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Business News/ Politics / News/  The next big step in banking reforms
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The next big step in banking reforms

The next big step in banking reforms

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The recommendations of the committee for the financial sector reforms, that were recently put up for public comment, seek to fundamentally alter the landscape of the Indian banking sector.

For one, they include greater autonomy for public sector banks (PSBs), unshackling them from the fetters of a multitude of “public sector" administrative regulators, allowing proportional representation of various stockholders—public and private—in truly empowered PSB boards.

The committee advocates greater liberty for all banks in general. Licensing of branches and automated teller machines by the Reserve bank of India (RBI) should cease and these should become tradable between banks. Doors should be opened for smaller banks to start, while banks that become undercapitalized according to the new norms should be promptly shut down. The monopoly of banks over access to the payment system and cheque writing facility should decline in step with its obligations to provide cheap funds to the government, priority sector and public sector entities.

Given the increasing range of services provided by financial firms, the committee envisages the financial holding company structure with subsidiaries ranging across various fields—banking and non-banking—as the model for the future.

What would be the broad impact on India’s banks if these suggestions are implemented?

First, the banking sector would become largely “ownership neutral". PSBs, domestic private sector banks and foreign banks would become largely indistinguishable in their operations and business models. Further, the distinction between banks and non-banking financial companies (NBFCs) would become far less watertight and areas of competition will be determined by the functions rather than forms of the competing institutions.

As the financial sector develops in India, the traditional boundaries between banks and NBFCs become fuzzy. Banks now sell insurance and mutual funds and provide portfolio and corporate treasury advisory services while NBFCs accept term deposits and provide loans.

To avoid perverse incentives and regulatory arbitrage, it is important that institutions serving essentially the same function face the same set of regulations whether they have a banking licence or not. For instance, secured creditors such as banks and NBFCs should have the same status with regard to the SRFAESI Act or debt recovery tribunals, which is not currently the case.

Regulations should deal with functions, not historical labelling of institutions. This is true not just for banks and NBFCs but across and within various sectors of the Indian financial landscape.

Going by the relative performance of different bank groups in recent years, PSBs have fared no worse than other groups. However, the future looks different.

The structure of the industry is changing. Going forward, fee-based wholesale and retail activities and complex financial products are likely to be far more important to banks. Here is where banks need superior human capital to excel. Government salary norms and administrative rules hamstring PSBs vis-à-vis their competitors.

PSBs are also losing the more affluent and younger customers to their private sector and foreign competitors. These trends are well captured in the considerably lower valuation multiples of PSBs compared with private banks. With listing and partial privatization, PSBs are increasingly being evaluated on profitability and competitiveness without the operational freedom that others enjoy.

It is only fair to let the PSBs play by the same rules if they are expected to deliver similar results.

But what about the social responsibilities of PSBs? Will this not be a banking sector solely targeted for the urban rich? Will banks any longer open branches in remote rural areas to aid financial inclusion? Will the government and RBI be able to achieve their distributional policies through banks?

The massive expansion of PSBs into rural areas was largely a feature of the 1970s and 1980s when licences were issued for urban or metro branches only if a certain number of rural or semi-urban branches were opened by the bank—the 4:1 rule. The pattern for branch expansion changed dramatically in the 1990s. With liberalization, PSBs effectively stopped adding rural branches. Given the same incentives, PSBs are no more inclined to serve the inclusion agenda than their private competitors.

From the government’s perspective then, inclusion is better served by setting appropriate norms and providing incentives at the policy level, without distinguishing between public and private banks. Both are equally likely to promote inclusion if and only if they find it in their best interests to do so.

Similarly for directed credit. In recent years, private banks have actually directed a greater share of their lending to priority sectors than PSBs though the composition of priority lending may be different.

Historically, bank nationalization has led to more credit to agriculture, villages and public sector undertakings but not to the small scale sector or thrust areas identified in recent five-year plans.

In terms of the credit quality of priority sector lending, PSBs have fared relatively poorly.

Uniform and detailed priority sector lending norms are likely to yield similar lending patterns on the ground regardless of whether the lender is a private or a public bank. Allowing banks to trade priority sector lending credit would ensure that priority sector lending is allocated to banks according to their capabilities in this area.

The core principles guiding these recommendations include regulations based on function, rather than form; and the separation between policymaking and bank management.

Policymakers should set suitable incentives and allow independent banks to pursue efficiency in that setting, not meddle in their functioning through action-specific regulations. Therein lies the essence of second generation reforms in Indian banking.

Rajesh Chakrabarti teaches finance at the Indian School of Business, Hyderabad, and was part of the research team that supported the work of the committee on financial sector reforms.

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Published: 06 Apr 2008, 11:04 PM IST
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