CIAO DATE: 8/01

Where Did India Miss a Turn in Banking Reform? Is there a comeback?

Pradeep Raje

CASI Working Paper
December 2000

Center for the Advanced Study of India

 

Introduction

A decade into financial sector liberalization ₁ , there has been little concerted effort at restructuring ₂ the Indian public sector banks ₃ (PSBs). Though there has been significant progress in banking regulatory reform in the decade, the lack of restructuring has slowed down the assimilation of the incentive structures inherent in the new regulations.

As a consequence, profitability and viability of the PSBs are still below global standards and even the median values within the Indian banking industry. (See Tables I and II) Intermediation costs are high, resulting in sticky and high nominal lending interest rates, to the point where a weak banking system has become a drag on the economy.

The fact that there have been no instances of systemic crises, contagion, bank nationalization post-liberalization, bank closures or bank runs, the usual hallmarks of banking crises (Demirguc-Kunt and Detragiache, 1997) should not divert attention from the fragility in the Indian banking system, especially since the PSBs command more than 80 percent market share of total assets in the banking sector.

Problems remain in terms of unresolved non-performing loans, poor management skills, continued distress and volatile operating performance from year to year. One state-owned bank has reported a net worth of minus eight percent for the financial year ended March 1999 and still continues to be in operation.

This paper is an enquiry into where India missed a turn in banking sector reform. This follows the conceptual tradition in Caprio (1996) who raised the issue of "widespread disappointment with (banking) reform" in African and transition economies. His key point is that disappointment with reform follows because incentive structures promoted by regulatory reform are not attuned to both institutions and the structure of the economy. This paper argues that Indian banking sector reform has been slowóto the point of disappointment in some quarters (Callen 1998)óbecause authorities failed to realize the importance of bank restructuring issues.

A secondary concern in this paper is to examine the regulatory and supervisory initiatives in recent years. Specifically, we report that regulatory and supervisory activism is trying to fill the void left by a lack of genuine bank restructuring. To the extent supervisory concerns are based on the least common denominator principle, that is, taking the weakest banks along, the efficiency of supervision is compromised.

We argue India missed not one but two turns on the bank reform road. The first missed turn came at the beginning of the reform process, when regulatory reform was considered to be synonymous with bank restructuring. With the characteristic vigor of a neo-liberalizing economy, India implemented a full set of regulatory measures designed to bring the country at par with global standards. Uniform and transparent accounting policies, however, exposed the embedded insolvency in the system.

The second missed turn came in the way Indian authorities responded to the exposure. Instead of addressing systemic issues, the apparent insolvency was treated as endogenous; that is, the result of imposing regulatory reform in preceding years. In a way, this turn reinforced the presumptions in the first turn: that a robust regulatory system alone should suffice to carry the banking system to health.

We further argue the missed turns may not have been intentional, but the result of a complex dynamics. First, post-currency crisis dynamics impose their own constraints on the leeway available to banking authorities. Second, the apparent lack of sensitivity on restructuring issues was consistent with the belief that the end of financial repression embodied in the rest of bank regulatory reform, as the McKinnon (1973) and Shaw (1973) thesis noted, was supposed to be earnings positive for the banks. It was expected the rejuvenated income streams would automatically address the issue of weak and bankrupt banks.

Chapter I lays the framework for the distinction between regulatory reform and restructuring. The two missed turns are illustrated and the consequences in terms of performance parameters are noted.

Chapter II analyzes how a post-currency crisis scenario puts an initial set of constraints on bank restructuring. Essentially, the wider reform process that follows a currency crisis is directed at stability and containment of the disruptions. Since bank restructuring is by definition a disruptive process, in the sense that it seeks changes in established relationships between owners, creditors, depositors and regulators, the de-emphasis on restructuring is calculated. This inherently sets in motion a perverse dynamics.

Once the reform process is underway, the perverse dynamics are reinforced due to the varying speed of reform in the banking sector and the rest of the economy. Chapter III explores this in detail, and points out that the Indian authorities' options (were) are limited. Chapter IV takes up the issue of how regulatory and supervisory activism fills in the void created by lack of restructuring. It examines the limits of such activism, and argues that though there may be significant gains from this model, it cannot replace restructuring. Chapter V concludes.

This paper expects to make two contributions to the theoretical literature on banking reform. First, by extending the 'Missing Model' of Caprio (1996), this paper asserts that even "appropriate" regulatory reform may not be a sufficient condition for reform success. A necessary condition is that banks be restructured, at the same time as reforms are implemented. A delay in restructuring the banks may create a perverse sequence of reforms that Caprio, Atiyas and Hanson (1994) found at the root of botched reform attempts.

The second contribution is to point out that reform content and pace, as also the post-reform dynamics are conditioned by the starting processes. I suggest that banking sector reform that follows a banking crisis is different from reform that follows a balance of payments or even internal fiscal crises.

Regulatory Reform vs. Restructuring

Restructuring, in our framework, is defined as equipping banks with the coping mechanisms to work the revised incentive structures, implicit in regulatory reform, into efficient and viable business models. Regulatory reform and restructuring have intersecting dimensions, but the critical difference lies in the agent driving the change.

To illustrate, though restructuring would include freeing banks of excessive external and internal constraints, in a manner that would enable them to increase the allocative efficiency of resources, a downward revision in statutory pre-emptions would qualify as regulatory reform. Improving banks' ability to put the resources released from the cuts to productive use would be restructuring.

Essentially, while regulatory reform attempts to set new incentive structures for banks to perform in a more prudent manner, and thereby pushes banks in a particular direction, restructuring processes are expected to enhance banks' ability to pull along.

Hawkins and Turner (1999, pp14-40), reviewing the restructuring practices in 18 countries in the 1970s to 90s, note "a diversity of possible approaches...The nature of the underlying causes may have an important bearing on the optimal official response." The appropriateness of competing solutions depends critically on the correct identification of the causes of unfolding banking difficulties. Although usually mixed in practice, several distinct causes can be identified, at least in theory. A vast literature has emerged on the proximate and underlying causes of bank crises. See Kaminsky and Rheinhart (1996a), Demirc¸g-Kunt and Detraigche (1997, 1998), Caprio and Klingbeil (1996, 1997). Calomiris and Gorton (1991), and Kaminsky and Rheinhart (1996a) provide excellent surveys.

What is most important is that regulatory reform alone has a slim chance of success unless accompanied by restructuring the system. Dziobek and Pazarbasioglue (1997) survey the success ratio of countries that used different instruments in the restructuring effort. As there is no unique way to measure the success of reform, they attempt a summary measure of relative progress in resolving banking sector crises.

The findings are interesting because they reinforce our conceptual division of regulatory reform versus restructuring. The Indian experience is quite in conformity with their survey ₄ (Table 5) where they find slow progress (as defined in their summary measure) is directly linked to the instrument mix used. "All of the slow progress countries made extensive use of central bank instruments; in all of these countries, the central bank was the only agency responsible for bank restructuring," (pp. 14).

On the other hand, countries that were most successful in their systemic restructuring operations had a limited role for the central bank as the sole agency for restructuring and provider of liquidity support. "In particular, the authorities that achieved the best results determined at an early stage that the problem was bank insolvency, not lack of liquidity, and they precluded extensive use of lender of last resort facilities" (ibid.).

I now turn to illustrating the two turns where Indian authorities missed the critical difference between reform and restructuring.

 

Chapter 1

Two Missed Turns

The fact that allocative efficiency of the banking sector hinges critically on its own operational efficiency did not fit into the early reform framework. The first wrong turn was in considering restructuring issues to be a subset of regulatory reform. This corresponds to the assumption that complying with regulatory best practices alone would ensure the health and stability of the banks.

The post-1991 Indian reform process is a large, often disjointed, collection of several smaller processes. The relative emphasis on the smaller processes differs, depending on where they plug into the larger process. The key to understanding what happened (or did not happen) is to realize that banking in India was never treated as an independent system, but only as a smaller, facilitative clog in the larger system.

Prior to 1991, the banking system was a part of the government's fiscal operations. 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. Industrial demand for credit was suppressed through elaborately disguised credit rationing. There was, therefore, no competition for resources. Industry was forced into submission as price takers. It was subsidizing the government, compared to other borrowers who were paying concessional rates of interest because they happened to figure in one of the government's many priority lists.

Banks were not autonomous profit-seeking entities, but operated, to a greater or lesser extent, as a quasi-fiscal mechanism, differing from the budget chiefly in the degree to which the funds employed can circulate rather than being an out-and-out grant (Hanohan 1997).

The overall reform package was aimed at enhancing the productivity and efficiency of the economy as a whole and also increasing international competitiveness (Rangarajan 1998). And banking sector reforms fitted in because

Structural reforms in areas such as industrial and trade policy can succeed only if resources are re-deployed towards more efficient producers who are encouraged to expand under the new policies. The reforms in the banking sector and in the capital markets are aimed precisely at achieving this primary objective (ibid.).

Thus, reforms only switched the roles of government and industry as prime end-users, but failed to equip the intermediary. Industry became the price maker, both by virtue of policy and the increased demand. But industry is composed of diverse agents, across a broad spectrum of risk. Allocative efficiency towards more efficient producers meant differential interest rates. Hence, the interest rate deregulation.

Government became the price taker in the deregulated scenario, bidding in the open market for the same pool of resources as industry. But what was profound was that the banking sector continued to be treated like a sub-system.

There is one possible reason for this lack of sensitivity: that the true state of banking sector health was never known earlier.

No Warning Signs

For one, the lack of the true picture of balance sheets may have meant a lack of recognition of the problems within. Until 1992-93, income recognition norms allowed banks to book interest earned but not paid as interest into their working profits. So quarter upon quarter, the asset side of the books would grow by the amount of interest, suggesting healthy growth. And interest earned would go into the profit figures, even though no money was received in payment.

Also, banks had to make provisions for non-performing loans that were defined in a narrow way. Unless the loan was already contested in court, loan loss assessments were purely subjective. Both ways, banks were reporting their version of the truth. Since banks were not required to make many disclosures, no one had reasons to believe otherwise. Even if they did, they couldn't lay their hands on any proof.

Secondly, the administered rate system worked on cost-plus pricing. The Reserve Bank worked out the lending and deposit rate structure to ensure that banks got a decent spread for their operations.

Thirdly, there was no competition in the product or the services markets. Almost all public sector banks were dishing out the same menu of products, at almost the same level of service. Service was also priced uniformly. So it did not make a difference to the customer what board hung outside the bank. In such homogeneity, efficiency becomes a rootless concept: measured against what? The foreign banks were restricted to the metro townships, and given their focus of top tier clients, they were not competition for the nationalized banks.

Fourth, the system hadn't been subjected to a shock. As happened in South East Asia in the post 1997 period, it often takes an external shock to expose the inefficiencies of the banking system.

Finally, explicit and implicit guarantees, along with government ownership, made any concept of efficiency redundant. Ownership, by itself, has no bearing on efficiency. But since the government seems to have treated banks as an extension of its own selfóas instruments of social justiceóit never sought economic returns.

The beginning of reforms changed this situation in two ways. The government started acknowledging banks as independent economic entities. And since financial reforms coincided with the implementation of capital adequacy norms, government was brought into play since it had to replenish the capital of nationalized banks. This seems to add an economic logic to statements of intent that banks would have to be internally viable and sustainable.

The Impact of Early Reform

Implementation of uniform and transparent accounting practices exposed the fragility of the system in terms of the bad loan problem and lack of profitability. According to the two ways in the literature of assessing the extent of banking crises, India had a crisis of systemic proportions between 1991-94.

One line of objective assessment follows Demirc¸g-Kunt and Detriagche (1998) who study the empirical relationship between banking crises and financial liberalization in a panel of 53 countries for the period 1980-95. They report banking crises are more likely to occur in liberalized financial systems and investigate the channels of transmission of banking sector fragility, post-liberalization.

Using primarily two studies, Caprio and Klingebiel (1996), and Lindgren, Garcia, and Saal (1996), Demirc¸g-Kunt and Detriagche classify an episode of distress as a full-fledged crisis if at least one of the following conditions apply:

i. The ratio of non-performing assets to total assets in the banking system exceeds ten percent;

ii. The cost of the rescue operation is at least two percent of GDP;

iii. Banking sector problems result in a large scale nationalization of banks;

iv. Extensive bank runs took place or emergency measures such as deposit freezes, prolonged bank holidays, or generalized deposit guarantees were enacted by the government in response to the crisis.

The banking sector distress never took the form of conditions (iii) and (iv), and the cost of the rescue operation of the Indian PSBs, condition (ii), is also not satisfied. Table IV reports cumulative recapitalization costs as percentage of GDP, and the maximum cost at any point does not exceed 1.6 percent of GDP (in 1997-98). But the ratio of non-performing assets to total assets in the banking system was much higher than the benchmark ten percent until about 1994-95, satisfying condition (i).

Full details of the recapitalization of Indian nationalized banks since 1993 are reported in Table V. Here, it would suffice to note that the Indian government pumped in as much as Rs 16,446.12 crore ₅ in the post-restructuring period, 1993-1999 ₆ . The total amount of capital infusion is Rs 20, 446 crore, including Rs 4,000 crore injected prior up to 1993 (RBI, 1993, para 7.12). The table shows that some banks had to resort to repeated doses of capital infusion to achieve the capital adequacy requirements, and to provide for loan loss provisioning.

Data on stock of non-performing assets (NPAs) prior to 1995-96 has not been released. The first mention of NPA stock is in the Reserve Bank Annual Report 1995-96 (para 7.35) which notes: "NPAs of all PSBs came down from 24.8 percent of their total advances as at end of March 1994 to a little below 20 percent as at end of March 1995." Assuming constant advances to total assets ratio of 0.41 ₇ , this implies the NPA to total assets ratio declined from 10.17 percent at end of March 1994 to a little below 8 percent by March 1995. Table III reports the movements in gross and net NPAs, as a ratio to total assets and total advances. Thus, India qualified as a banking crisis country based on the NPA condition.

The second line of objective assessment follows Caprio and Klingbeil (1996) who define ₈ a bank crisis pegged to a systemic non-performing loan problem, and list India as having "major bank insolvencies bordering on the systemic crisis" situation.

Their rationale is that a banking problem should be considered systemic when the banking system is insolvent: that is, if loan losses are sufficient to wipe out the system's capital. Caprio & Klingbeil further argue that even if the banking system is overtly solvent, the magnitude of the bad loan problem would indicate the distress in the industry.

For instance, they say, during the 1980s the capital in many developing country banks was less than five percent of assets. "Under these circumstances, if the non performing loans, net of provisions were ten percent of assets and banks collected 50 percent of these loans, then losses would be sufficient to wipe out the banking system's capital."

