CENTRE FOR NEW AND EMERGING MARKETS

Discussion Paper Series Number 17

THE INDIAN BANKING INDUSTRY: A COMMENTARY

Sumon Kumar Bhaumik London Business School

Paramita Mukherjee ICRA Limited, Calcutta

July 2001

Contact details: Anna M Malaczynska Tel: +44 (0)20 7706 6964 Fax: +44 (0)20 7724 8060 www.london.edu/cnem © London Business School, 2001

Abstract: During the 1990s, the Indian banking sector witnessed more reforms than most other sectors

of the Indian economy. Interest rates have been deregulated, and entry into the banking sector

has been liberalized. The cash reserve ratio and the statutory liquidity ratio are at their historic

lows, thereby granting the banks control over a greater share of their deposit base. Banks are

now allowed to invest in hithertofore contraband assets like equity. Further, non-interest

income by way of fees and off-balance-sheet activities is increasingly becoming an important

part of banks' revenues. Finally, banks routinely take positions in the markets for complex

instruments like derivatives. At the same time, however, these financial intermediaries are

supposed to maintain capital adequacy ratio at the stipulated minimum level, mark assets to

market, classify assets to identify doubtful and loss loans, and make provisions for non-

performing assets. Despite the spate of reforms, the Indian banking industry continues to face

several problems: many banks, mostly in the public sector, continue to underperform in terms

of return to assets; the volume of non-performing assets continue to be at an alarmingly high

level; and the issue of deposit insurance remains hostage to the fact that about 80 percent of

the deposits in the country remain in the control of public sector banks. The paper takes a

close look at the issues and challenges facing the Indian banking industry. It concludes that

the evolution of the banking sector in India is likely to take the form of emergence of

universal or quasi-universal banks, and that, therefore, risk management and development of

an appropriate regulatory system remain the main challenges facing the banking industry in

the foreseeable future.

JEL Classifications: G21, G28, G38

2

Non-Technical Summary

Independent India inherited a weak financial system. Commercial banks mobilized household

savings through demand and term deposits, and disbursed credit primarily to large

corporations. Indeed, between the years 1951 and 1968, the proportion of credit going to

industry and trade increased from an already high 83 percent to 90 percent. This increase was

at the expense of some crucial segment of the economy like agriculture and the small scale

industrial sector. This lop-sided pattern of credit disbursal, and perhaps the spate of bank

failures during the sixties, forced the government to resort to nationalization of banks.

The main thrust of nationalization was social banking, with the stated objective of increasing

the geographical coverage of the banking system, and extension of credit to the priority

sectors. This phase of banking in India was characterized by administered interest rates, and

the government and/or Reserve Bank of India’s (RBI) intervention with respect to credit

disbursal. Further, a significant part of the banks’ deposit base was preempted to support

government expenditure through statutory measures like the cash reserve ratio (CRR) and the

statutory liquidity ratio (SLR). There is little doubt about the fact that the twin objectives of

nationalization had been met by the last decade of the twentieth century. The number of

branches of the nationalized banks increased by 55,505 between 1951 and 1990, and the

emergence of a large number of rural branches helped widen the delivery points for rural

credit.

However, despite the successes of bank nationalization in India, the banking sector remained

mired in problems, and was incompatible with the paradigm of the market economy which

was gradually emerging as the dominant economic paradigm worldwide. As late as 1990, the

interest rates were still being fixed by the RBI, directed credit was still in vogue, and

government ownership of 88.5 percent of the banking industry (measured in terms of deposit

base) created enormous moral hazard problems for the depositors and the banks’ management

alike. The crisis in the banking industry was manifested in the financial performance of the

banks: while the gross operating profit of scheduled commercial banks as a proportion of total

assets rose marginally from 0.8 percent in 1970s to 1.5 percent in 1990s, the net profit of

these banks declined.

3

With economic reform emerging as the primary agenda of the central government in 1990, the

banking-financial sector in India witnessed a significant degree of liberalization since the

early nineties. Between 1992 and 1997, interest rates were liberalized, and banks were

allowed to fix lending rates subject to a cap of 400 basis points over the prime lending rate

(PLR). Further, the CRR was reduced to 9.5 percent by 1997, and the SLR was reduced to 25

percent. Banks were further encouraged to increase the returns on their operating assets when,

in 1994-95, they were allowed to invest in equity. At the same time, in pursuance of the

recommendations of the first Narasimham Committee, entry of new banks and the expansion

of branching network of existing banks were deregulated. At the same time, banks were asked

to maintain risk weighted capital adequacy ratio of 8 percent, mark assets to market, identify

problem loans on their balance sheets, and make provisions for bad loans. This phase of

reforms was completed by March 31, 1998.

During this period, the competition unleashed among banks by way of the deregulation of

entry and branching norms was supplemented by competition from non-bank financial

companies (NBFC). The deposit base of NBFCs grew from Rs. 20,438.5 crore in 1991-92 to

Rs. 101,672.4 crore in 1995-96, a rise of 397.5 percent, the rise of the deposit base of

commercial banks during the same period being 88 percent (see Figure 2). The NBFCs, which

typically offered higher interest rates on deposits than commercial banks, gained

respectability with the introduction of prudential norms aimed at making them safe

depositories for savings. All registered NBFCs were required to achieve a minimum capital

adequacy norm of 6 percent by March 31, 1995, and 8 percent by March 31, 1996. Further,

they were required to obtain a rating from Indian credit rating agencies, and invest 10-15

percent of their deposits in liquid assets.

But while the increasing competition in the banking industry led to product innovation and

quality competition, major problems continued to persist. Profitability of nationalized banks

continued to be a problem, and the ratio of net profits to total assets of these banks remained

at 0.77 percent, lower than the corresponding ratio for domestic private (1.04 percent) and

foreign banks (0.97 percent). Even more worrying was the fact that the net non performing

assets (NPA) of scheduled commercial banks continued to rise, stood at Rs. 23,761 crore in

1997-98. The public sector banks contributed to about 89.4 percent of the net NPAs. The

problem is further complicated by the fact that the fear of accumulating NPAs and the

required provisioning for the same might have rendered banks unwilling to make loans to

non-blue chip companies. Finally, in order to meet their capital adequacy requirements, banks

4

raised tier II capital through bonds which were typically subscribed to by other banks, thereby

increasing the system wide downside potential of adverse shocks.

The paper examines the following issues concerning the Indian banking industry: (a) whether

public sector banks should be privatized, (b) how the banks can best deal with the NPAs that

have an adverse effect on their balance sheets, (c) how the banks can best deal with greater

competition and manage the new forms of risk, and (d) whether there should be deposit

insurance reform such that there is greater confidence in the banking system and yet reduction

of moral hazard on the part of stakeholders. It concludes that in the absence of any political

consensus about privatization of the public sector banks (and hence consolidation of the

banking sector), and given the policy and business trends in the financial sector in general, the

Indian banks are likely to opt for the universal banking route to risk diversification and

revenue generation. The challenge facing the Indian policy makers, therefore, is to design

policies that can regulate well the complex financial institutions that are poised to emerge in

the Indian market.

