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Students Corner - A Decade of Economic
Reforms in India - A Review

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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 -An Assessment of Reforms

While financial institutions and financial markets are two generic mechanisms for transferring resources from the surplus sectors to deficit sectors, their relative significance varies from country to country. In the context of the underdeveloped capital market in India, financial intermediaries or institutions have traditionally played a predominant role in meeting the fund requirements of various sectors in the form of credit and investment. The major institutional purveyors of credit in India are banks (commercial banks and cooperative banks), DFIs and NBFCs. Traditionally, banks and NBFCs predominantly extended short-term credit and DFIs mainly provided medium and long-term loans. Insurance companies and mutual funds provided medium to long-term funds mainly in the form of investments. This distinction has got somewhat blurred in recent years. While financial intermediaries play an important role in the growth process by encouraging saving and investment and by improving the allocative efficiency of resources, this role is performed well only when financial intermediaries are sound, stable and efficient.

The key objective of reforms in the financial sector in India has been to enhance the stability and efficiency of financial institutions. To achieve this objective, various reform measures were initiated that could be categorised broadly into three main groups: enabling measures, strengthening measures and institutional measures. The enabling measures were designed to create an environment where financial intermediaries could respond optimally to market signals on the basis of commercial considerations. Salient among these included reduction in statutory pre-emptions so as to release greater funds for commercial lending, interest rate deregulation to enable price discovery, granting of operational autonomy to banks and liberalisation of the entry norms for financial intermediaries. The strengthening measures aimed at reducing the vulnerability of financial institutions in the face of fluctuations in the economic environment. These included, inter alia, capital adequacy, income recognition, asset classification and provisioning norms, exposure norms, improved levels of transparency, and disclosure standards. Institutional measures were aimed at creating an appropriate institutional framework conducive to development of markets and functioning of financial institutions. Salient among these included reforms in the legal framework pertaining to banks and creation of new institutions.

Although there was a broad commonality in the objectives and instruments of reforms for all types of financial intermediaries, the pace and sequencing in each segment of the financial sector was determined keeping in view the state of development of the segment, its systemic implications and certain segment-specific characteristics. In view of their overwhelming dominance in the financial system and their systemic importance, reform measures were first introduced for commercial banks and subsequently extended to other financial intermediaries such as DFIs, NBFCs (especially public deposit-taking NBFCs) and co-operative banks, and insurance sector.

Commercial Banks

Reforms in the commercial banking sector had two distinct phases. The first phase of reforms, introduced subsequent to the release of the Report of the Committee on Financial System, 1992 (Chairman: Shri M. Narasimham) focussed mainly on enabling and strengthening measures. The second phase of reforms, introduced subsequent to the recommendations of the Committee on Banking Sector Reforms, 1998 (Chairman: Shri M. Narasimham) placed greater emphasis on structural measures and improvement in standards of disclosure and levels of transparency in order to align the Indian standards with international best practices. Reforms have brought about considerable improvements as reflected in various parameters relating to capital adequacy, asset quality, profitability and operational efficiency.

Stability Parameters (Capital Adequacy and Asset Quality)

Since banks are highly leveraged and exposed to risks, the capital adequacy requirements provide them with the financial cushion to cope with adverse effects on their portfolio. With the introduction of capital to risk-weighted asset ratio (CRAR) norms in 1992, significant improvement was noticed in the capital position of banks operating in India. While in 1995-96, 75 out of 92 banks had a CRAR of above eight per cent, as on March 31, 2002, 92 out of 97 banks operating in India had CRAR above the statutory minimum level of nine per cent.

There has been an improvement in overall capital adequacy of banks after the introduction of CRAR norms. However, as some banks in the public sector were not able to comply with the CRAR norms, there was a need to recapitalise them to augment their capital base. After the introduction of banking sector reforms in 1992, an amount of Rs.17,746 crore was infused as recapitalisation support to nationalised banks till March 31, 2002. At the same time, the Government’s share in the capital of public sector banks (PSBs) is being diluted gradually with several banks making public offerings of their equity shares. Between 1993-94 and 2001-02, 12 public sector banks mobilised equity capital of Rs.6,501 crore through this route, including a premia of Rs.5,252 crore. However, available data suggest that some improvement in CRAR was also due to internal generation of funds.

Consequent upon the introduction of prudential norms relating to asset classification, income recognition and provisioning, the most visible structural change in the banking sector was an improvement in their asset quality. The share of NPAs, in gross as well as net terms, declined significantly during the reform period. The ratio of gross NPAs to gross advances of scheduled commercial banks (SCBs) declined from 15.7 per cent as at end-March 1997 to 10.4 per cent as at end-March 2002. For PSBs, in particular, the ratio of gross NPAs to gross advances witnessed a perceptible decline from 23.2 per cent as at end-March 1993 to 11.1 per cent as at end-March 2002.

