Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: The Indian Approach
Scheduled Commercial Banks: Performance

Since the reforms began in the early 1990s, financial performance, especially of public sector banks, has gradually improved. Illustratively, the return on assets (RoA) of public sector banks has improved markedly over the last few years, to reach 1.1 per cent of total assets in 2003-04. Operating expenses have also been by and large contained. Most other bank groups also witnessed similar improvements, although provisioning levels for old private banks have declined. Since the initiation of reforms, the financial health as well as efficiency of the public sector banks has closely matched and for several such banks, even surpassed their private sector and foreign counterparts. The competitive pressures induced by the new private sector and foreign banks has re-energised the Indian banking sector as a whole: new technology is now the norm, new products are being introduced continuously, and new business practices have become common place.

Regarding asset quality, the ratio of gross non-performing loans (NPL) to total loans which was at a high of 15.7 per cent for SCBs at end-March 1997 witnessed a marked decline to 7.2 per cent at end-March 2004. Net NPLs also witnessed a significant decline, driven by the improvements in loan loss provisioning, which comprises over half of the total provisions and contingencies. At the same time, in view of the impending Basel II with its focus on operational and market risks, in addition to credit risks, banks have improved their capital adequacy ratio. The overall capital adequacy ratio of SCBs at end-March 2004 was 12.9 per cent; for most banks, the ratio was higher than this figure, as against the regulatory requirement of nine per cent. All banks (except one), including the systemically important banks, satisfy the regulatory capital adequacy requirements⁵. Only one bank had capital adequacy ratio below the regulatory minimum at end-March 2004, but its share in total banking sector assets was less than 0.5 per cent. Notwithstanding definitional differences, the capital adequacy ratio of the Indian banks is broadly comparable with the international levels. However, emerging markets with a high quantum of NPL also tend to have higher provisions. Finally, the capital to asset ratio of banks is also in consonance with international levels.

Since the 1980s, the Government has injected funds towards strengthening the capital base of nationalised banks. There appear to be three distinct phases of recapitalisation: phase I (regular and general) covering the period 1984-85 to 1992-93 when all nationalised banks were recapitalised without any preset norm; phase II (pre-designed under a recovery programme) covering the period 1993-1995, when financial sector reforms were given a big push and recapitalisation of all nationalised banks had to be accorded priority; and, phase III (case-by-case basis) covering the post-1995 period wherein Government, as the owner of banks, had to improve their capital position to the stipulated levels. This also included years (2000-01 and 2003-04) when no capital injection was provided to the nationalised banks. Several banks have since returned substantial amount of capital back to the Government. The total recapitalisation till end-March 2004 aggregated Rs.22,516 crore, equivalent to roughly one per cent of GDP at current prices during 2003-04 . Around the same time, measures were undertaken to broaden the banks' capital base.

The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980 and the State Bank of India Act, 1955 were amended to allow banks to raise capital not exceeding 49 per cent of their equity. Equity sales in the market aggregating over Rs.8,000 crore have been made by the PSBs, with several banks approaching the market twice. Over the period 1993-2004, as many as 17 PSBs have accessed the capital market; their divestment presently ranges from 57 - 75 per cent.

The funding volatility ratio (FVR) is calculated as the ratio of total borrowed funds net of liquid assets to total assets net of liquid assets. It measures the extent to which banks rely on volatile liabilities to finance their assets. A FVR<0 implies volatile liabilities are more than fully covered by liquid assets and reverse for FVR>0. A FVR=0 implies volatile liabilities are fully covered by liquid assets. The smaller the ratio, the better the liquidity profile. An assessment of the key performance indicators suggests that there is still room for further improvement. First, there is headroom to improve the capital cushion in terms of Tier-I capital, in order to build up a cushion against market, operational and other non-measured risks. Second, notwithstanding improvement in credit quality, NPLs at Rs.64,786 crore remain high with gross NPL/gross advances at 7.2 per cent at end-March 2004⁶. Third, most emerging markets with high quantum of sticky assets also have high 'coverage' (i.e., provisions/NPL). Despite the improvements in 'coverage' by Indian banks over the last few years, it remains low compared to international standards. Some significant recoveries have been effected under the SARFAESI Act, 2002 (Rs.1,748 crore at end-June 2004) and other accompanying measures (Rs.18,899 crore)⁷.

On the positive side, first, loan classification norms in India are, at present, on par with international best practices, so that the decline in NPL has occurred despite the gradual switchover to more stringent norms. Second, the difference between gross and net NPL has gradually narrowed, reflecting the improved loan loss provisions by the banking sector, despite the differential provisioning levels across bank groups⁸. Third, profitability of the banking sector has improved in recent years, with return on assets trending at around one per cent, a figure comparable with international levels. A part of this high profitability level was the result of high trading incomes in a soft interest regime. The significant improvement in non-interest income notwithstanding, its share in total income for PSBs is still around 20 per cent, compared with about 25 per cent for foreign banks.

