The health of the banking sector is vital to the prosperity of India. The Reserve Bank of India produces an annual report on the trend and progress of banking. Its latest report, which covers the year 2003-04, has a credible story to tell of the progress in reforms, improvement in operating performance and generally robust growth of credit during the year. This, of course, reflects the general macroeconomic growth and improvement in industry and trade.
It is a sign of the times that the RBI's latest report makes a bow to markets by presenting a picture of the improved stock performance of public sector banks. This is a reflection of the distance travelled since 1991. Many public sector banks are today the darlings of the punters and the target of foreign institutional investors and foreign direct investment participants. It is the credit of these banks that notwithstanding the various constraints the public sector managers face, they have not only improved delivery of credit but also increased the profits, so that they have good market ratings.
The credit flows have been quite robust, although credit to agriculture and small industries could have done better. An important feature of the year was the growth of retail credit and credit for housing. Even with this growth, the ratio of bank assets to India's gross domestic product is only around 71 per cent, while it is significantly higher in China and more so in developed countries. There is a scope for increasing the access to and flow of credit for the economy, even given the robust growth in recent years.
Growth of credit to medium and large industries in 2003-04 was lower than in the previous year. This is attributed by the report to the greater dependence of these corporate bodies on the internal resources and on the stock market itself. One sector which showed growth in the year was infrastructure, for which credit grew by 41.6 per cent, compared to 35 per cent in the previous year. But, the total credit is still low at Rs 10,927 crore ' a small inflow compared to the large demand posed by the sector. India's banks have increased credit to wholesale trade by 104. Bank lending to non-banking financial corporations showed a decline in the year. Retail loans, including housing, exhibited an increase of 23.7 per cent, while housing alone showed a growth of 42 per cent. This shows the impact of the positive policy incentives given for housing by the government in recent years.
The report points out that while there has been boom in housing loans, the poorer sections have continued in a state of neglect. This is mainly because of the insistence on margins. Given the fact that 90 per cent of the housing shortage affects the weaker sections of the society, action has to be taken to reverse this trend. The National Housing Bank is taking an initiative in this regard by setting up a Mortgage Credit Guarantee Corporation, which will guarantee payments of principal and interest by borrowers. Whether this will improve access of weaker sections to housing loans remains to be seen. A more important approach is one which utilizes the funds under Indira Awas Yojana as margin money to leverage larger loans for the rural housing sector from housing finance companies. One good thing is that the proportion of non-performing assets under this head (Housing and Retail) has only been around 2.8 per cent ' a lower figure than feared by analysts earlier.
While banks are intermediaries between savers and borrowers in general, the Indian banking system has a preferred borrower ' the government of India and the states. Investments in government securities were as high as 41.3 per cent of the total net demand and time liabilities (of the deposit and other borrowed resources) of the banks at the end of March 2004. This is as against the statutory requirement of only 25 per cent. Banks lend willingly to government because they get returns assured and are freed of the hassle to raise capital to match increased loan assets. This is a perverse incentive for banks to avoid the risks in lending to business. There has to be a balanced growth of lending to different sectors.
One of the indicators of bank performance is the ratio of NPAs to the total assets of the bank. The NPA performance of scheduled commercial banks decreased from 2.5 per cent in 2001 to 1.2 per cent in 2004. More significantly, in gross terms, the amount decreased from Rs 32,450 crore to Rs 24,600 crore during the period. This is a measure of liability, which would have fallen on the fisc, if the NPAs have ultimately to be discharged by the government taking over the responsibility. The reduction in the NPAs is welcome.
In public sector banks, the ratio of net NPAs to total assets has fallen from 2.7 per cent to 1.3 per cent. This is lower than those of old private sector banks, whose ratio stands at 1.8 per cent now. The new private sector banks show a better result with a ratio of 1.1 per cent only. This ratio is low, especially because they have started only recently.
The improvement in the net NPA ratio is partly due to the liberal provision, which the banks have made out of their profits earned during the last year. These profits are due to improvement in the valuation of the admittedly large holdings of government securities consequent on the fall in the ratio of interest. This has been an unintended, but clear, benefit of the declining interest rates. The RBI has, however, been rightly insisting that excessive concentration of bank assets in gilt-edged securities may not be desirable, in the light of a possible rise of interest rates. It has been advising the banking system to provide for an investment fluctuation reserve.
Mention has also been made by the RBI about the Ashok Ganguly committee's report on lending to small and medium industries. I am particularly concerned about one of the recommendations of the committee that banks should set up a dedicated non-banking finance company type of institution to handle credit to clusters of small industries. This is an admission by the RBI that NBFC operations are more flexible and ultimately more efficient than those of a bank. Why then is the RBI wary of encouraging NBFC operations in general' One only hopes that the Ganguly committee's recommendation does not face the same fate as the Regional Rural Banks, which were started similarly. It is now being proposed that they be merged back with their parent banks. There is still an urgent need to improve the governance of banks, particularly in regard to small industries. This has to have priority over banks' setting up of special NBFC type institutions.
One of the ideas put forward in the report on improved lending to infrastructure is that while credit enhancement guarantees are significant, they cannot substitute diligence. While increasing lending to infrastructure, it must be ensured that guarantees do not blind lenders to inherent risks. Also, levy and collection of user charges are vital for the revival of infrastructure lending.
One suggestion is regarding the share of governance by promoters and stake-holders in banks. While the RBI is in favour of the merger of banks, it is restricting the ownership of banks to people whom it considers 'fit and proper'. The RBI is assuming a heavy responsibility in taking on itself the right to decide who is 'fit and proper' to run a bank. The regulator should not get itself involved in determining such rights to hold stakes in banks. Whether the central bank will exclude certain persons on the basis of due diligence is not clear. This can lead to some controversy and litigation. What applies to general corporate governance, namely, that those who have stakes have proportionate share in governance, should hold good for banking also.
All in all, the Report on Trend and Progress of Banking for 2003-04 is a credible document, presenting a picture of vibrant growth in the banking sector. It indicates various technological improvements which have helped performance. Further reforms have been promised. Let us hope that 2004-05 will be equally promising for this sector in India.