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The Indian Banking IndustryTABLE
Topic Page
EVOLUTION OF BANKING 4
PRE-INDEPENDENCE (1786-1947) 4POST-INDEPENDENCE 5STRUCTURE OF THE BANKING SECTOR 8PUBLIC SECTOR BANKS 9PRIVATE SECTOR BANKS 10FOREIGN BANKS 12CONCENTRATION IN THE BANKING SECTOR 13SECTORAL TRENDS IN CREDIT DEPLOYMENT 15BANKING SECTOR REFORMS 21ASSETS AND LIABILITIES STRUCTURE OF SCBS 22LIABILITIES 27
ASSETS 28STRUCTURAL REFORMS 32IMPACT OF REFORMS ON BANKS 35PROFITS 35CAPITAL ADEQUACY 36DEPOSIT GROWTH 37ASSET QUALITY AND NON-PERFORMING LOANS 37BANKING INDUSTRY PERFORMANCE 39INCOME 40YIELDS 44INTEREST COST 48
SPREADS 50INTERMEDIATION COSTS 52PROFITABILITY 56RETURN ON ASSETS 57CAPITAL ADEQUACY 60ASSET QUALITY 63COMPETITION FROM OTHER INSTITUTIONAL INTERMEDIARIES 70FINANCIAL INSTITUTIONS 70NON-BANKING FINANCE COMPANIES 77MUTUAL FUNDS 80FINANCIAL DISINTERMEDIATION 82
DOMESTIC TRENDS 86MERGERS 86CONSUMER BANKING 88INTERNET BANKING 88ANNEXURE: KEY INDICATORS OF INDIAN SCBS 89CONTENTS
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Introduction
In India, given the relatively underdeveloped capital market and with little internal
resources, firms and economic entities depend, largely, on financial intermediaries to
meet their fund requirements. In terms of supply of credit, financial intermediaries can
broadly be categorised as institutional and non -institutional. The major institutional
suppliers of credit in India are banks and non -bank financial institutions (that is,
development financial institutions or DFIs), other financial institutions (FIs), and non-
banking finance companies (NBFCs). The non-institutional or unorganised sources of
credit include indigenous bankers and money-lenders. Information about the unorganised
sector is limited and not readily available. An important feature of the credit market is its
term structure: (a) short-term credit; (b) medium-term credit; and (c) long-term credit.
While banks and NBFCs predominantly cater for short-term needs1, FIs provide mostly
medium and long-term funds.
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EVOLUTION OF BANKING
Pre-Independence (1786-1947)
The evolution of the modern commercial banking industry in India can be traced to
1786 with the establishment of Bank of Bengal in Calcutta (now Kolkata).
Subsequently, three Presidency Banks were set upat Calcutta in 1806, Bombay
(now Mumbai) in 1840, and Madras (now Chennai) in 1843. In 1860, the concept
of limited liability was introduced in banking, resulting in the establishment of a
number of joint sector banks. The early 1900s led to the establishment of a number
of indigenous joint stock banks, such as the Bank of India, Bank of Baroda, and the
Central Bank of India.
In 1921, the three Presidency Banks were amalgamated to form the Imperial Bank
of India (IBI). This new bank took on the triple role of a commercial bank, a
banker's bank and a banker to the government. The establishment of the Reserve
Bank of India (RBI) as the central bank of the country in 1935 ended the quasi-
central banking role of the IBI. It ceased to be banker to the Government of India
(GoI) and instead became agent of the RBI for the transaction of government
business at centres at which RBI was not established. IBI also acted as a bankers'bank by holding their surplus.
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Post-Independence
India inherited a weak financial system after Independence in 1947. At end-1947,
there were 625 commercial banks in India, with an asset base of Rs. 11.51 billion.
Commercial banks mobilised household savings through demand and term
deposits, and disbursed credit primarily to large corporations. Following
Independence, the development of rural India was given the highest priority. The
commercial banks of the country including the IBI had till then confined their
operations to the urban sector and were not equipped to respond to the emergent
needs of economic regeneration of the rural areas. In order to serve the economy in
general and the rural sector in particular, the All India Rural Credit Survey
Committee recommended the creation of a state-partnered and state-sponsored
bank by taking over the IBI, and integrating with it, the former state-owned or
state-associate banks. Accordingly, an act was passed in Parliament in May 1955,
and the State Bank of India (SBI) was constituted on July1, 1955. More than a
quarter of the resources of the Indian banking system thus passed under the direct
control of the State. Subsequently in 1959, the State Bank of India (Subsidiary
Bank) Act was passed (SBI Act), enabling the SBI to take over 8 former State-
associate banks as its subsidiaries (later named Associates).
The GoI also felt the need to bring about wider diffusion of banking facilities and
to change the uneven distribution of bank lending. The proportion of credit going
to industry and trade increased from a high 83% in 1951 to 90% in 1968. This
increase was at the expense of some crucial segment of the economy like
agriculture and the small-scale industrial sector. Bank failures and mergers resulted
in a decline in number of banks from 648 (including 97 scheduled commercial
banks or SCBs and 551 non -SCBs) in 1947 to 89 in 1969 (compr ising 73 SCBsand 16 non -SCBs). The lop-sided pattern of credit disbursal, and perhaps the spate
of bank failures during the sixties, forced the government to resort to
nationalisation of banks. In July 1969, the GoI nationalised 14 scheduled
commercial banks (SCBs), each having minimum aggregate deposits of Rs. 500
million. State-control was considered as a necessary catalyst for economic growth
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and ensuring an even distribution of banking facilities. Subsequently, in 1980, the
GoI nationalised another 6 banks2, each having deposits of Rs. 2,000 million and
above.
The nationalisation of banks was the culmination of pressures to use the banks as
public instruments of development. The GoI imposed `social control on banks, of
which priority sector lending was a major aspect. It introduced restrictions on
advances by banking companies. These were intended to ensure that bank advances
were confined not only to large-scale industries and big business houses, but were
also directed, in due proportion, to other important sectors like agriculture, small-
scale industries and exports.
Since 1969, there has been a significant spread of the banking habit in the economy
and banks have been able to mobilise a large amount of savings. While the number
of bank offices has increased from 8,262 in June 1969 to 68,561 in March 2003,
average population per office has declined from 64,000 to 16,000. While aggregate
deposits of commercial banks have increased from Rs. 46.46 billion in June 1969
to Rs. 12,809 billion in March 2003 (Rs. 15,019 billion at end-March 2004), credit
has also increased from Rs. 35.99 billion to Rs. 7,292 billion (Rs. 8,354 billion at
end-March 2004). The 1969 nationalisation had raised public sector banks (PSBs)
share of deposit from 31% to 86%, while the nationalisation of 1980 raised the
same to 92%.
However, by the 1980s, it was generally perceived that the operational efficiency
of banks was declining. Banks were characterised by low profitability, high and
growing nonperforming assets (NPAs), and low capital base. Average returns on
assets were only around 0.15% in the second half of the 1980s, and capital
aggregated an estimated 1.5% of assets. Poor internal controls and the lack of
proper disclosure norms led to many problems being kept under cover. The quality
of customer service did not keep pace with the increasing expectations.
In 1991, a fresh era in Indian banking began, with the introduction of banking
sector reforms as part of the overall economic liberalisation in India.
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STRUCTURE OF THE BANKING SECTOR
The banking sector in India functions under the umbrella of the RBIthe
regulatory, central bank. The Reserve Bank of India Act was passed in 1934 andthe RBI was constituted in 1935 as the apex bank. The Banking Regulations Act
was passed in 1949. This Act brought the RBI under government control. Under
the Act, the RBI received wide-ranging powers in
regards to establishment of new banks, mergers and amalgamations of banks,
opening and closing of branches of banks, maintaining certain standards of banking
business, inspection of banks, etc. The Act also vested licensing powers and the
authority to conduct inspections with the RBI.
Banks in India can broadly be classified as regional rural banks or RRBs,
scheduled commercial banks or SCBs, and co-operative banks. The scope of the
present comment includes the SCBs only.
The SCBs for the purpose of this comment can be classified into the following
three categories:
Public sector banks or PSBs (SBI & its associates, and nationalised banks);
Private sector banks (old and new); and
Foreign banks.
ABLE OF CONTENTS
CREDIT MARKET STRUCTURE
In India, given the relatively underdeveloped capital market and with little internal
resources, firms and economic entities depend, largely, on financial intermediaries
to meet their fund requirements. In terms of supply of credit, financial
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intermediaries can broadly be categorised as institutional and non -institutional.
