30 Years Of Economic Reforms | Taking stock of Indian banking

One of the key pillars of the 1991 reforms was in the financial sector. In his Budget speech then finance minister Manmohan Singh highlighted that the objective of the reforms “would be to preserve its basic role as an essential adjunct to economic growth and competitive efficiency, while improving the health of its institutions.” Singh also announced appointing a high level committee to “consider all relevant aspects of structure, organisation, functions and procedures of the financial system.”

Accordingly, a committee was appointed under chairmanship of M Narasimham, former Governor of the Reserve Bank of India (RBI) whose suggestions centred on the banking sector given the economy’s dependence on it. Yet, 30 years later, the banking sector continues to be a major economic concern. How did this journey with much promise turn out to be a let-down?

In 1990, there were 75 banks and the size of the banking sector was Rs 2.9 lakh-crore or 50 percent of the GDP. The public sector banks, including the State Bank of India, constituted nearly 91 percent of the banking system, with private banks contributing merely 3.4 percent to the banking system. The return on assets was 0.39 percent with much of the contribution coming from foreign banks. The return on assets of the public sector banks and private banks was just 0.13 percent and 0.03 percent respectively. When it comes to prudential norms, capital and reserves as percentage of GDP was 1.66 percent for public sector banks and 1.50 percent for private sector banks.

(in %)

Fast forward to 2020 and we see a mixed bag. In the past 30 years while GDP multiplied 24 times, the banking assets multiplied 63 times, implying that banking assets are now at 135 percent of GDP. We also see that industry composition has changed significantly with the share of public sector banks (PSBs) in total banking liabilities declining to 61 percent. This decline has been captured almost in entirety by new private sector banks (NPSBs) whose share stands at 26 percent in 2020. In 1994, the RBI licenced the NPSBs to usher in competition and there has been some success on this front. The NPSBs, along with foreign banks, have led the rise in percentage of capital and reserves to liabilities to 8.21 percent, nearly five times the 1990 levels.

Despite the growth in banking assets, we don’t see similar growth in the number of banks. If we remove the foreign banks and small finance banks given their insignificant contribution, the number of banks declines from 53 in 1990 to 34 in 2020. One of the planks of the Narasimham committee was to increase the number of private banks but this has not happened on expected lines. The RBI has so far licenced 14 new banks of which just nine remain. Even within the nine banks, the performance of the NPSBs such as IDBI Bank, Yes Bank and IDFC First Bank has been below expectations.

Another source of concern is profitability. The return on assets (ROA) of the banking system has increased by 0.08 points in the last 30 years. The return on public sector bank assets has turned negative, depressing the overall numbers. Though the NPSBs do better on ROA, they have been facing a declining trend and banks such as IDBI Bank, Yes Bank, and IDFC First Bank have been generating negative ROA for the past few years. The return on assets has also been impacted by a surge in Non-Performing Assets (NPAs) which was due to poor lending decisions. As the NPA picture was improving, the pandemic struck, and the NPAs are expected to rise to double digits.

Given this 30 year broad sweep, how do we take stock of India’s banking sector? We have strong positives in growth and increasing privatisation of the industry. The not-so-positives are increasing industry concentration by a few banks and slipping profitability. While slipping profitability is an outcome of many factors, the one on concentration of banking in a few hands could have been avoided.

For some reason, the RBI has been very stringent in giving licences to new commercial/universal banks. In the 1990s, the RBI gave 10 licences (of which four banks closed) followed by two each in the 2000s and the 2010s. This is not even a drop in the ocean. The central bank allowed on-tap licensing but has preferred to reject, rather than accept, more applicants. The RBI has been more liberal with differentiated banks. In the late 1990s, it awarded 10 licences to local area banks which was not a successful experiment. In 2014, it gave 11 new licences to payment banks and 10 licences to small finance banks (SFB). While payment banks have struggled so far, the SFBs have been broadly successful.

Of late, the RBI has been thinking of different ways to open up universal banking space other than licencing. For the first time the RBI allowed a foreign bank, DBS Bank, to amalgamate Lakshmi Vilas Bank (LVB). Also, one of the RBI internal working groups recommended corporates and large NBFCs to get bank licences after appropriate due diligence. While large NBFCs becoming banks is acceptable to most, there has been large criticism of allowing corporates bank licences.

Another issue is India’s complex web of banking regulation. The PSBs are regulated both by the central government and the RBI, with the former having higher weight on regulatory matters. Similarly, the co-operative banks are dual regulated by respective state governments and the RBI. The central bank had weaker powers to regulate Non-Banking Finance Companies (NBFCs) and Housing Finance Companies (HFCs) were regulated by the National Housing Bank. Since the crisis in all these sub-sectors, we have seen the transfer of regulating the HFCs to the RBI and strengthening of the NBFC and co-operative regulation at the RBI’s end. However, there has been no attempt to end dual regulation of PSBs despite the Narasimham committee’s suggestion 30 years ago. With the financial system getting increasingly interconnected, it is important that all the regulatory responsibilities lie with the RBI.

Yet another issue is the falling governance standards across most banking groups. Whether it is government-appointed Boards at the PSBs or private shareholder-appointed Boards at private banks, there have been some serious cases of omission. There has been a historical association between mis-governance and banking crises as seen in the 2008 global financial crisis. The recent Indian banking crisis is an addition to this list of mis-governance. The RBI has taken several measures to improve governance, but they are limited to private banks as the government controls PSBs.

Summing up, Indian banking has come a long way since 1991. The private banks have played an instrumental role in this transition bringing new technology and products to the banking space. Except for the failure of some private banks, the experience with private banks has been better. However, despite this improvement, Indian banking is still a work in progress on some core issues. The pandemic has hit the banking sector adversely but the overall impact has not been as bad as we had initially expected. The quote by 19th century French critic and novelist Jean-Baptiste Alphonse Karr sums up the last 30 years of the banking sector in India: “the more things change, the more they remain the same”.