Banking reform in India has entered a difficult phase.
Much was achieved in the first seven years: international rules on bank capital, classification and provision for bad loans were introduced; interest rates were deregulated; half a dozen state banks are listed on the stock exchange and their dominance is being challenged by new private banks and mutual funds.
Yet Indian banks, particularly state-owned ones, are weighed down by too many employees with poor risk-taking skills, belligerent unions and a legal system that gives them few rights. Their managers are not free to take commercial decisions and are unaccountable, perpetuating poor performance.
Removing these constraints will mean taking on the powerful and entrenched vested interests, such as the trade unions and wilful defaulters, and replacing poor managers of these banks. Yet ignoring them will entail crippling costs.
According to the central bank, 27 state banks owned 81 per cent of total bank assets and earned 70 per cent of total profits; 44 foreign banks owned 8 per cent of assets but contributed 15 per cent to profits; and 34 Indian private banks owned 11 per cent of assets and earned 15 per cent of profits at the end of March 1999.
This year loan growth was robust at more than 17 per cent while deposit growth slowed down. Indian banks are expected to post better profits than last year, when profits were clipped by 4 per cent because of a slowdown in manufacturing.
The government faces an obvious dilemma with the state banks: it is reluctant to let go completely, partly because they finance a large part of its deficit, but the more dole-outs the banks need, the faster its deficit rises, eventually sapping its own strength through interest costs. In his budget speech in February, finance minister Yashwant Sinha struck an uneasy compromise.
The state banks would sell new shares, letting the government’s ownership go down to 33 per cent (from more than 51 per cent now), a demand put forward by a bank reform committee two years ago. But he ruled out the induction of any strategic partner to help run these banks and comforted their restive unions by asserting that no state bank will be closed down. Far from indicating a renewed zeal for reform, this is an admission that the banks need new capital and the government cannot give it to them.
The governor of the Reserve Bank of India (central bank), Bimal Jalan, told bankers as much in January. “When higher and higher capital will be required, the question of government ownership of banks and the percentage of this ownership will come to the forefront. Even if the economy grows at the current rate and the capital adequacy norms are at the same level as at present, banks, barring of course the three weak banks, will require fresh capital worth Rs100bn ($2bn) in the next five years or so while the current headroom available to banks is Rs10bn.”
The political uncertainty that has delayed their corporatisation may have cost the banks and the government dear. Five years ago shares in profitable state banks were much sought after. Today they languish, making it more expensive for them to raise capital. In March several banks rushed to issue Tier II bonds to meet a central bank directive, hiking their capital to risk-weighted asset ratio to 9 per cent from 8 per cent.
State Bank of India, the largest commercial bank, issued bonds worth Rs10bn. G Vaidya, chairman of SBI, says: “This is a stop-gap measure to meet an internal decision to keep the capital ratio at above 12 per cent. The bank plans to sell global depository receipts later this year.” In contrast, professionally-managed private banks, such as HDFC Bank and ICICI Bank, set up to showcase economic reforms in the mid-1990s, are flush with capital.
HDFC Bank, which quotes at the highest price-to-earnings ratio among Indian banks, merged with Times Bank this year, making it the biggest private bank. Aditya Puri, managing director of HDFC Bank, says: “We don’t need capital for the next 18 months or so.” ICICI Bank sold shares worth $175m by listing on the New York Stock Exchange in March this year.
This war chest will, among other things, help it to buy other banks if it needs to. Unless the government improves the perception of investors by letting them go, its shares in state banks will soon be worthless. It has promised an autonomy package, although the details are still unclear, and has asked state banks to submit proposals to retire some of their employees.
The three weak state banks – United Commercial Bank, Indian Bank and United Bank of India – will find it hard to obtain any further dole. While the finance minister’s assertion that they will not be closed must have been music to their ears, he did not recapitalise them in March this year, reportedly insisting on an explicit restructuring package. The government’s representatives on their boards recently held that the banks would not pay their employees the wage rise the industry unions negotiated with the Indian Banks Association (IBA), an industry organisation, in March.
This has provoked the unions to declare a strike and a showdown seems inevitable. Addressing bankers in Mumbai recently, the finance minister asked them to get tough with wilful defaulters and promised to set up a financial restructuring authority and new loans recovery courts and bring in laws that will help them enforce their rights. At the same meeting, Pannir Selvam, chairman of the IBA, said the Board for Industrial and Financial Reconstruction – a refuge for sick companies misused by wilful defaulters to keep banks from recovering their dues – should be abolished, otherwise bad loans would double in two years.
It is common knowledge that some large defaulters hold banks to ransom and cracking down on them will not be easy. Recently SBI, HDFC, the biggest mortgage bank, and rating agency Duff & Phelps announced they would set up a credit information bureau. It is not just taxpayers but the economy that pays the cost.
To be able to lift GDP growth to around 7–8 per cent, real interest rates in India must fall. Inflation has fallen to less than 4 per cent, largely due to a fall in import tariffs and productivity gains in the manufacturing sector. But the government’s high borrowing costs and the high intermediation costs of state banks keep interest rates high. It also encourages better borrowers to access the capital markets directly.
Fast-growing private bond funds are quick to snap up good credits. As a result banks are losing a good chunk of deposits as well as borrowers. On April 1, the central bank cut key interest rates and the cash reserve ratio by one percentage point. A few banks cut lending rates but clearly the pressure on margins is growing.
Private banks such as HDFC were quick to adapt. The bank spotted opportunities in fee-based businesses and leveraged its technology shrewdly to sell services to stockbrokers, stock exchanges and small co-operative banks. Both HDFC and ICICI have emerged as leaders in Internet banking, using it to rope in expatriate Indian clients and link up corporate customers with their suppliers.
Ramesh Sobti, head of ABN Amro, says: “We have diversified our portfolio to include capital market-related products. As Indian companies have turned to local debt markets in a big way, we are there to advise, arrange and lend.” ABN Amro has emerged as one of the largest arrangers of structured finance for Indian companies, competing with investment banks such as DSP-Merrill Lynch.
Besides, it has a primary dealer licence to trade in government securities, a strong custody business with assets of $1.5bn and is the second largest importer of gold since the government allowed banks to trade the commodity. It plans to beef up its retail business, acquired from Bank of America, and hopes it will contribute around 30 per cent of profits in a few years, up from 15 per cent today. Not all private or foreign banks have done as well, however.
A central bank report said of the 44 foreign banks in India just four – Citibank, ANZ Grindlays, Bank of America and Standard Chartered – accounted for more than half of foreign banks’ assets and 87 per cent of their profits.
Even among the nine high-profile, new, private banks some, such as IndusInd and UTI Bank, made mistakes – the former went in for large, high-cost forex deposits and the latter was hit by a large loan default – which have slowed their growth. Indian banks need internal reform that requires changing processes, managers and the way they do business.
Much depends on how quickly the state banks are rid of the government’s crutches. Pressure to do that is building and soon something will have to give.