5

Introduction

The last three decades of the twentieth century witnessed the emergence of a number of issues

that spurred debates and discussions among economists. During the seventies, economists

grappled with the breakdown of the Bretton Woods system and the emergence of stagflation

in the aftermath of the OPEC induced oil shock. Later, during the eighties, debates raged

about the supply side tax cuts of Ronald Reagan and the emergence of mergers and

acquisitions and junk bonds as major corporate-financial phenomena. Finally, in the nineties

economists split hair about the “new” economy and the “taming” of business cycles.

However, while the world quickly adjusted to flexible exchange rates, and while wild

gyrations in the equity prices of technology related companies do not make headlines any

more, one phenomenon continues to haunt economists through the decades: fragility of the

banking system.

From Sweden to Brazil, and from the United States of America (USA) to Japan, banks seem

to “go bad” with monotonic regularity. The South East Asian currency crisis of 1997 brought

to the fore the fact that while such a crisis may not be triggered by bad banks per se, the

extent of the crisis and the ability of a country to emerge out of the crisis fast enough depends

crucially on the soundness of its banking system. To make matters worse, the banking

industry itself is evolving rapidly, thereby forcing economists and policymakers to look at the

industry through the proverbial crystal ball, rather than in retrospect. In sum, it is more

difficult than ever to discuss the economic prospects of a country without taking a look at the

problems and prospects of its banking system.

Independent India inherited a weak financial system. Commercial banks mobilized household

savings through demand and term deposits, and disbursed credit primarily to large

corporations.1 Indeed, between the years 1951 and 1968, the proportion of credit going to

industry and trade increased from an already high 83 percent to 90 percent. This increase was

at the expense of some crucial segment of the economy like agriculture and the small scale

industrial sector. This lop-sided pattern of credit disbursal, and perhaps the spate of bank

failures during the sixties2, forced the government to resort to nationalization of banks.

1 This was due to the fact that the commercial banks were controlled by a handful of people through interlocking of directorships, and these people were entrenched in the corporate sector (Ghosh, 1988). 2 Bank failures and mergers led to a decline in the number of banks from 566 in 1951 to 90 in 1968 (India Banking Yearbook, 1995).

6

The main thrust of nationalization was social banking, with the stated objective of increasing

the geographical coverage of the banking system, and extension of credit to the priority

sectors. This phase of banking in India was characterized by administered interest rates, and

the government and/or Reserve Bank of India’s (RBI) intervention with respect to credit

disbursal. Further, a significant part of the banks’ deposit base was preempted to support

government expenditure through statutory measures like the cash reserve ratio (CRR) and the

statutory liquidity ratio (SLR).3 There is little doubt about the fact that the twin objectives of

nationalization had been met by the last decade of the twentieth century. The number of

branches of the nationalized banks increased by 55,505 between 1951 and 1990, and the

emergence of a large number of rural branches helped widen the delivery points for rural

credit (Sarkar, 1997).

However, despite the successes of bank nationalization in India, the banking sector remained

mired in problems, and was incompatible with the paradigm of the market economy which

was gradually emerging as the dominant economic paradigm worldwide. As late as 1990, the

interest rates were still being fixed by the RBI, directed credit was still in vogue, and

government ownership of 88.5 percent of the banking industry (measured in terms of deposit

base) created enormous moral hazard problems for the depositors and the banks’ management

alike. The crisis in the banking industry was manifested in the financial performance of the

banks: while the gross operating profit of scheduled commercial banks as a proportion of total

assets rose marginally from 0.8 percent in 1970s to 1.5 percent in 1990s, the net profit of

these banks declined.

With economic reform emerging as the primary agenda of the central government in 1990, the

banking-financial sector in India witnessed a significant degree of liberalization since the

early nineties. Between 1992 and 1997, interest rates were liberalized, and banks were

allowed to fix lending rates subject to a cap of 400 basis points over the prime lending rate

(PLR). Further, the CRR was reduced to 9.5 percent by 1997, and the SLR was reduced to 25

percent. Banks were further encouraged to increase the returns on their operating assets when,

in 1994-95, they were allowed to invest in equity. At the same time, in pursuance of the

recommendations of the first Narasimham Committee, entry of new banks and the expansion

3 The CRR requires banks to maintain a specified fraction of their total time and demand deposits as cash balances with the RBI. The SLR, on the other hand, requires them to invest a specified proportion of time and demand deposits in government securities and quasi-government securities like bonds issued by the Industrial Development Bank of India (IDBI). As late as 1991, the magnitudes of CRR and SLR were 15 percent and 38.5 percent respectively.

7

of branching network of existing banks were deregulated.4 At the same time, banks were

asked to maintain risk weighted capital adequacy ratio of 8 percent, mark assets to market,

identify problem loans on their balance sheets, and make provisions for bad loans. This phase

of reforms was completed by March 31, 1998.5

During this period, the competition unleashed among banks by way of the deregulation of

entry and branching norms was supplemented by competition from non-bank financial

companies (NBFC). The deposit base of NBFCs grew from Rs. 20,438.5 crore in 1991-92 to

Rs. 101,672.4 crore in 1995-96, a rise of 397.5 percent, the rise of the deposit base of

commercial banks during the same period being 88 percent (see Figure 2). The NBFCs, which

typically offered higher interest rates on deposits than commercial banks, gained

respectability with the introduction of prudential norms aimed at making them safe

depositories for savings. All registered NBFCs were required to achieve a minimum capital

adequacy norm of 6 percent by March 31, 1995, and 8 percent by March 31, 1996. Further,

they were required to obtain a rating from Indian credit rating agencies, and invest 10-15

percent of their deposits in liquid assets.6

But while the increasing competition in the banking industry led to product innovation and

quality competition, major problems continued to persist.7 Profitability of nationalized banks

continued to be a problem, and the ratio of net profits to total assets of these banks remained

at 0.77 percent, lower than the corresponding ratio for domestic private (1.04 percent) and

foreign banks (0.97 percent). Even more worrying was the fact that the net non performing

assets (NPA) of scheduled commercial banks continued to rise, stood at Rs. 23,761 crore in

1997-98.8 The public sector banks contributed to about 89.4 percent of the net NPAs. The

problem is further complicated by the fact that the fear of accumulating NPAs and the

required provisioning for the same might have rendered banks unwilling to make loans to

non-blue chip companies. Finally, in order to meet their capital adequacy requirements, banks

raised tier II capital through bonds which were typically subscribed to by other banks, thereby

increasing the system wide downside potential of adverse shocks. In view of these 4 Between 1991-92 and 1996-97, the number of domestic private banks and foreign banks rose from 23 to 34, and from 23 to 39 respectively. Between June 1993 and March 1997, the number of branches of domestic private and foreign banks rose from 3,887 to 4,535, and from 141 to 181 respectively. 5 The fiscal and financial years in India run from April 1 to March 31 of the following year. 6 Despite the regulatory measures, uncertainty about the asset portfolios and business practices of NBFCs subsequently affected the growth of NBFCs. Their deposit base on March 31, 1999 stood at Rs. 20,428.93 crore. 7 The average PLR of banks declined by about 200 basis points between 1991-92 and 1997-98, but the cheap money policy followed by the RBI have been responsible for it than price competition among banks.