The major institutional suppliers of credit in India are banks and non -bank
financial institutions (that is, development financial institutions or DFIs), other
financial institutions (FIs), and non-banking finance companies (NBFCs). The non-
institutional or unorganised sources of credit include indigenous bankers and
money-lenders. Information about the unorganised sector is limited and not readily
available. An important feature of the credit market is its term structure: (a) short-
term credit; (b) medium-term credit; and (c) long-term credit. While banks and
NBFCs predominantly cater for short-term needs1, FIs provide mostly medium and
long-term funds.
Structure of Indian Banking Industry at end-March 2003 (end-FY2003)
At end-FY2003, these SCBs had a network of 53,882 offices, and total assets
worth Rs. 16,989 billion, making them the most active and dominant financial
intermediaries in the country.
Public Sector BanksThe banking sector in India has been characterised by the predominance of PSBs.
The PSBs had 47,677 offices (SBI & associates: 13,735; nationalised banks:
33,942) at end-FY2003, and their assets of Rs. 12,852 billion at end-FY2003
accounted for 75.7% of assets of all SCBs in India. An estimated 63.4% of the
offices of PSBs at end-FY2003 were in these areas: rural/semi-urban.
The PSBs large network of branches enables them to fund themselves out of low-
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cost deposits. At end-FY2003, PSBs accounted for 75.7% of assets, 79.6% of
deposits, 74.2% of advances, 74.5% of income, and 88.7% of offices of all SCBs in
India, thus clearly demonstrating their dominance of the Indian banking sector.
However, PSBs have suffered a gradual loss of market share, mainly to new private
sector banks. PSBs accounted for 80% of asset growth of SCBs during FY2003,
compared with 51.9% during FY2002, and 75.3% during FY20014.
Select IndicatorsPSBs
End-FY2003
(Courtesy: Reuters
SBI is the largest PSB, and also the largest SCB in India. At end-FY2003, SBI
accounted for 22.1% of the aggregate assets of all SCBs in India. Further, five out
of the six largest SCBs in India are PSBs (refer Table below). The below
mentioned six SCBs accounted for 47.3% of assets of all SCBs in India at end-FY2003.
Major SCBs in India at end-FY2003
A
ICICI Bank is a new private sector bankCourtesy: Reuters
Private Sector Banks
As of end-FY2003, there were 30 private sector banks operating in India through
5,879 offices. These can further be classified as old (OPBs) and new private sector
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banks (NPBs). At end-FY2003, there were 21 OPSBs operating in the country.
These banks had an estimated 4,737 offices at end-FY2003, are regional in
character and, except for a few, have a comparatively small balance sheet size.
In July 1993, as part of the banking sector reform process and as a measure to
induce competition in the banking sector, the RBI permitted entry by the private
sector into the banking system. This resulted in the introduction of 9 private sector
banks. These banks are collectively known as the `new private sector banks
(NPBs), and operated through an estimated 988 branches at end-FY2002. With the
merger of Times Bank Limited into HDFC Bank Limited in February 2000, and
the entry of Kotak Mahindra Bank Limited (KMBL) during March 2003, there are
nine NPBs in India at present.
Select IndicatorsPrivate Sector Banks
Courtesy: Reuters
At end-FY2003, the total assets of private sector banks aggregated Rs. 2,973
billion and accounted for 17.5% of the total assets of all SCBs. Although the share
of private sector banks in total assets has increased from 12.6% at end-FY2001,
most of the gain has been accounted for by NPBs. The share of NPBs in the share
of assets of all private sector banks increased from 27.5% at end-FY1997 (2.4% of
assets of SCBs) to 64.6% at end-FY2003 (11.3% of assets of SCBs). By contrast,
the share of OPBs banks (in total assets of SCBs) has declined from 6.4% at end-
FY1997 to 6.2% at end-FY2003; their share of assets of private sector banks has
declined from 72.5% at end-FY1997 to 35.4% at end-FY2003. At end- FY2003,
three (ICICI Bank, HDFC Bank, and UTI Bank) of the five largest private sector
banks (by asset size) were NPBs (refer Table below). The five largest private
sector banks controlled 62.5% of assets of all private sector banks at end-FY2003.
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Major Private Sector Banks in India at end-FY2003
(Rs. billion)
Courtesy: Reuters
Foreign Banks
At end-FY2003, 36 foreign banks were operating in India through 208 offices. All
offices of foreign banks were in urban and metropolitan areas. At end-FY2003, the
total assets of foreign banks aggregated Rs. 1,164 billion and accounted for 6.9%
of the total assets of all SCBs (refer Table below). In recent years, because of
closures and increased competition from NPBs, the share of foreign banks in
aggregate assets of SCBs has declined from 8.1% at end- FY1999.
Select IndicatorsForeign BanksEnd-FY2003(
Courtesy: Reuters CBs
The biggest foreign bank in India by asset size is Standard Chartered Bank,
followed by Citibank, and the Hongkong & Shanghai Banking Corporation
(HSBC) (refer Table below). As of end-FY2003, the five largest foreign banks
accounted for 77.9% of assets of all foreign banks in India.
Major Foreign Banks in India at end-FY2003(Rs. billion)
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Assets Deposits Advances Investments IncomeSource: rbi.org/
The primary activity of most foreign banks in India has been in the corporate
segment. However, in recent years, foreign banks have started making consumer
financing a larger part of their portfolios, based on the growth opportunities in this
area in India. These banks also offer products such as automobile finance, home
loans, credit cards and household consumer finance.
CONCENTRAT ION IN THE BANKING SECTOR
The concentration in the Indian banking sector has declined gradually during the
last few years. This is illustrated by table below. While the share of the largest SCB
SBIhas declined only gradually, other PSBs have lost gradual market share to
NPBs. Overall, while the share of the five largest banks in total assets has declined
from 45.2% at end-FY1997 to 42.8% at end-FY2003, the share of the ten largest
banks has declined from 60.3% to 58.2%. As the table below illustrates, PSBs havegradually lost market share to NPBs. However, amongst the PSBs, the share of the
SBI & associate banks has increased at the expense of the nationalised banks
from 36.7% of assets of PSBs at end-FY1997 to 38.4% at end- FY2003.
Nationalised banks have witnessed the most significant decline in share of assets of
all SCBsfrom 52.5% at end-FY1997 to 46.6% at end-FY2003. They have lost
market share mainly to NPBs, whose share of total assets increased from 2.4% at
end-FY1997 to 11.3% at end-FY2003. Foreign banks, with limited branch
presence, have also witnessed a decline in share of assets. NPBs have expanded the
most in the deposit market as well, with their share of total deposits increasing
from 2.4% at end-FY1997 to 8.5% at end-FY2003. By comparison, the share of
nationalised banks declined from 56.2% to 50.8%.
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Share of total assets of SCBs in India(Percent of assets of all SCBs)
As 2
Source: goidirectory.nic.in
An analysis of the state-wise share of deposits and credit indicates that at end-
FY2003, PSBs continue to be dominant (with more than 85% of deposits of SCBs)in many major statesUttar Pradesh, Punjab, Madhya Pradesh, Rajasthan, Bihar,
Haryana, and Orissa.
Share of bank deposits in major states
Foreign banks, despite the apparently superior quality of services they offer, have
not been a major competitive threat in Delhi, West Bengal, Maharashtra,
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Karnataka, and Tamil Nadu, where their presence is greatest. These five states
accounted for an estimated 94.4% of deposits of foreign banks at end-FY2003. In
fact, foreign banks have lost market share in these statesfrom 12.5% of deposits
at end-FY1999 to 8.5% of deposits at end-FY2003. Private sector banks have
gained more than 25% of deposits in many major states Maharashtra, Tamil
Nadu, Kerala, and Jammu & Kashmirbut the impact on PSBs is smaller than on
foreign banks. The trends so far indicate that, even after a decade of reforms, PSBs
continue to dominate in most of the states.
SECTORAL TRENDS IN CREDIT DEPLOYMENTAn analysis of gross bank credit (GBC)6 of SCBs reveals that while the share of
industry has declined from 50.1% at end-FY1998 to 42.4% at end-FY2002, the
share of personal loans has increased from 10.4% to 12.3%. Similarly, the share ofagriculture in total credit has also declined from 9.5% at end-FY1998 to 8.7% at
end-FY2002.
Distribution of outstanding credit of SCBsend FY1998 to end-FY2002(in percent)
As at end March
An analysis of GBC of select SCBs accounting for 8590% of bank credit of all
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SCBs indicates that GBC to agriculture increased 17.9% during FY2003, as
compared with growth of 17% during FY2002, and 17% during FY2001. The
agricultural sector was impacted by a severe drought in 2002, with the monsoon
season rainfall (June-September 2002) being 81% of normal. This adversely
impacted on the farm sector in several States, producing a contraction in real GDP
originating from `agriculture and allied activities. The production of food grains
was adversely affected with a 14.6% decline to 182.6 million tonnes during
FY2003. As a result, GDP from agriculture declined 3.2% during FY2003.