Another notable feature has been that banks' exposure limits in India have gradually been brought on par with international standards. Effective March 31, 2002, the exposure ceiling is computed in relation to total capital as defined under capital adequacy standards (Tier-I plus Tier-II) and includes credit exposure (funded and non-funded credit limits) and investment exposure (underwriting and similar commitments). The exposure limits for single borrowers, at present, stand at 15 per cent and that for group borrowers at 40 per cent; the latter is extendible by an additional 10 per cent in case of financing infrastructure projects .

Banks foreign exchange exposure is limited by position limits, which in most cases, limit a bank's open position to 15 per cent of Tier I capital. Foreign exchange-related credit risk is limited and the magnitude of foreign currency lending is small (around 5 per cent of gross advances at end-March 2004).

Interest rate risk could be important in the event of a large shock. The 'gap' method estimates indicate that an increase of 200 basis points in interest rate is likely to have a positive impact of 4.9 per cent on banks' net interest income, with the largest impact being on PSBs (RBI, 2003). To safeguard banks' investment portfolio against adverse movements in interest rate risk, the Reserve Bank advised banks to build up an Investment Fluctuation Reserve (IFR) of a minimum of five per cent of investments under 'Available for Sale' (AFS) and 'Held for Trading' (HFT) categories, within a period of five years (i.e., by end-March 2006) beginning end-March 2002. At end-March 2004, 20 PSBs had build up IFR of three per cent and above. Bank group-wise, the IFR ratio was the highest for PSBs (3.1 per cent) and the lowest for new private banks (2.3 per cent).

Banks exposure to sensitive sectors (capital market, real estate and commodities) remains low. While public sector banks have negligible exposure to the equity market, it remains slightly higher for new private banks. The vulnerability on this count appears to be limited. The buoyancy in the housing market has increased banks' exposure to real estate: at 1.6 per cent of total loans in 2003-04, this, however, is within the overall cap of 5 per cent to sensitive sectors. Nonetheless, banks need to be on guard against rise in loans to the housing sector. Cross-country evidence suggests that-

1. housing price peaks tend to follow equity price peaks with a lag of around one year, and

2. the feedback from property prices to credit growth is strongest in countries with a greater prevalence of variable rate mortgages. This indicates a possibility of mutually reinforcing imbalances in the real estate market and the financial sector, with implications for financial stability.

Banks have ample liquidity in view of their large holdings of Government securities - at around 41 per cent of their net demand and time liabilities at end-March 2004 - well in excess of the statutory requirement of 25 per cent - and predominance of stable deposits as a core source of funding. Among the major bank groups, foreign banks seem to rely more on borrowed funds than the other three groups. Funding volatility ratio¹⁰ suggests that the dependence of the Indian banking sector on volatile liabilities to finance their assets is relatively limited

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⁵In order to ensure smooth transition to Basel II norms, the Annual Policy Statement 2004-05 proposed to phase the implementation of capital charge for market risk in respect of their trading book exposures (including derivatives) by March 31, 2005 and banks would be required to maintain capital charge in respect of the securities included under the 'available for sale' category by March 31, 2006.

⁶Using a dynamic panel framework to examine the determinants of problem loans in state-owned banks in India, Das and Ghosh (2003) find that at the macro level, GDP growth and at the micro level, real loan growth, operating expenses and bank size as the factors affecting problem loans.

⁷These included selling of assets to Asset Reconstruction Company of India Ltd. (Rs.9,631 crore), recoveries under Debt Recovery Tribunal (Rs.7,845 crore) and recoveries under compromise settlement (Rs.1,095 crore) and Lok Adalats (Rs. 328 crore).

⁸In June 2004, the Reserve Bank introduced graded higher provisioning on the secured portion of NPAs as on March 31, 2004, ranging from 60 per cent to 100 per cent over a period of three years in a phased manner, with effect from March 31, 2005. However, in respect of all advances classified as 'doubtful for more than three years' on or after April 1, 2004, the provisioning requirement would be 100 per cent. The provisioning requirement for unsecured portion of NPAs under the above category would be 100 per cent as hitherto.

⁹As a temporary measure, the Reserve Bank has increased the risk weight on housing loans from 50 per cent to 75 per cent as a risk containment measure.

¹⁰The funding volatility ratio (FVR) is calculated as the ratio of total borrowed funds net of liquid assets to total assets net of liquid assets. It measures the extent to which banks rely on volatile liabilities to finance their assets. A FVR<0 implies volatile liabilities are more than fully covered by liquid assets and reverse for FVR>0. A FVR=0 implies volatile liabilities are fully covered by liquid assets. The smaller the ratio, the better the liquidity profile.