8

developments, between 1997 and 2000, the central government and the RBI set up two

different committees to provide guidelines for the second generation reforms for the banking

sector: the second Narasimham Committee to provide guidelines for the second generation

reforms of the banking sector, and the Varma Committee to provide guidelines about

treatment of weak public sector banks.

Second generation banking reforms

The second Narasimham Committee undertook its evaluation of the Indian banking sector at a

crucial point of time: the currency-banking crisis in South East Asia, and the assertion by the

Tarapore Committee that the banking sector of the country should be strengthened to meet

international standards before the rupee is made fully convertible on the capital account of the

balance of payments. The report of the committee, submitted in 1998, focussed on

strengthening the foundations of the banking system, as well as on issues like upgradation of

technology and human resource development.

The report stressed two aspects of banking regulation: capital adequacy, and asset

classification and resolution of the NPA-related problem. 9 It recommended that the capital

adequacy ratio be increased to 9 percent by 2000 and further to 10 percent by 2002. It also

suggested that measures of capital adequacy should take into account market risk of the

banks’ assets,10 including the exchange rate risk of foreign currency held by the banks.

Further, it proposed that the entire portfolio of government securities with banks be marked to

market within a 3-year period. Finally, the committee suggested that an asset should be

classified as “doubtful” if it is in the substandard category for 18 months to begin with, and

that this period be reduced to 12 months over time.11

In order to reduce the moral hazard associated with government ownership, the committee

suggested that banks should not be recapitalized using government funds. However, it

acknowledged the fact that the government might have to play a role in the removal of NPAs

from the banks’ balance sheets by way of asset reconstruction companies (ARCs).

Specifically, the government might have to guarantee the bonds issued by the ARCs, the

proceeds from which would be used to buy the bad assets of the banks at a discount. 8 The volume of gross NPAs has been estimated to be double the volume of net NPAs. 9 The committee proposed that the average level of net NPAs as a fraction of credit outstanding for all banks be reduced to 5 percent or less by 2000 and to 3 percent by 2002. For banks with international presence, the corresponding targets for gross and net NPAs were proposed to be 5 percent and 3 percent, and 3 percent and 0 percent respectively. 10 In conjunction with this, the banks were encouraged to undertake risk management by way of value at risk (VaR) modelling.

9

Implicitly linking ownership with performance, the second Narasimham Committee

suggested a reduction in the minimum stipulated holdings of the government in the equity of

public sector banks to 33 percent.12 It also favored separation of monetary policy and bank

supervision, and suggested that a supervisory body for banks be formed in line with the

Financial Services Authority (FSA) of United Kingdom.

While the second Narasimham Committee proposed reforms which were indubitably good in

so far as the health of the banking system is concerned, it stopped short of proposing closure

of public sector banks like United Bank of India, United Commercial Bank and Indian Bank

which were clearly underperforming even by the modest standards of the public sector banks.

The unenviable task of formulating a policy to deal with weak public sector banks was,

instead, left for the Varma Committee.

The Varma Committee concluded that the public sector banks were under pressure because of

the prudential norms regarding asset classification and provisioning for NPAs, and because of

the intensification of competition subsequent to the first phase of banking sector reforms.

However, the committee pointed out that the dismal performance of the weak public sector

banks were not merely on account of exogenous shocks, but rather that internal problems like

limited number of products, poor risk management systems and mediocre service had also

contributed to the weak performance. It concluded that mergers and narrow banking are

unlikely to resolve the problem of weak banks, and while privatization is perhaps the best

course of action it would be difficult to attract private bids for public sector banks the cost of

restructuring which would be prohibitively high.

The committee identified persistence of the large volume of NPAs as the biggest challenge

facing the weak public sector banks, and proposed that ARCs be used as the vehicle for

alleviating this problem. Importantly, the committee categorically stated that the weak banks

would have to reduce cost of operation by way of reduction in staff strength, an economically

sound proposition that has been difficult to implement in light of the Indian political

economy.13 It proposed that the staff strength of weak public sector banks be reduced by 25

percent. Moreover, it argued that if VRS fails to reduce the operations cost of these banks, 11 The committee suggested that the banks be asked to adopt the international standard with respect to income recognition, thereby reducing the relevant time period from 180 days to 90 days. 12 The central government is attempting to effect such a reduction with the help of appropriate legislation, but the proposal has met with significant resistance from the opposition parties.

10

there should be across-the-board wage cuts for their employees.14 Once again, given the

political economy of the Indian banking industry, this was a radical proposal.

While the various committees have accurately identified the malaise (adversely) affecting the

evolution of the Indian banking system into an efficient and globally competitive industry,

and have paved the way for many a reform, trade unionism, lack of political will to take hard

decisions, moral hazard and sheer inefficiency continue to haunt this critical component of the

Indian financial system. While any commentary about the industry cannot divorce itself from

positive analysis, thereby taking into consideration the political economic realities, it is also

imperative to touch upon normative aspects of policy making without which there cannot be a

vision about the way forward. Attaining a balanced mix of the positive and the normative

would be the challenge that has been addressed in the subsequent analysis.

Issues facing the Indian banking system

The issues facing the Indian banking system today are, ironically, very similar to the issues

that were raised nearly a decade ago. The liberalization of the banking industry and the

introduction of prudential norms have opened the door for greater competition on the one

hand, and have reduced the vulnerability of the banking system on the other. However, the

bane of the Indian banking sector continue to be a clutch of banks with weak balance sheets

and weaker prospects of improving asset quality and profitability simultaneously. Further, the

large yet weak banks are in the public sector. As a consequence, the policy debate about

banks continues to encompass the following issues: (a) whether public sector banks should be

privatized, (b) how the banks can best deal with the NPAs that have an adverse effect on their

balance sheets, (c) how the banks can best deal with greater competition and manage the new

forms of risk, and (d) whether there should be deposit insurance reform such that there is

greater confidence in the banking system and yet reduction of moral hazard on the part of

stakeholders.