During FY2003, industrial sector recovered as evident in a sharp rise in the
production and imports of capital goods. Industrial performance is dominated by
the behaviour of manufacturing, and during FY2003, the manufacturing sector
contributed 86% of the growth of overall industrial production. The industrial
recovery enabled a healthy growth in exports, and resulted in upswing in non -food
credit from the banking system. The industrial sector GDP increased 5.7% during
FY2003 because of improvements in infrastructure, lag effect of increased
agricultural output during FY2002, and improvement in exports. Industrial activity
was broadly insulated from the impact of the drought, except in the durable
consumer goods segment.
Sectoral Real Growth rates in GDP at factor cost1993-94 prices
Ninth Plan(FY1998-
Reflecting the recovery in industrial activity from March 2002, GBC to industry
(medium and large) increased 16.3% during FY2003, as compared with increases
of 5.8% during FY2002, and 10.5% during FY2001. The recovery permeated all
segments during FY2003, with manufacturing contributing more than 80% of the
overall growth of industrial production. Indian industry was largely insulated from
the impact of the drought, except in the durable consumer goods segment where
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production was adversely impacted. In recent years, there has been increased share
of GBC to housing and other non-priority sector personal loans. GBC to housing
increased 55.1% during FY2003, as compared with growth of 38.4% during
FY2002, and 14.5% during FY2001. Accordingly, the share of housing loans in
GBC increased from 3.4% at end-FY2001 to 5.6% at end-FY2003. Housing loans
accounted for 15.4% of incremental GBC during FY2003, as compared with 9.2%
during FY2002, and only 3% during FY2001. During FY2003, growth of credit to
housing continued to remain high, because of tax incentives as well as the decline
in interest rates. In May 2002, RBI liberalised the prudential requirements for
housing finance by banks and investment by banks in securitised debt instruments
of housing finance companies (HFCs). Residential housing properties now attract a
risk weight of 50% as compared with the previous 100%. Because of liberalised
prudential requirements and general decline in interest rates, there has been a
significant decline in the interest rates charged by banks on housing loans. Many
banks have set their lending rates lower on housing loans, and at times below PLR,
due to lower risk weight. Many banks have con sistently exceeded the targets
prescribed for providing housing loans during FY2002 and FY2003. While
minimum prescribed allocations for housing finance by SCBs increased from Rs.
50.46 billion during FY2002 to Rs. 85.74 billion during FY2003, disbursements
increased from Rs. 147.46 billion to Rs. 338.41 billion.
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Sectoral Deployment of Gross Bank Credit
-03 21-03-0322-03-02
As compared with PSBs, foreign banks have placed increased thrust on consumer
financing, which has enabled them to enjoy consistently higher yields and margins.
Personal loans accounted for 23.6% of outstanding credit of foreign banks at end-
FY2002, as compared with 18.9% at end-FY2001. By contrast, with the slowdown
in the economy, PSBs have only recently placed increased focus on consumer
financing. Personal loans accounted for 12.5% of their credit at end-FY2002, as
compared with 11.7% at end-FY2001, and 9.9% at end- FY1998.
Bank Group-wise distribution of outstanding creditend-FY2000 to end-FY2002
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As the following table indicates, industry wise, the largest credit growth over thepast five years has been observed in power, roads and ports, computer software,
telecom, gems & jewellery, petrochemicals, cement, electricity, and food
processing. By contrast, GBC has declined or stagnated in traditional commodity
sectors such as jute textiles, tobacco & tobacco products, leather & leather
products, rubber & rubber products, tea, and vegetable oils. During FY2003, while
GBC to industrysmall, medium and largeincreased 13.6% to Rs. 2,608.21
billion, some major industries showed a decline in GBC. The important amongst
these were coal, sugar, tobacco & tobacco products, and other engineering. By
comparison, some important industries that have showed an increase in GBC
during FY2003 include computer software (growth of 52%), roads & ports
(49.3%), power (45.8%), cement (22.6%), electricity (20.9%), cotton textiles
(18%), and gems & jewellery (16.8%).
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Industry wise deployment of gross bank credit
(Percent)
As on last
As on last reporting Friday of March 2003 2002 2001 2000 1999
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BANKING SECTOR REFORMS
In general, the post-nationalisation period during the 1970s and 1980s was marked
by a high degree of regulation and control. The two dominant financialintermediariescommercial banks and long-term lending institutionshad
mutually exclusive roles and objectives and operated in a largely stable
environment, with little or no competition. Long-term lending institutions were
focused on the achievement of the GoIs various socio-economic objectives,
including balanced industrial growth and employment creation, especially in areas
requiring development. They were extended access to long-term funds at
subsidized rates through loans and equity from the GoI and from funds guaranteed
by the GoI, originating from commercial banks in India and foreign currency
resources, originating from multilateral and bilateral agencies. The banks
functioned in a heavily regulated and controlled environment, with an administered
interest rate structure, quantitative restrictions on credit flows, high reserve
requirements, and pre-emption of a significant proportion of lend able resources
towards the `priority and government sectors. The banks formed a captive pool of
resources for the government's borrowings. Since the government was the largest
borrower in the economy, it could assume the role of price maker. The imposition
of high statutory liquidity reserve (SLR) requirements and cash reserve ratio (CRR)
requirements and priority sector norms led to a significant reduction in the bank
operational flexibility in asset deployment, and to credit rationing for the private
sector. Interest rate controls led to sub-optimal use of credit, and low levels of
investment and growth. The administered interest rate system worked on cost-plus
pricing. The RBI worked out the lending and deposit rate structure to ensure that
banks got a decent spread for their operations. The resultant heavy regulation led toa decline in productivity and efficiency. Although the business volumes improved,
asset quality suffered because of the higher incidence of concessional and directed
lending. To evaluate the systemic banking problems, the GoI set up a nine-member
Committee on Financial Systems, under the chairmanship of Mr. N. Narasimham,
in 1991. The Narasimham Committee Report, published towards the end of 1991,
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contained far-reaching recommendations for the banking sector and formed the
basis of the sectors reform process.
These reforms were undertaken together with, and formed an important element of,
the overall economic reforms of the 1990s. The salient features of these reforms
were:
introduction of stricter income recognition and asset classification norms;
introduction of higher capital adequacy requirements;
introduction of higher disclosure standards in financial reporting;
introduction of phased deregulation of interest rates;
and lowering of SLR and CRR requirements.
Assets and Liabilities Structure of SCBs
The reforms in the banking sector were targeted at both the asset and the liability
sides of the balance sheet. Before the banking sector reforms are discussed in
detail, it would perhaps be instructive to look at how Indian banks raise funds and
how these funds are deployed. The liability profile of the Indian banking sector is
presented in the following Table.
Liability Profile
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As the Table shows, the major sources of funds for the Indian banking sector are
deposits, which accounted for 79.8% of SCBs liabilities at end-FY2003, as
compared with 81.1% at end-FY1999. Deposits are of three kinds:
Demand deposits, accounting for 12.1% of deposits of SCBs at end-FY2003,
carry zero interest and are, typically, used by corporates for storing funds for short
periods. Demand deposits offer unlimited liquidity in that they can be withdrawn at
any time.
Savings deposits offer only a slightly lower degree of liquidity but carry a low
interest rate (presently 3.5% per annum). Savings deposits accounted for 22.3% of
the deposits of SCBs at end-FY2003. However, the operating costs of servicing
these deposits are high as they consist of a large number of small value accounts
that are geographically widespread (61% of savings deposit accounts of SCBs are
in rural and semi-urban areas). SCBs try to enhance the share of savings deposits
from retail customers as these offer lower costs as well as higher stability.
Term deposits are the most illiquid of the three and carry the highest interest cost.
Term deposits can have a minimum maturity of 15 days7. Term deposits accounted
for 65.6% of deposits of SCBs at end-FY2003. In terms of maturity, only 34.8% of
term deposits at end-FY2002 had a maturity of less than 1 year. Nearly 55.4% of
term deposits were for maturity periods of 1 to 5 years. An estimated 9.8% of term
deposits were for maturity periods exceeding 5 years.
An analysis of bank deposits by type indicates that the `household sector
accounted for 66.7% of outstanding deposits of SCBs at end-FY2002, followed by
Government (10.6%), foreign (10.2%), financial sector (6.9%), and private
corporatenon financial (5.7%). At end-FY2002, households accounted for 87.3%
of savings deposits of SCBs, 62.8% of term deposits, and 46.3% of current
deposits. Despite the significant increase in branch network, urban andmetropolitan branches of SCBs accounted for 66.4% of deposits of all SCBs at
end-FY2002.
There is a flow of resources from the rural/semi-urban branches as indicated by the
fact that the credit extended by rural/semi urban branches of SCBs is less than the
deposits of these branches.
