Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Credit Market Structure

In the context of relatively underdeveloped capital market and with little internal resources, firms or economic entities depend largely on financial intermediaries for their fund requirements. In terms of sources of credit, they could be broadly categorised as institutional and non-institutional. The major institutional purveyors of credit in India are banks and non-banking financial institutions, i.e., development financial institutions (DFIs) and other financial institutions (FIs) and non-banking financial companies (NBFCs) including housing finance companies (HFCs). The non-institutional or unorganised sources of credit include money-lenders, indigenous bankers and sellers for trade credit. However, information about unorganised sector is limited and not readily available. The credit market is the predominant source of finance. An important aspect of the credit market is its term structure, viz., (i) short-term credit, (ii) medium-term credit, and (iii) long-term credit. While banks and NBFCs predominantly cater to short-term needs, FIs provide mostly medium and long-term funds. However, the actual time-length of the credit availed would depend, inter alia, on the production-sale cycle.

Banks in India can be broadly classified as commercial banks and co-operative banks. In terms of ownership and function, commercial banks can be grouped into three categories-public sector banks, regional rural banks and private sector banks (both domestic and foreign). These banks have over 67,000 branches spread wide across the country. After initiation of financial sector reforms, competition in the banking sector has increased. Porter (1985) crystallises competition as a composite of five forces, viz., rivalry amongst existing firms, potential entry of new competitors, potential development of substitute products, bargaining power of suppliers and bargaining power of consumers. (Porter, Michel E., (1985), Competitive Advantage: Creating and Sustaining Superior Performance, The Free Press, New York). In the context of banking, all these are relevant except perhaps the bargaining power of suppliers. The threat of new entrants and substitute products as well as the rivalry amongst existing banks are becoming increasingly apparent in the Indian banking industry.

Competition among commercial banks has increased with the entry of new private sector banks and the permission to foreign banks to increase their number of branches in the 'nineties. After the guidelines issued in January 1993, 8 new private sector banks are presently in operation. These banks use state-of-the-art technology. Further, following India's commitment to the WTO agreement in respect of the services sector, foreign banks, including both new and the existing ones, have been permitted to open up to 12 branches a year with effect from 1998-99 as against the earlier stipulation of 8 branches. Also, competition among public sector banks has increased with relaxation of many guidelines, allowing for portfolio shifts for optimising the ultimate objectives. With the amendment to the Banking Companies Acts 1970/1980, public sector banks are now allowed to access the capital market to raise funds. This has diluted the shareholding of the Government, although it is still the major shareholder with a minimum 51 per cent of total equity. Local Area Banks (LABs) are also being set up to induce competition in urban, semi-urban and rural areas.

The competition in the banking sector has so evolved in the recent years that the market structure of the banking sector has tended to be oligopolistic. While the number of banks is reasonably large, the dominance of public sector banks, and especially of a few large banks continues. Such banks accounting for large share of deposits and advances as market leaders are able to influence decisions about liquidity and rate variables in the system. But, even such banks may face challenges in the future and face tougher competition, given the gradual upgradation of skills and technologies in competing banks and the restructuring and re-engineering processes being attempted by both foreign and private sector banks.

Since bank nationalisation in 1969, there has been significant growth in the geographical coverage of banks and the amount of resources mobilised by banks. The spectacular increase in deposits as percentage of national income to 48.7 per cent in 1999 as against 15.5 per cent in 1969 testifies to the favourable impact of branch expansion. There has also been a sharp increase in credit to agriculture, small-scale industries, trade and other activities which had little access to bank finance before 1969.

Prior to financial sector reforms, commercial banks functioned in a regulated environment, with administered interest rate structure, quantitative restrictions on credit flows, fairly high reserve requirements and pre-emption of significant proportion of lendable resources for the priority and the government sectors. While the quantitative restrictions led to the credit rationing for the private sector, interest rate controls led to sub-optimal use of credit and low levels of investment and growth. At the same time, flexibility of monetary policy in influencing the volume and cost of credit was constrained by considerations relating to domestic debt management and the need to finance the resource needs of the government sector. The resultant 'financial repression' led to decline in productivity and efficiency and erosion of profitability of the banking sector in general.

It is in the background of these circumstances that the development of sound commercial banking system was worked out mainly with the help of the recommendations of the Committee on the Financial System (Chairman: Shri M. Narasimham), 1991. The consequential financial sector reforms envisaged interest rate flexibility for banks and reduction in reserve requirements, besides a number of structural measures. Interest rates, as a consequence, have emerged as a major signalling device for resource allocation. This apart, credit market reforms included introduction of new instruments of credit, changes in the credit delivery system and integration of functional roles of diverse players, such as, banks, financial institutions and non-banking financial companies (NBFCs). The gradual introduction of a loan system in the place of a cash credit system has facilitated banks in planning their cash flows better, and in reducing the costs of uncertainty. At the same time, there has been greater competition with the introduction of new private sector banks and the permission given to foreign banks to open branches, as also with progressive improvement in the role of the non-banking sector. Restrictions on project financing by banks have been removed. With the result, the share of term loans as percentage of total bank loans went up to 34.9 per cent as at the end of March 1999 from 26.1 per cent as at end-March 1995.