The Caprio and Klingbeil definition and framework is intuitively appealing since its focus is not so much on concrete events like a bank going bust, but on the silent dynamics within the banking systems. The definition admits of events that have all the signs of insolvency (narrowly defined as elimination of capital), yet with no outward manifestations of a spectacular crisis. "Financial distress of the banking system, when a significant portion of the system is insolvent but remains open, is perhaps the pernicious type of insolvency"(ibid.). As we will show later, this is an apt rendering on the kind of financial distress in the Indian banking industry.

Data on capital, reserves and net worth along with gross and net non performing assets of all bank groups are included in Table VI. Based on the Caprio and Klingbeil assumption that 50 percent of the gross non performing loans are realized, the resulting write off would deplete 62 percent of the net worth (capital and reserves) of public sector banks as at end of March 1999, up from 56 percent at end March 1998. Working with reported net non-performing loan levels ₉ , the level of capital depletion is 28.92 percent at end March 1999, as against 26 percent in the previous year.

As a further word of caution, Caprio and Klingbeil note "estimates of non performing loans are usually biased downward, suggesting that the definition of systemic crises is quite conservative," and add the caveat that the reported level on NPAs are always understated. Therefore, the final tab on capital may be higher. We add two more caveats in the Indian context:

i. The level of net NPAs is grossly underestimated as it takes into account collateral securities and promoter guarantees. With the delays in the Indian legal system, weaknesses in contract enforcement and bankruptcy laws, the realizable value of collateral securities is perhaps much lower than the stated book values. The realizable component of the loans is overstated, thus depressing the recognized value of the NPL.

ii. Second, Indian regulatory requirements are weaker than OECD norms in at least two respects. An asset is qualified as non-performing only if it has not serviced interest and principal in two consecutive quarters of a year (6 months), as against the global norm of one quarter (3 months). See Hawkins and Turner 1999 for a comparison. And, small loans (below Rs 25,000) are not subject to account-wise recognition and provisioning. Given the large number of accounts that would make individual asset recognition an accounting nightmare, the Reserve Bank decided to apply a summary provisioning norm ₁₀ on the total amount outstanding in small loans.

The two assessments above suggest that though the PSBs were overtly solvent, the implementation of regulatory standards uncovered a systemic crisis-like situation in the PSBs. According to the Caprio-Klingbeil assessment, the PSBs are still in a crisis situation, with 62 percent of their net worth depleted as at end of March 1999, though the crisis is not as severe as to be systemic.

The above assessments of the impact of regulatory reform must be qualified as the bad loan data pertains to an indefinite number of past years. Prior to reforms in 1991, bank balance sheets revealed little on the health of banks. There was no uniformity in accounting policies; income not earned was taken on the income and expenses statements. The former issue was addressed in 1991 ₁₁ . Income recognition norms, provisioning and asset classification norms were implemented in phases beginning 1992.

Second Missed Turn

The second missed turn came in the way the authorities responded to the emerging situation. Instead of addressing systemic issues, the bad loan and strained capital problem was treated as strictly endogenous, the outcome of regulatory changes. It was expected the problem would disappear with the progressive end of financial repression, in line with the McKinnon (1973) and Shaw (1973) theses. This diagnosis was reflected in the choice of restructuring instruments.

The burgeoning stock of NPAs was not considered to be a particularly shocking development, since it was only an overt recognition of a problem that had been dormant for decades.

Reforms were expected to lead to increased credit flows: banks' balance sheets would outgrow the stock of NPAs; the NPA to total assets ratio would shrink. Improved credit worthiness of businesses, recharged by the reforms, would ensure quality earnings in future and limited growth in NPAs. Increased earnings would be ploughed back into cleaning up the balance sheets.

But this model did not incorporate internal operational efficiency of banks themselves. This probably explains why restructuring received a low priority. The theoretical argument explains why recapitalization was the principal restructuring instrument ₁₂ used.

Capital infusion (new equity) amounts to writing off the capital invested earlier. In theoretical terms, it satisfies the condition that existing equity owners (the government, in this case) must first bear the loss when a bank goes bankrupt. It also means an immediate access to fresh equity to tide over solvency issues.

Though new equity is one of the first-defense instruments in bank restructuring ₁₃ , its efficacy depends on the incentives it seeks to promote. If the new equity is pegged to strong incentives to banks to change their working procedures, the effect will be markedly different from the case where it is a no-questions-asked attempt to shore up the balance sheet.

In the Indian case, capital infusion was tied to ambiguous and asymmetric incentives. For example, the Memorandum of Understanding approach (where the regulatory authority and the bank management would agree to a charter on minimum performance benchmarks for the coming year) initiated in 1993-94, was pegged to added benefits if the bank met the criteria, not to negative caveats if it failed. Not unsurprisingly, the rate of slippage was high. By 1996, the central bank was forced to threaten penalties if banks failed to deliver on the agreed benchmarks, but no action was subsequently taken ₁₄ .

Since the government rescue was not strictly conditional on performance, it further weakened the bank's internal incentive structures. As Hawkins and Turner (1999) note: "Any government rescue can weaken a private institution's sense of responsibility for its own actions. It is therefore important that the terms of any rescue or bailout should not encourage irresponsible behavior in the future." The conditions were almost immaterial as government was expected to fund future depletions, out of both moral obligation as sole equity owners, and to ensure stability in the banking system.

To an extent, even capital infusion in India fails the test of a good restructuring instrument. The Narasimham Committee's (1991) recommendation on limiting the geographical reach of banks ₁₅ , and thereby their business ambit was never considered by the government. Bank mergers, too, were not considered explicitly as there was significant confusion on the objectives. There is little point in the merger of two or more banks, virtually indistinguishable from each other in all respects, if it does not lead to cost cutting and reduction in overlapping businesses. There are no efficiency gains, either. Without corresponding reforms in the real sector, as those pertaining to labor laws, mergers in isolation would have served no purpose.

Takeover by foreign banks is one model that has been successfully used in many countries. But this course was not available as the government clearly stated that it was not parting with management control even if it was selling equity in the nationalized banks ₁₆ .

Focus on Regulatory Compliance

The second (mis)diagnosis of the problem seems to have been further clouded by confusion about the purpose of regulatory reform and the government's role as owner of banks. This was at the same time as banks started reporting huge losses (1994-95). Though the central bank realized the imposition of regulatory standards was only the first step, the confusion arose on the steps to follow. There was promise of restructuring but uncertainty on how it should be accomplished.

Restructuring issues were further subsumed into the regulatory processes as the central bank visualized a limited role for owners and a greater onus on the regulatory system. As Dziobek and Pazarbasioglu (1997) point out, the extent of central bank involvement was limited in countries with a successful record of restructuring. Countries where the central bank continued to oversee restructuring had poor records. In the Indian case, the regulator took upon itself the task of recasting the incentive structures through regulatory reform. The limits to such activism are discussed later in Chapter IV.

...A number of steps have been taken to improve the financial health of the banks. The introduction of prudential norms-norms relating to income recognition and asset classification and capital adequacy are important steps which were overdue . These norms basically serve two purposes. First, they ensure that the balance sheets and the income and expenditure statements provide a true reflection of the health of banks. Unless you know what the true health is, you cannot prescribe appropriate medicine... The government has done its part by injecting more capital into banks, enabling them to conform to capital adequacy standards " (Rangarajan, 1994, emphasis added).

This statement provides an important insight into the minds of the regulator and the government. It tells us, first, of a realization that the implementation of prudential norms was nothing special; it was overdue in any case. Banks, internationally, had moved on to the Basle Accord 8 percent rule as early as in 1988, though the rule was supposed to be applicable only to OECD countries in the first phase. Staying out of a global benchmark would have imposed costs on domestic banks and corporates. The implementation of the Accord rules was not only overdue, it was unavoidable.

Secondly, it tells of the underlying process: that the norms were to help determine the true health of the system. Third, there is a vague promise of "an appropriate medicine" once the true state of banks had been determined.

The role of government is outlined clearly. Its role is said to be limited to injecting more capital into banks, as a one-time grant to enable them to meet capital adequacy standards. That is, the government's (as owners) role was limited to ensuring mechanical compliance with prudential benchmarks.

That is one of the turning points in the whole debate. Restructuring became irrelevant to the extent of being subsumed in the regulatory process. Instead of repairing the clocks for various malfunctions, the Indian approach was to restore all clocks to a uniform 12 o'clock: That is, replenish their capital to the minimum regulatory standards.

Even assuming that regulatory compliance with capital adequacy norms was the be-all and end-all of the banking reform agenda, there seems to have been a grave misunderstanding of the scope and context of the prudential norms. The Bank of International Settlements (BIS) did not intend the 8 percent capital adequacy norms to be a static concept. The stipulation of a minimum capital to risk-weighted asset ratio was to be complemented by a policy of intervention if the ratio fell below the minimum for a particular bank (Sen and Vaidya, 1997). The policy of intervention could be either to sell or liquidate a particular bank or ask the shareholders to replenish the capital base.

Dewatripont and Tirole (1994) argue that a dynamic policy of intervention is essential if capital adequacy norms are to have the right incentive effect. The argument is that a call for additional capital from shareholders acts as a disincentive to the shareholders to take on more risk and counters the tendency of the management to "go for broke" (go in for riskier investments, hoping that the profits would redeem the situation). The crux of the argument is that existing shareholders begin to exert great influence over management decisions.

But in India, the annual "no-questions asked" recapitalization exercises defeated the incentive structure in capital adequacy norms. Recapitalization became an end in itself. In fact, the reform ideology of avoiding interference in management of government-owned entities justified the government not taking any position relative to banks.

Government's role ended with restoring the capital base of banks. Regulators were supposed to take care of the rest, including asking management all the uncomfortable questions that shareholders should ideally be asking. This comes closest to a situation of complete abdication of shareholder responsibility.

Further proof of abdication of this responsibility can be gleaned from the annual memorandums of understanding (MoU) approach to corporate planning introduced in 1992-93. At a follow-up discussion after his presidential address at the 14 ^th Bank Economists' Conference, the central bank governor said:

The MoU with the RBI is truly the corporate plan of banks. It is part of the banks' own effort to improve the situations prevailing in the bank. It only spells out what banks intend to doólike committing oneself to an external authority--so that it imposes a greater sense of discipline to achieve targets. (Rangarajan, 1994, p17)

But the MoUs (or corporate plans) were to be signed between the banks and the Reserve Bank (as regulator), not the government as principal body of equity owners. Annual MoUs between the RBI and the 27 nationalized banks were introduced in 1993, which set out certain performance criteria to be met during the coming year. These covered profitability, internal controls, modernization, capital adequacy, non-performing loans, and business growth (Callen, 1998). It is not difficult to see that these are principally issues of concern to shareholders. Instead, the task was delegated to the Reserve Bank, as regulators. This completes the picture where restructuring issues were not considered the shareholder's concern, the assumption being that regulatory reform and regulators alone could effect the desired changes.

Rangarajan referred to the discipline of subjecting oneself to an external authority. But a closer reading suggests little disciplinary content in the MoU approach. Banks were not penalized for failing to meet with the specified targets, unlike in a corporate scenario where shareholders take the management to task for failing targets. There was no stick; instead, there was only an enticing carrot: Banks that met the performance criteria were given more autonomy in their internal administration and recruitment. The asymmetric nature of the so-called discipline effectively scuttled the last chance of bank management being held accountable for their actions.

The MoU concept became an annual exercise in budgeting, without commensurate tracking of achievements. Over time, it was diluted. Budget 1998 repackaged the concept as an autonomy package for PSBs that met certain performance benchmarks like capital adequacy over nine percent, non performing loans of less than ten percent, a three-year profit record etc. That the incentive structure is asymmetric (does not penalize the laggards) should be obvious in that as of March 1999, only 17 of the 27 public sector banks qualified for autonomous status (RBI, Annual Report, 2000, para 1.27)!

Second Phase of Reforms

By late 1996, after the capital adequacy and related norms had been implemented in full, banks and regulators started speaking of the "Second phase of reforms ₁₇ ", the implicit understanding being that creating institutions and upgrading regulatory systems was the completed first phase. The then central bank governor argued for splitting the reform process conceptually into two phases (Rangarajan, 1997):

i. The first phase (1991-97) of reforms had laid the base for a sound and viable banking system.

ii. Having achieved reasonable success in the first phase ("even though we have to travel still some distance"), the second phase would create the environment for banks to operate in a corporate (deregulated) environment.

Thus, there was a significant change in the relationship between the regulator and the regulated banks, between banks and other segments of the market, and between banks and borrowers. This has progressively evolved over time. Yet, in our framework this was not restructuring. A closer reading of the second-generation reform measures suggests that the so-called empowerment of banks was only regulatory reform in a different garb.

Consider, for instance, the resource management aspect of the central bank's move from micro management to macro management. This is summarized in Reddy (1997).

In 1997-98, we have replaced credit planning discussions between the RBI and select commercial banks with resource management. In credit planning exercises, the emphasis was on allocation of resources to various sectors and areas, virtually at administered interest rates, consistent with the Plan objectives. In the resource management exercises, it is different. First, we exchange views on the asset-liability management as a whole and not merely quantitative deposit and credit aspects. Secondly, we seek qualitative assessment of the banks in terms of their own risk perceptions and internal control systems. Thirdly, we obtain the banks' views on their goals, strategies and likely scenarios of magnitudes and composition of assets/liabilities. Fourthly, together we agree not only on performance indicators but also critical parameters where significant deviations are monitored closely. Fifthly, we assure ourselves that flow of credit to priority sector is achieved. Sixthly, we take the opportunity to obtain feedback so that we in the RBI could fine tune our policies and procedures. Finally, the exercise provides an opportunity to share perceptions on state of the economy. In fact, the exercise helps us to refine our macro projections on the basis of micro-details presented by banks.

From the regulatory view, the objective of the exercise has changed; banks have been empowered. Yet, like the capital adequacy reform, these changes were an overdue minimum, barely consistent with the reform objectives. There is nothing spectacular in the reform timeline. But what queers the pitch is that the central bank had to guide banks to do what they were supposed to be doing under the deregulated regime.

Over the year 1999-00, the central bank issued detailed guidelines on internal risk management practices, covering assets and liabilities, interest rate risk and foreign exchange risk. Though banks are free to use their own models if they are more sophisticated than the base minimum, the sheer fact of the regulator setting a base minimum model for public use suggests that the entire exercise has been reduced to regulatory reform.

In the US, for example, the Federal Reserve has its own proprietary model of risk management in banks, which is kept secret. Banks are expected to have their own models, and report the outputs at specified frequencies to the regional Fed. The Fed runs the base numbers through its own model to check for divergences.

Perhaps it can be said that some regulatory support is required to help banks acclimatize to their new found freedoms. Instead of every bank having to re-invent a risk management model for itself, a uniform model could get them started earlier.

In India, the second phase of reforms (until now) has only equipped banks with the basic financial coping mechanisms to survive in a deregulated environment, but still falls short of any systemic efforts at restructuring.

