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 Markets - An Assessment of Reforms

Credit Risk, Capitalisation and Efficiency

The relationship between credit risk, capitalisation and efficiency has been tested empirically using regression analysis (simultaneous equation system). The empirical specification examining these issues in respect of three size classes of PSBs, viz., large, medium and small1 is addressed in Box VI.3. The broad findings emerging from the analysis are set out below:

• Greater soundness (higher capital position) leads to improvement in efficiency, particularly in the case of small banks. Improvements in efficiency, especially in respect of small banks, also have a positive effect on their soundness. Furthermore, the positive impact of efficiency on soundness is reinforced as higher profitability was found to be leading to increased soundness in the case of small and medium-sized banks.

• Better asset quality (greater stability) promotes greater efficiency in the case of medium-sized banks but not in case of other two bank size classes. However, the relationship between asset quality and efficiency was not found to be mutually reinforcing for any of the bank groups.

• Soundness and stability were found to be reinforcing each other. In other words, adequately capitalised banks in the small and medium categories are less prone to credit risk. In the case of latter category, in particular, improvements in credit risk management also had a beneficial effect on stability through improvements in the capital position.

• On the whole, the empirical findings suggest that capital, credit risk and efficiency are interlinked, and to a certain extent, they reinforce and complement one another.

To conclude, various reform measures introduced in the banking sector have resulted in remarkable improvement in banks’ capital position as reflected in the overall increase in their capital adequacy ratio. Asset quality of the commercial banking sector on the whole also improved markedly inspite of gradual tightening of prudential norms and the slowing down of the economy in recent years. There is evidence to suggest that competition in the banking industry has intensified. Significant improvement was also discernible in the various parameters of efficiency, especially intermediation costs, which declined significantly. Profitability of commercial banks, on the whole, improved significantly despite a decline in spread and higher provisioning following the introduction and subsequent tightening of prudential norms.

It was found empirically that in the case of the Indian banking sector, ownership did impinge on the efficiency of banks as old private sector banks performed better, in terms of various parameters, than those PSBs which divested their equity in the 1990s, which, in turn, performed better than the fully Government-owned banks. The performance of new private sector banks was well above all other bank groups. At the same time, however, it needs to be noted that the fully Government-owned banks showed remarkable improvement in almost all parameters in recent years and that their performance is gradually converging with that of better performing banks. Finally, financial soundness and stability tended to reinforce each other in the case of Indian banking sector and that there was no evidence of various stability measures impinging on the efficiency of financial institutions.

Notwithstanding significant improvements as set out above, there are several challenges that lie ahead. Much of the improvement in the capital position of banks in the initial years, especially in the case of PSBs, was due to recapitalisation support from the Government. This is not a sustainable option. Banks, therefore, need to further improve their profitability so that they can increase their capital funds through internal generation. Improved financial performance is also necessary when banks enter the market for raising capital. Notwithstanding improvement in the asset quality, the level of NPAs appears high by international standards. A major challenge in the years ahead, thus, lies in bringing down the non-performing assets. Alongside, provisioning for non-performing assets also needs to be enhanced. Tightening of the provisioning norms and a switch-over to the forward-looking provisioning would further enhance the stability of the Indian banking sector. A related issue concerns a large amount of loss assets being carried by banks in their books. Such assets, which ideally should be written off, still constitute about 10 per cent of the gross NPAs mainly for the reason that many of the accounts are under litigation and cannot be written off before resolution of such cases. Profitability in India is still low as compared to several developing countries and banks need to make concerted efforts to improve their profitability by diversifying their business, especially into non-fund-based activities.

The co-operative banking sector in India comprising urban co-operative banks (UCBs) and rural co-operative banks such as state co-operative banks (StCBs) and district central co-operative banks (CCBs) has an extensive branch network and reach in the remote areas. Though much smaller as compared to scheduled commercial banks, co-operative banks constitute an important segment of the Indian banking system and have traditionally played an important role in creating banking habits among the lower and middle-income groups and in strengthening the rural credit delivery system.