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Apart from deposits, the other major source of funds is a banks net worth. Banks
are required to fund a certain proportion of their assets (weighted by their risk) by
their net worth. This proportion is known as the capital adequacy ratio (CAR). For
all SCBs, the minimum CAR was increased from 8% to 9% from the year ended
March 31, 2000, as per Basel norms, covering both on and off-balance sheet items.
Liability Profile of SCBs
The asset profile of SCBs in India is presented below:
Asset Profile of SCBsend-FY2003
Source: goidirectory.nic.in
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The funds raised by banks are deployed under two major headsloans &
advances, and investments. As of end-FY2003, loans & advances constituted
43.6% of the total assets of SCBs, while investments accounted for 40.8%. The
assets financed by the banks are linked to the liabilities through statutory
regulation, principal among which are the SLR and the CRR that mandate banks to
maintain a certain minimum proportion of their deposits in certain designated
liquid assets. The CAR also determines the nature (i.e., riskiness) and the quantum
of assets a bank can finance.
Advances by Indian banks, generally, take three formscash credit (CC), bills
purchased and discounted, and term loans. CC (49.8% of outstanding advances of
SCBs at end-FY2003) is the most popular mode of borrowing by business concerns
in India. The advantage of this mode is that the borrower does not need to borrow
the entire limit sanctioned at once. The borrower can withdraw only the amount
needed and return any surplus funds. When the customer requires temporary
accommodation, he may be allowed to overdraw his current account, usually
against collateral securities. While the overdraft is theoretically temporary, in
practice, bankers set regular limits for overdrafts also, in addition to the CC limit.
CC is generally given for a period of up to 12 months, with subsequent reviews.
Bill purchase and discounting (8.3% of outstanding advances at end-FY2003)
involves the financing of shortterm trade receivables through negotiable
instruments. These negotiable instruments can then be discounted with other banks
if required, providing the bank with liquidity. Term loans (41.9% of outstanding
advances at end-FY2003) are longer duration loans given typically for financing
projects, core working capital (WC) requirements, and normal capital expenditures.
The investments of banks are, primarily, in government securities in India (76.8%
of investments at end-FY2003). Banks in India, and especially PSBs, generally
hold government securities far in excess of their SLR requirements. Investments in
government securities benefit banks in the following ways. While the return is low,
the investments are virtually risk-free and there is no danger of generation of
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NPAs. Thus, government securities provide banks with a steady source of risk-free
income. Banks would naturally prefer to lend to the government at market-
determined rates than make `risky' loans to the private/corporate sector. Even
strong SCBs voluntarily invest in excess of SLR requirements in a bid to minimise
credit risk while increasing profitability. Such investments also do not entail
priority sector commitments, whereby a PSB has to set aside 40 paise for the
priority sector (priority sector requirements are detailed below) for every rupee that
it lends. Further, in an environment of declining interest rates, a fall in interest rates
results in an increase in prices of government securities. During the last three years,
SCBs have significantly improved their profitability by investing largely in
government securities, reaping trading gains with the declining yields and rising
prices. The system of fixed managerial compensation also discourages PSB
managers from taking risks. There is little incentive for officials of stateowned
banks to take additional risk. A failure or loss can lead to career damage, whereas
success may bring little reward. Thus, it is far easier to maintain a high proportion
of Government bonds with zero risk of default. Incentive and career structures in
PSBs do not encourage or reward dealing success. PSBs avoid any possible
investigation of their lending and any risk of default by investing in government
debt, both important considerations for their management in the current
environment.
Asset Profile of SCBs
Source: rbi.org/
The major elements of the reforms relate to the assets and liabilities side of the
balance sheet and are discussed in the following sections below.
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Liabilities
Liberalisation of Interest Rate on Deposits
Beginning 1992, a progressive approach was adopted towards deregulation of the
interest rate structure on deposits. The rates have been gradually freed, and at
present, the interest rate on term deposits have been completely deregulated. The
only administered interest rate is that on savings bank deposits, with a prescribed
interest rate of 3.5% per annum. The continued regulation of interest rates on
savings deposit (aggregating Rs. 3,023 billion or 22.3% of deposits at end-
FY2003) provides a degree of comfort to the PSBs since their margins are already
falling and deregulation is likely to spur added competition on the funding side.While the PSBs have an advantage in funding costs on account of their vast branch
network, new private and foreign banks tend to incur lower operational costs.
Capital Adequacy
The RBI also adopted a strategy to introduce the attainment of CAR of 8% in a
phased manner was adopted. Based on the recommendations of the Committee on
Banking Sector Reforms, the minimum CAR was further raised to 9%, effective
March 31, 2000.
Phased Increase of CAR
(Percentage)
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Assets
Interest Rate on Loans and Advances
During 1975-76 to 1980-81, the RBI prescribed both the minimum lending rate
(13.5%) and the ceiling rate (19.5%). During 1981-82 to 1987-88, the RBI
prescribed only the ceiling rate, which was also progressively reduced to 16.5% in
1987-88. During 1988-89 to 1994-95, the RBI switched from a ceiling rate to a
minimum lending rate. The minimum lending rate, which was initially fixed at
16%, was increased to 19% in 1991-92, but, subsequently, lowered to 14% in
1993-94. After 1992, rates on priority lending were also allowed to be set more
freely. In October 1994, lending rates on loans exceeding Rs. 0.2 million were
freed. In April 1998, rates on loans under Rs. 0.2 million were also freed provided
they did not exceed the Prime Lending Rate (PLR) that the banks were allowed to
set. Banks are also allowed to offer loans at below-PLR rates to exporters or other
creditworthy borrowers, including public enterprises. Banks are now required to
announce the PLR and the maximum spread charged over the PLR. Currently,
interest rates are prescribed for only three categories of loans: first, for loans below
Rs. 0.2 million, interest rates cannot exceed the PLR: second, lending rates for
exports are prescribed: and third, ceilings are prescribed on certain advances inforeign currency.
Reduced Cash Reserve and Statutory Liquidity Requirements
A major reform measure has been the gradual reduction in statutory pre-emptions
in the form of CRR and SLR requirements. CRR and SLR together aggregated
42% of deposits in the early 1980s, rising to 53.5% of deposits in 1990. This pre-
emption meant a decline in the share of deposits available for loans, even to the
priority sectors. The CRR has been progressively reduced from 15% in 1989 to
4.5%8 at present. Currently, SCBs are required to maintain with the RBI a CRR of
4.5% of the Net Demand and Time Liabilities (NDTL), excluding liabilities subject
to zero CRR prescriptions). The RBI has indicated that the CRR would ultimately
be reduced to the statutory minimum of 3%. However, with effect from the
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fortnight beginning November 3, 2001, all exemptions on the liabilities have been
withdrawn except inter -bank liabilities for computation of NDTL for the purpose
of maintenance of CRR. The SLR, which was at a peak of 38.5% during September
1990 to December 1992, has been reduced to the present statutory minimum of
25%.
These measures were designed to give greater discretion in the allocation of funds
to the SCBs and enable them to raise their profitability. The share of low interest
bearing cash and bank balances in total assets has declined from 16.6% at end-
FY1998 to 9.5% at end-FY2003. By increasing the quantum of investible funds in
the hands of banks, these measures also enhanced the need for efficient risk
management systems. While the reduction in CRR has resulted in an increase in
investible funds, the impact has been limited as the SCBs hold government
securities far in excess of the statutory minimum. SCBs' holding of government
and other approved securities aggregated 41.4% of their NDTL at end-December
2003. This has to be viewed in the context of the high level of fiscal deficit and
market borrowings by the government, which has the risk of crowding out bank
financing to the commercial sector. As the figure below shows, a large fraction of
bank deposits are being deployed for holding government securities. This ratio, as
is evident, has been increasing steadily over the last few years, and has persisted
even recently despite a strong economic recovery and, presumably, a consequent
increase in demand for credit.
Select Ratios of SCBs in India
Source: goidirectory.nic.in/
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In deciding on a trade-off of lendable resources between increasing credit flows
and investing in government securities, the economic, regulatory and fiscal
environment favours the latter. Restricted commercial lending (arising from
structural changes in corporate resource raising patterns and multiple oversight
processes for PSBs), coupled with distortions in borrowing and lending structures
(including interest rate restrictions, the former artificially raising the cost of funds
for intermediaries and the latter relating to various PLR related guidelines for
SMEs and priority lending), have made treasury operations an important activity in
improving banks profitability. On the other hand, declining interest rates have
made holding government securities more profitable. There is also significant
potential of portfolio appreciation because of the trend of declining interest rates in
the economy. The system of fixed managerial compensation also discourages PSB
managers from taking risks.