Privatization

There seems to be general agreement about the hypothesis that public sector banks (PSBs)

underperform vis a vis the domestic privately owned banks (PvSBs) and the foreign banks

(FBs). This view is usually based on analysis of the profitability of the banks, and the quality

of their balance sheets; public sector banks, on average, are less profitable and have larger

13 However, a generous voluntary retirement scheme (VRS) offered by the State Bank of India and some other banks in the recent past was successful in the sense that more people opted for VRS than was originally envisaged. 14 In harmony with the proposal to reduce operating cost and staff strength, the Varma Committee proposed that the branch network of the weak banks be rationalised.

11

NPA to asset ratio than the domestic private banks and the foreign banks (see Figures 3

through 7).15 Interestingly, however, there has been only one systematic empirical study

attempting to test the aforementioned hypothesis. The econometric analysis of Sarkar, Sarkar

and Bhaumik (1998) reported that, as of 1994, the profitability of the private nontraded banks

and that of the public sector banks were not significantly different. Further, there was

practically no distinction between private domestic and public sector banks in terms of cost

efficiency.

The study is six years old and the data does not reflect the full impact of the process of

liberalization that was initiated in the aftermath of the formulation of the first Narasimham

Committee. However, even this limited study raises the possibility that profitability, and to an

extent cost efficiency, of banks is significantly determined by the extent of market discipline

to which the banks’ management are subjected. This proposition finds further support from a

casual comparison of the performances of the new domestic private sector banks (NPvSBs)

whose shares are publicly traded, old domestic private banks (OPvSBs) whose shares are

publicly traded, and old domestic private banks which are still closely held.16

Pragmatic policy making cannot divorce itself from the political economy, and an essential

part of pragmatism in the Indian context is that public sector banks are unlikely to be

privatized in the foreseeable future.17 It has sometimes been suggested that, as an intermediate

step, it would perhaps be prudent to corporatize all public sector banks that are not already

listed at stock exchanges, sell at least 26 percent (and perhaps a higher proportion) of the

banks’ equity to private investors, and list the banks at the Bombay and National stock

exchanges. However, in such an event, the government would continue to be the majority

shareholder and, therefore, the banks would remain open to political suasion while the

management remain steeped in moral hazard. Hence, while, in principle, the presence of other

stakeholders with a voice would increase the probity of the banks, and pave the way for some

15 As of March 31, 2000, the return on assets (ROA) for public sector banks was 0.15 percent while that of old private sector banks, new private banks and foreign banks were 0.2 percent, 0.08 percent and 0.49 percent respectively. On the same day, the net NPA to asset ratio of public sector banks stood at 2.9 percent, the ratio being 2.3 percent for domestic private banks and 1 percent for foreign banks. 16 See Tables 1 and 2 in the Appendix. They control for ownership/majority stake, and highlights the difference between the performance between listed and non-listed banks. The average ROA for the closely held private banks should be taken into account after omitting Ganesh Bank which is clearly an outlier. Similar, the ROA of public sector banks should be taken into account after omitting Indian Bank and UCO Bank. 17 In any event, privatization of state owned banks may not be easy because an examination of a bank’s book provides very imperfect information about the possibility of loans/assets turning bad in the future. Hence, a private investor would insist on thorough due diligence that might make the process of privatization very costly. Alternatively, he would insist on a steep discount over any valuation, thereby making the process of privatization politically infeasible.

12

form of market discipline, however weak, the probability of offloading minority shares of

public sector banks to private investors remain low.

In other words, in order to effectively sell shares of public sector banks to minority

shareholders, the government would have to signal that it as the owner it encourages

maximization of profits and shareholder value. Hence, the first stage of the process of

restructuring has to involve an improvement in the quality of the banks’ balance sheets.18 This

process would have to involve a resolution of the banks’ problems with respect to NPAs, and

the introduction of measures and institutions that allow banks to take a reasonable amount

risk to augment their returns while providing options to manage and hedge against these risks

adequately.

Non Performing Assets

Perhaps the biggest concern of the weaker banks in India, most of which are state owned, is

that they have significant amounts of NPAs on their balance sheets. As of March 31, 2000,

the volume of net NPAs in the Indian banking system was Rs. 30,152 crore, of which the

“contribution” of the public sector banks was Rs. 26,188 crore. This problem was brought

into focus by the first Narasimham Committee, and has subsequently been addressed by the

second Narasimham Committee and the Varma Committee. The general consensus seems to

be that the NPAs of banks should be offloaded to ARCs. Such a move would take the NPAs

off the balance sheets of the banks, and thereby improve their profitability by way of lower

provisioning requirement. At the same time, it is expected, the ARCs would be able to

recover more bad loans (and perhaps at a faster pace) because they would be dedicated

towards loan recovery.

The use of ARCs has been an integral part of banking sector restructuring in a number of

countries (Hawkins and Turner, 1999). In many transition economies of eastern and central

Europe, banks saddled with large volumes of NPAs were split into “good” banks and “bad”

banks whereby the latter effectively functioned as ARCs.19 The good bank-bad bank policy

paradigm also saw the light of the day in Australia (State Bank of South Australia), Brazil

(Bamerindus, Bank of Rio de Janeiro), Finland (Savings Bank of Finland, STS Bank),

Sweden (Nordbanken, Gota Bank) and Thailand (Bangkok Bank of Commerce) among

others. In many other economies like those of the Japan, Malaysia and South Korea, bad loans

18 This would indeed be a tall order. The fact that the shares of public sector banks are being traded below their issue price at the stock exchanges indicate that the private investors have little faith in the ability of the government to turn the banks around with hard and politically difficult measures. 19 Of course, the extent of loan recovery in central and eastern European countries was minimal and much of these bad loans eventually had to be written off.

13

of banks were passed onto ARCs. Typically, ARCs purchase the bad loans from the banks at

a discount after raising money with the help of government backed bonds.

But how easy is it for ARCs to recover bad loans from the defaulting borrowers? In the Indian

context, it has proved difficult to close down and foreclose the assets of a defaulting

company, especially if the company has a large number of employees. Notwithstanding the

reforms of the rigid laws governing labor and exit policy that have been drafted in the Budget

for the fiscal year 2001-02, the opposition to the reforms by trade unions and mainstream

political parties indicate that actual implementation of these reforms would be difficult at

best.

It is also difficult to envisage defaulter-ARC interaction on lines of a Chapter 11 bankruptcy

proceeding. In a Chapter 11 type proceeding, the management of the defaulting company is

not ousted,20 and the company is allowed to continue operations, but it has to come up with a

clear and convincing plan that indicates how the creditors would be compensated. In a sense,

therefore, till the loan is eventually repaid, the company is bound by a commitment the terms

of which can be set by the ARC (or the bank). In India, since major defaulters include public

sector companies and large private sector companies that are often controlled by families or

tightly knit groups of people, the primacy of the ARC may not be acceptable nor practicable.

