Reforming India’s Troubled Banking Sector

May 28, 2014 Posted by India Briefing Reading Time: 6 minutes

By Camille Chen

DELHI – Last Tuesday, Governor of the Reserve Bank of India (RBI), Dr. Raghuram Rajan, delivered a speech on reforming India’s banking sector at the Competition Commission of India’s Annual Day Lecture. Dr. Rajan identified and discussed various structural problems that exist under the status quo, and described the Indian banking sector as on “the cusp of revolutionary change.”

In his speech, Dr. Rajan detailed his intention to increase competition through the reduction of bank obligations, establishment of differentiated small-scale banks and potentially some payment banks while stepping up efforts to make structural changes within the public sector banks.

Old Problems

Following the two waves of nationalization that swept across India’s commercial banking sector in 1969 and 1980, the Indian government has remained in control of the majority of the country’s banks. Currently, nearly three-quarters of all loans in India are made by public sector banks in which the government holds a majority stake. In contrast, foreign banks only possessed a five percent market share in India-based loans last year.

Because of this widespread government ownership, however, many Indian banks have historically been protected from competition and often receive preferential access to liquidity adjustment facilities and other credit policies from the RBI.

In exchange for these privileges, however, banks are required to accept obligations that facilitate the achievement of the government’s economic goals. These obligations include financing the government through maintaining the Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR) and allocating a certain proportion of loans to “priority sectors” as defined by the government. Dr. Rajan characterizes this cooperation between the government (represented by the RBI) and these banks the country’s first grand bargain.

Among these privilege-receiving banks, public sector banks are even more closely tied to, and controlled by, the government as the majority stake is held by the state. Public sector banks undertake special services and risks in the interest of developing the economy, and are in turn heavily protected by the state. This is the second grand bargain Dr. Rajan references, and points out that this bargain in particular is holding back many Indian banks from becoming more competitive.

“Governments have historically found it difficult to ensure such healthy competition because intervention has to be just right,” said Dr.Rajan. “Governments typically are tempted to go beyond intervening to create a fair competitive environment, and instead have turned to determining winners and losers themselves.”

Because of frequent government intervention, the Indian banking sector has enjoyed a “monopoly over financing corporations and households” according to Dr. Rajan. While the banking sector has managed to maintain low interest rates to attract businesses in issuing loans, it is also still receiving savings deposits from households. Since banks need pay little interest to households that save, these cheap deposits allow banks to make substantial profits. Nonetheless, these consistent low interest rates have resulted in banks giving out bad loans. As growth slows down and interest rates rise to curb inflation this year, there are more people who cannot pay back the money they borrow, increasing the percentage of non-performing assets (NPA) in loans.

As reported in the Wall Street Journal, public sector banks shoulder around 90 percent of India’s NPA since previous banking policies allowed the government, as well as large government-affiliated companies, to borrow cheaply and accumulate large amounts of debt. Due to political pressure to lend to “priority sectors,” public sector banks are also unable to diversify their lending as much as private sector banks.

In addition to the problem of mounting bad loans, the Indian banking sector also faces the issue of limited penetration into the countryside. The Indian rural population is known for keeping cash savings and has little tendency to borrow. This reduces the incentives for commercial banks to extend their services into rural regions since they are not profitable. Along with the lack of financial services in the countryside, informal moneylenders continue to thrive in India – only about 35 percent of adults in India have bank accounts according to The Economist. In the long run, as India’s rural economy develops, there will need to be more secure, systematic financial services.

New Challenges

As the Indian economy expands, a state-dominated banking sector fraught with problems such as the accumulation of Non-Performing Assets (NPA) will ultimately be unable to keep pace with demands for capital investments in public or private projects, and public-private partnerships (PPP). This discrepancy is especially problematic for infrastructure projects and other long-term development initiatives.

If a private entrepreneur experiences a capital shortage in the middle of an infrastructure project and needs another loan, the banking sector may not be able to fulfil this demand. As a result, a private enterprise may be forced to seek alternative financing sources, namely in corporate bond and equity markets, to reduce investment risks. Because of this, the current banking system is less competitive vis-a-vis other financial institutions in attracting potentially-profitable clients.

India’s banking sector must also seek to tackle the current unwillingness of households to deposit savings in banks. Because of low interest rates resulting from government interventions, households are often encouraged to borrow money from banks, but have no incentive to pool their savings there.

Overall, the two grand bargains that underlie India’s banking system are weakening. A competent banking sector is important for a country’s economic growth in the long run, as it serves as a secure financing source for households and firms. It can also be more easily controlled, monitored and steered by the government for developing certain industries and regions than financial markets.

“We cannot go backwards to revive the two bargains – that means reversing development and bottling the genie of competition, neither of which would be desirable for the economy even if feasible. Instead, the best approach may be to develop the financial sector by increasing competition and variety, even while giving banks, especially public sector banks, a greater ability to compete,” explained Dr. Rajan.

Reforming the Banking Sector

As election season comes to a close, Prime Minister Narendra Modi must now join Dr. Rajan in reviving the stagnant Indian economy and reforming the country’s banking system. The RBI is aiming to reform and strengthen the Indian banking system through fostering increased competition in both the private and public sectors, especially in making public sector banks more competitive.

After an almost decade-long hiatus in issuing normal commercial banking licenses, the RBI resumed the processing of applications last year and granted banking licenses to IDFC (a large infrastructure finance group) and Bandhan Financial Services (a small microfinance group) recently. To further increase competition, the RBI is considering introducing differentiated licenses under which bank operations will be restricted geographically, and in terms of product variety. This will ultimately make banks more adaptable to local needs.

Public sector banks appear to have more internal structural problems, as evidenced by Dr. Rajan’s assertion that the government is attempting to take its hands out of managing public sector banks. The RBI plans to do this by letting more private actors hold public sector banks’ shares, increase the length of tenure for CEOs at public sector banks, separate the position of the Chairman and the CEO and give more power to independent banking and finance professionals. However, there are some inevitable obstacles to this proposal. Making these structural changes to government-owned banks requires the RBI to win the approval of parliament and, perhaps more importantly, government officials who currently have control over public sector banks and may not welcome these changes.

Although the Indian banking sector is “on the cusp of revolutionary change”, the RBI has a long way to go to make this revolution happen.

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