Priority Sector Lending Requirement
Priority lending was a major aspect of `social banking, and part of the mechanism
to set up cross subsidy from `free lending. The nationalisation of the banks
enabled the government to exert significantly greater pressure to lend to the
priority sectors. Post nationalisation, there were initially no specific targets fixed in
respect of priority sector lending. However, in November 1974, banks were
advised to raise the share of these sectors in their aggregate advances to 331/3% by
March 1979. In March 1980, the target was revised to 40% by March 1985. By the
1980s, about 55% of the funds available, after the CRR and SLR requirements,
were met (i.e., about 25% of deposits) went into priority and quasi-priority lending.
Beginning in the 1990s, the 40% (of net bank credit or NBC) priority sector
lending requirement (for PSBs and private sector banks) remained but its burdenwas eased by freeing the rates on loans above Rs. 0.2 million 10, raising the rates
on small loans and making additional types of credit available11. The requirement
was increased to 32% for foreign banks in 1993. Thus, the priority sector has been
liberalised only to the extent that the interest rates have been liberalised and
additional types of credit have been made eligible. In fact, the share of priority
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sector advances in the gross bank credit of SCBs increased from 14% in June 1969
to 33% in March 2003. As of end-FY2003, all the bank groups had achieved their
priority sector lending targets.
Priority Sector Lending of SCBs
(Rs. billion)
High priority sector lending targets have been one of the major factors behind the
high NPAs of SCBs. While the share of priority sector lending in NBC is around
42.5% of PSBs, their share of NPAs was around 47.2% at end-FY2003.
Segment wise Distribution of NPAs at end-FY2003
(Rs. billion)
Asset Classification and Provisioning Norms
The prudential norms relating to asset classification have been tightened. The
earlier system of eight `health codes has been replaced by the classification of
assets into four categories:
Standard, Sub-standard, Doubtful, and Loss assets, in accordance with international
norms. The provisioning requirements of a minimum of 0.25% were introduced for
standard assets from the year ended March 31, 2000. The provisioning
requirements have also been prescribed for sub-standard, doubtful and loss assetcategories. The RBI has imposed a provision of 0.25% on standard assets; 10% on
sub-standard assets, 20-50% on doubtful assets (depending on the duration for
which the asset has remained doubtful), and 100% on loss assets.
The recognition of NPAs has also been gradually tightened, so that since March
2001, loans with interest and/or installment of principal remaining overdue for a
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period of more than 180 days are classified as non-performing. The period has
been shortened to 90 days from the year ending March 31, 2004, but provisions are
required to be made from March 31, 2002. Banks have also been required to
progressively `mark-to-market their holdings of government securities.
Structural ReformsCompetition:
Since the initiation of banking sector reforms, a more competitive environment has
been created wherein banks are not only competing within the industry but also
with players outside the industry. While existing banks have been allowed greater
flexibility to expand their operations, new private sector banks have been allowed
entry. After the guidelines were issued in January 1993, nine new private sector
banks are in operation. Competition amongst PSBs has also intensified. PSBs are
now allowed to access the capital market to raise funds. This has diluted the
Governments shareholding in them, although it remains the major shareholder in
PSBs, holding a minimum 51% of their total equity. Although competition in the
banking sector has been increasing in recent years, the dominance of the PSBs, and
especially of a few large banks, continues.
The PSBs are, thus, able to influence decisions about liquidity and rate variables in
the system. Although a significant decline in such concentration ratios is unlikely
in the near future, the PSBs are likely to face tougher competition, given the
gradual upgrade of skills and technologies in competing banks and the
restructuring and re-engineering processes being attempted by both private sector
and foreign banks. Moreover, banks are also facing stiff competition from other
players like non-bank finance companies, and mutual funds (MFs).
Government Ownership and Management of PSBs
Though the government has allowed equity dilution of its stake in nationalised
banks, it has not ceded management control. Equity dilution has largely been a
capital raising exercise, without greater non -governmental shareholder
supervision. Individual voting rights, the key instrument of shareholder
participation, are still limited by rules to a maximum of 10% of the total voting
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rights of all the shareholders of the banking company13. Nationalized banks are
accountable to the Indian Parliament. Key appointments and policies have to be
vetted by government. As long as shareholders are denied full voting rights, and
are placed at par with government, there seems little or no scope for effective
transition to market discipline. Little effort has also been made to encourage sound
bank management practices through a system of incentives, nor are there
significant disincentives. Top management salaries in the nationalized banks
continue to be pegged to salaries at comparable levels in government. The system
of employee wage negotiations cutting across the banking industry without
reference to either the health or the paying ability of individual banks means that
employees or management have little stake in the health of the bank. Even if the
government stake falls to 33%, as long as banks are covered under the definition of
State under the Indian Constitution, there seems to be little to no flexibility on the
human resource issue. To examine the relationship between Government
ownership and performance, the RBI recently compared the performance of banks
based on select parameters at two levels: (a) comparison of a representative sample
of five PSBs which divested their Government holding early in the reform process
with a representative sample of five wholly government-owned PSBs, and (b)
comparison of the aforesaid two categories with old private sector banks as a
group.
The findings for the period FY1996 to FY2002 indicate:
PSBs wholly owned by the GoI had the highest ratio of operating expenses
to total assets.
Interest spread (net interest income to total assets) of wholly government-
owned PSBs was lower than divested PSBs during each of the seven years,
but generally higher than old private sector banks.
Profitability (ratio of net profit to total assets), on an average, was the
lowest for wholly government owned PSBs. However, the gap narrowed
down significantly from FY1999 onwards.
Asset impairment (ratio of gross NPAs to gross advances) during each of
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the years under reference in respect of wholly-government owned PSBs
was the highest.
The CAR of wholly-government owned PSBs was the lowest. However,
their CAR has improved over the years.
Banks Entry into Insurance With the enactment of the Insurance
Regulatory and Development Authority (IRDA) Act, 1999, banks and
NBFCs have been permitted to enter the insurance business. The RBI has
issued the final guidelines for banks entry into insurance business. For
banks, prior approval of the RBI is required to enter into the insurance
business. The RBI would give permission to banks on a case-by-case basis,
keeping in view all relevant factors. Banks having a minimum net worth of
Rs. 5 billion and, satisfying other criteria in respect of capital adequacy,
profitability, NPA level and track record of existing subsidiaries, can
undertake insurance business through joint ventures, subject to certain
safeguards. The maximum equity contribution such a bank can hold in the
joint venture company will normally be 50% of the paid-up capital of the
insurance company. On a selective basis, the RBI may permit a higher
equity contribution by a promoter bank initially, pending divestment of
equity within the prescribed period. Banks which are not eligible as jointventure participants, as above, can make investments up to 10% of the net
worth of the bank or Rs. 0.5 billion, whichever is lower, in the insurance
company for providing infrastructure and services support. Such
participation shall be treated as an investment and should be without any
contingent liability for the bank. Banks are also now allowed to undertake
referral arrangements with insurance companies, through their network of
branches, subject to certain conditions to protect the interests of their
customers. Under the referral arrangement, banks provide physical
infrastructure within their select branch premises to insurance companies
for selling their insurance products to the banks' customers with adequate
disclosure and transparency and, in turn, earn referral fees on the basis of
premia collected.
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At present, amongst the PSBs, the SBI has floated a life-insurance subsidiary.
During FY2003, seventeen PSBs, 9 private sector banks, one foreign bank, and
a subsidiary of a private sector bank were given 'in principle' approval by the
RBI for acting as corporate agents of insurance companies to undertake
distribution of insurance products on non-risk participation basis.
IMPACT OF REFORMS ON BANKS
To gauge the effects of reforms on the banking industry, it is imperative to view
the reforms over a period of time. When the reform process was launched in 1991,
the banking sector received a jolt. Implementation of uniform and transparent
accounting practices exposed the fragility in the system in terms of the bad loan
problem and lack of profitability.
Profits
Till the adoption of the prudential norms, 26 out of 27 PSBs were reporting profits.
In the first post-reform year, i.e., FY1993, the combined profitability of the PSBs
turned negative with a net loss of Rs. 32.93 billion during FY1993, with as many
as 12 nationalised banks reporting net losses. However, subsequently, there hasbeen a significant improvement. The PSBs reported a net profit of Rs. 11.16 billion
during FY1995, compared with a net loss of Rs. 43.49 billion in FY1994. In recent
years, the net profits of PSBs increased 48% during FY2003 to Rs. 122.94 billion
during FY2003, as compared with a growth of 92.5% during FY2002. However,
net profits of PSBs declined 15.7% during FY2001, mainly because of voluntary
retirement scheme (VRS) expenses12. All the twenty-seven PSBs reported net
profits during FY2003 and FY2002, as compared with 25 during FY2001, and 19
during FY1996. The net profits of all SCBs have also increased from Rs. 19.60
billion in FY1996 to Rs. 170.68 billion during FY2003 (refer Table below). Net
profits, as per cent of average assets, have increased significantly from 0.53% in
FY1999 to 1.06% in FY2003.