For the same reason, it may be difficult for the ARCs to implement, on a case-by-case basis,

debt-equity swaps, and later sell this equity of the defaulting companies at market clearing

prices to those who may want to take over the defaulting companies.21

The only two options facing a ARC, therefore, are to recover loans by way of the debt

recovery tribunals, and to sell the bad loans off to asset management companies which would

be interested in investment in these de facto junk “bonds.” Despite the claims of success made

by the banks, thus far only a small fraction of the total volume of bad loans have been

recovered with the help of the tribunals. But in the absence of an effective exit policy and

foreclosure law, it would be difficult for ARCs to persuade private investors to buy the bad

loans, and hence the use of tribunals may be the only viable option.

20 In fact, the defaulting debtor may also get fresh loans but these loans enjoy seniority. 21 In Thailand, in a variation of this strategy, ownership of defaulting companies were handed over to investors who did not want to make lump sum payments for the bad assets, but who entered into profit-sharing agreements with the creditors.

14

Competition, Consolidation and Risk Taking

The Indian banking sector was introduced to competition when, in accordance with the

suggestions of the first Narasimham Committee, entry was deregulated and both domestic and

foreign banks were allowed to expand their branch networks. However, an early study by

Sarkar and Bhaumik (1998) indicated that the deregulation did not have a significant impact

on the extent of competition faced by the public sector banks, who controlled about 83.9

percent of the deposits in 1994.22 Since then, however, the share of deposits controlled by

these banks has declined to 79.3 percent, thereby indicating that the extent of competition

may have increased in the Indian banking industry. Much of the reduction of market share of

the public sector banks can be attributed to the emergence of the new domestic private sector

banks, who control about 5 percent of the deposits. In other words, there is prima facie

evidence that the Indian banking sector is becoming more competitive.

Economists have traditionally argued that competition is good because it improves the overall

efficiency of an industry by way of creative destruction. Stiroh (2000), for example, argued

that in the USA exit of weak banks and reallocation of the business of these banks among the

surviving stronger ones have significantly added to the efficiency of the country’s banking

sector. However, while the positive impact of competition on an industry’s efficiency cannot

be brought into question, competition may also precipitate major systemic crises. For

example, “price” competition among banks, as well as between banks and money market

mutual funds, in the USA during the early eighties, following the abandonment of Regulation

Q, led to asset-liability mismatch in many banks (Bhaumik, 1996).23 The consequence was an

increase in the exposure of the balance sheets of weak banks to real estate and junk bonds,

which precipitated the banking crisis in the USA during the late eighties.

In other words, if a bank fares poorly in the face of competition, there is a high probability

that it would take risks to either make up for poor net returns on traditional banking assets,

and/or to expand business to the point where it would be deemed too-big-to-fail. This would

be the consequence of the stylized agency problem that affects the relationship between

22 Since the ability of a bank to expand its business and increase its business depends on the amount of deposits it controls, the share of deposits it controls is a fairly good proxy for the extent of its market power, when market power of a firm itself is negatively related to the extent of competition in the industry. 23 Banks had to compete for deposits with the money market mutual funds and hence once Regulation Q was abolished banks increased their deposit rates. Hence the cost of funds of the banks reflected the relatively high interest regime of the post oil shock period. At the same time, a significant part of the banks’ assets were in the form of long term government bonds that had been issued during the low inflation era prior to the OPEC induced oil shock. Hence, there was a severe mismatch of returns on assets and liabilities.

15

managers and the other stakeholders of firms. Anecdotal evidence suggests that in India this

agency problem leads to the evergreening of de facto bad loans, largely because banks’

exposures to other assets are somewhat restricted. However, given the potential for adverse

selection in traditional banking activities, and given the low rates of return on loans made to

blue chip companies,24 banks are increasingly turning to high risk-high return lines of

business like credit card business and consumer lending, as well as fee-based off-balance-

sheet activities. While the downside potential of such businesses is as yet unknown, the

payments crisis at the Calcutta Stock Exchange highlighted the fact that the banks remain

vulnerable to negative shocks on account of their off-balance sheet exposures.25 The

experience of banks in developed financial markets suggests that this problem is likely to be

exacerbated as the banks increase their exposure to complex financial products like

derivatives (Peek and Rosengren, 1996).26

Exposure of banks to equities and real estate is reflected in their balance sheets and hence it

can easily be monitored. However, by their very nature the downside risk of off-balance-sheet

activities cannot be assessed until after they have a negative impact on the viability of banks.

Indeed the only way to estimate the exposure of banks to such risks is to effect continual on-

site monitoring which can be prohibitively expensive. Hence, the need of the hour is to

provide options such that banks are able to cope with competition without imperiling the

health of the banking system.

For example, it has been shown that in India the ability of a bank to profitably involve itself in

banking activities significantly depends on the geographical distribution of its branches, and

banks located in weaker economic regions are inherently at a disadvantage vis a vis the other

banks (Rajaraman, Bhaumik and Bhatia, 1998). Hence, if weak banks in the economically

backward regions are asked to improve their profitability, and they are unable to do so by way

of traditional banking activities, they may have to expose themselves to high risk-high return

activities. At the same time, if the weakness of these banks stems also from relatively lower 24 Since it is risky to lend to non-blue chip companies, and given that addition of appropriate risk premia to the PLR might result in averse selection, banks in India have often preferred to lend through the commercial paper route than through traditional banking channels. Evidence abound that blue chip companies with good credit ratings are able to raise money with commercial papers at yields that are 100 basis points or more lower than the PLR. 25 Brokers at the Calcutta Stock Exchange had provided bank guarantees against their equity market exposures. In the aftermath of a rapid fall in the equity prices during March 2001, the brokers were unable to meet their commitments and hence the stock exchange was forced to invoke the bank guarantees. 26 As of now, Indian banks are required to match swaps and options back-to-back in the foreign exchange market. The internal market for interest rate swaps is in its infancy, and equity options have not yet been introduced. However, with further liberalization of the Indian financial sector, the banks

16

capability to assess and manage risks, the downside potential of the high risk-high return

activities could be significant. However, this impasse can be resolved by allowing banks to

trade loans among themselves (Demsetz, 1999); banks in more prosperous regions can make

“good” loans in excess of the capacity defined by their deposit base, and then bridge the gap

by selling the loans off to banks in the weaker regions who would have the money but few

“good” debtors.27

The geographical segmentation of the Indian loan market leads to one other important issue.

A strategy to cope with competition that has come into vogue in the banking industry

worldwide is mergers. Earlier, mergers among banking institutions were often limited to

smaller banks who merged to attain better economies of scale and to gain access to remote

markets. The rationale behind the more recent phenomenon of mergers among large banks too

goes beyond the logic of economies of scale28 and increased market power, and can be

associated with strategies aimed at gaining market access (especially in the context of cross-

border merges) and strategies pertaining to repositioning of banks in their native markets

(ECB, 2000).29 While the evidence about the impact of mergers on profitability and efficiency

gains is mixed at best, it has been argued that gains accruing to the post-merger entity have

been underestimated in the economics literature, and that such gains can actually be

substantial (Kwan and Wilcox, 1999). Further, studies have concluded that while gains in

terms of cost efficiency is minimal subsequent to banks’ mergers, there can be significant

gains in profit efficiency on account of greater diversification of risks.