The implementation of prudential norms characterised the initial phase of the financial reforms. Once the framework of improved soundness of financial intermediaries was provided, attention was bestowed on deregulation of the credit market. The gradual scaling down of cash reserve and statutory liquidity requirements has afforded flexibility to banks to manage their asset portfolios. The average CRR has been progressively brought down to 8.5 per cent in August 2000 from its peak at 15 per cent during July 1989 to April 1993. The SLR, which was at a peak of 38.5 per cent during September 1990 to December 1992, had been reduced to the statutory minimum of 25 per cent by October 1997. Besides, the coverage of priority sector has also been appropriately enlarged to include software and agro-processing industries and venture capital, while the existing priority sector categories have been broadened, giving the banks larger access in meeting the priority sector targets. Selective credit controls were eliminated over time. In addition, credit restrictions have been gradually removed/relaxed for purchases of consumer durables, and loans to individuals against shares and debentures/bonds.

An important development in the financial sector in the recent years has been the diversification and growth of para-banking activities. In India, following the erstwhile UK model, wherein diverse financial activities can be undertaken only through separate affiliates, banks were allowed to undertake non-traditional activity, i.e., leasing through separate subsidiaries in 1983 by amending the Banking Regulation Act, 1949. From 1986-87 and onwards, banks were allowed to set up subsidiaries to undertake other non-traditional activities, such as, mutual funds, hire purchase, factoring, etc. A number of banks have sponsored mutual funds (for example, State Bank of India, Canara Bank and Indian Bank). In 1994, banks were also allowed to undertake departmentally para banking activities, such as, leasing, hire purchase, factoring, etc. Presently, banks can undertake para banking activities either through subsidiaries or in-house or both.

The reasons for banks entering para-banking activities include the need for diversifying earnings, maximising economies of scale and scope, making profits, and also the desire to have leading market positions in financial services.

Merchant banking is an important area where subsidiaries of banks have made their presence felt. Merchant banking includes services, such as, pre-issue, management of public issue, etc., and as such is dependent on the conditions in the stock market. Prior to 1983, banks used to undertake merchant banking activites in-house. In 1983, they were allowed to set up separate subsidiaries for undertaking merchant banking activities and the first banking subsidiary in the field of merchant banking was the SBI Capital Market, which started functioning in 1987 when the capital market was buoyant. There are now a number of bank subsidiaries involved in the merchant banking activities, such as, PNB Capital Services, BOI Finance, Indbank Merchant Banking Services, etc.

The dealing in government securities is another area where banks have been fairly active. Banks also set up subsidiaries for acting as primary dealers for government securities which include SBI Gilts, PNB Gilts, Gilts Securities Trading Corporation (set up by Canara Bank and Bank of Baroda).

Banks, through their subsidiaries, also provide services, such as, factoring (SBI Factors, Canbank Factors, etc), securitisation of loans and receivables into debt securities (Citi Bank), stock broking (SBI Securities, PNB Securities, etc.), financial guarantee for infrastructure projects, etc. Venture capital is a new area where banks have entered. The main players include Canbank Venture Capital Fund. SBI, Andhra Bank, Union Bank of India have contributed towards equity of venture capital funds floated by Technology Development and Investment Corporation of India (TDICI), Gujarat Investment Corporation, etc. Many banking subsidiaries, such as, SBI Home Finance, BOB Housing Finance, and PNB Housing Finance, are also quite active in the field of housing finance. Banking subsidiaries are also operating in the credit card business, e.g., SBI Cards and Payment Services Ltd. 4.15 There is a shared responsibility between the Reserve Bank and SEBI in the regulation of para banking activities of banks. In India, a prudential regulatory framework based on capital adequacy is in place in the case of para-banking subsidiaries as well. It is also important to adopt an arms-length approach between a bank and its subsidiary since involvement of banking subsidiaries in any activity that is subject to 'bubbles' and irregularities could impose financial burden on parent banks. But, as the problems of subsidiaries are hardly quickly noticed, public sector banks have been required to provide a consolidated balance sheet including position of their subsidiaries from the year ended March 31, 2000 to correctly reflect their financial strengths and weaknesses as is the case in the US. Such a transparent practice will help individual investors to make informed choices better.