NPAs generally tend to be higher in economic downturns as during such phases, there is increased possibility of default by borrowers. In India, the average GDP growth rate, which was 6.8 per cent during the period 1992-93 to 1996-97, decelerated to 5.4 per cent during the next five-year period. Despite this slowdown, gross NPAs of PSBs as a proportion of gross advances, on an average, declined from 20.7 per cent to 13.9 per cent. Factors contributing to this decline related inter alia to improvements in credit appraisal and monitoring and recovery of past NPAs.

The difference between gross and net NPAs of PSBs (the latter typically equals about one-half of the former) reflects both obligatory provisions made against NPAs and the limited write-offs of NPAs undertaken by these banks.

As per the statistics of distribution of SCBs in terms of the ratio of net NPAs to net advances the number of domestic banks with net NPAs above 10 per cent of net advances declined between 1996 and 2002. The reduction in the number of banks with high net NPAs was particularly noticeable for public sector banks. The number of foreign banks with net NPAs above 10 per cent, however, increased in recent years, on account of the impaired asset position of some small foreign banks.

NPAs – both gross and net – as a proportion of advances/assets have declined since the early 1990s. In absolute terms, however, the stock of NPAs has been increasing. This is mainly due to the NPAs accumulated in the past on which interest due keeps on adding to the stock of NPAs every year. Doubtful assets form as much as 60 per cent of the NPAs, while sub-standard assets (which are of more recent origin) account for about 30 per cent. Furthermore, while there has been a decline in sub-standard assets in absolute terms since the late 1990s, the amount of doubtful assets increased. It is important to note, however, that incremental NPAs as a proportion of gross NPAs remained low and varied between 3-5 per cent during the period 1998-99 to 2001-02

Net NPAs (i.e., that portion of NPAs, which is not provided for) raise a major concern for the solvency of a bank. Although net NPAs as percentage of net advances in PSBs declined gradually from 10.7 per cent in 1994-95 to 5.8 per cent in 2001-02, they are still sizeable. There was also a wide divergence between gross NPAs to total assets (4.6 per cent) and net NPAs to total assets (2.3 per cent) for SCBs as at end of March 2002, reflecting mainly the extent of provisioning made.

Various reform measures introduced to recover past NPAs have met with limited success. For instance, in terms of the guidelines issued in May 1999 to PSBs for one-time non-discretionary and non-discriminatory settlement of NPAs of small loans (operative up to September 30, 2002), a meagre amount of Rs.668 crore was recovered by PSBs. Likewise, under the modified guidelines for recovery of the stock of NPAs of Rs.5 crore and less as on March 31, 1997 (valid up to June 30, 2001), an amount of Rs.2,600 crore was recovered by PSBs by September 2001. Debt Recovery Tribunals (DRTs) could decide only 9,814 cases involving Rs.6,264 crore pertaining to PSBs till September 30, 2001. The amount recovered in respect of such cases amounted to Rs.1,864 crore. As many as 3,049 cases involving Rs.42,989 crore were pending with DRTs as on September 30, 2001.

In the more recent period, the Reserve Bank and the Government of India have undertaken several more measures to contain the NPA problem. In order to strengthen the institutional set up for debt recovery, Lok Adalats and Settlement Advisory Committees were established. For improving the information sharing among the financial intermediaries, the Credit Information Bureau of India Ltd. (CIBIL) was set up. The Reserve Bank also put in place a system for periodic circulation of details of wilful defaults by borrowers. The Corporate Debt Restructuring (CDR) mechanism was institutionalised to provide a timely and transparent system for restructuring of the corporate debt of Rs.20 crore and above. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act was enacted in 2002. All these measures are expected to provide a fresh impetus to the recovery efforts by banks.

Parameters Relating to Competition and Efficiency

Improvement in the efficiency of financial intermediaries has been at the core of the reform process. In order to provide greater choice to customers and promote competition, the Reserve Bank permitted the entry of new private banks and more liberal entry of foreign banks. Consequently, nine new banks were set up in the private sector and the number of foreign banks increased significantly from 26 as at end-March 1996 to 44 as at end-March 1999. ‘In-principle’ approval was granted to two more new banks in the private sector in February 2002. There was, however, some consolidation in the banking industry, particularly in the new private and foreign bank segment. As at end-March 2002, there were 8 new private sector banks and 40 foreign banks.

