inherently wrong in setting out social priorities for bank lending. Social banking need not conflict with canons of sound banking but when banks are required by directive to meet specific quantitative targets, there is as our own experience has shown the danger of erosion of the quality of the loan portfolio.
In the last few years the overall proportion of net NPAs to the total portfolio has come down. Gross NPAs amounted to a little under twice the proportion of net NPAs. The reduction in the level of NPAs partly reflects banks efforts at recovery and the write-offs of losses and provisioning for non performing loans which banks were enabled to do as a result of infusion of Government funds as part of a recapitalisation programme. The figure of NPAs, however, remains uncomfortably high as an average even as it conceals wide individual variations with the position of some banks being quite disconcerting. The NPA figures incidentally do not include advances covered by Government guarantees which have turned sticky. It is also important to ensure that the classificatory norms for NPAs are strictly adhered to in letter and spirit and to see that the phenomenon of ever greening does not mask the true situation.
An important aspect of the continuing reform process is thus to reduce further the high level of NPAs as a means of institutional strengthening. While there is reason to expect that with a combination of policy and institutional development, new NPAs could in future be lower than hitherto, the problem remains of the huge backlog of existing NPAs which impinges severely on banks performance and their profitability. Several approaches are possible. The earlier Committee had suggested the creation of an Assets Reconstruction Fund (ARF) to take these assets off banks books at a discount. Recapitalisation through infusion of capital is another approach and has been used in the case of some banks. In the last six years massive budgetary funds have been used for recapitalisation of public sector banks. This a costly and over time, not a sustainable option. The problem, however, remains and consideration would need to be given to revisiting the concept of an ARF.
Another measure intended to enhance the financial strength of the system is the enhancement of capital funds of banks. At the time of the earlier Committee reported the desirable and feasible target for capital adequacy seemed to be the level set by the Basle Committee of BIS. Several developments have taken place since. We now have a better idea of the nature and volume of risk weighted assets. As observed earlier, with greater volatility in exchange markets and the greater use of interest rate variations as instruments of monetary policy the market of asset price risk of both foreign assets and domestic investments is now quite considerable. Banks have also been getting more exposed to off balance sheet risks. Banking is essentially an exercise in risk management. All these considerations suggest the need to review anew the minimum prescriptions for capital adequacy with a view to their possible enhancement.
Another important measure of the strength of the system is its profitability levels. The high level of NPAs has been a proximate cause for the low profitability levels of our public sector banks. Other factors have been the large number of unremunerative branches, low productivity, over manning and arcane methods of operations apart from the impact of directed credit and high pre-emptions of funds. Spreads in the Indian banking system remain high and yet profitability levels are low. There has been some improvements in recent years is net profits for Public Sector Banks (PSBs) as a group (partly as a result of some recapitalisation in some of them). With increasing competition from foreign and private banks, margins will come under further pressure and issues of customer orientation productivity and efficiency in relation to profitability will come to the fore.
Action on strengthening the foundations of the system by improving asset quality enhancing capital and improving profitability would need to go along with structural changes in the system. One of the more important developments that has been taking place in international banking is the revival of the phenomenon of universal banking in terms of which the distinction between commercial investment and development banking is getting blurred. In this country also we are moving towards this concept. Commercial banks have been making in larger measure than before, term finance to industry and providing investment banking services apart from setting up subsidiaries in such diverse areas as mutual funds securities trading and factoring. At the other end of spectrum the development finance institutions (DFIs) are increasingly getting into the areas of working capital finance and have also set up banking and mutual fund subsidiaries. The financing requirements of Indian corporates, whether from the DFIs or from the banks, are now being seen as an integrated operation. Non-banking financial companies (NBFCs) have proliferated in India in areas like consumer finance, hire purchase, equipment leasing and housing finance. How their activities should be integrated into the financial system and regulated is an issued which needs to be examined.
The financial structure is thus evolving towards a continuum of institutions rather than discrete specialisation and the facilities that are being provided are to be seen as aspects of a spectrum of financial services in keeping with relationship banking. Universal banking in fact provides for a cafeteria approach or, if one were to vary the metaphor it would take on the role of a one stop financial supermarket. These developments also have implications for the framework are content of regulation.