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Net Profits of SCBs in India
(Rs. billion)
Capital AdequacyAs of end-FY1993, only one PSB had a CAR of above 8%. The equity capital of
the PSBs has been rising steadily after the reformsfrom Rs. 30.34 billion at end-
FY1991 to Rs. 141.75 billion at end-FY2003. By end-FY1996, the outer time limit
for attaining capital adequacy of 8%, eight PSBs were still below the prescribed
level. Since then, the CAR has improved for all major categories of banks. Overall
CAR of the banking sector has improved significantly from 10.4% at end-FY1997
to 12% at end-FY2002, and to 12.6% at end-FY2003. At-end FY2003, the CAR of
91 out of 93 SCBs exceeded the stipulated minimum of 9%; only 2 NPBs had CAR
below the stipulated minimum of 9%.
Distribution of SCBs by CAR
A key factor in the quick improvement in the CAR of PSBs is that the GoI owns a
majority stake. Thus, the GoI did not need to resort to complicated procedures
observed in the rehabilitation process of banks in Korea and Japan, to inject funds
into major banks. Till FY2003, the government had injected Rs. 230 billion
towards recapitalisation of 19 nationalised banks.
Deposit Growth
The deposits of the banks have also increased over the years. After the securities
scam of 1992, bank deposit mobilisation increased, as a greater part of the
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household sector savings started to move from the stock markets to the banking
sector. Over the last decade, the deposits of all SCBs increased 4.6 timesfrom
Rs. 2,619 billion at end-FY1992 to 13,559 billion at end-FY2003. Deposits
increased at a compounded annual growth rate (CAGR) of 16.1% between FY1999
and FY2003, as compared with 5.4% between FY1993 and FY1997. As indicated
in figure below, overall efficiency of the banking sector (as measured by deposits
as a percentage of GDP) has also increased.
SCBs deposits as a percentage of GDP
Source: rbi.org/
Asset Quality and Non-Performing Loans
The position on the asset quality front has also improved over the last few years.Net NPAs, as percentage of net advances of all SCBs, has declined from 8.1% at
end-FY1997 to 4.3% at end-FY2003. During FY2003, there was also an absolute
decline in the NPAs of SCBs. Gross NPAs declined Rs. 21.47 billion during
FY2003, as compared with an increase of Rs. 71.20 billion during FY2002.
Amongst the bank categories, three of the eight SBI & associate banks had net
NPA to net advances exceeding 10% at end-FY1997. Their number declined to just
one at end-FY2000, and nil thereafter. The number of nationalised banks having
NPAs exceeding 10% also declined from seven at end-FY1997 to three at end-
FY2002, and two at end-FY2003. In the case of old private sector banks, this
number declined from three to two over the same period. None of the new Indian
private sector banks had net NPAs exceeding 10% during FY1997 to FY2002;
however there was one new Indian private sector banks with net NPAs exceeding
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10% at end-FY2003. In the case of foreign banks operating in India, the number of
banks with NPAs/net advances exceeding 10% increased from three at end-
FY1997 to 14 at end-FY2002, before declining to 8 at end-FY2003.
Frequency distribution of Net NPAs to Net AdvancesSCBs
While as a percentage of advances, the net NPAs have come down, in absolute
terms, net NPAs had increased from Rs. 277.74 billion at end-FY1997 to Rs.355.54 billion at end- FY2002. Similarly, while gross NPAs/gross advances have
declined from 15.7% at end- FY1997 to 8.8% at end-FY2002, the gross NPAs of
the SCBs increased from Rs. 473 billion at end-FY1997 to Rs. 687.14 billion at
end-FY2003. However, during FY2003, recoveries of NPAs outpaced additions
resulting in a decline in both gross and net NPAs.
Since 1993, the growth of NPAs has been held below asset growth, even while
interest rates have been liberalised. At the same time, provisioning has increased,
so that the gross NPAs, as per cent of assets, have declined from 7% at end-
FY1997 to 4% at end-FY2003; net NPAs, as per cent of assets, have also declined
from 3.3% at end-FY1997 to 1.9% at end-FY2003. In terms of credit allocations,
banks investments in government securities, which earlier formed a major part of
credit allocations, have been nearly unaffected by the liberalisation. Including the
reduced CRR requirements, SCBs cash balances with the RBI; and investments in
India in government & approved securities aggregated 37.6% of assets at end-
FY2003. During FY1998-2003, the growth in SCBs investment in government
securities exceeded the growth in assets. During FY2004, while aggregate deposits
of SCBs in India increased 17.3%, investments in government and approved
securities increased 24.1%; bank credit increased 14.6%. As discussed, government
debt is an attractive instrument with its higher market-based rates and minimal
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limited capital requirement (zero until the increase in risk weighting to 2.5% in
1998). PSBs also avoid any possible investigation of their lending and any risk of
default by investing in government debt, both important considerations for their
management in the current environment.
A decade after financial sector liberalisation, although there has been a significant
improvement in the banking industry performance, there has been little concerted
effort at restructuring the PSBs. As a consequence, profitability and viability of the
PSBs are still below global standards and even the average values within the Indian
banking industry. Intermediation costs are high, resulting in high nominal lending
interest rates. The fact that there have been no instances of systemic crises,
contagion, bank closures, bank runs, bank nationalisation post-liberalization,
should not divert attention from the problems of high and unresolved NPAs,
inadequate management skills, and relatively volatile operating performance.
BANKING INDUSTRY PERFORMANCEWhile carrying out a time-scale performance analysis of the Indian banking sector,
it is important to keep in mind the perceptible impact that the phased
nationalization has had on the structure and performance of the Indian banking
sector. The nationalization of the banking sector was an endeavor by the Central
Government to achieve geographical expansion and increase directed lending to
the priority sectors, including agriculture and small-scale industries. The
nationalisation was successful, to a large extent, in meeting the social objectives of
the government. The total branch network of commercial banks increased more
than eight-fold from 8,262 branches in 1969 to 68,561 in March 2003. During the
same period, the growth in advances to the priority sector, including agriculture
and small-scale industries outstripped the growth in aggregate credit. As a result,
the ratio of priority sector credit to total credit by SCBs increased from 14% in
June 1969 to 33% by end-March 2003.
The following discussion will analyse the financial performance of the Indian
banking industry against the following parameters:
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Income;
Yields;
Interest Costs;
Spreads;
Intermediation Costs;
Profitability;
Return On Assets;
Capital Adequacy; And
Asset Quality.
Income
The total income of all SCBs in India increased 14% during FY2003 to Rs. 1,724
billion, compared with a growth of 14.5% during FY2002, and 14.5% during
FY2001. While interest income increased 10.7% during FY2003 (10.4% during
FY2002) to Rs. 1,407 billion, other income increased 31.2% during FY2003
(42.1% during FY2002) to Rs. 317 billion. Interest income has declined from
87.1% of income during FY2001 to 84% of income during FY2002, and to 81.6%
of income during FY2003.
During FY2003, the income of PSBs increased 9.6% to Rs. 1,285 billion,compared with a growth of 13.3% in FY2002. Their dominance in the banking
sector is attested by their consistent share of 78% to 79% of income of all SCBs
during FY1998-FY2002. However, because of the ICICI merger, the PSBs share of
total income declined to 74.5% during FY2003. Because of the merger, the NPBs
recorded the highest increase in income of 104.7% during FY2003, followed by
OPBs (3%). The foreign banks recorded an income decline of 7.1% during
FY2003, caused by declining interest rates, and a reduction in the number of
foreign banks operational.
Income Trends and Growth Rate(Rs. billion)
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(10.7)
Interest income, which constituted 81.6% of income during FY2003, increased
10.7% during FY2003, compared with 10.4% during FY2002. The growth in
interest income was led by a healthy growth in advances and investments, rather
than yields (which declined). Domestic advances and investments of SCBs
increased 16.6% during FY2003 to Rs. 13,810 billion (refer Table below),
compared with a growth of 21.5% during FY2002, and 18.5% during FY2001.
Overall advances and investments increased 16.2% during FY2003 to Rs. 14,343
billion, as compared with a growth of 21.2% during FY2002, and 18.5% during
FY2001. A recent study by the RBI on finances of selected 997 non-Government,
non -financial large public limited companies has indicated that while incremental
borrowings from banks increased from Rs. 55.85 billion in FY2002 to Rs. 63.99
billion in FY2003, the share of incremental bank borrowings in external funds
decreased from 65.1% to 53.6%. However, the share of external sources of funds
such as issues of equity and trade creditors increased during FY2003.
SCBsAdvances/Investments and Growth
Non-interest (or other) income of SCBs increased 31.2% during FY2003 to Rs.