An increase in the number of players in the banking sector led to increased competition as is reflected in the bank concentration ratio, measured in terms of the share of top 5 banks in assets, deposits or profits. The share of top 5 banks in total assets declined from 51.7 per cent in 1991-92 to 43.5 per cent by 2001-02. Similar trends were evident in deposits and profits as well .

6.26 The positive impact of increased competition in the banking industry was also evident from the net interest income or spread, measured as the difference between interest income and interest expenditure as a proportion of assets. Initially, the deregulation of lending rates led to an increase in interest spread . However, as competition intensified, spread tended to narrow. The gradual lowering of the Bank Rate and its effect in lowering banks’ prime lending rates (PLR) resulted in further narrowing of spread . It is significant to note that the decline in spread took place across all categories of banks with the decline being more pronounced in the case of new private sector banks. Spread in the case of foreign banks were relatively higher than those of public and private sector banks. These trends are in line with international experience (Claessens, Demirgüc-Kunt and Huizinga, 1998).

Significant variations observed in spread across bank groups were mainly on account of large differences in their non-fund based activities. For instance, the technology-intensive new private and foreign banks have been generating substantial income from fee-based activities arising from off-balance sheet-based business, enabling them to afford a larger decline in their spread . On the other hand, PSBs tend to rely more heavily on interest income, reflecting lack of sufficient diversification into fee-based activities. An important challenge for PSBs, thus, would be to diversify their activities to augment their non-interest income.

Despite the fact that banks were required to follow income recognition and provisioning norms and that there was intensification of competition, all major bank-groups in India remained profitable. There was also an increase in the number of profit-making PSBs over the reform period. Since the mid-1990s, profitability of SCBs, as measured by Return on Assets (RoA) has not showed a definite trend and has hovered in the range of 0.5-0.8 per cent. The ratios in respect of new private sector banks, however, declined during the same period. Foreign banks remained the most profitable amongst all the major bank groups. The ratio of other income to total assets also did not show a definite trend for the SCBs as a group, but the share of such income was high in the case of foreign banks. Cross-country evidence suggests that profitability of banks in India is on the lower side as compared to most developing countries, which is generally in excess of one per cent. On the other hand, in the industrialised countries, profitability is lower at around 0.5 per cent (Claessens, Demirgüc-Kunt and Huizinga, 1998).

Improvement in efficiency was also evident from the intermediation cost. Between 1996-97 and 2001-02, the cost of intermediation for SCBs declined from 2.85 per cent to 2.19 per cent (Table 6.8). The intermediation cost declined in respect of all categories of banks barring foreign banks. In the case of foreign banks, the intermediation cost increased between 1996 and 1999 due to addition of a significant number of foreign banks, which had to begin their operations with initial high start-up cost. Although the intermediation cost declined thereafter, it was still significantly higher in comparison with 1996 and other bank groups. The decline in intermediation cost was more pronounced in respect of private bank groups. This was possible due largely to their technology-driven operations, especially new private banks, all of which are 100 per cent computerised. The decline in intermediation cost in general, could be ascribed to growing competition in respect of business, enhanced application of information technology and improvements in payment and settlement system. While intermediation cost in general of PSBs increased in 2000-01 because of the rise in wages consequent upon the wage settlement, there was a significant lowering of intermediation cost in 2001-02 due to the decline in staff costs, subsequent to the voluntary retirement scheme (VRS).

Another test of improvement in efficiency could be the trend in real interest rates. Cross-country experience suggests that positive and stable real interest rates play an important role in efficient allocation of financial resources (Goyal and McKinnon, 2003). Real interest rates in India remained generally positive in the 1980s. In the post-reform period, real lending rates remained positive for all the years. Real deposit rates also remained positive barring one year, i.e., 1994-95 when they turned negative. While real lending rates generally declined during the 1990s as compared with the 1980s, real deposit rates increased during the same period. As a result, the gap between the lending rate and the deposit rate, in real terms, narrowed significantly in the second half of the 1990s. This was reflective, to an extent, of the increased competitiveness and efficiency of the Indian commercial banks.

Another aspect of efficiency could be the difference between domestic and international benchmark rates. There has been a noticeable decline in the difference between real interest rates in India and international benchmark rates (LIBOR 1 year) since the mid-1990s. After deregulation of interest rates, India’s real domestic interest rates (deflated for movements in exchange rates) have got better aligned with international benchmark rates, notwithstanding the adverse impact of the East Asian crisis during the latter half of the 1990s. This suggests increased integration of the banking sector with the rest of the world.


- - - : ( A Comparison with Other Countries ) : - - -

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