Improving Indian Banks’ Performance by James A. Hanson Overview • India liberalized credit markets to support the real reforms/more credit for the private sector. • Benefits but increasingly limited by – Crowding out from public debt and deficits – Weak Incentives for debt service, related to weak judicial, informational and institutional incentives • Weak incentives in public banks, not generating enough capital for growth, especially of private credit. • Need to focus on incentives for principal agents (banks) • Regulators face New Challenges • Resolution of problems more urgent now that other sources of private sector finance drying up. India Started bank liberalization in 1992 Focus on Markets: price, alloc., competition • Reduced directed credit allocation (SLR) • Gradually liberalized interest rates, even on priority credit • Increased competition – Let clients switch banks, Reduced RBI lending control – Licensed new private, quasi-private and foreign banks – Non-bank intermediaries grew until the 1997 crisis – Liberalized the capital market – Allowed offshore borrowing and capital inflow. • Strengthened regulation and supervision, unlike most liberalizing countries • Liberalization largely completed by 1997-98 Reforms Restarted Dep. Growth Figure 1 India: Money(M3 in Sept.): GDP, Deposit Rate & Inflation M3/GDP 40.0 M3+NBFCs % of GDP 70.0 35.0 60.0 Interest Rate and Inflation (%) 30.0 50.0 M3 (% of GDP) 25.0 Ave. M3/GDP, 1987-92 Interest Rate 40.0 20.0 1 yr. Deposit Inflation (CPI) 30.0 15.0 20.0 10.0 5.0 Free 10.0 Rate 0.0 0.0 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 Other Sources of Private Credit Grew • NBFCs • Equity—easier rules and entry of foreign players • Bonds and Private Placements • Offshore borrowing. But • NBFCs have declined since 1997 crisis • New inflows and demand for offshore funds drying up. • India’s capital market is one of largest but it is down India is still bank dominated: Banks assets more than double market capitalization. Banks are critical Private credit growth, bank performance were not up to expectations. Why? 1. Crowding out by Government Debt 2. Large Role of Public Sector Banks 3. Large NPLs – Weak judicial and informational framework – Public banks lack incentives 4. Profit Squeeze on Banks limits internal capital generation, raises risks. Crowding out: Gov. debt absorbed much of bank growth, reflecting its large deficit; credit grew slowly Figure 2. India: Banks' Government Debt, Credit, and Investments Selected Years (percent of GDP) 60% 50% 40% 30% 20% 10% 0% 85-86 90-91 95-96 98-99 00-01 Credit Gov. Debt Other Elig. Invest. Other Investments Gov. Debt/Dep. , 2000, Percent (IFS) Korea -3.6 Philippines 22.7 Chile -3.1 Hungary 23.0 Thailand 1.4 Pakistan 24.6 Malaysia 2.3 Morocco 26.5 Peru 3.2 Argentina 30.8 S. Africa 4.9 India 34.6 Czech Rep. 4.9 Russia 35.3 China 6.0 Brazil 43.3 Egypt 7.8 Mexico 48.8 Venezuela 8.2 Algeria 50.6 Bangladesh 10.9 Indonesia 56.3 Poland 14.8 Turkey 64.7 Colombia 16.4 Average 21.4 Gov. Debt is attractive but it must held even if it weren’t attractive • Gov. Debt has low risk, low capital weight, no priority sector obligation, making it attractive • But macroeconomic constraints mean that Gov. debt has to be held, if not by banks, then by the public, meaning less deposits, so still crowding out • Crowding out is now by interest rates, not by fiat, but it is still crowding out. • Attractiveness of Gov. debt simply determines interest differential between public and private debt. Large Public Sector Bank Role Figure 3. Asset Shares of Commercial Banks by Type New Private Banks 100% Old Private Banks 90% Foreign Banks 80% Reg. Rural Banks 70% 60% 50% Nationalized Banks 40% 30% 20% State Bank Group 10% 0% 1993-94 2000-01 Large Public Sector Bank presence associated with slower financial and economic development, worldwide • Weak incentives for sound lending and collection Credit Misallocation (bad lending & collection processes) Borrowers develop culture of non-payment. • Weak Governance: – Multiple Conflicting Goals – Political Interference – Lack of clear incentives to staff, who become an interest group. – Weak Information/non