A close analogy would be that reforms till now have put a complete set of equipment in a novice car driver's hands, expecting the tools alone will teach him to drive.

Limited Redressal

While systemic bank restructuring was ignored due to wrong diagnosis of the problem, limited attempts have been made at restructuring individual weak banks.

First, simultaneously with the recapitalization of the PSBs in 1992-93, capital infusion was linked to a stipulation of time bound performance criteria for each PSB. The allocations of capital were made conditional upon the banks drawing up a business restructuring plan aimed at achieving viability over the medium term of 2-3 years. Banks were to make a specific commitment that recapitalization was a sustainable operation. These commitments were formalized into agreements between the management of each of the banks receiving capital from the government, and the Reserve Bank (RBI 1994, para 1.36).

An independent assessment of this exercise cannot be made because banks were simultaneously working on different fronts. But statutory compliance seems to have become an end in itself. The Reserve Bank noted: "In this regard, the performance obligations and commitments undertaken by the nationalized banks as part of the government's recapitalization program have proved useful. All the 19 nationalized banks submitted documents containing performance obligations and commitments required on their part for 1995-96" (RBI, 1996, para 7.35).

Perhaps the central bank also realized that banks were not delivering on their commitments. The RBI was forced to stipulate penalty clauses. "The banks have been advised that non-fulfillment of commitments/obligations mentioned would attract penalty (ibid.). The penalties were never levied, perhaps because of the difficulty in isolating management failure from the economic factors impacting bank performance.

The second attempt, in 1995-96, was directed specifically at four banks identified as weak. The RBI called in four study groups consisting of outside consultants to go into the problems of four weak PSBs: Central Bank of India, Bank of Maharashtra, UCO Bank, and United Bank of India (RBI, 1996, para 1.48).

The study groups were to "draw up concrete action plans and suggest strategies for their (identified banks) turnaround. By the end of the year 1995-96, Indian Bank had reported an industry record loss of Rs 1,336.4 crore and had also been identified as a weak bank (ibid.). The consultants' reports were discussed with the bank management and the government, and implemented. Since these were technical reports that focused on the banks in isolation, taking the environment as given, banks made little gains from the implementation. Once again, the fact that the problem was systemic and needed to be treated differently was ignored.

The latest attempt follows a revival of interest in bank restructuring issues in the last two years (1999-2000), driven principally by the realization that a weak banking system is a drag on the economy and the single largest potential source of a financial crisis. The latter has much to do with the Asian crisis.

In February 1999, the Reserve Bank of India, in consultation with the union finance ministry, set up a Working Group under the chairmanship of M.S. Verma ₁₈ . It was to suggest measures for revival of weak public sector banks (emphasis added, Verma, 1999, para 1.4) though the working group itself was called the "Working Group on restructuring weak public sector banks."

The position was seconded by the union finance minister in the budget speech for 1999-2000, where he noted "A Working Group has recently been set up by us to devise appropriate strategies for dealing with the problem of restructuring weak banks including their NPAs " (Budget 1999, emphasis added).

It is clear from the above that even after a decade of banking problems, there is still lack of appreciation that revival and restructuring are not synonymous. While the finance minister referred to the latest effort as restructuring of the weak banks, the Reserve Bank of India spoke of it as a measure for the revival of public sector banks. The Working Group's report itself uses the terms interchangeably: "However, a stage has now been reached where further efforts at restructuring (emphasis added) some of these banks cannot be confined merely to infusion of capital and giving certain targets for improvement in performance. One would necessarily need to look into their ability to achieve a minimum level of competitive efficiency in order that their operations become profitable on a sustainable basis" (Verma 1999, para 1.3).

Indeed, it is clear from the terms of reference of the Working Group that its task was limited to the identification of the "potentially revivable banks," and to "suggest a strategic plan of financial, organizational and operational restructuring for weak public sector banks." That is, not only was the scope of the Working Group limited to the weak banks identified by it, its charter was limited to suggesting revival packages.

Thus, it was never intended to be an exercise in restructuring the banking industry as a whole. The problem of other distressed banks was out of bounds for the working group. The Working Group's report, submitted in October 1999, is said to be "under consideration of the government and the Reserve Bank of India"(RBI, 2000).

Unfinished Agenda

As Indian reforms approach a decade, little has been done by way of restructuring the PSBs. Dziobek and Pazarbasioglu (1997) report ₁₉ that while all countries in their sample had diagnosed shortcomings in the regulatory and accounting framework, almost all had taken measures to address it, like in the Indian case.

Most countries had also identified deficient bank management and control as an issue but countries where effective measures were taken reported substantial to moderate progress. Indeed, countries where lesser or no measures were taken on this score reported slow progress.

Most importantly, countries where the state-owned banks were an identified problem had the least progress on measures to correct the situation. Not surprisingly, they report slow progress.

Three specific elements are discussed below in order of severity of the unfinished agenda:

Ownership

Though the government has allowed equity dilution of its stake in nationalized banks ₂₀ , it does not appear to be serious about ceding or sharing management control. Equity dilution has instead turned into a capital raising exercise for banks, without the corresponding will to allow greater shareholder supervision. Individual voting rights, the key instrument of shareholder participation, are still limited by rules to a maximum of 10 percent ₂₁ . This was reinforced in the Budget speech of the finance minister where he said "public sector nature of the nationalized banks will continue even if the government stake drops to 33 percent" (Budget 2000).

There is, of course, no explicit definition of public sector nature of nationalized banks. Regulatory policy does not discriminate between ownership pattern of banks. The burden of social objectives, captured in the 40 percent priority sector lending stipulation, applies to all banks; it is marginally lower for foreign banks. Indeed, one of the silver linings in the Indian set up is that the regulators have always been scrupulously unbiased between any ownership groups.

The public sector nature perhaps means banks will continue to be "State", as defined in Article 12 of the Indian constitution. This confers a whole range of privileges on banks but at the same time places them at a disadvantage in competitive markets. Since nationalized banks are accountable to Parliament, they get enmeshed with the government at different levels. 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 is no scope for effective transition to market discipline.

Management

While it is true that banking skills cannot be created overnight, no effort was made to promote sound bank management practices through a system of incentives, nor were there disincentives for reckless behavior. Top management salaries in the nationalized banks continue to be pegged to salaries at comparable levels in government. Lack of personal accountability is a carry over from bureaucratic principles. Indeed, the pernicious system of employee wage negotiations ₂₂ cutting across the banking industryówithout reference to either the health or the paying ability of individual banksómeans that employees or management have no stake in the health of the bank ₂₃ .

Wage costs are the single biggest item in non-interest costs and accounted for 17.45 percent of the total expenses of all banks in 1998-99, and 19.63 percent for the public sector banks (RBI, 1999).

Speaking three years into the reform process, Patil (1994) noted that "banks are often thought to be dealing primarily with money and their strength is supposed to lie in the amount of money they command. This is one of the greatest myths with which we have been living...Their true assets and liabilities are their staff. But, all along, Indian banks have totally neglected this area.

First, we do not recognize that banking is a specialized type of activity. There is a mistaken belief that universal franchise bestows a fundamental right to all citizens at some appropriate age to get jobs in banks irrespective of the type of their education. Even after such a gross neglect at the recruitment level, no attempt is made to give the new appointees requisite training. The second illusion is that all bank staff have the fundamental right to handle all types of operations so that they can eventually rise to the post of an executive director if not chairman. There is no recognition that different jobs require certain expertise, often gained through on-the-job training. Such an approach to handling valuable human resources is again influenced by vague ideals of social justice at the cost of organizational efficiency (ibid., p114).

There has been some revision of interest in the matter, especially after the public sector banks complained bitterly of staff desertions. Bank chairmen have used both industry and popular lobbies to make the point that the private banks are luring away the nationalized banks' talent pool, whereas they have no way to retain motivated employees. But government is prohibited by the constitution of India from denying any rights as to recruitment or promotions, or playing favorites. So we have a stalemate: bankers and government realize the gravity of the human resource issue but can do nothing about it.

Read with the ownership issue (above), the situation does not look very promising even if government stake falls to 33 percent. As long as banks are covered under the definition of ëState' under the Indian constitution, they will have little to no flexibility on the human resource issue.

Operations

This is something that bank management is fully accountable for, but up to a point. Almost full interest rate deregulation and freeing of service income from cartels ₂₄ has meant the income side is determined by competition in the marketplace for products and services. But the expense side is much more sticky and endogenously determined.

Establishment costs (including all running expenses except salaries) have a sticky component, which is that banks are not fully allowed to rationalize branches. Though the liberalized branch licensing policy allows closure of branches in metropolitan and semi-urban centers, there is still a bar on closing down branches in centers which has only one bank branch. Part of the problem is with banks themselves. They have failed to use the leeway to rationalize branch outlets in the over-banked metro centers, choosing instead to upgrade some branches to specialty service ₂₅ branches.

On the income side, the picture is mixed with some banks having excelled in harvesting non-interest income, and some banks doing well in treasury operations. But overall, there seems to be no clear corporate strategy to specialize in any one sector. Banks still want to be all things to all men. As a result, the vagaries of the macro-economic situation seem pretty much to dictate the mix of interest and non-interest incomes. For 1998-99, interest income amounted to 88.09 percent of total income and 9.02 percent of total assets, marginally different from 87.25 percent and 9.10 percent, respectively, in the preceding year.

Recent Activity

The Asian crisis has served to refocus attention on restructuring issues. The renewed focus on the banking sector has been driven by two major considerations.

First, the growing globalization of banking operations, driven by a combination of factors, such as, the continuing deregulation, heightened competition and technological advancements, have altered the face of banks from one of mere intermediary of funds to one of provider of quick, efficient and consumer-centric services. In the process, the potential for risks has also increased.

Secondly, the widespread banking problems that have plagued large areas of the globe have raised a gamut of questions relating to the linkages between banking reforms and reforms of other segments of the financial sector, the extent of exposure to sectors which are characterized by asymmetric information problems, and the ëcontagion' effect. "It has, therefore, become necessary to promote robust financial practices and policies, especially in respect of banks, in order to sustain financial stability. This is all the more true in developing economies where assets of the banking system constitute a substantial proportion of financial sector assets" (RBI, 2000b).

I now turn to analyzing the constraints that forced India to miss the turns. The next chapter argues the options for restructuring are inherently constrained when economic and banking reform follows a currency (Balance of payments) crisis.

 

Chapter 2

Understanding the post-crisis dynamics

The working hypothesis of this paper is that the evolutionary path and success of banking reform must be seen in context of the starting points and the surrounding environment.

The literature on banking crises (cited earlier) is rich in its portrayal of the consequences that follow a wrong assessment of the starting point. This paper asserts (for details see accompanying work) banking reform evolves differently when it is initiated following a wider economic crisis, than it does after a banking crisis.

In the former case, as seen in Latin America and the transition economies, the wider economic reform effort aims at reducing the adjustment pains. The focus on reducing dislocation in credit flows usually implies a soft approach to banking sector problems. In Chapter 3, this point will be elaborated further, but here it would suffice to say that when the wider reform effort is tuned to pumping the economy, de-emphasis on the banking sector is calculated.

This is not difficult to understand. Bank restructuring is by definition a disruptive change since it leads to changes in established credit relationships.

However, the path is very different when banking sector reform is taken up as an independent module following an internal banking crisis. Though the overall cost to the economy is no less, the diagnosis of the problem admits of no ambiguity and usually, there is much greater choice in restructuring instruments.

An important caveat is the initial conditions alone do not guarantee a particular evolutionary path. There are countries where banking sector fragility following economic liberalization led eventually to a currency crisis. And there are instances where the fragility was contained leading to a stronger banking system. Success depends on the right diagnosis and proper set of restructuring instruments (Dziobek and Pazarbasioglu, 1997). See Kaminsky and Rheinhart (1996a), Demirc¸g-Kunt and Detraigche (1997, 1998), Caprio and Klingbeil (1996, 1997) for empirical evidence.

In the Indian case, however, the initial conditions happen to be extremely important, because the early banking reform effort did not rid itself of the pre-reform mindset. Specifically, the banking system continued to be relegated to the background as a small sub-system. Also, an over emphasis on non-disruptive change had implications for the pace and content of reform in later years. This is illustrated in the rest of this chapter.

BoP Crisis

Much of the context of this paper is rooted in the dynamics around the currency crisis of 1990-91. Hence it would be appropriate to put in a detailed background to "There was a time in 1991 when the foreign currency assets in the Reserve Bank of India had fallen as low as one billion US dollars" (Rangarajan,1998).

After the first three decades, post independence, the Indian economy grew at an average 3.5 percent per annum. However, in the second-half of the 1980's the economy clocked an unprecedented 5.6 percent average growth rate, pulling up the decadal (1980-90) average to 5.5 percent. This was in response to trade and industrial liberalization measures initiated since 1985. Here it would suffice to note that the reform strategy of the late 1980s turned out to be unsustainable. A loose fiscal policy combined with a fixed exchange rate led to a burgeoning fiscal deficit and a serious balance of payments mismatch.

In the 1970s and 1980s, the fiscal deficit of India was of the order of 6 percent. By 1991, the fiscal deficit of the Government of India alone had touched 8.3 percent. Interest payments became the largest single item of expenditure in the Government of India's budget, and constituted very nearly 4 percent of the GDP in 1990-91. The current account deficit touched about 3.2 percent of the GDP ($10 billion) in 1990-91. Inflation was at 12 percent per annum.

Iraq's invasion of Kuwait in August 1990 sent oil prices sky rocketing. As Rangarajan (ibid.) recalls,

India being a net importer of oil, the burden was so large in that particular year that we had to draw down the bulk of our reserves in order to meet the increased oil budget. This drawing down of the reserves, in turn, resulted in a downgrading with respect to the rating of the country, which had further impact upon the financing of the current account deficit.

So a vicious cycle was set in motion ó the drawing down of the reserves, downgrading of the rating and inability to finance the deficit through commercial borrowings. All of this resulted in a very serious situation as far as the balance of payments was concerned." Finally, by December 1990, the Reserve Bank of India was left with reserves of no more than $ 1 billion, barely enough to cover 2 weeks' imports. The union government summoned emergency IMF aid of $1.8 billion under its Structural Adjustment Program in January 1991. See Joshi and Little (1997) for a review of the circumstances leading to the crisis and post-crisis response.

The achievement of balance of payments viability ₂₆ was the central objective of most IMF-supported adjustment programs (Parker and Kastner, 1993). Its standard response to aid requests was to impose conditions ("conditionalities") and extract firm commitments as to the components of and time-frame for structural reform.

Though it seems so obvious in retrospect, literature on the viability of balance of payments was only beginning to recognize that internal fiscal sustainability was as important as explicit policies on the balance of payments side.