In India, mergers among banks is no longer a new phenomenon. But most of the mergers have

involved relatively small banks like ICICI Bank and UTI Bank for whom merger is a

convenient way to enjoy economies of scale and enhance distribution networks.30 However,

may be allowed to run options books and enter into other contingent claims contracts that would increase their risk exposure significantly. 27 Note that the informational asymmetry between the banks in the prosperous and the weaker regions, sellers and buyers respectively, would be significant. However, since the seller bank would have to interact repeatedly with the buyer bank and other banks, it can be assumed that signalling issues related to reputation would prevent the seller bank from systematically making and passing on “bad” loans to the buyer bank. 28 Indeed, there is some degree of agreement among economists that mergers do not contribute to scale economies, and that, in fact, there can even be scale efficiency losses in the aftermath of mergers (Berger, Demsetz and Strahan, 1998). 29 Indeed, mergers among banks might reduce the number of banks within a country, but the extent of competition is ever increasing. Technology has allowed banks to reach out “virtually” into geographical areas where they have no physical presence. At the same time, non-bank financial organisations like money market mutual funds are offering bank-type services like check writing facilities. Hence, it is by no means certain that merger would augment the market power of two or more banks. 30 Earlier attempts at merger involve merger of “good” and “bad” banks at the behest of the government and the RBI. However, such mergers often do not work, and affect the viability of the

17

since many of the weak banks are in the public sector, merger is not always a viable option to

simulate creative destruction in the Indian context, and merger among the public sector banks

would be a farce in the absence of post-merger cost cutting measures that would certainly

involve large scale labor retrenchment. In sum, the use of mergers as a strategy to cope with

competition is somewhat limited in the Indian context, corporatization and privatization of all

the public sector banks have to precede mergers if its strategic potential is to be fully

realized.

Deposit Insurance

Deposit insurance has long been endorsed by economists as an important pillar of a robust

banking sector. It can help prevent bank runs (Diamond and Dybvig, 1984), and can also

make banking sector restructuring acceptable to deposit holders, thereby giving the regulators

the political support that is a necessary precondition for any successful reform process

(Hawkins and Turner, 1999). At the same time, the existence of deposit insurance schemes is

usually cited as the major source of moral hazard. Specifically, the deposit holders, who are

creditors to the banks, are less likely to monitor the activities of the management and the

equity holders if they believe or know that their deposits are insured. Hence, regulators have

to trade off the ability of deposit insurance schemes to prevent bank runs against its ability to

foster moral hazard. This problem came into focus sharply in the aftermath of the banking

crisis in the USA during the eighties. However, it has not emerged as a major policy issue in

the Indian context.

In India, an overwhelming proportion of the deposits lies with the public sector banks. Hence,

although India has in place an explicit deposit insurance system by way of which all

depositors are insured up to Rs. 100,000, the general view is that this cap on deposit insurance

is not credible. This view has found support from the government’s decision to infuse capital

into weak public sector banks at regular intervals, despite policy announcements to the

contrary. But the decision of the government to gradually make the returns on investments in

the flagship US-64 scheme of the Unit Trust of India (UTI) market related,31 as well the

recent thrust in the direction of structural reforms indicate that the fiscal crunch might make

the government and the RBI try to reduce the potential fiscal impact of bank failures and

good bank rather than enhancing the (joint!) profitability of the merged entity. A case in point is the merger of Punjab National Bank with New Bank of India. 31 In 1998, the returns on the investments of UTI declined because of a decline in equity prices. However, UTI had made a pre-commitment to pay its investors a reasonably high return on their US-64 investments, and the promised return was clearly not in harmony with the returns accruing to UTI. The mutual fund honoured it commitments, but it was pressurized by the government to agree to link the subsequent returns of their schemes to market returns.

18

closures to a minimum.32 In other words, the importance of an explicit and credible deposit

insurance scheme is on the rise. The importance of such a scheme has gained further

importance because the share of deposits controlled by domestic private sector banks and

foreign banks are on the rise and, as of March 31, 2000, these banks control 17.5 percent of

the deposits.

First of all, it should be understood that the clear theoretical case for moral hazard and its

potential impact on risk taking behavior of the banks notwithstanding, there is no strong

evidence to support the proposition that in the presence of a deposit insurance scheme a bank

would be more inclined to take risk (Gropp and Vesala, 2001). Indeed, any impact of deposit

insurance on risk taking behavior of banks can be counteracted by a bank’s desire to protect

its charter value, and by the presence of a significantly large number of creditors who are not

covered by deposit insurance.33 Hence, there can be no doubt about the fact that that the

deposit insurance scheme is a necessary component of a stable banking system. Indeed,

speculation, if any, should be about the nature of the deposit insurance scheme, and not as to

whether or not a banking system should include such a scheme.

Ideally, a deposit insurance scheme should attempt to prevent bank runs and, at the same

time, increase the willingness of the depositors to monitor the banks’ activities and

performance. Further, since the multitude of small deposit holders are unlikely to be able to

monitor banks effectively, the scheme should incorporate features that would encourage the

banks to be prudent in the context of risk taking. The experience of the banking industry in

the USA indicated that banks can be induced to be prudent about risk taking if the premia for

the deposit insurance are risk related, i.e., if it is not a flat amount.34 Further, the regulators

may lay down norms which the banks have to satisfy in order to be a part of the deposit

insurance system, the threat being that loss of insurance coverage would make it impossible

for a bank to raise deposits and carry on or expand its business.35 The depositors can be

induced to monitor the performance of the banks by restricting one claim per depositor 32 A RBI committee set up for evaluating and proposing changes to India’s deposit insurance system suggested that the paid up capital for each of the deposit insurance funds, one for the commercial and another for the cooperative banks, should be Rs. 500 crore. However, the aggregate amount of savings deposits with scheduled commercial banks stood at Rs. 199,120 crore on March 31, 2000, and hence it is not obvious as to whether a Rs. 500 crore corpus would be enough to instil confidence among depositors without invoking visions of implicit government guarantee. 33 An example of assets – from the creditors’ viewpoint – typically not covered by a deposit insurance scheme is subordinated debt. 34 The optimal premium for any level of risk can be estimated using the methodology proposed by Ronn and Varma (1986) which treats deposit insurance as a put option. The RBI committee proposed that the banks be charged premia in accordance with the riskiness of their asset portfolios, as indicated by their CAMEL ratings.

