India $20 trillion Economy: Is banking ready?

Team INCLUSION

India's banking system has expanded considerably in the last two decades and has weathered global financial storms. However, the approach so far has been conservative. Where the Indian banks would stand, if the country is to become a $20 trillion economy, analyses Team INCLUSION

When Prime Minister Narendra Modi asked, in January this year, the question, “India is a $2 trillion economy today. Can we not dream of an India with a $20 trillion economy?”, he was echoing a powerful, nuanced and intensely compelling set of questions.

Some among them—ranging from ease-of-doing business, innovation, digital economy, manufacturing, entrepreneurship to skilled workforce—are all too familiar. However, the real white-knight is the financial sector. Isn’t it time for refashioning India’s financial sector, especially in banking, the lynchpin of the economy? Without doubt.

In India, the real economy is four times bigger than the financial economy and there is a huge need for banking sector reforms to support the growth. There is a need for greater consolidation and penetration. Also, there is a need for greater private sector participation for more efficiency as in the current setting, where more than 70 per cent of the industry is controlled by the government.

Therefore, it’s hardly surprising that barely a fortnight before he made the $20 trillion question poser, he had organised a highly-publicised two-day Gyan Sangam (knowledge confabulation), a bankers’ retreat, attended by chiefs of the central bank, Reserve Bank of India, all public sector banks, insurance companies and development agencies like NABARD. The event was convened by the Prime Minister to obtain a blueprint for the next generation of banking reforms, maybe with the $20 billion economy idea in mind.

Addressing the conclave in January 2015, he exhorted the bankers to redefine the parameters of success—for example, prioritise loans to enterprises which will generate more employment—and to dream big—establish banks which rank among the top banks of the world . He called for an end to lazy banking and political intereference. The banking sector of a country mirrors its economic rise. Japan and China had banks in the top ten banks of the world during their economic rise, the Prime Minister emphasised.

Six topics were identified for discussions: consolidation and restructuring of public sector banks for better efficiency, autonomy and recapitalisation; improving risk management, asset quality and recovery mechanisms; human resources-related issues with special focus on training and motivation of staff; global practices and use of technology in banking operations; financial inclusion/financial literacy and direct benefit transfer; and, priority sector lending and interest subvention schemes.

Faultlines Run Deep

The bankers’ conclave indicated the government’s seriousness in initiating banking reforms as much as the discussion points revealed the faultlines in the sector. The deliberations took place at Pune amidst an unhappy augury of strained profitability, sluggish credit offtake, stalled big projects worth Rs 18 lakh crore, rise in the number of wilful defaulters, and ballooning gross non-performing assets (GNPAs).

So, what ails the sector? India’s banking system has developed considerably since the 1990s and has weathered global financial storms with significantly less pain than some other countries. Competition in the banking sector has intensified as new private banks have been allowed to enter and most interest rates have been liberalised. Yet, more is needed to make the financial sector stronger and more efficient and to ensure optimal allocation of capital.

Is regulation a problem? According to S S Tarapore, an economist and Distinguished Fellow, SKOCH Development Foundation, it has generated more fog than it cleared. “The debate about the future course has put too much emphasis on who should regulate and who should supervise, rather than how to regulate and how to supervise. There is very little of how to do it. Today, regulators believe that regulatees don’t understand and regulatees believe that the regulators do not understand operations at all. That’s how we end up with a suboptimal system. Therefore the need for greater understanding between the regulator and the regulatee.”

 
“The debate about the future course has put too much emphasis on who should regulate, and who should supervise, rather than how to regulate and how to supervise. There is very little of how to do it.”
S S Tarapore, Distinguished Fellow, SKOCH Development Foundation

He adds that a growth rate of 10 per cent for the next 25 years is essential for achieving the $20 trillion GDP mark. “The end goal is a huge economy in the financial system, which will have massive impact, for which we need to be ready for. There is no gainsaying that regulation and supervisors, not just the regulated but the regulators, need to develop a better understanding of markets which would enable them to locate infringements at the incipient stage.”

Sampath Kumar Achary, Chairman, Andhra Pragati Grameena Bank, is of the view that the RBI has a proven record of regulating the banks very effectively. “Even during the international financial crisis, the Indian banks were less affected. Grameen Banks and RRBs are supervised by NABARD, regulated by the RBI and we have the guidance of the sponsor bank also. But in certain areas it is felt that we should have more freedom.”