Writing in 1993, Parker and Kastner (1993) provide an excellent review of the changing concerns:

Until recently, assessments of whether an economy was externally viable were based almost exclusively on balance of payments and external debt projections. These were used to profile future debt-service obligations and to estimate prospective financing gaps. The relationship between fiscal policy and balance of payments viability received less attention. Yet external projections alone cannot identify whether a country is on a sustainable path. The experience of many countries during the 1980s showed that policies that channel a large share of private savings toward financing government deficits may raise inflation and interest rates, depressing growth. A satisfactory assessment of medium-term viability must entail a careful examination of the public-private resource flows implied by the external, fiscal, and monetary targets.

Thus, the package of IMF conditions on India sought:

i. a guarantee of fiscal consolidation in the immediate term;

ii. policies to ensure fiscal sustainability in the medium to long term;

iii. policies to address the viability of balance of payments issue.

The Indian government's response is expertly stated in Rangarajan (1998). "The response to this particular crisis was to put in place a set of policies aimed at stabilization and structural reform. The stabilization policies were aimed at correcting the weaknesses that had developed on the fiscal and the balance of payments side. The structural reforms were aimed at removing some of the rigidities that had entered into various segments of the Indian economy. The twin-pronged approach was to prevent the recurrence of the 1990-91 kind of crisis (ibid.).

Obviously, structural reforms could not be introduced unless a degree of stabilization was achieved. Equally, stabilization by itself would not be adequate unless structural reforms were introduced to prevent the recurrence of such problems. That was why we put in place, simultaneously, a set of policies aimed at both stabilization and structural reform (ibid.).

For a theoretical assessment of the components, see Joshi and Little (1997).

Context of Early Banking Sector Reform

It is important to understand that though banking sector reform was an integral part of the overall scheme of structural reforms, it was but a small, facilitating component. Rangarajan (1998) notes: "The overall package is aimed at enhancing the productivity and efficiency of the economy as a whole and also increasing international competitiveness."

Banking sector reforms fitted in because

Structural reforms in areas such as industrial and trade policy can succeed only if resources are re-deployed towards more efficient producers who are encouraged to expand under the new policies. The reforms in the banking sector and in the capital markets are aimed precisely at achieving this primary objective(ibid.).

This is broadly in line with the thesis that the end of financial repression would lead to a more efficient allocation of resources and thereby, provide a strong impetus to growth. There is a common thread running through all the measures that have been introduced since July 1991, and that is to improve the productivity and efficiency of the system as a whole. The productive sectors of the economy need for their successful functioning an efficiently operating banking system, which, while transferring funds from the surplus units to the deficit units does so at the minimum operational costs (Rangarajan, 1994).

Increase in allocative efficiency of the banking system was assumed to follow naturally out of the increased availability of resources and freedom from interest rate rigidities. Thus, in our framework, bank restructuring-defined as the processes to improve the allocative efficiency of banks-- was completely ignored in the first phase of reforms.

Since the financial sector reform process was embedded in the overall restructuring package, the government appointed a committee, headed by a former governor of the Reserve Bank of India, M Narasimham, to recommend the components and sequence of reforms. The Committee on Financial System (CFS) or the Narasimham Committee-I, as it was known in popular parlance, submitted its report in 1992, and became the basic building block of banking sector reform.

A detailed survey of reform measures, tagged to pre-reform status, year-wise changes, and current status is presented in Annexure I. (Sourced from Reddy (1998), Callen (1993) and updated until October 2000.) Here it would suffice to collect the reform measures into tractable groups.

First, measures to enhance the lendable resources of banks: sharp reductions were effected in the statutory pre-emptions, viz., Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). Since the beginning of financial sector reforms, total effective preemption has been brought down from 63 percent to around 35 percent. The effective ₂₇ CRR which was as high as 16.5 percent has been brought down to 9.75 percent (Reddy 1998). Note that these are "effective rates", taking into account the exemptions for certain categories of liabilities. In actual terms, there was a 15 percent CRR on net demand and time liabilities (NDTL) in the previous fortnight plus a 10 percent incremental CRR on the increase in NDTL over the level as on May 3, 1991. The incremental CRR was withdrawn in 1992-93 itself and the base CRR was reduced from 15 percent to the current ten percent.

The SLR was at 38.5 percent for domestic liabilities and 30 percent for non-domestic liabilities in 1990-91, leading to an effective rate of 34.5 percent. This has been brought down to 25 percent, and the distinctions between domestic and non-domestic liabilities have been removed.

Second, measures to remove interest rate rigidities. Prior to reforms, all interest rates, deposit and advances were administered by the Reserve Bank of India. On the deposit side, the central bank would set the number and structure of time slabs, and the corresponding rates. On the advances side, interest rates were set not only according to purpose of the loan, but also for maturity and amount of borrowings. Deposit rates were de-regulated in 1992, with the RBI setting only a maximum deposit rate for all term deposits, and a savings bank rate. But it was not until 1997 that banks were given full freedom to price their deposits. The savings bank rate still continues to be administered by the central bank.

Dealing with the complex maze of pre-reform lending rates was a more tricky exercise. But consistent with its gradualist approach of non-disruptive change and giving banks enough time to plan their operations ahead (Reddy, 1998), the RBI started by collapsing all lending rates into three slabs, based on amount. The rates were still administered. It was only in 1994 that banks were given the freedom to determine their own prime lending rates. However, there are three exceptions (ibid.).

Currently interest rate on smaller advances (up to Rs.200,000) should not exceed the bank's prime lending rate. There is thus a small element of concession for very small loans Lending rate for exports are still prescribed. This is tied in part to foreign exchange market operations: the central bank uses the rate to influence the leads and lags in foreign currency inflows ₂₈ . Finally, ceilings are prescribed in respect of certain advances in foreign currency, made by banks out of their holdings of foreign currency non-resident deposits.

Third, the introduction of prudential measures in line with the Basle Accord. These were introduced in April 1992. The implementation was staggered over a four-year period. Foreign banks were to reach the eight percent risk-weighted capital adequacy ratio by March 31, 1993. Indian banks with international operations by March 31, 1994, and other banks were to meet the target of four percent by March 1993 and eight percent by March 1996 (RBI< 1991-92, para 1.74).

Fourth, measures to enhance competition: Compared with the restrictive bank license policy in the pre-reform period, reform sought to encourage competition by allowing freer entry of foreign banks and the setting up of new private sector banks. Between 1991 and 1998, the number of foreign banks in India doubled from 21 to 43, and existing foreign banks were allowed to open 36 new branches. In January 1993, the central bank issued guidelines for the entry of new private sector banks and nine new banks were set up.

Fifth, measures to enhance transparency and disclosure in bank balance sheets. The CFS had noted that the state of the banking system is hidden behind the opaque balance sheets which reveal much less than they hide. Transparency in balance sheets was also one of the modes to ensure accountability of management.

Measures in regard to supervision, accounting standards, etc. are presented in detail in the Annexure III.

Callen (1993) divides the reform strategy into two broad groups: (i) gradually relaxing controls that have repressed the financial system; and (ii) developing the institutional infrastructure to manage a deregulated financial market. This is a useful framework, especially when examining the sequence of reforms.

Legacy Mindset

Here it is necessary to add that other than regulatory reforms, the first flush of liberalization measures (1991-1994) were clinically isolated from a reform mindset. For instance, while a cut in statutory pre-emptions in the first few years were supposed to release resources for banks, the central bank was inclined to view it as a natural fallout of the government reducing its draft on bank resources, following fiscal discipline.

Consider this:

i. A final set of measures originated in the fiscal adjustment and a combination of macro-economic stabilization and structural reforms undertaken by the government in the context of which, it was considered feasible to moderate the levels of statutory pre-emptions in terms of both the cash reserve ratio and the statutory liquidity ratio. As part of the proposals for reforming the financial sector, the Narasimham Committee on the Financial System had recommended a reduction in the pre-emptions of banks' resources. In response, the government has agreed to meet their borrowing needs increasingly from the market instead of pre-emption of banks resources (RBI, Annual Report 1991-92, para 1.14).

ii. Considering the anticipated decline in 1992-93 in the monetized deficit of the Centre and the reduction in the Centre's market borrowing program, it was decided to reduce the SLR on an incremental basis. Accordingly, up to the level of NDTL (excluding non-resident liabilities) as on April 3, 1992, the SLR will remain unchanged at 38.5 percent, and for any increase in NDTL above the April 3, 92 level, the SLR would be 30 percent (ibid., para 1.30).

iii. Obviously, the issue of cutting back pre-emptions was also linked to monetary management. In light of high inflation rates in the preceding year, the central bank did not want to aggravate the excessive overhang of liquidity. Thus, despite the realization that "the statutory requirements of banks have reached such high levels that they have tended to be counter productive and this has fostered the process of disintermediation to some extent, the pace of reduction in reserve requirements needs to be carefully worked out as too rapid a pace of adjustment could conceivably aggravate the problem of excessive liquidity creation in the economy" (ibid., para 7.25).

Early history of banking sector reform is replete with instances that show the banking sector was still considered a small sub system.

Selective Reforms

Further evidence of selective absorption of reform measures lies in the government's response to the Narasimham Committee recommendations. Reforms commensurate with ending repression were taken up immediately while some reforms that had a bearing on restructuring issues were delayed or dropped.

The full set of measures can be seen as addressing both the flow and stock problems in banks (Sheng, 1996). The "stock" problem is dealing with banks' current balance sheets, cleaning up NPLs and restoring capital. The "flow" problem is improving the quality of banks' earnings so the balance sheet does not quickly deteriorate again. This usually involves operational restructuring to improve efficiency, which encompasses improved credit assessment, specialization, better information systems and cost cutting (BIS, 1999).

The difference, however, lay in the implementation of the recommendations. The recommendations on the flow side were commensurate with ending financial repression, which was the avowed objective of reforms. Also, these recommendations were within the sole ambit of the Reserve Bank of India, as regulator and supervisor. They did not need any special political concurrence. So their passage was relatively easier.

Trouble came on the stock sideólike putting up asset reconstruction companies (ARC), forcing the banks to go public, etc.ówhere the onus of change was on the government to convince parliament to enact the enabling Acts. The ARC recommendation did not find political and academic backing and was put in abeyance. ₂₉

On the capital side, some of the healthier banks, of course, accessed the market. The weaker banks didn't have balance sheet strength to do so, and had no option but to fall back upon recapitalization funds.

Focus on Non-Disruptive Change

Thus, the initial conditions set the tone for content and pace of banking reform measures. The de-emphasis on bank restructuring was specifically to avoid any shocks that would derail the reform process.

To complete the historical context of the reform process, it would be useful to understand the Reserve Bank of India's approach to the content and sequence of reform measures. This has been expertly collected in Reddy (1998) and it would be worthwhile quoting in full:

The approach could be summarized as pancha-sutra or five principles.

First, cautious and proper sequencing of various measures giving adequate time to the various agents to undertake the necessary norms.

Second, mutually reinforcing measures, that as a package would be enabling reform but non-disruptive of the confidence in the system.

Third, complementarity between reforms in banking sector and changes in fiscal, external and monetary policies, especially in terms of co-ordination with the government.

Fourth, developing financial infrastructure in terms of supervisory body, audit standards, technology and legal framework.

Fifth, taking initiatives to nurture, develop and integrate money, debt and foreign exchange markets, in a way that all major banks have an opportunity to develop skills, participate and benefit.

Again, the logic of banking sector reform follows from the approach to the larger body of reform in that the objective is (a) non-disruptive change, (b) in a democratic manner by taking all constituents along, and (c) ensuring that alternatives are in place before dismantling existing structures.

This is a clear exposition of the constraints facing the regulatory authorities. Principally, the initial conditions and surrounding environment place constraints on the content and pace of reform. The next chapter considers the constraints in detail.

 

Chapter 3

Restructuring vs. Real Sector Reforms

The initial setting for the reform process set off a perverse sequence of measures. The problem was in the coincidental timing: the pressures of a newly liberalizing economy essentially forced the pace in some areas of banking before or at the same time as the infrastructure in finance was being put in place. And in some places, bank reforms had to slow down for the real sector reforms to catch up.

It is a complex web of causality that runs both ways between the real and banking sectors. And, it is almost impossible to disentangle the strands of causality, at least in the initial phases. Without a clear understanding of the dynamics, the burden of assumption is that the banking and real sectors evolve together. The emphasis, however, was on the real sector. Caprio and Summers (1993) argue "reforms in the financial sector cannot prudently run too far ahead of those in the real sector."

Since bank restructuring is a disruptive process, broadly, this expectation leads to a "now on" attitude to reform. That is, equip banks with the wherewithal to react to the changing economic environment from now on; but don't disrupt existing relationships. The theoretic foundation of the argument is that banks will use the flexibility to endogenously pace themselves with real sector reforms, leading to a more purposeful, efficient and remunerative meshing of the two sectors.

These issues are not particular to India. Post-liberalization banking distress in almost all countries has been related to a mismatch between banking and real sector reform, apart from the usual suspects within banking reforms.

Unfortunately, the literature suggests that the "now on" approach to harmonious reform does not always work. Reviewing the history of botched banking reform in many countries after 1973, Caprio, Atiyas and Hanson (1994) find a uniform thread of "perverse sequencing" that explains failure and "disappointment with reform." Often more visible aspects of reform (where the financial system meets the real economy), such as complete interest rate deregulation, bank recapitalization, or more recently, the creation of stock exchanges, have been pursued before basic infrastructure in finance--auditing, accounting, legal systems, and basic regulations--have been prepared (ibid.).

The sequence is perverse because "participants in the financial system, both individuals and organizations, take time to adjust to changes in incentives (implied in the regulatory reform)." But the visible changes happen before agents have had an opportunity to adjust. The result is a mess-up. It is important to begin re-shaping the regulatory environment early on in the reform process, along with other institutional development measures (Caprio 1996).

Perverse Sequencing

We argue that the simultaneous start of banking and regulatory reform, and the "more visible aspects" of reform created a perverse sequence. For instance, in the first three years of reform (1992-94), banks were hit with deposit interest rate deregulation, rationalization in lending rate slabs, significant liquidity inflows due to reduction in statutory pre-emptions (the more visible aspects), even as income recognition, asset classification and capital adequacy norms were being implemented ₃₀ .

To the extent the reform process itself was a crisis resolution exercise, it is not difficult to see that the perverse sequence was unintentional. Could it have been organized differently? Perhaps no. The visible aspects could not have waited indefinitely for the banking system to be upgraded to global norms. And it would not have been possible to push the banking system to adopt the new norms in one quarter alone. The process of instituting regulatory reform has proved to be a particularly arduous task in almost all countries, including the developed economies. Caprio (1996) discusses why regulatory changesóalong with other financial reformsóare so difficult.