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316.56 billion, compared with a growth of 42.1% during FY2002 and 6.6% during
FY2001. The other income mainly consisted of profit on sale of investments
(45.1% of non -interest income), commission, exchange & brokerage (33.4%), and
profit on exchange transactions (8.9%). Other income has increased substantially
during the last two years because of the substantial profits on the sale of
investmentsnet profit from sale/revaluation of investments increased from Rs.
30.26 billion in FY2001 to Rs. 93.41 billion in FY2002, and to Rs. 142.62 billion
in FY2003. Banks have been able to report significant capital gains on account of
the downward movement of interest rates. With their substantial holding of
Government securities, SCBs have profited from a significant decline in yields on
government securities. Net profit from sale/revaluation of investments as a percent
of aggregate net profits has increased from 18.7% in FY1999 to 80.8% during
FY2002, and 83.6% during FY2003. Yields have declined because of the excess
liquid funds of commercial banks flowing into the Government securities market.
During FY2003, yield on 10-year Government securities declined by 115 basis
points to 6.21% at end-March 2003. During FY2004, due to the reduction of the
repo rate by 50 basis points from 5% to 4.5% from August 25, 2003, there was a
sharp decline in the yields and the 10-year yield touched a historic low of 5.23%.
The 10-year yield reached a further low of 4.95% on October 16, 2003. However,
the markets stabilised in view of the RBI's low inflation outlook and reiteration of
the soft interest rate stance. The benchmark 10-year yield declined to 5.14% at end-
March 2004. Even after significant sale of higher-interest Government securities,
SCBs continue to hold a high proportion of higher -interest government securities.
As the table below shows, nearly 70% of the SCBs outstanding investments in
central and state government securities at end- FY2003 carried an annual interest
rate exceeding 10%. Further, an estimated 23% of these securities at end-FY2003
(29.3% at end-FY2002) carried an annual interest rate exceeding 12%.
Interest Rate Distribution of SCBs investments in central and state
government securities
(Percentage of total)Less than 6% 6-8% 8-10% Over 10%
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Income from commission, exchange and brokerage is another major source of non-
interest income, accounting for 6.1% of income of SCBs during FY2003. Such
income is mainly earned from off-balance sheet activities such as forward
exchange contracts, guarantees, acceptances, and endorsements. Income from
commission, exchange and brokerage increased 14.7% during FY2003 to Rs.
105.70 billion, mainly because of a 31.4% increase in contingent liabilities to Rs.
11,642 billion. Foreign banks are very active in derivatives, with the exposure offoreign banks in forward currency contracts increasing from Rs. 3,609 billion at
end-FY2002 (57.3% of forex exposures of all SCBs) to Rs. 4,172 billion at end-
FY2003 (54.7% of forex exposures of all SCBs). Contingent liabilities represented
68.5% of liabilities of SCBs at end-FY2003, as compared with 57.7% at end-
FY2002.
Contingent liabilities and income from commission, brokerage and exchange of
SCBs
Contingent
As discussed below, the growth in income lagged the growth in average assets,
which increased 14.3% during FY2003, compared with a growth of 17.7% during
FY2002, and 16.7% during FY2001. As a result, yields have declined over the past
few years. Interest earned, as per cent of average assets, declined from 10% during
FY1999 to 8.70% during FY2003. However, non-interest incom e, as per cent of
average assets, increased from 1.46% during FY1999 to 1.96% during FY2003.
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The increase in non -interest income (because of trading profits from interest rates
declines) has partially offset the decline in income from advances and investments
(because of interest rate declines). Total income, as percent of average assets, has
declined by 80 basis pointsfrom 11.46% during FY1999 to 10.66% during
FY2003.Because of the merger of ICICI and ICICI Bank, the figures for FY2002
are underestimates. However, the decline in yields has been accompanied by a
decline in cost of deposits.
Interest and Non-Interest Income of SCBs
As can be seen from the above table, foreign banks report a substantially higher
non-interest income (as percent of average assets). Foreign banks are the most
active in off-balance sheet activities. Their contingent liabilities aggregated 482.8%
of liabilities at end-FY2003, and income from commission, exchange and
brokerage accounted for 11.5% of income of foreign banks during FY2003.
YieldsFor all SCBs, income from advances, which constituted 39.8% of income of SCBs
during FY2003, increased 15.3% during FY2003 to Rs. 686.36 billion, compared
with a growth of 7.5% during FY2002, and 16.6% during FY2001. By comparison,
advances increased 14.5% during FY2003 to Rs. 7,405 billion, compared with a
growth of 22.9% during FY2002, and 18.1% during FY2001. The growth in
income from advances outpaced the growth in average advances, mainly because
of the full inclusion of income for FY2003 of merged ICICI Bank as compared
with 2 days inclusion for FY2002). However, yields on average advances have
been declining because of the decline in interest rates in the Indian economy. The
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yield on average advances for all SCBs has declined from 12.34% in FY1999 to
9.90% in FY2003. The PLR of PSBs declined from 10-13% in March 2001 to
9.75-12.25% in December 2003. On balance, PLRs were lower as at end-FY2003
than the corresponding levels as at end-FY2002 for the three groups of SCBs. The
following Table sets forth the decline in PLR for the last few years.
Trends in PLR of SCBs
(Percent per annum)
Source: RBI, Source: rbi.org/
Interest/dividend income from investments, which constituted 36.2% of SCBs
income during FY2003, increased 8.9% during FY2003 to Rs. 623.59 billion,
compared with a growth of 13.8% during FY2002, and 14.4% during FY2001. By
comparison, investments increased 18.1% during FY2003 to Rs. 6,938 billion,
compared with a growth of 19.5% during FY2002, and 18.9% during FY2001.
However, as with advances, the growth in investment income lagged the growth in
average investments, which increased 18.7% during FY2003, compared with
19.2% in FY2002, and 20.2% in FY2001. The yield on average investments for all
SCBs increased from 11.89% in FY1999 to 9.73% in FY2003. The decline in yield
was because of revised provisioning norms, high investment in India in
government and approved securities, and a decline in yield on government
securities. The monetary and credit policy for the second half of FY2001,
announced in October 2001, had resulted in introduction of a significant change in
banks valuation of investments. Investments are now to be classified into three
categoriesheld to maturity (HTM), available for sale (AFS), and held for trading
(HFT). At end-FY2003, SCBs investments AFS accounted for 75.4% ofinvestments, followed by HTM (20.2%), and HFT (4.2%). The HTM category
securities need not be marked to market and cannot exceed 25% of the portfolio.
Earlier, the RBI had stipulated that banks must mark to market at least 70% of the
portfolio. Many banks had, however, marked 100% of the portfolio to the market
to take advantage of the declining interest rates. The decline in yield on
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investments has also been because of increased investment in domestic government
securities. Incremental investments in domestic government and approved
securities accounted for 96.2% of incremental investments of SCBs during
FY2003, compared with 79.1% during FY2002. Higher investments in government
securities was also accompanied by a decline in yields on government securities
over the past few years.
Average Yield levels on Govt. securities
(Per cent per annum)
A positive impact of the declining interest rates was an appreciation in prices of
securities resulting in a 52.7% increase in net profit from sale/revaluation of
investments during FY2003. Including such profits, yield on average investments
declined from 12.34% during FY2002 (11.79% during FY2001) to 11.96% during
FY2003. Interest income on balances with RBI and interbank funds, which
constituted 3.9% of SCBs income during FY2003, declined 14.4% during FY2003
to Rs. 67.99 billion, compared with a growth of 23.2% during FY2002, and 18.1%
during FY2001. Such income declined because of a 21.7% decline in cash and
bank balances to Rs. 1,607 billion at end-FY2003, caused by lower CRR.
However, income on such balances has been boosted because of an increase in the
interest rate payable on eligible cash balances maintained with RBI. The annual
interest rate was increased from 4% to 6% (from the fortnight beginning April 21,
2001). With effect from the fortnight beginning November 3, 2001, the interestpaid on eligible cash balances was at the Bank Rate. However, average call money
rates declined from 6.58% in April 2002 to 5.86% in March 2003, and to 4.40% in
December 2003. Overall, the yield on cash and bank balances increased from
4.01% during FY2002 to 3.72% during FY2003.
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CRR MovementsFY1999 to FY2004Per cent (effective date)
Overall, the decline in yields on advances and investments has resulted in a
decline in yield on average interest bearing assets of SCBs, which declined from
10.87% in FY1999 to 9.27% in FY2003 (refer Table below).
Yield Indicators of SCBs
(Per cent per annum)
.40% 9.73%Source: banknetindia.com/
Another reason for the falling yields is the focus of banks on highly rated clients.