19

irrespective of the number of accounts held by him,36 making the deposits coinsured,37 and

paying out the insured amount in installments, thereby increasing the time cost of the

depositors.

The problem in the Indian context is that much of the aforementioned incentive related

strategies would not work for the public sector banks, may of whom are weak, simply because

the ownership of these banks would decrease the credibility of these strategies. For example,

so long as depositors believe that the government would rather violate any cap on the amount

of insurance than face a political backlash, they would not monitor the banks’ performance

effectively. The threat of elimination of insurance coverage for weak or imprudent banks too

would not be credible if they are owned by the government. In other words, as observed

implicitly in several other contexts, while privatization may not be a panacea for the Indian

banking industry, it may well be a necessary step towards improved efficiency and greater

viability. However, since it is unlikely to happen in the foreseeable future, a discussion about

privatization of public sector banks in India is moot.

Looking Ahead

The classical definition of banks suggests that they are intermediaries between savers and

investors. Subsequent developments in the economics literature explicitly took note of the fact

that banks are not merely intermediaries, rather they are institutions which manage risks on

behalf of the risk averse depositors. However, the view was that a bank manages risks by

diversifying its loan portfolio among competing projects with varying degrees of risk. In the

current scenario, the banks are consistently pushing the frontiers of risk management.

Compulsions arising out of increasing competition, as well as agency among between

management, owners and other stakeholders, are inducing the banks to look for avenues to

increase revenues. One manifestation of this is the increasing importance of fee-based

activities, and off-balance-sheet activities in a bank’s “life.”

More recently, as legislation like the Glass-Steagall Act have come under attack from

economists and banking sector professionals, banks are being exposed to activities that have

traditionally been outside the bounds of banking per se. Banks have emerged as fund 35 The RBI committee proposed that a bank’s deposits should not be covered unless it has a minimum CAMEL rating of C, and it satisfies capital adequacy requirements as laid down by the RBI. 36 The RBI committee felt that the Indian deposit insurance system should continue to provide coverage per deposit and not per depositor. However, it argued that certificates of deposits issued by the banks, and deposits that were essentially cash collateral against bank loans should not be covered by deposit insurance.

20

managers, brokers, underwriters of securities, and channels of distribution for insurance

products. In other words, universal banking, once a controversial organization, despite its

successful existence in countries like Germany and Switzerland, is increasingly becoming

acceptable and mainstream.38 The Indian banking industry too is catching up with this

international trend. Banks now routinely offer brokerage facilities to the depositors. The

recent tie-up between Standard Chartered Bank and Royal Sundaram insurance company,

whereby the former would act as a conduit for marketing the latter’s products, too is a step

towards the formation of universal banks. Futher, “development” financial institutions (DFIs)

like ICICI and IDBI now own significant amount of shares in commercial banks like ICICI

Bank and Federal Bank, and NBFCs like HDFC, thereby bringing closer together commercial

banks and financial institutions the nature of whose assets and liabilities are significantly

different from those of commercial banks.

The evidence about the scope efficiency of universal banks is fairly mixed (Berger, 2000).

There is agreement about the fact that universal banks can achieve revenue efficiency gains

through cross-selling and integration of the distribution channels of different types of

financial products. They can also gain through greater diversification of their risks which, in

turn, increases their ability to make high risk-high return investments, and increases the

credibility of the guarantees which they provide on behalf of customers against payment of

fees. However, scope inefficiencies can surface in the form of incompatibility among the

personnel associated with different divisions of the banks. Further, an universal bank might

face credibility problems if it is believed that it underprices its weaker products and makes up

for the revenue shortfall by overpricing the stronger products.39

However, while the expansion of scope through adoption of universal banking may be a

double edged sword for a bank, there is little evidence to suggest that amalgamation of

traditional banking products with insurance products, brokerage services etc. would increase

the riskiness of a bank’s portfolio. Indeed, Laderman (2000) argued that significant exposure

to underwriting of life insurance and casualty insurance products, and securities brokerage 37 The committee also suggested that deposits up to Rs. 90,000 should be insured completely, but that any amount in excess of Rs. 90,000, and less than the cap of Rs. 100,000, should be insured to the extent of 90 percent. 38 The regulators in the USA, for example, continue to distinguish between a commercial and an investment bank. But it allows bank holding companies to own financial institutions of various types, thereby allowing de facto existence of a weak form of universal banking. 39 In general, there can be conflict of interest arising out of the different functions of an universal bank (RBI, undated). For example, in order to ensure that the investment banking division of the bank does not suffer underwriting losses, and thereby loss of reputation, an universal bank may be tempted to use part of its deposit base to prop up the prices of the pre-existing securities of a firm whose new

21

reduce the probability of bankruptcy among bank holding companies.40 In other words, so

long as a bank is able to reap economies of scope through appropriate organizational

structure, there is no compelling reason to stop the formation of universal banks through fiat

and regulation.

If the majority equity stake of the public sector banks, which account for 81.9 percent of the

Indian banking industry in terms of deposit base, remain in the hands of the government, the

industry is unlikely to witness consolidation and evolution in the form of strategic mergers.

Any merger among public sector banks is likely to be in the form of good bank-bad bank

merger which is typically not a harbinger of improved efficiency. The process of evolution,

therefore, is likely to involve emergence of universal banks. In recognition of this possibility,

the second Narasimham Committee and the Khan Committee, set up by the RBI, proposed

that the DFIs and commercial banks be allowed to tread into each other’s “territory.”

Specifically, the view was that banks should be allowed to make term loans, and the DFIs

should be allowed access to short term funds by way of deposit mobilization and access to the

money market.41 Further, the Khan Committee’s report suggests that the DFIs should be

allowed to convert themselves into banks or NBFCs over a period of time.

Thus far, the emphasis has been on the abolition of the distinction between DFIs and

banks/NBFCs on the basis of the maturity structure of their assets and liabilities. However,

an universal bank is not merely one which has both short and long term assets and liabilities

on their balance sheets. It is also one which is simultaneously engaged in many lines of

businesses ranging from traditional banking to investment banking and underwriting and

marketing of insurance products. The view of the RBI about this stage of evolution of

universal banking in India is as yet not apparent, even though the apex bank and the Insurance

Regulatory and Development Authority (IRDA) have allowed State Bank of India and Vysya

Bank to own, in part, insurance companies. What is certain is that if the Indian banking sector

does cross this threshold, there would be a significant increase in the complexity of the

products associated with the banking sector. In other words, a post-evolution (universal) bank security the bank is underwriting. This would expose the depositors of the banks to risk for which they may not receive the appropriate risk premium. 40 Laderman’s empirical analysis involving all possible combinations of bank holding companies and nonbank financial companies in the USA indicated that the standard deviation of a bank holding company’s return on assets declined with such exposure. 41 Note that if banks are allowed to make term loans, they would not face asset-liability mismatch problem because they already have long term liabilities like term deposits on their balance sheets. Indeed, if banks are allowed to make long terms loans, as in the current regime, it would provide them with an alternative to holding illiquid long term government bonds to effect asset-liability mismatch. However, if DFIs are allowed to tap short term funds, they would also have to be allowed to