Our stress on unintentional perversity is intentional. Assessment of perversity is available only in hindsight. Consider, for example, a particular case of a jumbled sequence: yields on government market borrowings were deregulated earlier than lending rates. Banks, flush with liquidity from the released pre-emptions, and faced with slack demand for commercial credit, lined up for government securities. Patil (1994) astutely noted: "A question may, therefore, be asked as to how banks can adjust to such an emerging situation unless interest rates are freed. Obviously we cannot have market determined yields (through auctions) on government securities and T-Bills together with administered rates in regards to loans and deposits."

Consider another question of relative sequencing of deposit and lending rate deregulation. The obvious point is that the market for raw material (deposits) has to be freed up at the same time (if not earlier) than the market for finished goods (lending rates). An insight into why this could not be done in the "obvious" manner comes in the remarks by RV Gupta (1994), the then Special Secretary to the Government, heading the Banking Division ₃₁ . It is worth quoting in full because it reflects the gamut of government's concerns.

...The question of deregulating interest rates becomes important. What to free first, the deposit rate or the advance rate? The advance rate has been deregulated as far as the maximum (rate) is concerned, but we have got a floor. ₃₂ Do we need a floor at all or not? In a way, the market has given the answer because the floor has been violated by banks subscribing to commercial paper. Do we still need to continue with the floor?... But the question that arises is, what happens to the bottom line of some of the loss-making public sector banks if we remove the floor? Will they be able to absorb the shock unless deposit rates in turn go down and what happens if deposit rates go down and there is inflation at the rate of 9-10 percent? Are savers going to put their money into banks? So you have got this set of complex issues and I don't think I can give you a straight answer as to what is better.

Quite simply, this is a summary statement of the many pressures in play. Deposit rates could not be deregulated as early as interest rates because profit maximizing banks would have slashed deposit rates to levels where real returns were negative. A negative real savings rate could have destabilized the savings rate, leading to whole new dynamics. So a cushion of positive real rates was required even at the high levels of inflation. The perversity becomes obvious only in retrospect but the ground situation at the time justified the sequence.

Examining the entire gamut of issues at the bank-real sector border is beyond the scope of this paper. We document just three issues, chosen in order of the intensity of the debate (and concern) to practicing bankers. ₃₃

Priority Sector Banking

The most contentious issue in the post-reform era pertains to the priority sector for the simple reason that the "market failure" argument is most profound for agriculture, small businesses, road and water transport operators, and small scale industry. The market failure argument basically says that unconstrained markets will not dispense credit to sections with no repayment records (like new businesses) or even poor records, businesses where the risk is largely uninsurable, like agriculture, and where the cost of maintaining a relationship exceeds the potential returns, like in small loans to small industry, businesses or agriculture.

Given the value added in GDP from these sectors and also current and potential employment, it is not surprising to find the government and the regulators aligned in favor of some kind of state intervention. Historically, ever since the nationalization of banks in 1969, this policy has taken the form of targets for priority sector lending. Bank nationalization in 1969 coincided with the adoption of the Fourth Five Year Plan, with its strategy for agrarian development that laid considerable emphasis on technological modernization (Charkravarty, 1987). One important element is the strategy was providing adequate credit to the agricultural sector. There was also a renewed emphasis on poverty alleviation and employment generation in the planning process. This led to exertion of intense pressure on public sector banks by the government to lend to priority sectors (Sen and Vaidya, 1997, p 15). Beginning at 25 percent of incremental credit, the priority sector target was increased to 33 percent by 1979 and to 40 percent in 1985.

Another component of the policy was to provide credit to the priority sector at highly subsidized rates. This was in line with the general primacy accorded in planning and associated economic actions to social objectives over commercial results.

But the debate is not centered on continuing with priority targets though the Committee on Financial Sector reforms (Narasimham committee, 1991) advocated a sharp cut back to ten percent. Explaining the rationale why the proposal was rejected outright, Rangarajan referred to the importance of the agriculture and informal sector in the growth process, and in the reduction of rural and urban poverty levels. "It is only with respect to provision of credit to the small and marginal farmers and people of low income groups that special attention is required (Rangarajan 1994, p 11).

Nor is the debate about the subsidy element. "If we have to maintain the viability of rural credit institutions, it is important that the rates of interest charged are reasonable. What is relevant in the context of provision of rural credit is not so much credit at concessional rates as timely and adequate credit" (ibid.). The subsidy element in rural credit was removed early on in the reform exercise, and currently, loans below Rs 200,000 are eligible for a small concession on the bank's prime lending rates.

The debate is really on where banks plug into the credit delivery system, and whether restructuring the system would relieve banks of some of the costly infrastructure in branch networks, without in any way compromising the credit delivery system.

The rural credit delivery system in India suffers from a problem of too many agencies chasing the same goal. There are the rural branches of commercial banks, the credit cooperative societies (at three levels: Primary Agricultural Credit Societies, Primary Co-operative Banks and Land Development Banks), and finally, the Regional Rural Banks. The institutionalization of rural credit started with the establishment of co-operatives following the enactment of Co-operative Societies Act in 1904. Efforts to develop the co-operatives were intensified following the recommendations of the Rural Credit Survey Committee in 1954. Based on the Recommendations of the All India Rural Credit Review Committee in 1969, a multi-agency approach to rural credit was adopted with the commercial banks supplementing the efforts of the co-operative banks (RBI, Trends & Progress of Banking, 1998-99, Box III.1).

To further strengthen the rural credit system, a third channel to the rural credit system was added by instituting Regional Rural Banks in 1975. This followed the recommendations of a working group, set up by the government, which identified the various weaknesses in the cooperative structure and commercial banks. The group, therefore, recommended a third category of banks that "combined the rural touch and experience of co-operatives with the modernized outlook and deposit raising capabilities of commercial banks" (Sen and Vaidya, 1997, p 142). ₃₄

Wall to wall coverage was aimed ostensibly to ensure that availability of credit was never a problem in the rural areas. But as Rangarajan noted, the rural credit delivery system still suffers from many weaknesses (1994). Credit is often too little, too late, and this defeats the whole purpose of credit in the seasonal activities that are so common to small agriculture, business and industry. Instead, the coverage has turned into the millstone around the Albatross' neck, with the multiple agencies in various degrees of distress.

Of the 177 Regional Rural Banks whose results were reported in the Reserve Bank's annual compilation, Trends and Progress of Banking in India, 1998-99, 132 banks reported profits while the rest continued in losses. Indeed, the number of profit making banks increased from 109 in the previous year. Overall, the loss-making banks reported a net loss margin (net loss as a percentage of total assets) of 2.45 percent, while the profit-making banks reported net profit margins of 1.55 percent, and the system ended with a slender, 0.70 percent net profit margin (ibid., para 2.60).

Though the cooperatives account for the largest share in direct institutional finance for agriculture and allied activities, the sector is plagued by losses resulting from high transaction costs and poor recovery performance. No firm numbers are available, because of the delays in compiling data. The obvious weakness in the cooperative structure has been examined by innumerable committees. One finding that seems unanimous is that the organizational structure of the co-operative banking system in India is far too complex and there are just too many people living off the business of making small loans.

The structure itself has been identified as the key contributory factor for their high transaction costs. Thus, some restructuring of the organizational set-up is considered as one option for improving the viability of the co-operative banking system. The mounting overdues of the co-operative institutions have severely restricted their capability of recycling funds for promoting faster agricultural growth. High overdues also make these institutions ineligible for availing of refinance facility from the apex refinancing body for agricultural credit (ibid., Box III.1).

No firm data is available either on the rural operations of scheduled commercial banks. As a matter of policy, the Reserve Bank does not recognize the distinction between rural and other branches of a bank. But personal discussions with bankers suggest they find the establishment costs of maintaining a large number of rural branches to be incommensurate with the earnings. One point that has been made with considerable emphasis is that a large branch network was necessary in the development stages when the focus of banking was on mobilizing household savings in the hinterland. Now that the savings habit is well entrenched, banks need not keep up the establishments as full fledged branches.

Bankers argue that they cannot be held hostage to the weaknesses in the rest of the credit delivery system ₃₅ . Perhaps it is impolitic to air their private views that the banking system needs to be split into rural and non-rural (ëcommercial') businesses. But the need for restructuring the banking system entirely, to tune it closer to the needs of the real economy, was taken up by the Committee on Financial System (Narasimham Committee, 1991).

The committee recommended the "banking system should evolve towards a broad pattern consisting of:

i. three or four large banks (including the State Bank of India) which would become international in character;

ii. Eight to ten national banks with a network of branches throughout the country engaged in ëuniversal' banking;

iii. Local banks whose operations would be generally confined to a specific region;

iv. Rural banks (including Regional Rural banks) whose operations would be confined to the rural areas and whose business would be predominately engaged in the financing of agriculture and allied activities" (para 16).

In line with this approach, the Committee had also recommended re-definition of the priority sector, which was to include only small and marginal farmers, the tiny sector of industry, small business, transport operators, village and cottage industries, rural artisans and other weaker sections. This redefined priority sector was to receive ten percent of the total credit. Above all, the Committee recommended a review at the end of three years to see if directed credit programs needed to continue any longer (Varghese, 1997).

These recommendations were never taken up. One reason was the shaky theoretical foundation of having banks engaged in limited business activities, and particularly, limited to certain geographical areas. The literature on banking crises in the US, especially, is rich with instances where a seasonal or sustained downtrend in some businesses, or geographical areas has precipitated a widespread crisis.

The bottom line of the issue remains that the system is sub-optimal. The priority credit system and rural credit delivery mechanisms are failing in the allocated task. This failure carries a huge economic cost to the rest of the banking system. Finally, no progress has been made on the issue for fear of dislocating established relationships. Sooner, rather than later, a choice will have to be made on a starting point for shaking the system.

Enforcement, Bankruptcy and Exit Policies

The second issue we take up is of interaction between the bank sector and the real sector in terms of enforcement of loan contracts, bankruptcy codes and exit policy for soured loans. To be sure, there is nothing that regulatory reform can do about these issues. Banks' own efforts at coping with change were (are) paralyzed by lack of progress on these key issues.

Enforcement of loan contracts in India is a tricky issue. An advanced legal system notwithstanding, loan contracts are typically not exhaustive as they are, say, in the US. The legal system is overburdened with a backlog of cases which arises from nitpicking on implicit and explicit content of contracts (or lack thereof). Specifically, the Indian loan system is based on hypothecation of fixed and movable assets. In hypothecation, the ownership and use remains in possession of the borrower, though constructively the assets are mortgaged to the bank. This is perhaps the usual course of banking operations throughout the world, as a pledge system operates to the detriment of banks' interest. In pledge, the ownership is both constructively and actually with the bank; inability to retain possession effectively operates as losing control.

But hypothecation also means that banks have to invoke the legal system to obtain transfer of ownership. They cannot seize assets of defaulting borrowers to effect possession. Only a legal decree can effect a transfer of ownership.

Delays in the legal system, especially when the bank has only constructive possession of valuable assets, mean that the assets are either disposed or much reduced in value when the bank actually (if ever) gets charge over them.

Hawkins and Turner (1999, p20) tabulate the time for typical legal procedures: Indian courts take the longest time. The credibility of measures to realize collateral or other steps to enforce repayment of loans depends on an efficient, rapid and transparent legal process. Bankers in Argentina, Brazil, Malaysia and Thailand have often noted that deficiencies in their legal systems have created a culture of non- repayment, rendering threats of legal action against delinquents ineffective. Long cases are expensive, and justice delayed is justice denied. Realizing pledged assets through the courts has often taken years in eastern Europe, India, Mexico, Peru and Thailand (ibid.).

The culture of repayment also suffered because of periodic loan waiver schemes. Debt recovery procedures remain grossly inadequate as banks claims are extremely difficult to enforce through the legal system (Callen, 1998). It was to address these issues that the Committee on Financial Sector (Narasimham Committee, 1991) suggested special tribunals for the recovery of bank loans.

Banks, at present, experience considerable difficulties in recoveries of loans and enforcement of securities charged to them. The delays that characterize our financial system have resulted in the blocking of a significant portion of funds of banks and development financial institutions in unproductive assets, the value of which deteriorate with the passage of time. The committee considers there is urgent need to work out a suitable mechanism through which the dues of banks and financial institutions could be realized without delay and strongly recommends that Special Tribunals be set up to speed up the process of recovery (Narsimham, 1991, para 14).

The legislation ₃₆ for setting up the Debt Recovery Tribunals (DRTs), as the special courts were called, was passed on August 10, 1993, and tribunals were set up in Calcutta, Delhi, Bangalore, Jaipur and Ahmedabad, along with an Appellate Tribunal in Bombay the following year. But by March 1995, the whole initiative was in jeopardy as the Delhi high Court quashed the DRT notification for the Delhi region ₃₇ . The Supreme Court finally decided in 2000 that the DRTs were constitutional.

But the DRTs were soon afflicted by the general malaise in the legal system: of too few presiding officers, lack of infrastructure and help from the respective state governments. The Reserve Bank constituted a Working Group in March 1998 (Chairman: N V Deshpande) to review the functioning of the DRTs, and suggest measures to improve their efficacy. The Working Group, in its report submitted in August 1998, made a number of recommendations addressing both the structural aspects relating to the functioning of the DRTs as well as legal lacunae observed in the Act. The Government of India has broadly accepted the recommendations and a bill, viz., the Recovery of Debts due to Banks and Financial Institutions (Amendment) Bill 1999 was introduced in the Parliament seeking amendments to certain provisions of the Act.

Later, following the Budget announcements in 1998-99, an Expert Group was constituted by the Government under the Chairmanship of T. R. Andhyarujina, former Solicitor General of India, to suggest appropriate amendments in the legal framework affecting the banking sector, and specifically, in the functioning of DRTs and suggest amendments in various external legislations such as, the Transfer of Property Act, foreclosure laws, Stamp Act, Indian Contract Act, etc. (RBI, Trends & Progress of Banking in India, 1998-99). The Expert group's report is under consideration of the government, but the task is not easy as some of the issues like the Transfer of Property Act and Stamp Act are also in the purview of the state governments.

The Narasimham Committee II (1999) has suggested the need for several legislative amendments to existing laws which affect operations of banks including recovery through sale without judicial intervention, changes in Transfer of Property Act to facilitate securitization, reduction in stamp duties, clarity in law on matters arising from computerization and electronic funds transfer, structure of the banking system, etc.

According to the Committee, the evolution of legal reforms has not kept pace with the changing commercial practice and with the financial sector reforms. As a result, the economy has not been able to reap the full benefits of the reform process.

No significant progress has been made in strengthening the recovery process ₃₈ . Perhaps realizing that legal recourse is doomed to delays and sub-optimal solutions, the government and the Reserve Bank of India have asked banks to go in for compromise proposals. The tradeoff is between some interest and principal forgone in the recovery of the outstanding balance as against indefinite delays and uncertain recovery.

