Project on Indian Financial Market - Module: 5
Financial Sector Effeciency
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Preface & Introduction

Finance plays an important role in the process of economic development. For performing this role effectively, it is necessary that both financial institutions and financial markets are efficient. Various reform measures initiated in the 1990s are, inter alia, aimed at making the financial institutions and markets efficient. The Module: 5 - "Financial Sector Efficiency" examines, in detail, financial sector efficiency, especially of the banking sector. Efficiency of both the markets and the institutions has improved following competitive pressures resulting from deregulation of financial markets, advances in technology, blurring of distinctions among providers of financial services and increasing integration of markets.

Financial sector efficiency reflects efficiency of both financial markets and financial institutions. Markets are viewed as efficient when market prices faithfully reflect all available information, so that it is not possible for any trader to earn excess profits in a systematic manner, based on the available information. A financial entity, on the other hand, could be viewed as relatively efficient when it offers competing services at relatively lower prices, without exposing it to higher levels of risk. In a competitive market, inefficient institutions are expected to be driven out by efficient ones, unless protected under certain safety nets or bailout measures. With a view to enhancing financial sector efficiency, therefore, it is necessary to not only foster competition among institutions but also to develop a system that facilitates transparent and symmetric dissemination of maximum information to the markets.

The financial sector reforms in India since the early 'nineties that covered the deregulation of financial markets, advances in technology, growing customer sophistication, stricter regulations and transition to undertaking banking activities under a flexible interest rate and exchange rate environment have generated intense competition among banks, non-banks and other financial institutions in India. Its impact has been felt in terms of competitive pricing of services, narrower spreads and improvement in the quality of services. Competition among financial institutions is also expected to have enhanced efficiency in saving mobilisation, credit allocation and in the provision of a diversified range of financial services. Indian markets have also become more information sensitive and, as a matter of policy, transparent dissemination of quality information on critical economic and financial variables has been accorded high priority. As a result of this, as also the deregulation of financial markets in terms of market forces setting asset prices, the informational efficiency of the markets has improved, which has also helped in the conduct of public policies.

Generating enhanced competition in the banking sector has been an integral part of the overall design for creating a more efficient and stable financial system. Greater competition is sought to be fostered by permitting new private sector banks and more liberal entry of branches of foreign banks. As on March 31, 2000 eight new private sector banks and 42 foreign banks were in operation. In the rural and semi-urban areas, competition is being encouraged through Local Area Banks. Modest diversification of ownership of select public sector banks has helped the process of autonomy and also contributed to strengthening the competitive pressures. Over a period of time, this has resulted in a gradual reduction of spreads (defined as net interest income to total assets) and a tendency towards their convergence across all bank-groups, except foreign banks. Reduced spreads have been supported by improved efficiency reflected in a decline in the intermediation costs as percentage to total assets, especially for public sector banks and new private sector banks, due largely to a decline in their wage costs. At the same time, there has been a gradual improvement in the capital level of the banking sector and on asset quality (Module: 4). This is evident from the plot of CRAR and net NPAs (as per cent of net advances) of public sector banks for the years 1995-96 and 1999-2000 . The improved efficiency and stability of the banking sector as analysed in the previous chapter augurs well for the Indian financial system.

Although the banking industry in recent years has become more competitive, cost reductions have enabled banks to maintain their profitability levels. All the eight banks of the SBI Group have return on asset ratios exceeding 0.50 per cent. The same is the case for all new private sector banks. Among schedule d commercial banks other than foreign banks, only four nationalised banks and four old private sector banks have return on asset ratios up to 0.25 per cent. In contrast, in 1999-2000 as many as 14 out of 42 foreign banks have return on asset ratio up to 0.25 per cent. Since 1993-94, there are indications of improvement in the efficiency of the Indian banking system (Box VII.1). The spreads of scheduled commercial banks declined in the latter half of the 'nineties. The wage bill as percentage of total assets had also declined during this period from 2.05 in 1995-96 to 1.66 in 1999-2000.

The share of financial institutions (comprising all-India term lending and refinancing institutions, state level institutions, investment institutions like UTI, LIC and GIC and its subsidiaries, and other institutions like DICGC and ECGC) in the total assets of banks and financial institutions taken together grew from 26.2 per cent in 1980-81 to 34.5 per cent in 1990-91 and further to 36.0 per cent by 1999-2000. In the recent years, the effect of competition on the efficiency was also in evidence for financial institutions. For all-India financial institutions, the spread declined from 2.25 per cent in 1998-99 to 1.80 per cent by 1999-2000, at which it was almost 100 basis points lower than that for the public sector banks. The wage bill as percentage of total assets at 0.14 per cent was also lower than that of banks. It is, however, necessary to note that the operating environment of banks and financial institutions and their areas of strategic operations are different and, therefore, the ratios may not be strictly comparable.

With regard to profitability-based indicators, the median profit per employee of public sector banks witnessed a significant rise, between the periods 1996-97 and 1999-2000, due largely to a rise in the same in the case of the SBI Group. Most of the other bank groups also posted a significant rise in this ratio, the most prominent being in the case of the new private sector bank group. Among other indicators, non-interest income to working funds, which also is reflective of a bank's profit margin, posted a modest increase for the median public sector bank, while the median foreign bank posted a noticeable rise in this ratio.

In addition, other earnings/cost-based indicators have also been used to examine the efficiency of banks in the Indian context. Using the ratio of wage bill to total expenses, it is observed that over the last two years, this ratio has remained at a high level for public sector banks, while the same has a remained low for foreign banks and new private sector banks. The return on advances, defined as the interest earned on advances/bills to average advances has witnessed a decline for the median bank and across all bank groups.

