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Banking: Betting on reforms

Mar 23, 2002

While the budget has curtailed fiscal concessions for other sectors, it has extended benefits to the banking sector. Even though the quantum of concessions given to the sector may not benefit it directly, it’s a step in the right direction to improve the structural problems faced by the banking industry. The biggest challenge worrying the sector today is, the availability of quality assets. The gross non-performing assets (NPAs) of the public sector banks escalated to Rs 566 bn as on September 2001 from Rs 548 bn on March 2001 and Rs 530 bn on March 2000. Rising NPAs not only reduces the sector’s yield on advances but it also has an adverse impact on profitability of banks. Although public sector banks possess rich branch network and manpower, their resources remains underutilized. Inefficient debt recovery tribunals, unclear foreclosure and bankruptcy laws discourage banks to make optimum utilization of their resources.

NPA analysis
 Growth in gross NPAsNet NPAs as a % of advances
Public sector banks2.60%3.20%7.40%6.70%
Private sector banks2.30%26.80%5.40%5.40%
Foreign banks10.90%17.50%2.40%1.90%
All SCBs 2.90%5.80%6.80%6.20%
SCBs: Schedule commercial banks

To help the sector in dealing with the menace of NPAs, the government has clubbed together three separate bills on foreclosure, securitisation and ARC (asset reconstruction company) into the Banking Sector Reforms Bill. The proposed bill is expected to clear the way for the assets reconstruction companies to tackle the growing problems of NPAs on which banks are yielding no income. An ARC would buy NPAs from banks, securitise it and sell it to the potential investors. The proposed ARC will be a pilot project. The equity participation for the proposed ARC is being worked out with banks, FIs and multilateral agencies. The idea of roping in multilateral agencies like Asian Development Bank (ADB) and International Finance Corporation (IFC) in the ARC is to attract foreign investors in the upcoming market for securitised NPAs. The benefit of these moves, however, depends on how soon and effectively these plans are implemented. If ARC is going to depend on the staff deputed by weak banks, its recovery chances for NPAs are doubtful.

Increasing the allowance for bad and doubtful debts from 5% to 7.5% of net profits of banks (before provision) would encourage banks to clean up their accounts by going for accelerated provisioning. The measure is expected to benefit banks with large-scale operations and with higher operating margins, as they will save more taxes compared to a bank with lower operating margins. However, as a proportion of net profits, the taxes saved will remain at around 1% of net profits for all banking companies.

Another indirect advantage given to the sector was introduction of dividend tax. Banks are likely to benefit from the removal of the tax-efficient status of debt schemes of mutual funds, which benefited investors in the higher tax brackets. Short-term debt mutual funds have received large inflow of funds in the last two years. But liquid and money market mutual funds would now no longer be attractive with the removal of tax saving opportunity. Consequently, these funds are expected to flow into the banking system, which will lower cost of funds for banks.

The reduction of small savings rate by 50 basis points and proposal to link these rates to yields on government securities would remove structural rigidities in interest rate administration for the economy as a whole. It will provide a level playing field for the banks with flexible interest rate regime. Also the ceiling of Rs 200,000 on Government of India relief bonds will bring back investors to banks fixed deposits.

To improve the efficiency of the sector, the budget has opened up the sector for foreign banks. The Government of India has given an option to foreign banks to either operate as branches of their parent or to set up subsidiaries. In case a foreign bank decides to operate as a subsidiary it will have to adhere to all banking regulations, including priority sector lending norms, applicable to Indian banks. On the one hand priority sector lending norms for foreign banks will increase to 40% from 32%, on the other, they will have an advantage in terms of widening their reach. Foreign banks are presently required to take a branch licence before opening a branch. But now under the proposed subsidiary set up, they will have to only inform the apex bank. The government is also proposing to relax the maximum ceiling of voting rights of 10% for such subsidiaries. This move is expected to increase the penetration of foreign banks in India, leading to healthy competition in the banking system. Several foreign banks operating in India may choose the subsidiary route for the benefits it offers in terms of geographical expansion and lower taxes. The subsidiary route would also make the consolidation process easier. Permitting higher foreign direct investment in the private sector banks will facilitate the consolidation process. However, it will increase competition for domestic banks particularly in the retail-banking segment.

Significant steps have been also taken to develop the debt markets. Banks are one of the most active players in the government securities (G-Sec) market. The transactions in this market are conducted either through telex or on phone. However, the introduction of negotiated dealing systems (NDS) will facilitate electronic bidding in auctions and secondary market transactions in G-Sec. It will also help in dissemination of information on trades on a real time basis, which was hitherto not available. The launch of Clearing Corporation of India (CCIL) will address the need for efficient securities settlement system. These measures will widen the breadth of the markets, providing liquidity to the banking system.

The government is initiating measures to make the sector globally competitive. However, its results will be reflected only in the long term. Falling interest rates have impacted the sector’s performance in terms of interest margins and profitability in the near term. However, with an expected revival in the economy, loan demand would pick up, reducing pressure on interest spread. Increase in government spending on roads and power sector, good agriculture growth, lower interest rates and recovery in commodity prices are some of the factors which would fuel the credit off-take.

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