In the Union Budget for 1999-2000, it was indicated that to settle chronic cases, especially those relating to the small scale sector in a timely and speedy manner, PSBs would be encouraged to set up settlement advisory committees. ₃₉ Accordingly, the Reserve Bank has communicated guidelines to all PSBs for the constitution of Settlement Advisory Committees (SACs) for compromise settlement of non-performing assets of the small scale sector. The guidelines would cover all non-performing assets (NPAs) that are chronic and at least three years old as of March 31, 1999 and will be operative only up to September 30, 2000. A fixed time frame has been set to avoid the moral hazard problem.

The guidelines apply to non-performing loans in the small scale industrial sector and small businesses, including trading and personal segment and agricultural sector. It can also cover the cases pending before the courts/Debt Recovery Tribunals (DRTs). However, consent decree to reflect the compromise settlement will have to be obtained in such cases. The Reserve Bank has advised all the public sector banks that their boards may lay down norms for compromise settlements and frame suitable guidelines for SAC on the basis of the guidelines set out by the Reserve Bank. Once the settlement amount is calculated as per the Reserve Bank guidelines, it should normally be paid at one time. The bank's board should review the decisions taken by the SAC and also ensure that the process of settlement is completed within six months.

The settlement schemes have been in operation for a year now, and it is too early to fix their success ratio. The theoretical point is that a compromise scheme is the second best option only because legal recourse to contract enforcement has failed. The compromise approach has often been positively rated in banking literature as it presents the "human face" of banking. On the other hand, it has been severely castigated for disparaging the loan discipline and respect for contracts that is so essential for a viable banking system. The bottom line remains that no significant progress has been made to strengthen the recovery climate and the enforcement of contracts in the country.

The second aspect of the problem is bankruptcy procedures and in general an exit policy. India does not have a standard form bankruptcy ₄₀ code that would provide incentive for inefficient firms to shut down and, at the same time, provide an incentive and even legal protection for efficientóthough financially strainedófirms to continue operations. The reason is not difficult to fathom in light of the grave distrust of organized industry and the State's own mandate to protect jobs even at the cost of efficiency.

There exist several legal barriers to exit. The important ones are:

i. Industrial disputes Act, 1947, which stipulates that no large industrial unit is allowed to retrench workers or close down the firm without the permission of the central government;

ii. Urban Land (Ceiling and Regulation) Act, 1976: prevents firms from selling land without the permission of the respective state government;

iii. The Sick Industrial Companies (Special Provisions) Act, 1985 which makes it obligatory for a sick unit to refer itself to the Board of Industrial and financial Reconstruction (BIFR) within 60 days of its audited accounts (or when the fact of sickness is determined) being published.

Sen and Vaidya (1997, pp125-130) consider the bankrupt state of the bankruptcy procedures and exit policy in industry. But from the bank's point of view, complicated and time consuming exit procedures for industry only prolong the agony of bad loans sitting in balance sheets. Worse, the law entrusts the resolution of sick industries to an independent board, taking it out of the purview of banks. Rehabilitation schemes, proposed by the BIFR, have the force of law and banks may well be asked to loan additional amounts even at concession rates to facilitate rehabilitation of sick units.

The virtual impossibility of liquidating an insolvent company has eroded the threat of bankruptcy as an ex ante performing and monitoring instrument. The difficulty of creditors to recover a loan is another significant problem of effective corporate discipline (Callen, 1998).

Indeed, the pseudo-bankruptcy procedures have been used as a haven for avoiding discipline. The (quiet) revolt against the BIFR has become stringent as banks and financial institutions have alleged that companies are increasingly resorting to the protection afforded by the BIFR to escape the loan discipline. This is particularly vexing as financial institutions have just started flexing their muscles on good corporate governance, having started using the loan covenants to convert debt into equity.

The ex ante threat is to sell off the equity in the market or to a willing bidder. The threat of open sales is a powerful one indeed, partly because of the established psyche of not parting with management control even when it is obvious that current management has failed to run the company. And, it is partly due to the opprobrium attached to such open market sales. To date, there has been only one case where a financial institution has resorted to bidding to sell its stake in a distressed company ₄₁ .

In private conversations, bankers at development financial institutions recount innumerable cases where the management has forced the companies into sickness, just to obtain bank concessions and even permissions to alienate high priced property from the balance sheet. Indeed, one banker leading the revolt suggests there is a strong market for companies referred to BIFR, which have real estate on their books.

The third aspect relates to the bank's own exit from problem loans on their books. As matters stand, there seems to be no way of resolving the non-performing loan problem quickly and painlessly. The Committee on Financial sector (Narsimham Committee, 1991) suggested Asset Reconstruction Funds, as an institution that would buy out troubled loans from banks and make special efforts at recovering value from the assets.

The committee believes that an arrangement has to be worked out under which at least part of the bad and doubtful debts of the banks and financial institutions are taken off the balance sheet so that the banks can recycle the funds realized into more productive assets. [Committee] proposes the establishment, if necessary by special legislation, of an Asset Reconstruction Fund (ARF) which would take over from banks a portion of the bad and doubtful debts at a discount, the level of discount being determined by independent auditors on the basis of clearly stipulated guidelines...ARF should be provided with special powers for recovery (Narsimham, 1991).

Use of a special vehicle like asset reconstruction funds or asset management companies is a common practice worldwide to relieve banks of the bad debts on their books as also to relieve them from the pressure of chasing recovery and collections. See Hawkins and Turner (1999, p 40) for a list of countries. But the implementation of the ARF concept remained mired in conceptual confusion in the early reform years.

This is worth recounting in full because it is rich in textures on regulator's concerns.

One method that is suggested under which the NPA is transferred from the bank to another institution, which will have the responsibility to collect or realize the assets. It does not solve the fundamental problem. All that we have done is to transfer the problem from one bank to another institution. Now, as a result of specialization, we can reap some benefits, in the sense that the new institution will have only one responsibility, to realize the assets. There is also the other view that the banks which were originally responsible for giving the loans must also be made responsible for recovering them. In our country, where there is a wide branch banking network with so many branches, creation of an asset reconstruction fund, taking away the NPA from various banks and entrusting them to another organization is not a workable proposition (Rangarajan, 1994).

Worse, the ARF concept seems to have been spiked precisely because of doubts whether the banks would still be competent to operate efficiently on the bank-real sector interface. Sample this:

We have thought about bank specific or a region specific ARF. What is the purpose of doing this? This approach will achieve some results only if the residual bank is capable of organizing itself better, and is capable of going into the market and raising funds. If the bank is overstaffed or if it is not performing well for a variety of reasons and we have not tackled those problems, merely the creation of another institution will not serve any purpose (Rangarajan, 1994).

Clearly, the whole issue of feedback is most pronounced here. Indian regulators felt shy of making a beginning with the ARF concept because of doubts whether it will be enough. As a result of this muddled thinking, the ARF concept was put in the freezer.

It was revived again by the Committee on Banking Sector Reform ₄₂ (CBSR or Narsimham ñII, 1998) which recommended transfer of non-performing assets to an Asset Reconstruction Company. The ARC, which would take over all loan assets in the doubtful and loss categories, would issue to the banks NPA Swap Bonds representing the realizable value of the assets transferred, provided the stamp duties are not excessive.

However, the RBI noted in its Annual report (1998-99, para 1.74):

The international experience with such arrangements has, however, been mixed. In India, progress in setting up of ARCs, is yet to be seen partly because the Debt Recovery Act and other relevant legislations are yet to be strengthened. Besides, the ARCs could engender moral hazard problems. It is, therefore, necessary to attempt to make Debt Recovery Tribunals (DRTs) more effective in their operation. More importantly, debt recovery systems need to be improved across the board to ensure efficiency of the financial sector.

So as late as 1999, the confusion of whether to begin with ARF (or ARC) was just as strong, with regulators doubting the efficacy of setting up an institution if the residual bank was likely to stagnate in an unreformed environment.

The Verma Committee (Verma, 1999) made another attempt at justifying why banks should be divested of their bad loan portfolio if they were to run a non-handicapped race. It said: [The committee] too has seen separation of NPAs as an important element in a comprehensive restructuring strategy for weak banks and considers this mechanism to be an acceptable solution to the problem of accumulated NPAs and the resultant strain on profitability of banks. It went on to stress an elaborate structure of ownership and management of the proposed ARC. But the report is still said to be under consideration of the RBI and the government.

A senior Reserve Bank official said the ARC issue is under active consideration of the regulator and the government. But the two sides have not been able to reach a consensus on (i) scope of ARC and (ii) its tenure. The Bank official said the regulator wants to limit the moral hazard problem by having one or two ARCs, covering the entire banking sector. They have ruled out bank-specific ARCs. The RBI's argument is that a bank (or region) specific ARC may potentially lead to a nexus between banks and the reconstruction company. This would lead to a sub-optimal resolution. But the government apparently is of the view that a few ARCs would be burdened with too many accounts and too great geographical reach. They would thus be unable to take up the recovery aspect seriously. In the end, the solution will only amount to parking the bad loans out of the bank balance sheets into a separate entity.

The second point of difference is that the regulator wants a fixed tenure for the ARC, after which the bad loans will revert to the parent bank. This again is driven by a will to limit the moral hazard ₄₃ . A fixed tenure will force the ARC to be more selective in its approach to loan resolution and recovery. The government sees no point in a fixed tenure, especially if it means the unresolved bad loans will come back. Its view hinges on a lack of incentive for the ARC to rush its work, since it has an escape route available to it. Thus, the whole issue of moral hazard, and appropriate incentive structures is haunting the critical ARC initiative.

Human Resource and Technology Interface

The third aspect of the banking-real sector interface is the management of human resources, especially with the induction of cost-saving technology. India is still struggling with an exit policy for labor in general. This has become pressing as Indian industry is a late convert to realizing efficiency gains through serious technology upgradation.

So also in the banking sector where management have realized that product delivery to customers hinges critically in cutting edge technology, rather than physically-manned branch outlets. But the stumbling block is there is no vision on what to do with the staff that is rendered surplus. Large scale computerization in banks, for instance, started in 1993, only after a round of concessions to the bank staff by way of salary hikes ₄₄ . This caught banks in a double-blind: they have to invest heavily in technology and keep paying the surplus manpower.

Employee productivity in the Indian banking industry is extremely low by global standards, reflecting the surplus labour. Indeed differential in employee productivity is pronounced within the industry.

It can be seen that employee productivity, in two of the most important indicators, is highest for the new generation of private banks. The nationalized banks have the lowest employee productivity. This is intuitively consistent with the fact that the new generation of private banks started operations in 1994 with an optimal mix of labor and technology. In fact, use of technology was one of their unique selling points to the new generation of Indian businesses and individuals in the post-reform era.

Delivering a whole range of products across different technology platforms came to be a business platform in the sense that it was a reaction to the low-efficiency human interface in the older generation of banks. The financial performance and levels of service of the new generation private sector banks have set the pace for nationalized banks. But the latter do not have investible surpluses to invest in technology on a scale consistent with their operations. Some progress has been recorded in the absorption of technology in nationalized banks.

But without a corresponding clarity on surplus labor, these banks have focused on inducting technology only in metropolitan areas or in larger branches in non-metro areas, where competitive pressures are intense. This marks a sedimentation within the industry. Bankers say their attention is dovetailed into the metro areas, and so is investment. Returns apparently justify this management attention and investment. But the flip side is that non-priority branches (which form the bulk) are not getting management attention and investments. These branches are stagnating, and without doubt contributing little to the bottom line and productivity numbers. One senior banker had recounted there is nothing special in the sedimentation. His point was the "10-90 rule" applies globally. Globally, ten percent of the business brings 90 percent of the profits. Similarly, ten percent of bank branches bring in 90 percent of profits, he said. There is no way of validating the claim because profitability data is not published branch wise nor aggregated by type of cities.

There is also no comprehensive compilation of the overstaffing within the nationalized banks, but ballpark figures suggest 25-50 percent overstaffing. The Verma Committee (1999), for instance, avoided any direct estimates of overstaffing. It worked in terms of staff costs as a percentage of total expenses ₄₅ . But apart from a wage freeze, it said: "initially, a reduction in the staff strength of the order of 25 percent is recommended. (Verma, 1999, Para 7.101).

Higher estimates of overstaffing typically come from progressive bankers who suggest that current policy must take into account future advances in technology. Their point is that the human interface will be required only in customer sign-on, advisory and trade related services. The numbers currently engaged in these services would not form more than ten percent of the total staff. To that extent, current policy must plan for eventual retrenchment of the surpluses in the next 2-3 years.

There seems to be a greater emphasis of resolving the human resource surplus problem in banks than in other public sector enterprises. The Union finance ministry took up the issue of a voluntary retirement scheme in banks in November 1999. According to its estimates there were 59,338 excess employees (19 percent) in 12 nationalized banks on the basis of a business per employee (BPE) cut-off of Rs. 100 lakhs, and if the bar were to be raised to Rs 125 lakhs, the number multiplies manifold to 1,77,405 (54 percent).

The VRS policy was announced in September 2000, and provides for 60 days pay for each year in service or years to retirement which ever is lower. This amounts to a pay of Rs 3-4 lakhs per employee, and a total outgo of Rs 800 crore on the part of the banking system. The scheme is to be in operation till the end of March 2001. No targets have been set for the expected downsizing from the VRS. The finance ministry has committed that there will be no replenishment of jobs so vacated.

Yet, the whole drive seems to skirt the issue of human-technology interface. Banks are hiring domestic and international consultants to chart an information technology policy, select hardware and software. Technology does not appear to be part of a long term strategic vision in the industry. The consultant approach is an obvious way of jump starting the technology gap and would certainly avoid waste of management time in catching up with technology trends. Yet, the lack of integration between technology and the rest of the bank is glaring.

One argument could be that tackling the human resource problem was relatively easy as banks had benchmarks to work with; dealing in technology and evolution of consumer tastes is far more complex. Our limited point is that ten years of banking reform has still not sensitized bankers that they need to integrate various componentsóinterest costs, risk, liquidity, technology, human resources, etc.óto arrive at an optimal production frontier.

As we have noted earlier, regulators and supervisors have had to prompt bankers into thinking along these lines. The scope and limitations of regulatory activism is the subject of the next chapter.

 

Chapter 4

Limits To Regulatory Activism

Bank regulators and supervisors have taken a largely paternal approach to weak banks all these years. One upshot of the misunderstanding between regulatory reform and restructuring is that the regulators had to take on the additional task of suggesting restructuring to banks and take up cudgels for their revival.

The second result is that regulation and supervision have to continuously take into account the impact on laggard banks, compromising efficiency on both counts. The best example of the "least common denominator" principle is that Indian asset recognition norms have not been able to move to the international one quarter basis, even after two years on the scheduled date. Assets were to be classified as sub-standard (first category of impaired or classified assets) if the interest or principle has been overdue for more than a specified period. Indian norms specified a progressive move from four quarters in 1996 to one quarter. However, the final transition between two quarters to one quarter could never be made, though in October 2000, the Reserve Bank of India scrapped the past due principal. ₄₆

But there are limits to how far regulators and supervisors can go. Concessions to one bank or a set of banks increase the moral hazard problem for the rest. It is biased against the banks that keep on the straight and narrow path. And the continued existence of weak banks in the system biases investor opinion against the system, making it all the more difficult for the stronger banks to raise capital and resources. Finally, current developments in international thought would make accommodation increasingly difficult in coming years.