22

would have to put into place an efficient risk management system that can not only predict

future movements in fundamental economic and financial variables like interest rates, but can

also understand and appreciate the correlation among the prices of various assets.42

If the banks are subjected to increasing competitive pressure, they are likely to adapt

themselves to the situation, and move up the learning curve, however steep. But agency

problems will prevail, and government ownership might aggravate moral hazard problems

among the public sector banks. Hence, the health of the system would ultimately depend on

the ability of the regulating agency, the RBI or an independent regulatory agency on lines of

the FSA, to monitor the banks effectively and to proactively mitigate problems with the

banks’ portfolios. Strengthening of the regulatory set up, such that it is capable of preventing

catastrophes without inhibiting the evolution of banking practices and products in response to

competition, is the main challenge facing the Indian banking sector in the foreseeable future.

make short term loans and own other short term assets so that they are able to avoid the aforementioned mismatch. 42 The Khan Committee’s report recognized the importance of risk management in a complex financial organization, and emphasized the need to mandate extensive in-house risk management capabilities for the post-evolution DFIs.

23

References

Berger, A. N., “The integration of the financial services industry: Where are the efficiencies?”

Board of Governors of the Federal Reserve System: Finance and Economics occasional

paper no. 2000-36, 2000.

Berger, A. N., R. S. Demsetz and P. E. Strahan, “The consolidation of the financial services

industry: Causes, consequences, and implications for the future,” Board of Governors of the

Federal Reserve System: Finance and Economics occasional paper no. 1998-46, 1998.

Bhaumik, S. K., “Liberalization vs regulation: Some lessons for financial restructuring,”

Journal of Transforming Economies and Societies, 3(2): 2-14, 1996.

Demsetz, R. S., “Bank loan sales: A new look at the motivations for secondary market

activity,” Federal Reserve Bank of New York: Staff Report no. 69, 1999.

Diamond, D. W. and R. H. Dybvig, “Bank runs, deposit insurance and liquidity,” Journal of

Political Economy, 91: 401-419, 1983.

European Central Bank, Mergers and acquisitions involving the EU banking industry: Facts

and implications, 2000.

Ghosh, D. N., “Banking: lessons from Indian experience,” SBI Monthly Review, 28: 531-543,

1988

Gropp, R. and J. Vesala, “Deposit insurance and moral hazard: Does the counterfactual

matter?” European Central Bank working paper no. 47, 2001.

Hawkins, J. and P. Turner, “Bank restructuring in practice: An overview,” Bank for

International Settlements: Policy Paper no. 6, 1999.

Kwan, S. H. and J. A. Wilcox, “Hidden cost reductions in bank mergers: Accounting for more

productive banks,” Federal Reserve Bank of San Francisco: Working Paper no. 99-10, 1999.

Laderman, E. S., “The potential diversification and failure reduction of bank expansion into

nonbanking activities,” Federal Reserve Bank of San Francisco: Working Paper no. 2000-01,

2000.

24

Peek, J. and E. S. Rosengren, “Derivatives activity at troubled banks,” Federal Reserve Bank

of Boston: Working Paper no. 96-3, 1996.

Rajaraman, I., S. K. Bhaumik and N. Bhatia, “NPA variations across Indian commercial

banks: Some findings,” Economic and Political Weekly, XXXIV(3-4), 1999.

Reserve Bank of India, Report of the working group on reforms in deposit insurance in India,

1999a.

______, Report of the working group on restructuring of weak public sector banks, 1999b.

______, Harmonising the role and effects of development financial institutions and banks,

1999c.

_______, Report of the Narasimham Committee on Banking Sector Reforms, 1998

______, Report of the Narasimham Committee on financial system, 1991.

______, Trends and progress in banking in India, several issues.

Ronn, E. and K. A. Varma, “Pricing risk-adjusted deposit insurance: An options based

model,” Journal of Finance, 41: 871-895, 1986.

Sarkar, J. and P. Agarwal, “Banking: The Challenges of Deregulation,” (in) K. Parikh (ed.)

India Development Report, Oxford University Press, 1997

Sarkar, J., S. Sarkar and S. K. Bhaumik, “Does ownership always matter? Evidence from the

Indian banking industry?” Journal of Comparative Economics, 26: 262-281, 1998.

Sarkar, J. and S. K. Bhaumik, “Deregulation and the limits to banking market competition:

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Federal Reserve Bank of New York: Staff Report no. 98, 2000.

25

APPENDIX

Table 1

26

Table 2

27

27

Percentage listed at stock exchanges

0.0

20.0

40.0

60.0

80.0

100.0

120.0

1994-95 1995-96 1996-97 1997-98 1998-99 1999-00

Financial year

Perc

ent

PSB OPvSB NPvSB

Figure 1

28

Share of deposit base

0.01.02.03.04.05.06.07.08.09.0

10.0

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00

Financial year

Perc

ent

76.077.078.079.080.081.082.083.084.085.0

Perc

ent

OPvSB NPvSB FB NBFC (% of bank deposits) PSB

Figure 2

Note: The share of deposits of PSBs is being measured on the secondary axis.

29

Return on total assets

-0.40-0.30-0.20-0.100.000.100.200.300.400.500.60

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00

Financial year

Perc

ent

PSB OPvSB NPvSB FB

Figure 3

30

Figure 4

Net interest margin as percent of total assets

00.5

11.5

22.5

33.5

44.5

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00

Financial year

Perc

ent

PSB OPvSB NPvSB FB

31

Figure 5

Operating cost as percent of total assets

0.000.501.001.502.002.503.003.504.00

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00

Financial year

Perc

ent

PSB OPvSB NPvSB FB

32

Figure 6

Intermediation cost as percent of total assets

00.5

11.5

22.5

33.5

4

1991-92 1996-97 1997-98 1998-99 1999-00

Financial year

Perc

ent

PSB PvSB FB

33

Figure 7

Net non-performing assets

0

500

1000

1500

2000

2500

3000

1994-95 1995-96 1996-97 1997-98 1998-99 1999-00

Financial year

Rup

ee c

rore

0

5000

10000

15000

20000

25000

30000

Rup

ee c

rore

OPvSB NPvSB FB NBFC PSB

Note: The volume of NPAs of PSBs is being measured on the secondary axis.

34

Figure 8

Non performing assets of public sector banks

0

5

10

15

20

25

30

1994 1998 1999 2000

Financial year

Num

ber o

f ban

ks

MT20 10-TO-20 LT10

Note: MT20 : more than 20 percent 10-TO-20 : 10 – 20 percent LT10 : less than 10 percent

35