One of the statutory publications of the Reserve Bank of India, the Trend and Progress of Banking, has the most authentic statement on Indian banking covering a specified period. The most recent one released on November 14 covers the period July 1, 2010 to June 30, 2011. On the face of it, the report might appear dated even on the date of its release.
However, its value as a source of contemporary data is in no way diminished as it deals with issues and banking sector problems of more recent periods.
Besides, reports such as these look at the future also and it is these portions that considerably add to its value.
For a bird's eye view on Indian banking, one need not go beyond Chapter I, which deals with perspectives. Having acquitted themselves creditably during the global financial crisis, domestic banks have continued to manage growth with resilience during 2010-11, “with ample reserves of capital and liquidity, improved performance in profitability and asset quality.''
One of the many strengths banks have is the opportunity to expand their business — traditional as well as new — in a high growth economy. However, the prevailing interest rate environment and their disproportionately large exposures to certain interest rate sensitive sectors such as real estate pose significant risks even in the near term.
In the run up to Basel III, banks need to mop up large capital and liquidity.
Pursuit of financial inclusion through appropriate business models is another challenge.
Finally, their endeavour to converge with the International Financial Reporting Standards (IFRS) needs to be backed up with adequate infrastructure, including technology and human resources.
Lurking vulnerability
Extensive studies conducted by the RBI, using sophisticated techniques, reveal a high degree of interconnectedness among Indian banks. This can make the system vulnerable in the event of failure of one or more banks depending on the degree of interaction.
Regulatory curbs on interbank exposures have helped containing the risks. But if non-banks are included in the analysis, the risks become greater.
Financial conglomerates in India, now led by banks and organised under the bank subsidiary model, are being encouraged to adopt the holding company model. According to an RBI-appointed working group, necessary incentives will have to be given and a proper regulatory and legal environment created to encourage the migration to the holding company pattern, which is less susceptible to operational risks.
Innovative financial products have been introduced in India to manage the risks in an efficient way. CDS (Credit default swaps) introduced in October is one such product. However, given its complex nature, the RBI has permitted CDS selectively (on listed corporate bonds and unlisted but rated bonds of infrastructure companies). Market participants will have to build a robust system of risk management.
Troublesome NPAs
Management of asset quality is a key task. Despite gross NPAs (non-performing assests) declining steadily from 15.70 per cent in end March, 1977, to 2.25 per cent in March, 2011, there are areas of concern.
Some recent trends can put pressure on the asset quality of banks. Notably, aggressive lending during the high growth phase has resulted in slippages. Recoveries have not kept pace with slippages. Besides, in a fast changing interest rate environment the possibility of a slippage in asset quality is real.
Challenges before banks
To sustain high and inclusive growth of recent times, there is a need to raise the level of domestic savings and channel these savings into investment.
It follows that banks have to offer more interest to their depositors and lower the rate they charge on their loans. The key issue, therefore, is to reduce the net interest margin (NIM), which is high in India compared to some other emerging markets.
The most important task is to further improve the operating efficiency on top of what has already been achieved by optimising the operating costs, that is, non-interest expenses including wages and salaries, transaction costs and provisioning expenses. This will enable banks to lower their lending rates without compromising on profitability.
If pursued effectively, financial inclusion will provide banks accessible to sizable low cost funds as also opportunities for lending to the small volume segment.
A major challenge of the next decade is financing millions in the unorganised sector, self-employed in the micro and small business sector, small and marginal farmers, as also rural share-croppers in the agricultural sector. Other challenges include financing affordable housing and education needs of low income households.
Looking ahead
The RBI report is optimistic about the future. There are enough opportunities to grow but banks will have to reckon with several key challenges. Globalisation, deregulation and diversification and consolidation of the financial system are all unstoppable forces, which will make banking more complex as well as riskier. The banking sector has become intricately linked to financial markets and, hence, more vulnerable to financial market stress.
Over the medium-term, to take full advantage of the opportunities while simultaneously addressing the new challenges, the process of institutional strengthening assumes critical importance. Banks need to be guided by four principles — efficiency, stability, transparency and inclusion.
Over the long-term, they need to focus on growth through inclusion, innovation and diversification while complying with domestic regulations and internalising international best practices.
