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Banks: Of reforms and more...

Apr 20, 2007

Financial sector reforms in India introduced as a part of the structural adjustment in the early 1990s have had a profound impact on the functioning of the financial institutions, especially banks. The principal objective of financial sector reforms was to improve the allocative efficiency of resources, ensure financial stability and maintain confidence in the financial system by enhancing its soundness and efficiency. At the same time, reforms were also undertaken in various segments of financial markets, to enable the banking sector to perform its intermediation role in an efficient manner. What also needs to be noted is that the reforms were not driven by any banking crisis nor were they an outcome of any external support package. They were undertaken much before the financial sector crisis was recognized by international agencies and other countries in early 1990s and before the Asian financial crisis.Various measures initiated over the last decade-and-a-half have significantly strengthened the commercial banking sector in terms of profitability, asset quality and capital comfort. The soundness parameters of the banking system, in particular, have shown sustained improvement.Thumbs up!
Thanks to persistent reforms initiated in this direction, the asset quality of the Indian banking sector has improved significantly over the past one decade. The sector's gross NPAs which stood at 15.7% of advances and 7.0% of total assets in FY96, declined to 3.3% of advances and 1.9% of total assets in FY06. Similar trend can be seen in the net NPA ratios during the same period, reflecting better recoveries by banks and well-appraised allocation of funds. The improved financial performance of the sector is reflected in the profitability parameters. However, the impact of intensified competition can be inferred from the significant reduction in interest spread over the reform period.

The sectors' operational snapshot
Net profit
Source: Trends and Progress in Banking

Several balance sheet and profitability indicators also suggest that the Indian banking sector indicators are moving towards global benchmarks.

Global comparison
FY06 (%)RoACARNPA / advances
UK 0.812.81.0
Source: IMF Global Financial Stability report

Thumbs down!
In January 2006, the Reserve Bank of India (RBI) allowed Indian banks to augment their capital base by issue of innovative perpetual debt instruments and perpetual non-cumulative preference shares eligible for inclusion as Tier I capital, debt capital instruments and redeemable cumulative preference shares eligible for inclusion as Upper Tier II capital. As the date for compliance with Basel - II norms closes in, Indian banks have to strengthen their capital bases to maintain the mandatory CAR. The government's stake in most state-owned banks is at or near the required minimum of 51% leaving little or no headroom for further dilution. The state-owned banks have therefore been proposed to utilise the avenue of hybrid capital to shore up their capital base. While hybrids will be a positive for the larger banks, which either ways can access perpetual debt at a reasonable rate, the ones with lower credit ratings will fail to derive any benefits from the same. Also, as larger banks have access to overseas funds, the hybrid capital route is expected to only facilitate their growth, rather than balance the growth of all entities in the sector.

While consolidation appears to be inevitable, there has hardly been any forward movement in this direction, apart from consolidating banks that have not been performing well. The RBI has restricted itself to formulating guidelines for the same without instigating any proactive measure. A stronger political will is required and the 'reform-oriented' government might have to play a bigger role to facilitate larger mergers amongst state-owned banks. The four takeovers (two forced by the regulator and two voluntary) over the last 12 months, have commanded valuations based on the value of their franchise, thus accentuating the significance of size and reach.

Yet to pass the litmus test...
The RBI has been proactive in aligning the domestic banking sector to global best practices by sketching a roadmap for implementation of Basel II accord for capital adequacy (by FY08E) and inviting foreign investment in private sector banks (by FY09E). It, however, remains to be seen as to how the players in the sector respond to the new set of reforms and adapt themselves in an environment of intensified competition and 'survival of the fittest'. With the success of these reforms, the sector is expected to come into its own.

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