Recapitalisation Charade

Many big corporates had sought restructuring of their loans. Total stressed advances at scheduled commercial banks in India increased to 11.1 per cent of total advances in March 2015 from 10.7 per cent in September 2014, the RBI disclosed in June this year. Stressed assets include GNPAs and loans that have been restructured by banks. GNPAs of banks increased to 4.6 per cent of total advances in March this year from 4.5 per cent in September 2014, the central bank said, adding that stress on bank books won’t go away easily.

In India, the real economy is four times bigger than the financial economy and there is a huge need for banking sector reforms to support the growth. There is a need for greater consolidation and penetration. Also, there is a need for greater private sector participation for more efficiency as in the current setting, where more than 70 per cent of the industry is controlled by the government.

Behind such colossal problems lie the perils of government ownership that has led to government crowding out of private investment, regulatory failures, administrative inefficiencies, political interference, crony captalism. Then the government tries to square the circle by resorting to recapitalisation, but the vicious cycle continues.

There is another looming challenge. In order to comply with the new Basel III norms, public sector banks in India need around Rs 8 trillion of capital until March 2018 (by when these norms are expected to be fully implemented). Their annual credit growth will be required to be 20 per cent. The government’s ability of capital infusion is severely constrained by fiscal consolidation.

As the government, the majority owner of public sector banks, is clueless on the recapitalisation issue, the RBI to some extent can support the capital needs of banks by stealth—by cutting cash reserve ratio (CRR) or the portion of deposits that commercial banks need to keep with the central bank on which they do not earn any interest. As of April 2015, the CRR is pegged at 4 per cent of bank deposits.

Too Scared to Fail?

According to the International Monetary Fund (IMF)’s Global Financial Stability Report of April 2015, Indian banks have less capacity among lenders in emerging markets to
absorb losses, a fact that could destabilise the country’s entire banking system.

Banking is supposedly a profitable business, but then, why do Indian public sector banks time and again need the prop of capital infusion by the government? After all, the spread between average deposit rates and average lending rates in India is one of the highest in the world. Why don’t we have stringent benchmarks to divert taxpayers’ money for such bailouts? The answer is, the government and central bank hold that commerical banks are too important to fail because one bank’s liquidation would cause a run on other banks or a wider systemic crisis.

“You allow a cooperative bank to fail but you say a commercial bank should not fail. The last failure was the year before I joined the Reserve Bank. It was Palai Central Bank, which failed in 1960. After that, have the Reserve Bank and the government allow a commercial bank to fail? The costs are borne by the system—that you transfer all the problems of one bank to another. But you don’t allow a bank to fail. Now, a zero-failure system does not work. So, what happens is that an attitude develops that the bank has the divine right to lose and yet live. This has to be changed. Now we are opening up the banking sector, to believe that there will be no failures means we are not accepting reality.”

The government’s ability of capital infusion is severely constrained by fiscal consolidation. As the government, the majority owner of public sector banks, is clueless on the recapitalisation issue, the RBI to some extent can support the capital needs of banks by stealth—by cutting Cash Reserve Ratio (CRR).
 

Sunil Kulkarni, Deputy MD, Oxigen Services (India), has another view. He says that the central bank does not permit commercial banks to go down as against cooperatives because the RBI is concerned about the customer deposit. “When it comes to banks and especially commercial banks, even today after several decades the total security that is available to a savings account holder is just Rs 1 lakh. The same amount is $100,000 in US, for instance. The same amount in purchasing power parity is something like Rs 15-20 lakhs in India. If we have Rs 15-20 lakh as deposit insurance, I think that if the government is able to do that, probably RBI will not bother about banks going belly up,” he observes.

Reorienting Strategies

At the Gyan Sangam, bankers signalled their readiness to reorient strategies to enable small ones to focus on niche capabilities, implement steps to bolster talent, use technology in a greater degree, strengthen risk management and work more closely with non-bank channels such as payment management systems or bank correspondents.

However, they urged the government to provide them greater leeway by implementing some of the reform recommedations of the P J Nayak committee: transferring government stake to an independent bank investment committee run by professionals, reducing the stake below 51 per cent in the long run, greater freedom in hiring decisions, lesser scrutiny from vigilance agencies, stronger debt recovery laws and fewer interference from governments in form of market-distorting debt waivers or interest rate caps. The government so far has remained non-commital on loosening its control on banks, recapitalisation or importantly, consolidation.

If the government carries through these far-reaching reforms, there is hope. It is noted that public sector banks have to play a greater role in making India a $20 trillion economy or even for that matter, achieving the right growth rate of 8.5 per cent to 10 per cent. However, we have lot of legacy issues from the 2008 liquidity crisis where most of the new generation banks or other banks were not lending. It is the public sector banks which came forward and supported the economy by lending even though there has been a global liquidity crisis. They also took the necessary efforts as per the RBI guidelines restructuring of quite a lot of accounts, says a former banker.