Faced with high NPA levels, banks are concentrating on safer clients who cannot
be charged high riskpremiums. Further, a higher proportion of assistance now takes
the form of CP, bonds and debentures. In the present situation of easy liquidity,
banks prefer investing in CPs, as they can deploy funds at interest rates higher than
call rates, and also avoid the higher transaction costs associated with bank loans. In
return for the higher liquidity they offer, these instruments are issued at lower
interest rates. 2.85 The discount rates on CP declined from a range of 6-7.75%
during end-March 2003 to 4.7-6.5% by end-March 2004. CP has now emerged asan important source of funding WC needs; however, it is restricted to a few large
companies with healthy credit ratings and does not enjoy wider market
acceptability. Further, SCBs investments in CP have declined in recent years
because of a decline in primary issuances by manufacturing companies having
access to sub-PLR lending.
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SCBs investments in CP, Shares, Bonds, Debentures, etc
(Rs. billion)
Interest CostAlthough all categories of SCBs have experienced a decline in yields on average
interest bearing assets, the decline has been accompanied by a decline in cost of
funds. Interest expended, which accounted for 54.3% of SCBs income during
FY200314, increased 6.9% during FY2003 to Rs. 936.07 billion, compared with a
growth of 12.1% during FY2002, and 12.7% during FY2001. The cost of deposits
constituted 88.3% of interest expended during FY2003, and increased 2.5% during
FY2003, compared with a growth of 12.3% during FY2002, and 11.8% during
FY2001. By comparison, deposits increased 12.7% during FY2003 to Rs. 13,559
billion, compared with a growth of 14% during FY2002, and 17.2% during
FY2001. Deposit mobilisation was higher during FY2001 because of Rs. 257
billion raised through India Millenium Deposits (IMD).
Over the last few years, the cost of deposits, and the cost of average interest
bearing funds has declined because of softening of interest rates in the economy.
The decline in interest rates is in consonance with the monetary policy stance of a
soft and a flexible interest rate regime. Bank rates have been reduced significantly
over the years (refer Table below). The reduction in bank rates acts as a signalling
device for a lower interest rate regime. However, the average lending rates of
banks continue to be substantially higher than the Bank Rate.
Thus, the relation between lending rates and Bank rate is now relatively weak.
Bank Rate Movements during FY1999 to FY2004
Per cent per annum (effective date)
The spreads of lending rates of commercial banks over their average costs of
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deposits reveal a marginal narrowing down FY1997. The RBI has noted that the
stickiness in the interest rate structure of commercial banks is because of a number
of reasons:
Average cost of deposits for major banks continues to be relatively high,
because of the high returns on alternative savings instruments. Despite
reductions in the administered interest rates on small savings and provident
funds in recent years, they yield higher returns than bank deposits. This
constrains the ability of banks to reduce deposit rates.
Longer-duration term deposits at fixed interest rates constitute a substantial
portion of bank deposits, thereby limiting the flexibility to reduce lending
rates in the short-term.
High NPAs increase the average cost of funds for banks.
High non -interest operating expenses of banks reduce the flexibility to
reduce interest rates.
In view of legal constraints and procedural bottlenecks in recovery of dues
by banks, the risk premium tends to be higher resulting in a wider spread
between deposit rates and lending rates.
The large borrowing programme of the Government, over and above SLR
requirements, gives an upward bias to the interest rate structure.
The deposit rates have been gradually freed from regulation, and, at present, the
only administered interest rate is that on savings bank deposits. The prescribed rate
of interest on savings deposits is 3.5% per annum. The average term deposit rates
have also declined.
Trends in Domestic Deposit Rates of SCBs(Per cent per annum)
In tune with the trend of declining interest rates over the past few years, the
average cost of deposits for SCBs declined from 8.05% in FY1999 to 6.46% in
FY2003. The cost of average deposits also declined significantly during FY2003
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because of lower growth in term deposits (because of lower accrual of interest in
view of declining interest rates, and a shift to current accounts in consonance with
higher industrial activity), and a shift in maturity structure of deposits towards
lower -cost lower-duration deposits.
Maturity Pattern of Deposits of SCBs(% of deposits)
goidirectory.nic.in/
The cost of average interest bearing funds has also declined from 8.23% in FY1999
to 6.80% in FY2003. Various policy measures over the years have, thereby,
resulted in lower average cost of interest bearing funds for SCBs (refer Table
below).
Cost of Deposits and Interest Bearing Funds of SCBs
SpreadsOver the past few years, although the yield on average earning assets has declined
for SCBs, the decline has been partially offset through a decline in cost of average
interest bearing funds. However, the gross interest spread (yield on average earningassets minus the cost of average interest bearing funds) declined from 2.64% in
FY1999 to 2.47% in FY2003. Another indicator of spreadsnet interest income as
a percentage of average assetsalso declined from 3.02% to 2.91% over the same
period.
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Spread Indicators of SCBs
(Per cent of average assets)
However, a distinguishing feature of SCBs performance during FY2003 was the
increase in gross spreads. The increase in spreads in FY2003 was caused by the
larger fall in cost of funds compared with the yields. One reason is the lower
deployment of cash balances because of CRR cuts. Another reason for the increase
in spreads during FY2003 is the assetliability maturity profile of banks. As of end-
FY2003, SCBs term deposits constituted 65.6% of deposits, and 52.3% of liabilities.
Term deposits carry a higher interest rate than savings deposits, and the interest rate
on term deposits is, usually, directly related to duration. Nearly all major SCBs
reported a shift in maturity structure of deposits, with an increased proportion of
shorter duration deposits during FY2003. In terms of maturity pattern, deposits of
SCBs with a maturity upto 1-year increased from 34.3% of deposits at end-FY2002to 37.8% at end-FY2003. Such deposits increased 24.3% during FY2003. By
comparison, the share of deposits with maturity exceeding 1 year declined from
65.7% to 62.2%. Such deposits increased only 6.7% during FY2003, with most of
the increase accounted for by deposits with a maturity exceeding 5 years. The shift
in maturity structure of deposits has benefited banks and provided them more
flexibility in responding to interest rate declines.
The increase in spreads has been accompanied with a significant improvement in
oninterest income. As a result, net operating income, as percent of average assets,
increased from 4.50% in FY2002 to 4.87% in FY2003. Further, the figure was
higher than 4.48% in FY1999. Foreign banks enjoy the highest spreads in India,
primarily because of high gross spreads, and significant off-balance sheet activities.
Over the last few years, while SCBs have reduced their PLRs and are now also
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extending sub-PLR loans, effective lending rates remain high. It is estimated that the
average lending rate of scheduled commercial banks has declined from a peak of
17.1% during FY1996 to 13.9% during FY2002. However, real interest rates have
not declined in the same magnitude. As a result, the effective real lending rate
continues to remain high.
Real Interest Rates(Percent per annum)
Intermediation CostsThe intermediation cost (operating expenses to average total assets) of SCBs showed
a significant decline from 2.84% in FY2001 to 2.38% in FY2002, and to 2.35% in
FY2003. This followed a significant increase during FY2001from 2.68% in
FY2000. Intermediation costs increased 12.9% during FY2003 to Rs. 380.88 billion,
compared with a decline of 1.3% during FY2002, and increase of 23.8% during
FY2001. Employee expenses constitute the largest proportion of intermediation
costs. However, their share of intermediation costs declined from 68% during
FY2001 to 62.1% during FY2003, mainly because of a significant decline in
employee strength for PSBs. Over the period FY2001-03, the decline in employee
expenses for PSBs has been the primary factor behind the significant decline in
intermediation costs (as percent of average assets). Employee expenses, as percent of
average assets, declined from 1.93% during FY2001 to 1.54% during FY2002, and
to 1.46% during FY2003. Employee expenses represented 13.7% of income duringFY2003, compared with 14.4% during FY2002, and 17.6% during FY2001. The
combined employee strength of all SCBs declined an estimated 0.7% during
FY2003, as compared with declines of 3.4% during FY2002, 8.1% during FY2001,
and 1.1% during FY2000. The combined employee strength of SCBs aggregated
0.839 million at end-FY2003.
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Staff Strength at SCBs
(Thousands)
The SCBs had manpower strength of 0.951 million at end-FY2000, of which PSBs
accounted for nearly 92%. PSBs accounted for almost all the decline in
intermediation costs during FY2002 and FY2003, and nearly all the increase in
intermediation costs during FY2001. During FY2001, 26 out of 27 PSBs (with the
exception of Corporation Bank) implemented a voluntary retirement scheme (VRS)
for their employees. As a result, their employee strength declined 8.7% during
FY2001 to 0.80 million. Employee strength of PSBs declined an additional 5.1%
during FY2002, and 0.2% during FY2003 to 0.755 million at end-FY2003. By end-
FY2003, PSBs had implemented employee reductions of approximately 13.5% of
their end-FY2000 levels. The cost of VRS was estimated at Rs. 123 billion. In
accordance w