A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 4 - Financial Sector Reforms

Financial Intermediaries -A Comparison with Other Countries

The financial performance of the Indian banking sector has been evaluated vis-a-vis select East Asian and developed economies.

1. Spreads in India were marginally higher than those in East Asian countries and major developed economies.

2. Profitability in India was found to be significantly higher than East Asian and advanced countries. Pre-tax profit of banks in East Asia turned negative in 1999 due to large losses as a result of the financial crisis. Profitability of banks in India remained stable at around 1.5-1.6 per cent during 1992-99. Although operating costs in India were higher than East Asian countries, to an extent, it was made up by other income, which was found to be higher than both groups of countries. Although in terms of all parameters (other than pre-tax profits) the Indian banks were better placed than their counterparts in Latin America, the comparison needs to be viewed with caution. High operating costs (and high spread ) in Latin American countries were, to a large extent, the legacy of the high-inflation period of the 1980s and the early 1990s, when there was little pressure on banks to cut costs. Secondly, "other income" seems to constitute a high proportion of earnings in Latin America. This was on account of their large holdings of Government bonds, which were included in "other income" rather than in interest income.

3. The level of competition, as measured by concentration ratio, in India compared favourably with several Asian and Latin American countries. The overall CRAR of the Indian banking system, although much above the prescribed level, was significantly lower than that of several countries in Asia and Latin America.

4. Finally, overall asset impairment in India was also at a much higher level in comparison with several other countries.

It may, thus, be noted that financial performance of the Indian banks has not been out of line with banks in other countries. While the capital position of the Indian banks remained comfortable, the asset quality, however, remains a cause of concern. Notwithstanding this, however, the positive impact of competitive pressures created by financial sector reforms in the early 1990s is becoming gradually discernible.

After the East Asian crisis, the stability of the financial system has assumed an added importance and many countries have initiated measures to strengthen their financial systems. However, the impact of the instruments used for achieving financial stability on efficiency is often not obvious. For instance, although the stipulation of minimum level of capital adequacy is expected to inculcate prudent behaviour on the part of banks and thereby enhance stability, its impact on efficiency of the banking system is not always apparent. This is because higher capital requirements may lead banks to assume higher risk or alternatively, make them lower their risk exposure. Thus, the relationship between capital and risk can be bi-directional depending on the risk appetite of the manager. While a risk-loving manager looking for high profits may assume higher risk, the behaviour would be opposite in the case of risk-averse manager. Credit risk also impinges on efficiency. Risks may be costly to manage in the sense that a high-risk firm may require additional capital and labour inputs to produce the same level of output. If it is more costly to run a risky firm, credit risk is expected to have a negative effect on efficiency. However, active risk-taking, which is expected to be rewarded by higher expected return, could have a positive effect on efficiency. There is also a relationship between capital and efficiency. Well-capitalised banks often tend to be better run, suggesting that the relationship between capital and efficiency is likely to be positive. On the other hand, efficiently run banks are able to generate higher profits, enabling them to plough back a part of their earnings into capital and thereby improve their capital position. Thus, capital, credit risk and efficiency are related to one another and the exact nature of the relationship depends on the behaviour of the financial entity. The literature in this context, drawing upon international experiences, shows how the exact nature of the relationship varies across countries (Box VI.2).

In the Indian case, for 1993-94 and 1994-95, it was observed that, in so far as profitability is concerned, foreign banks outperformed domestic banks and there was no discernible difference between unlisted domestic private and state-owned banks (Sarkar et al, 1998). It is possible that since the process of deregulation of the banking sector commenced in 1992, the impact of competitive pressures was felt much later. Recent research however, has observed that differences in profitability and cost efficiency between foreign and private banks and state-owned counterparts have diminished as the latter have improved their profitability (Shirai, 2002).

Enhancing efficiency and stability of the banking sector have been the key objectives of reforms in the financial sector in India. It is, therefore, important to understand not only the impact of various reforms measures on the stability and efficiency of the banking system as has already been done, but also the impact of stability measures, if any, on the efficiency of the system. In the Indian context, where public sector banks account for majority of the banking assets, the interrelationship among credit risk, capital and efficiency acquires an additional dimension. A related issue in the Indian context has been whether the public sector character of the banking system has impinged on its efficiency, although international evidence suggests that privately owned banks do not necessarily outperform the state-owned banks. Dilution of Government stake, it has been argued, could provide greater operational freedom to banks, which could have a positive impact on their efficiency. As these aspects are of crucial importance, an attempt is made to examine in the Indian context the following two issues: (i) whether there is a relationship between ownership and efficiency, and (ii) what is the exact nature of relationship among credit risk, capital and efficiency.