Regulators everywhere are wary of shaking the system too hard. No one knows how the system will respond to shocks; whether a small perturbation to one or more banks would lead to bank runs, and perhaps precipitate a systemic crisis. The literature on banking crises after 1975 documents many situations where even perceptibly strong banks were hit by a crisis of confidence in the whole system.

Moreover, bank regulators can never be certain if they are fully equipped to deal with the situation as it evolves. Above all, since a shakeout in the banking system has economy-wide ramifications, regulators are loath to be held holding the baby if matters go out of hand.

The situation is worse confounded when banks have not been appropriately restructured. Regulatory reform then has the added burden of carrying banks along. This implies an uncertainty in two directions:

i. Content of reform: whether ideal (as in text book) regulatory policy can be ported to the ground situation;

ii. Pace of reform: the time in transition and whether the concessions feed back positively in the direction of reform. Too long a time frame may defeat the purpose of regulatory change, and too short a period may shake the system too hard.

To that extent also, an unrestructured banking system places limits to regulatory activism.

Reform Content

Regulatory reform in India has been truly impressive. This is all the more credible given the various constraints and also that essential standards were implemented within a transition period of 3-4 years (1992-96). Follow-up action in later years has essentially sought to fine tune the denominations, and mop up any stray strands.

A full survey of regulatory reforms in the 1990s is provided in Appendix I. This section, however, is devoted to a different theme.

Caprio (1996) asked a fundamental question: why is it so difficult to implement regulatory reform in some countries? He argues that for reform to succeed and for financial systems to remain stable, there must be a regulatory framework that encourages prudent behavior and is attuned to both institutions and the structure of the economy. His key point is that disappointment with reform ₄₇ follows because incentive structures promoted by regulatory reform are not attuned to both institutions and the structure of the economy.

The fact remains that regulatory reform, without adequate and appropriate coping mechanisms is like water on a ducks' back. Apparent difficulty in implementing a full set of reforms in a particular time frame is often seen as a process of "seeding the reform process". But the delay is more often the result of accommodation of slow moving elements of the banking system, rather than of time for incentive structures to take root.

Often, the reform process just stalls because there is an unbridgeable chasm. This is usually the case in the last leg of particular processes: 90 percent of the task is completed but the last 10 percent often proves to be insurmountable. An apt illustration is the Indian authorities failure to move to the one quarter norm for identifying non-performing assets. Implementation of the norm was staggered in phases: it was four quarters in 1992, three quarters in 1993-94, any two quarters in a year in 1994-95, and was supposed to move to one quarter immediately afterwards.

However, the slowdown in the economy and resurfacing of the bad loan problem prompted the authorities to change the course of reforms to read consecutive two quarters (seven months, including the one month additional grace in which loans are considered 'past due' if not paid on exact due date). So it had remained until October 2000, when the credit policy scrapped the 'past due' grace period of 1 month. As matters stand, loans have to be arrears on principal or interest for two consecutive quarters to be recognized as non-performing.

One-half of one year is a long time for strained borrowers. Usually in concert with obliging bankers, they find ways of breaking the spell, paying off the arrears in the second quarter. The clock is then reset back to zero.

Essentially, the limits to regulatory activism are determined not by how fast the regulator can push the system, but by the banking systems' ability to pull. Without equipping banks with the ability to pull, regulatory activism will not only have to push harder, it may even be pushing an immovable object. Realizing that regulatory forbearance (that fraternal attitude that binds regulators to the least common denominator principle), is often the key to sudden banking crises, recent thought has turned to the efficacy of the supervisory system. That is, focus is now shifting to the supervisors, their mandate being to sniff out signs of incipient trouble before it takes a nasty turn.

Supervisory Activism

One of the better turns in Indian banking sector reform was the realization that supervisory functions need to be separated from regulatory functions. Although the Committee of Financial Sector (Narasimham committee, 1991) had recommended a unified supervisory body for all new institutions coming up in the post-reform period ₄₈ , the Reserve Bank of India internalized the logic to separate the regulatory and supervisory functions.

Both the regulatory and supervisory functions of RBI were earlier carried out through its Department of Banking Operations & Development (DBOD) till December 1993. The tasks were split when a separate department called the Department of Supervision (DOS) was formed to take over the supervisory function ₄₉ . In November 1994, RBI formalized a board structure for the supervisory process when it constituted the Board of Financial Supervision (BFS) to give undivided attention to the prudential supervision of banks, non-banks and financial institutions in an integrated manner ₅₀ (RBI, 1999c, para 1.2).

The BFS is an autonomous body and directs the policies and operations relating to the supervision of banks, non-banks and financial institutions. Its autonomy is enshrined in statute, even though the board is evenly split between top RBI officials and non-official directors ₅₁ .

Following the Basle committee on banking Supervision ₅₂ note, the Reserve Bank assessed its own position and noted that most of the Core principles were already enshrined in existing legislation or current regulations. Gaps had been identified between existing practice and principle, mainly in the area of risk management in banks, inter-agency cooperation with other domestic-international regulators and consolidated supervision. The RBI set up internal working groups to suggest measures to fill these gaps, and the recommendations are now in the process of being implemented (RBI 1999c, Foreword).

A second detailed self-assessment using the revised methodology set out by the Basle committee was done in October 1999, with the same results. The gaps in respect of asset-liability management and risk management have been plugged, with the supervisory authority putting out detailed guidelines after a period of consultation and debate.

Yet, a critical gap remains between the principles enshrined in the rules and their implementation. Most important is the supervisory structure. Though the autonomy of the BFS is provided in statute, the presence of four top central bank officials, who are as much involved in monetary policy making as in regulation framing, casts a doubt on the effectiveness of the arrangement. This is especially true when wearing the hat of supervisors, their decisions have an obvious bearing on the monetary system, integrity of payment systems and broader regulatory issues. That situation has not yet arisen. But as we explain later, the effectiveness of an independent supervisory system will be tested once the supervisors shift to a transparent Prompt Corrective Action (PCA) principle.

Prompt Corrective Action (PCA)

The Reserve Bank of India's (RBI) PCA draft ₅₃ guidelines broadly follow the trip wires approach of the US Federal Deposit Insurance Corporation Improvement Act (1991) ₅₄ . Essentially, a PCA regime lays out a plan for structured, early intervention in problem banks. That is, while the net worth of the bank is still positive ₅₅ . Early intervention limits supervisory forbearance by committing the supervisors to a course of non-discriminatory action when faced with a weak bank. However, supervisors still retain some discretion in application of prompt action.

Having an explicit regime serves a twin purpose. It protects against supervisory forbearance in the sense that the supervisor commits himself to remedying a situation that calls for corrective action. The supervisor explicitly becomes part of the process of remedial action, which will no doubt also include equity owners, depositors and large creditors, the deposit insurance companies. To the extent bank failure, in later stages, is an unambiguous and direct hit on the supervisors, the latter have that much more incentive for prompt action, and against forbearance.

The other benefit of a documented PCA is that it serves to negate the effect of at least some implicit guarantees in the banking system. The impact of implicit guarantees in the banking sector has been well documented in the developing countries. By promising action when banks trip on the wires, a PCA counters the soporific impact of guarantees. Also, since the PCA sets out the downside risks of failing to meet with acceptable norms, management and owners are armed with advance information on the potential hazards of ill considered banking actions. "Since both the discretionary and the mandatory actions are known a priori to banks, they help shape the future behavior of banks so that regulators have stronger ex-ante influence and are not faced as often with unexpected fait accompli " (RBI, 2000).

For a discussion on objectives of a PCA, see Goldstein and Turner (1996).

This paper argues that supervisory activism of the proposed kind cannot operate in an environment where equity owners have failed in the task of bank restructuring. Supervisory activism is not a substitute for restructuring.

The argument is intuitively simple. The goal of supervision is to contain the risk of one bad apple bank from spreading into a systemic risk. A PCA acts to constrain the bad apple's business ambit: the restrictions become tighter as the bank's soundness slips more. It is like an ice cream cone, the (business width) thickness tapers with depth. Essentially, the supervisor's concern is a one-way concern with the minimum essential ingredients of sound banking. Beyond asking for replenishment of capital to meet minimum levels and imposing business restrictions, supervisors do not carry the can for restructuring the bank or devising strategies for nursing the afflicted bank to health and glory.

The latter is the sole preserve of the owners and the bank management. Restrictions are negative in scope, whereas restructuring implies a positive effort at remedying some of the problems. Without any attempt at genuine bank restructuring to start with, a well-intentioned PCA will fail to carry credibility. If it is too strict, it may end up exacerbating even manageable bush fires. And if it is too loose in its application, the listed benefits cannot be obtained.

We argue that the Indian PCA suffers from the same design flaws as those that plagued most of regulatory reform: that it attempts to weave in restructuring the weak banks with the basic task of supervisory oversight and prompt action. To the extent a PCA is an incentive structure for banks' compliance, response must come from within the banks. What is totally at odds with the framework of an impartial supervisor is the attempt to fit in restructuring modes within the mandatory and discretionary actions in a PCA.

The ideological underpinning of the Indian PCA is supervisory activism for "major deficiencies in banks' functioning". As against the PCA in the United States and in other countries, which restricts supervisory ambit to prompt corrective action to prevent insolvency in banks, the Indian PCA is a rule-based regime not only against insolvency but also to correct deficiencies in the banking system.

It is considered desirable to build a broader PCA regime in India so as to delineate rule-based actions not only for the shortfall in capital but also for other indicators of deficiency so that a seamless paradigm of corrective actions can be put in place for major deficiencies in banks' functioning (RBI, 2000, para 4.2).

The design of the Indian PCA follows the history of supervisory activism as the sole bulwark against deterioration in banks' health. "The PCA should encompass certain actions which should bring immediate improvements , while some action points would be initiated in alignment with the severity of the problem" (ibid., para 5.2, emphasis added).

Based on this approach, the Indian PCA focuses on three parameters: (i) capital to risk-adjusted assets ratio (CRAR) (ii) net non-performing assets (NPAs) and (iii) return on assets (RoA), "which represent the three important parameters viz., capital adequacy, asset quality and profitability" (ibid., para 4.3). Trigger points have been set for each of the parameters, with a distinct set of mandatory and discretionary actions that follow in case of slippages. "A set of mandatory and discretionary action points, in conformity with the magnitude of the problems should be in place to bring about improvement in the functioning of banks" (para 5.2, emphasis added).

The distinction between mandatory and discretionary actions is justified by the

rationale (that) some of the actions are essential to restore the financial health of banks while other actions may be taken at the discretion of the RBI depending on the profile of the bank. In cases where banks do not show improvement, despite taking mandatory actions, some of the discretionary actions will get converted into mandatory actions.(ibid.).

Thus, with each step lower into default, the discretionary actions are turned into mandatory actions. This is a powerful mechanism of exercising restraint on banks. But, the conceptual failing of the PCA regime seeps through to the design of the trigger points and action points.

The three trigger points in respect of capital adequacy ratio have been set at bands of three percent, with the regulatory minimum at the global minimum level of nine percent. Thus, the three triggers are:

i. CRAR less than nine percent, but equal to or more than six percent

ii. CRAR less than six percent, but equal to or more than three percent and

iii. CRAR less than three percent.

This is in line with global practices, though the FDIC in the US works on a five-zone principle. But the design of trigger points in the other two areas suggests reapplication of the "least common denominator" principal.

Trigger points on NPAs and RoA have been set arbitrarily at the median levels of the entire banking sector in the previous year. The first trigger for NPAs has been set at ten percent, which excludes 2/3 ^rd of the public sector banks, old private sector banks and foreign banks" (ibid., para 6.2.1). The RBI discussion paper argues that as per the data in the Report on Trends and Progress of Banking in India (1998-99), these banks had net NPAs of ten percent or less whereas the new private sector banks had an average net NPAs of 4.1 percent. " Thus, the ten percent level could be the trigger level for PCA. This is an appropriate level considering that 9 percent is the ceiling for granting autonomy " (ibid.).

The trigger point for RoA have been set even more arbitrarily at 0.25 percent. The discussion paper notes the wide variance in RoA reported by the four sets of banks (public sector, old private sector, new private sector and foreign banks), and also the fact that internationally, one percent "is considered as a benchmark" (ibid., para 6.3.1). But except for the new private sector banks, none of the other groups come anywhere close. So the proposed PCA suggests a second-best solution: In view of the sharp variations in RoA, it is difficult to set a trigger RoA at a level close to the desired level, i.e., one percent. Keeping in view the Indian reality, a trigger point of below 0.25 percent has been proposed (ibid., 6.3.2, emphasis added).

Clearly, the design considerations in the trigger points are dominated by taking the bulk of the banking system along which fits in with the basic aim of a PCA as focus on the banks that fall in the exclusion zone. Yet, except for triggers for capital adequacy that are unambiguous, the other triggers for NPA and RoA are relativist in nature. Mixing up of absolute and relative trigger points in a comprehensive PCA regime is dangerous, because it provides no security against supervisory forbearance in the future. A gross slippage in the industry-wide indicators in one parameter, for instance, would lead to a resetting of the trigger points. The basic rationale of PCA as a bulwark against supervisory forbearance is lost.

The design of action points, linked to the trigger levels, provides greater evidence of supervisory activism. For complete details see the RBI discussion paper (RBI, 2000) but here it would suffice to note that action points are essentially tasks that the bank management should be focusing on. A PCA, by that yardstick, only reduces to a time-bound action agenda for the troubled banks.

This means two things. First, if gross incompetence of the bank management is the problem, then it escapes explanation how a time-bound, transparent PCAówhich is again the enunciation of basic management principlesówith the same set of managers would aid recovery.

Second, if the realization that bank management need the tough armor of the supervisor's diktat to be able to push initiatives, then the Indian PCA is not a program for structured, early intervention but only an alignment of the supervisor, owner and management towards the goal of improving the system. Theoretically, in this case, a PCA is just the supervisor taking on the additional roles of owner and bank management. The lack of an objective focus in the exercise undermines credibility.

 

Chapter 5

Conclusion

While it would be tempting to conclude a lack of reform orientation and even active resistance on part of the authorities to tackle the problems in the banking sector, this paper has argued otherwise. The focus on non-disruptive change all through the reform effort seems to have determined the course of reform, and the probability of its success. It has conditioned the policy response, at each step, to the bare minimum elements required to keep the banking system moving. Bank management have, therefore, failed to internalize the change in incentives, implicit in the reform effort.

