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 1992Focus 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

Figure 1India: Money(M3 in Sept.): GDP,

Deposit Rate & Inflation

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Inte

rest

Ra

te a

nd

In

fla

tio

n (

%)

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

M3

(%

of

GD

P)

M3/GDPM3+NBFCs % of GDP

Inflation (CPI)

Interest Rate 1 yr. Deposit

FreeRate

Ave. M3/GDP, 1987-92

Reforms Restarted Dep. Growth

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.

Figure 2. India: Banks' Government Debt, Credit, and Investments Selected Years (percent of GDP)

0%

10%

20%

30%

40%

50%

60%

85-86 90-91 95-96 98-99 00-01

Credit Gov. Debt Other Elig. Invest. Other Investments

Crowding out: Gov. debt absorbed much of bank growth, reflecting its large deficit;

credit grew slowly

Gov. Debt/Dep. , 2000, Percent (IFS)Korea -3.6 Philippines 22.7Chile -3.1 Hungary 23.0Thailand 1.4 Pakistan 24.6Malaysia 2.3 Morocco 26.5Peru 3.2 Argentina 30.8S. Africa 4.9 India 34.6Czech Rep. 4.9 Russia 35.3China 6.0 Brazil 43.3Egypt 7.8 Mexico 48.8Venezuela 8.2 Algeria 50.6Bangladesh 10.9 Indonesia 56.3Poland 14.8 Turkey 64.7Colombia 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

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1993-94 2000-01

Nationalized Banks

State Bank Group

Foreign BanksReg. Rural Banks

Old Private Banks

New Private Banks

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

Source: RBI, Trend and Progress in Bank ing , various years.

Figure 4India:Non-Performing Loans by Bank Groups

(% of Loans)

0.0

5.0

10.0

15.0

20.0

1997 1998 1999 2000 2001

New Private

Public Sector

Old Private

Foreign

11.112.4

6.8

5.1

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 borrowing1. 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

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0.5

1

1.5

2

2.5

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3.5

4

4.5

95-96 96-97 97-98 98-99 99-00 00-01

Pe

rce

nt

of

As

se

ts

public banks private banks old private banks new foreign

Public Sector banks face a squeeze fromcompetition, poor lending, and high costs

Source: RBI, Trend and Progress in Bank ing, 2000-2001

Provis.

OthCosts

Figure 6 India: Costs, Provisions and Net Profits (Sum= Net Revenue)

2000-2001

0

1

2

3

4

5

6

7

public sector banks old private banks new private banks foreign banks

Pe

rce

nt

of

As

se

ts

NetProfits

Provis.OtherCosts

Wages

0.42

2.03

0.620.81

0.93

Profits have fallen

Figure 7. India: Net Profit by Bank Group 1995-96 to 2000-01

-0.50

0.00

0.50

1.00

1.50

2.00

95-96 96-97 97-98 98-99 99-00 00-01

% o

f Ass

ets

Foreign

Public

Old Pvt.

New Pvt.

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 costsOr• 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.