To examine the relationship between ownership (public and private) and efficiency, an attempt is made to compare the performance of banks based on select parameters at two levels: (a) comparison of a representative sample of five PSBs which divested their Government holding early in the reform process with a representative sample of five wholly government-owned banks, (b) comparison of the aforesaid two categories with old private sector banks as a group. The parameters used are operating expenses, spread, net profit, asset quality and capital adequacy. The main points emerging from the analysis are set out below.

• During each year of the sample period ( i.e., from 1995-96 to 2001-02), 100 per cent Government-owned banks had higher ratio of operating expenses to total assets in comparison with those PSBs, which have divested their equity as well as old private sector banks. While the ratio for 100 per cent Government-owned PSBs was higher than the industry level, the ratio in respect of both old private sector banks and those banks which divested their equity was lower than the industry. The sudden fall in the operating expenses to total assets of PSBs in 2001-02 [Table 6.12(A)] was on account of reduction in wage costs (of the order of Rs.1,884 crore) consequent upon the introduction of voluntary retirement scheme (VRS) in 2000-01. The operating expenses, as percentage of total assets, for divested PSBs witnessed a sharp rise in 2000-01 [Table 6.12(B)]. It, however, was due mainly to large outgo on account of VRS-related expenditure incurred by these banks. This led to a reduction in the wage bill in the subsequent year, which, in turn, led to a marked decline in the operating expenses in 2001-02. The operating expense ratio for these banks is now lower than the earlier years, reflecting clear gains from the policy of labour force restructuring adopted by these banks.

• Interest spread (net interest income to total assets) provides a mixed picture. Interest spread of 100 per cent government-owned PSBs were lower in comparison with divested PSBs during each of the seven years due to their lower efficiency of raising resources, but were generally higher than those of old private sector banks.

• Profitability (ratio of net profit to total assets), on an average, of both old private sector banks and the Government-owned banks which divested their equity was, more or less, at the same level. Profitability of both the aforementioned bank groups was higher than those of fully Government-owned PSBs. The gap narrowed down significantly from 1998-99 onwards. The sharp rise in profits across most bank groups during 2001-02 was on account of capital gains on Government securities resulting from softening of interest rates and the containment in operating expenses.

• Asset impairment (ratio of gross NPAs to gross advances) during each of the years under reference in respect of 100 per cent Government-owned banks was much higher in comparison with PSBs, which divested their equity and old private sector banks. It is, however, significant to note that the gap, which was very wide during 1995-96 to 1996-97 (at about 14 per cent in respect of those banks that divested their equity and 15-18 per cent in respect of old private sector banks) narrowed down considerably by 2001-02 (at about 4 per cent in respect of banks which divested their equity and 5 per cent in respect of old private sector banks). The gap narrows down further if one takes into account net NPAs (after adjusting for provisioning and part payments received) of these banks. It also needs to be noted that net NPAs of partially Government-owned PSBs as at end-March 2002 stood lower than those of old private sector banks.

• Capital adequacy ratio (CRAR), on an average, in fully Government-owned PSBs was lower than those PSBs which divested their equity as well as old private banks. It needs to be noted that CRAR of fully Government-owned banks which, on an average, was roughly half as compared with old private banks and PSBs with reduced Government ownership, improved significantly over the last few years.

• In terms of all the above mentioned parameters, new private sector banks outperformed all other bank groups. While there was an increase in the divergence in terms of most financial parameters, the capital adequacy and NPA position of new private sector banks witnessed a convergence towards industry averages in recent times. For 2001-02, the data relating to new private banks reflect the impact of mergers, and are, therefore, not strictly comparable with those of the earlier years.

Where do these stylised facts lead? In terms of financial parameters, old private banks performed better than partially Government-owned PSBs, which, in turn, performed better than the wholly Government-owned PSBs. However, fully Government-owned PSBs showed a significant improvement in respect of almost all parameters from 1997-98 onwards and their financial performance tended to converge with partially Government-owned PSBs and old private banks. Although fully Government-owned PSBs also exhibited significant improvement in their credit risk management, as was evident in the decline in their NPAs in the last few years, NPAs level as such remained high as compared with old private banks and the partially Government-owned PSBs. In terms of capital position (CRAR) also, fully Government-owned PSBs witnessed a significant improvement, but the levels remained consistently below the PSBs with reduced Government ownership and private sector banks.

It is also significant to note that there has been a convergence in the financial performance of the partially Government-owned PSBs with old private banks in recent years. Asset quality of divested PSBs as at end-March 2002 stood significantly higher than that of old private banks. However, capital adequacy, which was slightly higher for divested banks in 1995-96 than old private sector banks stood slightly lower as at end-March 2002.