It is in failure to tackle the complex problems in the supporting real sector, as well as institutional restructuring issues within the banking sector, that reform managers have implicitly cast their lot with the bare minimum of banking reforms. This can be traced to a distinct lack of political will to tackle the many dimensions of the problem at the same time.

The silver lining is that at least the Reserve Bank of India, as banking regulator, has determinedly sought to upgrade regulatory standards. Discussion above shows that regulatory changes without a change in the environment in which banks operate amount to slim chances of success. Also, there are limits to regulatory activism.

We have argued that initial conditionsóspecifically, the post-currency crisis dynamicsóhave a significant impact on the course of reforms. Unless a determined effort is made to undo the damage of the post-crisis perverse sequencing and the initial inappropriate choice of instruments, reforms would continue to languish on a natural course. This chapter examines views to change the reform course.

1. Ownership Change

Perhaps the most important component in a strategy for change would be to privatize the banking system. There are three reasons why this would lead to immediate results.

First, it would sharpen the distinction between the commercial aspects of banking (profit maximization) and the social objectives. Transfer to private equity owners would instantly change the equation between bank management and the policy making apparatus in the government, leaving the former unconstrained to focus on the balance sheet. It will introduce the much-needed accountability in bank management. Being answerable to a body of shareholders would enforce higher standards of transparency and disclosure. These are objectives that regulatory reform attempts to promote, but without a sufficient target audience in mind, such changes end up with lip service to transparency and disclosure.

To be sure, ownership issues and privatization of banks is linked to the broader approach to privatization in India. Without any claims to great understanding of the political process behind privatization, one would guess bank privatization gets low priority both for the prospect of dispensing patronageóthough connected lending is strictly tabooóand for captive funding of the government's poverty alleviation programs. Also, getting banks into such a loop relieves the government of setting up the additional bureaucracy to monitor the status of assets created and the incremental income streams generated. Since banks are supposed to be naturally adept at selecting credit-worthy borrowers and taking effective follow-up action, it is almost inconceivable to visualize banks being separated from the poverty alleviation through supported asset creation paradigm.

Another view is that the government's privatization priorities are essentially dictated by the sale-ability of assets. Thus while telecom companies and airwaves have been effortlessly privatized, selling government share in nationalized bank's equity is a more difficult proposition. Investors would be wary of the excess manpower, high overhead costs and low profitability in the sector, apart from the fact that banking involves too much interaction with the government.

Finally, there is a view that still finds strong support that control over banks is the bare minimum of the commanding heights philosophy that formed the core of the Indian development paradigm.

2. Priority Sector & Directed Lending

The issue of adequate availability of credit to the weaker sections has often clouded debate on priority sector lending. Consequently, commercial banks are being loaded with high costs of a large rural branch network with obvious implications on overall profitability and manpower strength.

While it is aptly recognized (as evidenced in the report of several committees on the subject) that the core issue is not the quantum of credit but its timely availability, there has been little action, perhaps because the political system fears alienating a major constituency. In popular political debate, any attempt at right sizing the number of banks covering rural areas would amount to a conscious attempt to de-emphasize the rural sector and generally, an anti-rural bias.

A broad political consensus on reforming the credit delivery system has to be combined with innovative ways to attack the market failure argument. Indeed, credible alternatives on the latter issue would automatically ensure adequate and timely supply of credit to all sectors and effectively erode the resistance to change.

3. Human Resources

The issue of surplus manpower in the banking industry is inextricably tied to the larger issue of exit policy for labor and capital, which in turn is linked to issues of employment generation in the organized sector.

A beginning has, however, been made to sell a voluntary retirement scheme to bank employees which aims at cutting the active workforce by 20 percent.

More importantly, banks need the leeway to employ the technical professionals that they need and pay market competitive salaries. They need to break away from the concept of parity that often pervades bureaucracies. For instance, salaries in the banking sector are tied to salaries in the central government and its undertakings. Though the wage bill will inevitably rise, banks' return on investment in talented staff will increase and justify the increased wage bill.

4. Problem of Weak Banks

Half-measures, like selective performance monitoring of weak banks in return for recapitalization funds, etc., only tend to isolate the weak bank's management from the result of their inefficiencies. Repeated recapitalization only serves to increase the moral hazard as both management and depositors take government support as given. Unfortunately, the only way to shake them out of their empathy is to close down at least one weak bank and hold the management personally accountable for bad practices. That perhaps is the only way to break the vicious circle of "public sector nature" of nationalized banks eating into their profitability and viability, as also infuse a modicum of monitoring by the depositors.

I have examined the proposal to require banks to have part of their capital in uninsured debt, in large marketable lots as a way to infuse a greater degree of market monitoring of banks. I conclude that until such time as government ownership is the biggest source of moral hazard, no purpose is served by installing the uninsured debt model of market discipline. For market discipline to work, the down side risk of loss should be clearly quantifiable. If markets and depositors perceive no risk of loss ever, it is hard to visualize market discipline working.

 

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Endnotes

Note 1 Financial liberalization is defined as the removal of financial repression, in the sense of McKinnon (1973) and Shaw (1973). Typically, liberalization is dated the time of interest rate deregulation since it is an observable policy change (see Demircug-Kunt, Asli and Enrica Detraigche, 1998). This started in 1991. Here, liberalization is used in the more popular context of changes in a broad range of economic policies, including policies to open up the financial sector. Back

Note 2 Restructuring is defined as equipping banks with the coping mechanisms needed to respond to incentive changes in the liberalized framework. Back

Note 3 The PSBs command more than 80 percent of the total assets of the banking system (RBI 2000b, para 2.2). Back

Note 4 See Table 5, Dziobek and Pazarbasioglue (1997). India has not been considered in the sample. Back

Note 5 1 core = 10 million. Back

Note 6 There was no recapitalization in 1999-2000. Back

Note 7 Consolidated bank group-wise balance sheet data was not disclosed either. This is a backward extrapolation based on balance sheet structure post 1996. Back

Note 8 Caprio and Klingbeil (1996) define insolvency as cases where the bank's net worth is completely eliminated and list India as one of the cases with "major bank insolvencies" and "systemic crises." Back

Note 9 Net of provisions. Back

Note 10 A flat rate of 2.5 percent on the aggregate of all outstanding loans below Rs 25,000, raised to 5 percent in 1999-2000. Back

Note 11 Following the report of the Committee to Consider Full Disclosure of Published Accounts of Banks (Chairman: A. Ghosh), the Reserve Bank of India advised all scheduled commercial banks (excluding regional rural banks) to disclose accounting policies regarding key areas of operation at one place, along with notes to accounts in their financial statements the accounting year ending March 1991 (RBI, 1991, para 13.16). Back

Note 12 See Dziobek and Pazarbasioglue (1997) for the success ratio of central bank instruments, and recapitalization in bank restructuring. See also Enoch, Garcia and Sundarajan (1999). Back

Note 13 Support is usually made available by the central bank or the government through a direct budgetary grant. Some central banks have limited themselves to providing temporary (mostly short-term) support which was replaced by other sources (government budget) when the bank restructuring strategy was put in place as in Argentina, Kazakhastan, Latvia, and Mauritania (ibid.). Back

Note 14 Such penalties are always difficult because it is impossible to identify bad management decisions from the overall economic environment. Back

Note 15 The Committee had suggested that "[the banking system] should evolve towards a broad pattern consisting of (i) three or four large banks which could become international in character; (ii) eight to ten national banks with a network of branches throughout the country, engaged in universal banking; (iii) local banks, whose operations would be generally confined to a specific region; (iv) rural banks whose operations would be confined to the rural areas, and whose business would be predominately in financing of agriculture and allied activities. Back

Note 16 In Budget 2000, the union finance minister proposed to bring down the government equity in nationalized banks to 33 percent, but added the caveat that the "nationalized nature of the banks will not change." Back

Note 17 The Bank Economists' annual conference in (October) 1997 had 'Indian Banking: Second Phase of Reforms' as the main theme. Back

Note 18 Former Chairman, State Bank of India, and Honorary Adviser to the Reserve Bank of India. Back

Note 19 Table 4, ibid. Back

Note 20 Initially, the target of government ownership was 51 percent, which was reduced to 33% in the Union budget 2000-01. Back

Note 21 Section 12(2) of the Banking Regulation Act (1949) restricts shareholders in a banking company from exercising voting rights on poll in excess of 10 percent of the total voting rights of all shareholders. Back

Note 22 The Indian Banks' Association, representing management, negotiates with the officers' and employee unions, separately, for five-year contracts. Back

Note 23 The argument against doing away with the industry wage negotiations is that it would work against the interests of workers in the weaker banks, who are not at fault for the state of the bank. Back

Note 24 Until 1998-99, service fees for sundry banking services were set by the Indian Banks' Association, the umbrella professional body of bank management. Fees for foreign exchange services were set by the Federation of Foreign Exchange Dealers of India (Fedai). Back

Note 25 These branches deal in particular services like Non-resident Indian services, small scale or large industry services. Back

Note 26 A viable balance of payments is one in which a country's current account deficit can be financed, over the long term, by capital inflows on terms that are compatible with its development and growth prospects (Parker and Kastner, 1993). Back

Note 27 Since different components of liabilities had different CRR prescriptions, the effective rate is the weighted average. Back

Note 28 Exporters would rationally react to the expectation of an imminent downward movement in the exchange rate by delaying the inward foreign exchange remittances. Similarly, importers and others with foreign currency payment obligations would rush in, even earlier the due. This disturbs the normal leads and lags in the system. The interest rate on export proceeds and import finance is used to influence the expectations process. Back

Note 29 Discussed in detail in Chapter 3. Back

Note 30 See Annexure I. Back

Note 31 Currently deputy governor in the Reserve Bank of India. Back

Note 32 The RBI had dispensed with administered pricing of large loans but stipulated that banks set a minimum lending rate for themselves. As always, the State Bank of India's minimum lending rate became the industry standard. Back

Note 33 As captured in the theme and deliberations of the Bank Economists' Association annual conferences since 1994. Back

Note 34 There are currently 196 regional Rural banks, covering 451 districts in the country (RBI, Trends & progress of Banking in India, 1998-99, para 2.55). Back

Note 35 See the deliberations of the annual Bank Economists' Conferences for a detailed understanding of the problems in the credit delivery system, bankers views and regulator's response. Back

Note 36 "Recovery of debts due to banks and financial institutions Act, 1993" provided that monetary claims above Rs 10 lakhs (one million)be adjudicated by the Debt Recovery Tribunals. The Tribunals are expected to dispose of such claims within six months of such applications. The tribunals follow a summary procedure that is expected to expedite disposal of suits filed by banks. Back

Note 37 The government also filed a transfer petition for transferring the cases stayed by various High Courts to the Supreme Court so that the question of validity of the Act could be decided by the Apex Court. On March 18, 1996, the Supreme Court ordered that notwithstanding any stay order passed on any of the writ petitions, the DRTs shall resume their functions. Back

Note 38 However, the Union finance minister noted that the progress of DRTs is satisfactory. In Budget 1999-2000, he said: The Debt Recovery Tribunals, which were set up for expeditious adjudication and recovery of debts due to banks and financial institutions, have started showing encouraging results. Government has decided to set up five more DRTs and four more Debt Recovery Appellate Tribunals. Back

Note 39 Ironically, the Union finance minister suggested that banks were to blame for chronic cases. "The inability of banks to enter into timely compromise settlements of chronic cases of overdue loans leads to locking up of banks' funds and long drawn litigation in recovery suits. Public sector banks will be encouraged to set up Settlement Advisory Committees so that such chronic cases, especially those relating to the small sector, are settled in a timely and speedy manner. RBI will be issuing necessary guidelines to the banks in this regard." Back

Note 40 Bankruptcy is a screening mechanism designed to eliminate those firms which are economically inefficient and whose resources can be better used in some other activity (White, 1989) Back

Note 41 IFCI invited bids for sale of its stake in Modi Rubber, a sick company. Back

Note 42 The committee turned in its report in April 1998. Back

Note 43 The availability of a safety net or an easy exit option may influence banks to lend to riskier projects than they would have without the safety nets. This is called the moral hazard problem. Back

Note 44 Bank management actually had to pay an additional amount to staff, across the board, to bring them to accept computerization. This was buffeted by the government's solemn promises that there will be no retrenchment of surplus staff. Back

Note 45 "A 30-35 percent reduction in staff costs is required in the three (identified weak) banks so that the ratio of staff costs to operating income in these banks comes to the median level of the same ratio in public sector banks. (Para 7.100) Back

Note 46 Borrowers were allowed one month after end of the relevant quarter to pay up. That makes for a gap of seven months (6+1) before an asset is classified as substandard. The international norm is three months. (Hawkins and Turner, 1999). Back

Note 47 Reformers in Africa and in transitional economies have been especially disappointed, perhaps because of their high expectations. Back

Note 48 In the last decade, several new institutions have appeared on the financial scene. Merchant banks, mutual funds, leasing companies, venture capital companies and factoring services have now joined hire purchase companies in expanding the range of financial services available. ..The committee recommends that the supervision of these institutions, which form an integral part of the financial system, should come within the purview of the new agency to be set up for this purpose, under the aegis of the RBI. Back

Note 49 Tuya and Zamalloa (1994) discuss the question of whether the supervisory function should be located within or outside the central bank. However, in their survey, Folkerts-Landau and Lindgren (1998) suggest that the effectiveness of supervisory function, does not depend on the location, if the position of the supervisory authority is especially circumscribed in law and that a minimum set of conditions are met. "If these conditions are met, the location of the supervisory function becomes less relevant for practical purposes..." (pp. 45). Back

Note 50 Later, the Department of Supervision (the operating department) was bifurcated into Department of Baking Supervision (DBS) and Department of Non-banking supervision (DNBS). The former is responsible for the supervision of commercial banks and their merchant banking subsidiaries. However, the regulation and supervision of the financial institutions is still combined in a division within the DBS, called the Financial Institutions Division (FID). Back

Note 51 The Reserve Bank governor is the chairman of the BFS while the deputy governor in charge of supervision is the vice-chairman. The other two deputy governors together with four non-official directors from the Central Board of the RBI are members of the BFS (ibid., para 1.4). Back

Note 52 A committee of banking supervisory officials of G-10 countries, circulated a list of 25 Core Principles of Effective Banking Supervision, in 1997, in consultation with supervisory authorities of a few non-G 10 countries, including India. The Core Principles of Effective Banking Supervision independence and adequate resources are maintained (Folkerts-Landau and support a system of banking supervision whereby clear responsibilities and objectives are delineated and operational Lindgren, 1998) Back

Note 53 The Reserve Bank of India had circulated draft guidelines for the proposed PCA regime. Officials said in October 2000 the final guidelines would be ready shortly, with some modifications. Back

Note 54 See Benston and Kaufman (1997) for a review. Back

Note 55 This means, liquidation of the bank will not technically be insolvent. Back