Another widely used measure of efficiency is the cost-income ratio. Simply defined, it is the ratio of operating cost (non-interest expense) to net total income (total income less interest expense). Bank group-wise figures of this ratio reveals that both the SBI Group and the nationalised banks witnessed a decline in the ratio, which is an indicator of increased efficiency. The ratio has, however, witnessed an increase in respect of the other bank groups indicating a tendency towards gradual convergence of efficiency between the public sector bank group on the one hand, and other bank groups, on the other. However, the ratio is quite high by international standards and would need to be lowered further to improve efficiency.

In India, application of technology varies across different bank groups. Generally, public sector banks tend to use more labour intensive technology, while new private sector banks and foreign banks use relatively capital-intensive technology. The past history of these bank groups and the entry of new private sector banks into these groups have influenced the varying capital intensity in these groups. Historically, the bank groups use divergent input mix and have different goals and objectives. For example, while foreign banks have a greater concentration in the metropolitan areas, public sector banks have penetrated into rural and semi-urban areas. The possibility of exhausting branch level economies of scale in a public sector bank is expected to be quicker than that for a foreign bank. Hence, instead of analysing economies of scale for the scheduled commercial banks as a whole, economies of scale for various bank groups need to be studied separately.

A majority of studies relating to Indian banks, however, concern public sector banks (nationalised banks and banks belonging to the State Bank group) exclusively, in view of their dominance - accounting for four-fifths of the assets of the commercial banking system (excluding regional rural banks). A recent study has adopted the intermediation approach in examining the overall efficiency - technical, allocative and scale - of all public sector banks which operate under the same regulatory framework and are subject to same social obligations2 . The study decomposed overall efficiency into allocative efficiency and technical efficiency; with the latter further decomposed into pure technical efficiency and scale efficiency. It was found that the overall efficiency declined in the immediate post-nationalisation period of 1970-78 and remained unchanged thereafter (up to 1990). The study also noted fluctuation in technical efficiency during 1970-90 -improvement up to 1978 followed by decline in 1984 and improvement thereafter - entirely due to pure technical efficiency, with the scale efficiency remaining almost constant.

During the period 1990-96, the overall efficiency exhibited a slide as decline in technical efficiency-both pure technical efficiency and scale efficiency-was not offset by improvements in allocative efficiency. It was observed that the improvement in allocative efficiency was due to ushering in of financial sector reforms. A disaggregated analysis indicates that the deterioration in technical efficiency of public sector banks as a whole was primarily accounted for by four nationalised banks. These banks exhibited a sharp deterioration in the pure technical efficiency component following the introduction of prudential accounting norms of asset classification, income recognition and provisioning which sharply increased their provisioning requirement, causing severe dent on operating as well as net profits. The sharply increased provisioning requirement mainly reflected the surfacing of the stock-pile of non-performing assets accumulated primarily in the period prior to 1991-92. The marking to market of a progressively higher proportion of Government securities since 1992-93 also necessitated a higher order of provisioning in respect of a few banks. Consequently, the expected growth in the operating margin was not in line with the growth in deposits which gave rise to the underutilisation of the input, viz., deposits. Significant asset-liability mismatches also adversely affected on technical efficiency.

Developments in the subsequent period indicate that a majority of the public sector banks have been able to progress considerably towards the direction of passing the 'acid test' of achieving competitive efficiency. They have been actively engaged in overcoming the challenges of progressively conforming to the international best practices in various areas. The forces of competition are compelling banks to optimise resource use to attain pure technical efficiency and choose the optimal firm size including the quantity of various inputs and outputs so as to reap the maximum economies of scale/scope.

The efficiency of the financial system also depends to a substantial extent on the efficiency of the rural credit delivery system. While these issues have not been covered at length in this report, the Report on Trend and Progress of Banking in India 1999-2000, documented the developments in detail. However, it may be added here that several weaknesses remain in the rural credit delivery system. For instance, the credit cooperative system is plagued by high transaction costs. The organisational structure of co-operative credit system consisting of separate wings for providing short and long-term credit and multiplicity of tiers have contributed to these high costs.

Transaction or management costs and costs associated with credit risks are required to be met out of the interest spread available. Low interest spread/margin is affecting the credit cooperatives. As at end-March 1998, the overall net margin available to State Co-operative Banks (StCBs) ranged between 0.29 per cent (Gujarat) and 2.03 per cent (Andhra Pradesh). In the case of Central Co-operative Banks (CCBs), it ranged from 0.11 per cent (Andhra Pradesh) to 2.28 per cent (Himachal Pradesh). The position at the level of Primary Agricultural Credit Societies was more disturbing with the available information indicating that the net margins ranged from (-) 3.80 per cent (Jammu and Kashmir) to 0.40 per cent (Madhya Pradesh). At the level of Primary Co-operative Agriculture and Rural Development Banks (PCARDBs), the same ranged from (-) 1.93 per cent (Madhya Pradesh) to 1.53 per cent (Tamil Nadu).

To ensure the viability of co-operative banks, it is necessary to charge such rates of interest on their loans and advances as will cover the cost of raising funds, transaction and risk costs. Consequently, in view of the recommendations of the Narasimham Committee (1991), the StCBs and CCBs were given freedom from the interest rate regulations in regard to deposits and advances from October 1994 subject to the prescription of floor lending rate of 12 percent. Likewise State Cooperative Agriculture and Rural Development Banks (SCARDBs)/PCARDBs were also given the same freedom from August 1995.

The poor recovery of loans, coupled with high transaction cost and lower level of loan business, results in losses in large amounts and thus, low financial viability. The total losses increased from Rs.440 crore in 1997-98 to Rs.498 crore in 1998-99 in the case of short-term cooperative institutions, and from Rs.120 crore to Rs.137 crore in 1998-99 in the case of long-term institutions. Many of these institutions have accumulated losses, which outstrip their net worth.