The reform process has tried to achieve regulatory convergence among various financial intermediaries in view of their systemic importance. Therefore, the basic objectives and instruments of reforms for co-operative banks have been the same as for SCBs. However, given the special characteristics of co-operative banks, they have been extended certain dispensations in terms of pace and sequencing of reforms.

Information on CRAR of co-operative banks is not available. Therefore, for analysing the capital position of co-operative banks, alternative measures, viz., share capital to asset ratio, owned funds to asset ratio and compliance with minimum capitalisation norm under Section 11(1) of the Banking Regulation Act, 1949 were examined. Movements in share capital to asset ratio as well as owned funds to asset ratio indicate that there was very little perceptible improvement in capitalisation of co-operative banks between 1998 and 2002. Asset quality of co-operative banks during the same period also did not show any discernible improvement in any segment. Gross NPAs in absolute terms increased significantly in respect of all types of co-operative banks. However, NPAs as a ratio of total loans outstanding remained more or less unchanged for all types of co-operative banks barring scheduled UCBs, in respect of which they increased sharply from 2001. The increase in the stock of NPAs over the years reflected partly the impact of gradual tightening of income recognition and asset classification norms and partly general deterioration of recovery performance.

During the period from 1997-98 to 2001-02, interest spread of scheduled UCBs declined sharply and remained in alignment with those of commercial banks, while there was no significant change in spread of rural co-operative banks. This reflected greater competition between scheduled UCBs and commercial banks and general insulation of rural cooperative banks from such competition. Operating expenses as a proportion of assets, however, declined significantly across all segments of co-operative banks with the movement in respect of scheduled UCBs closely following those of SCBs. Profitability of scheduled UCBs, however, deteriorated, while there was some improvement in profitability of rural co-operative banks between 1997-98 and 2000-01.

The foregoing analysis, thus, shows that since the introduction of reforms, there has been very little perceptible improvement in either stability or efficiency of co-operative banks. In particular, the asset quality and profitability of scheduled UCBs showed some deterioration in the reform period. Positive impact of reforms, as has been witnessed in the case of commercial banking sector, may take longer to get manifested for co-operative banks given the late start of the reform process in this sector. Unless such a positive scenario evolves for the co-operative banking sector in the near future, the financial health of many of these banks would continue to remain a cause of concern.

It is significant to note that introduction of reforms and the consequent increase in competition has resulted in some convergence in operations of commercial banks and co-operative banks, especially scheduled UCBs. However, in the face of lower spread, while the commercial banking sector could maintain its profitable status, scheduled UCBs as a group incurred losses. Furthermore, while most of the loss-making commercial banks are relatively small, in the case of UCBs some of the large banks are incurring losses and this increases the vulnerability of the whole segment.

Detection of irregularities in a few UCBs in the recent past has raised concerns about the conduct of the management in co-operative banks. Although remedial measures have been taken to limit the contagion effect of such disturbances spreading to other segments of the financial sector, and mechanisms have also been put in place to avoid recurrence of such developments, the current duality of control over co-operative banks is an impediment to effective supervision of such entities. For this purpose, the Reserve Bank has suggested the establishment of a unified supervisory authority for UCBs and the related amendment of the Banking Regulation Act, 1949 is currently under consideration of the Central Government.

Between 1996-97 and 1998-99, deposits of UCBs grew much faster than those of commercial banks. Co-operative banks are allowed to offer higher interest rates than SCBs on saving and current account deposits. This, coupled with the same deposit insurance protection for co-operative and commercial banks, might have resulted in the higher deposit growth in co-operative banks. Such a situation, however, might create a moral hazard problem since in order to compensate for the higher cost of deposits mobilised by them, co-operative banks could deploy such funds in riskier avenues. Steps such as stricter entry point norms, enhanced internal control and corporate governance norms, effective supervision and increased market discipline through greater disclosure for co-operative banks are required to address the problem.