The entry of new private banks has raised the efficiency of India’s banks in the past. Efficiency will further improve as more banking licences will be granted. Banks will be able to open branches without prior RBI permission and foreign banks will be allowed to open branches and subsidiaries. However, India’s corporate bond market remains shackled. According to OECD’s India Economic Survey, 2014, the market has a capitalisation of only 5 per cent of GDP and therefore, ill-equipped to meet long-term financing needs, notable of infrastructure projects.

“Domestic institutional bond investors such as pension funds and insurance companies have to hold a large share of their assets in government bonds and foreign institutional investors face a cap on corporate bond holdings. This contrasts with the equity market, which has become world-class, thanks to liberalisation and sound regulation,” the OECD noted. It strongly recommended the government to liberalise the bond market by gradually relaxing the restrictions on domestic and foreign investors while ensuring srong supervision. No doubt, a well-developed and well-oiled corporate debt market is actuely needed if India has to chase the dream of a $20 trillion economy in the next 25 years.

Innovation Economy

Shaji K V, Chairman, Kerala Gramin Bank, says that for the India economy to reach $20 trillion in size, the first $10 trillion would have to come in normal growth, but the next $10 trillion can come only with innovation. “Some innovative technology should be there and then some production should happen because of that innovation. For that to happen regulation should also be somewhat innovative. The RBI should be more innovative, lot of innovative policies should be there. Otherwise the RBI will be behind the curve with the real economy,” he points out.

“Some of the innovations have to do with making affordable banking and financial products like savings, credit and insurance widely available to the rural poor,” Shaji observed. Of course, the government has an important role to play in creating space and a flexible architecture for innovation. Financial inclusion is crucial for achieving growth and broad-based poverty reduction goals. The poor have largely untapped potential for consumption, production, innovation and enterprise. The need is to do business with them so as to draw them out into the marketplace and out of poverty.

To help the rural banks, cooperative banks and commercial banks, a large number of rural credit bureaus on a district-wise basis, needs to be created so as to track all money transactions in a district. This could be easily created by using the Financial Inclusion Technology Fund (FITF) managed by Nabard, given there is a vision and a felt-need.

Technology as a Force Multiplier

“Improvements can also be made in leveraging technologies to bring in interoperability. The fact that the mobile has become an integral part of the rural social landscape makes it a potential tool to carry financial inclusion further. The skill with which Indian mobile communication companies have driven costs down, and the impact that the mobile phone has had on business and social practices, it would, in fact, from some points of view, be almost impossible to make financial inclusion happen without extensive use of mobile technologies,” Kulkarni recommends.

Maximising the full extent of mobile banking and e-payment benefits will require significant investments in infrastructure. All government departments and agencies will have to be fully networked to ensure that all information transfer is electronic. In order to increase the future economic viability of mobile banking and e-payment infrastructure investments, financial service providers and financial intermediaries will be required to align themselves as stakeholders in the set up. While progress has been made in some areas like government salaries and electronic tax payments, an integrated and comprehensive approach is required.

Community-based financial institutions like cooperatives have a much closer mission alignment with serving the underserved than conventional financial institutions. However, there is a systemic issue of governance, scalability and viability. Investment in creating and enduring such a model goes in tune with the democratic form of governance that we are wedded to.

Priority sector lending is a grey area. According to regulation, banks have to lend 40 per cent of their loan disbursements to agriculture, micro, small and medium enterprises (MSMEs), education, housing, weaker sections and export credit. However, it will be interesting to know how many of the existing private sector banks meet the lending requirement set out by the RBI. The results are shocking.

A large number of MSMEs consider challenges in access to finance as one of the biggest growth constraints. Credible studies have found that multiple problems like limited access to physical and support infrastructure, are saddled with have their roots in inadequate access to finance. The government must partner with banking institutions and stock market players to address this fundamental problem in a holistic manner.

The widespread implementation of Aadhaar provides a one of its kind opportunity for financial service providers to ride on its platform and reach the masses at minimal cost. The current policy and technology environment, combined with the benefits of using the UIDAI infrastructure as an overlay on the existing banking infrastructure can usher in an era of ubiquitous branch-less banking.

Tarapore quotes the wisdom of ancient Chinese philosopher Confucius: “It does not matter how slow you go as long as you don’t stop.” The point is, he says, if India could maintain the tempo in banking sector reforms—there was no dearth of ideas to do so in the Gyan Sangam, for instance—the $20 trillion economy goal could well be a reality.

(Comments are welcome at info@skoch.in)

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