transparency • Lower effective lending rates crowd out private banks • Difficulties in Regulation & Supervision • Result is often costly ―skeletons‖ for governments Credit Misallocation: Banks’ Gross NPLs High by International Standards Figure 4 India:Non-Performing Loans by Bank Groups (% of Loans) 20.0 Public Sector 15.0 12.4 Old Private 11.1 10.0 6.8 Foreign 5.0 5.1 New Private 0.0 1997 1998 1999 2000 2001 Source: RBI, Trend and Progress in Banking, various years. NPLs represent misallocation • Either borrowers are getting credit they cannot repay—poor selection of borrowers Or • Defaults mean someone must bear the cost, other borrowers (higher rates), depositors (lower rates), or taxpayers (bailout). Q. Why are NPLs High? A. Poor Incentives. 1. Weak legal (judicial) framework – Slow Judicial Proceedings, BIFR – Debt Tribunals have not been enough – Will new ordinance become law and make a difference? 2. Poor information on borrowing 1. And 2. Mean Poor incentives: – Why pay? – No credit record to maintain. Why are NPLs high (cont.)? • Public sector banks have NPL problems worldwide. In India worse than even ―old‖ private banks, which have similar clientele. • In Public sector banks, what are incentives – To choose borrowers well? – To collect promptly? – To use good contracts? Competition has pushed down bank margins Average Interest Margins 4.5 4 3.5 Percent of Assets 3 2.5 2 1.5 1 0.5 0 95-96 96-97 97-98 98-99 99-00 00-01 public banks private banks old private banks new foreign Public Sector banks face a squeeze from competition, poor lending, and high costs Figure 6 India: Costs, Provisions and Net Profits (Sum= Net Revenue) 2000-2001 Oth Costs 7 6 0.93 Percent of Assets 5 4 Net 0.42 Provis. Profits 0.62 3 0.81 Provis. Other 2 Costs 1 2.03 Wages 0 public sector banks old private banks new private banks foreign banks Source: RBI, Trend and Progress in Bank ing, 2000-2001 Profits have fallen Figure 7. India: Net Profit by Bank Group 1995-96 to 2000-01 2.00 1.50 Foreign 1.00 % of Assets New Pvt. Old Pvt. 0.50 Public 0.00 95-96 96-97 97-98 98-99 99-00 00-01 -0.50 Need more profits to • Write-off bad loans • Keep pace with growth • More private lending • Stronger regulation and supervision – Best Practices – Basel II • Privatize? More Profits require: • Better lending • Lower costs Or • Larger spreads (lenders pay more, depositors get less) Or Gov. will have to add capital Prerequisite to more private credit Reduce Crowding Out Better Performance(1): Better Legal & Judicial Framework Better incentives to service debt • New bankruptcy law will help/BIFR revamping. • Debt tribunals need – more support, – faster deliberations, and – penalties for willful default and delay • New ordinance: will it work? Better Performance (2) : Better Information Framework Improve incentives to service debt, select borrowers better. • Credit registry – who will manage it? – include non-banks and small borrowers. Better information improves Access • Small have asset: good credit rating • But system must go down to small loans • Which institutions can best provide access? • Currently, priority sector loans getting bigger, and rates constrain small lending. Better Performance (3) Cutting Costs in Public Banks • VRS will help, but needs to be managed • Computerization needed, but funds are lacking. Why can’t India export banking services? • Reducing or selling branches • Mergers Needed: An Exit Policy for Banks Better Performance(4) Better Incentives for Better Lending • Public banks need to improve incentives for – Selection of sound borrowers – Collection of debt service • Privatization: – Few examples of public banks that work well. – But low profits and lack of interest by foreign investors may make privatization difficult. Challenges to Reg & Supervision • Private Banks and Moral Hazard • Deposit Insurance levels Strengthening of Regulation & Supervision to Best International Practices For example, exposure limits, connected lending, income recognition, provisioning, and prompt corrective action. Particularly important for private banks without a reputation to protect.
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