Information about Asia and the Pacific Asia y el Pacífico

6 On the Way to a World-Class Banking Sector

Catriona Purfield, and Jerald Schiff
Published Date:
August 2006
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Information about Asia and the Pacific Asia y el Pacífico
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Dmitriy Rozhkov

In recent decades, the level of a country’s financial development has been accepted as one of the key determinants of the country’s economic growth. A positive relationship between financial development and growth has been established in the economic literature since the works of Schumpeter (1911) and Gurley and Shaw (1955), and has later been shown to exist at the cross-country, industry, and firm levels. More recently, a number of studies indicated that financial development is one of the determinants of economic growth.1

A developed and efficient financial (and, in particular, banking) system is important for the overall level of a country’s development for two related reasons. First, it provides an incentive for households to put their savings in a formal financial system, thereby making those savings available for productive investment. Second, it helps to ensure that available financial resources are applied according to their most productive uses, thereby maximizing the returns on investments, and improving productivity in the economy. In other words, the key economic contribution of banks is their role in efficiently intermediating between borrowers and lenders.

Furthermore, a strong and efficient financial sector helps to reduce vulnerabilities, which is especially important in the presence of large and potentially volatile capital flows. While theoretical predictions are some what ambiguous, many recent empirical studies have suggested that greater openness and competitiveness of banking systems reduce the probability of a systemic banking crisis.2

This chapter looks at India’s progress in building a strong and efficient banking system. It reviews the recent developments in the Indian financial sector, and assesses potential risks to the banking system posed by the recent rapid credit growth. It then turns to the remaining obstacles to financial development.

Recent Developments in the Indian Financial Sector

In recent decades, India has achieved significant progress in developing and deepening its financial system. All commonly used measures of financial sector depth (such as the ratios of banking system assets, deposits, and loans, and broad money (M3) to GDP) have substantially increased (Figure 6.1).

Figure 6.1.Indicators of Financial Depth, 1980–2005

(In percent)

Source: Reserve Bank of India.

Furthermore, in the 1990s and early 2000s, the Indian authorities have taken important steps toward deregulation of the banking sector. Interest rates have been progressively deregulated on both the deposit and lending sides,3 and competition has increased through entry of new private and foreign banks (Koeva, 2003). Over the same period, disclosure standards for banks have improved, and bank regulation and supervision have been steadily strengthened.

Most recently, the pace of financial development in India has accelerated. In 2004–05, annual growth of bank credit in India was 30.6 percent, compared with a growth of 15.6 percent in deposits (Figure 6.2). As a result, the credit-to-deposit ratio reached a record 66 percent in March 2005, and exceeded 100 percent when only new loans and deposits are considered. Data for April-December 2005 indicate that the growth of credit continued at an annual rate of just over 30 percent, while deposits grew by 17 percent in annualized terms over the same period.

Figure 6.2.Growth in Total Credit and Deposits, 2000–05

(In percent)

Source: Reserve Bank of India.

As a result of this acceleration, in 2004 India had the fastest real rate of credit growth in Asia, followed by Indonesia (Table 6.1). However, India’s experience with such high rates of credit growth was not unique. In fact, it was outpaced by several countries in emerging Europe and Central Asia, where real rates of credit growth exceeded 40 percent, driven in part by financial deepening and by the entry of foreign banks. Credit growth rates were lower among the industrial countries in Europe, but in some of them they significantly exceeded the GDP growth rates (notably in Ireland, Spain, and Greece).

Table 6.1.Real Credit Growth in Selected Countries and Regions, 2002–04(In percent)
Real Growth of Credit to Private Sector1Private Sector Credit to GDPCapital to Risk-Weighted AssetsNPLs to Gross LoansReturn on Assets
Sri Lanka4.49.712.928.629.931.510.016.0
Emerging Asia6.
Emerging Europe15.122.521.032.134.738.
Western Europe3.05.07.1133.7137.2141.
Latin America1.6−3.93.833.831.531.
Middle East and Central Asia14.615.820.535.136.037.618.313.61.7
Sub-Saharan Africa11.511.88.314.115.214.716.913.33.1
Source: IMF, Monetary and Financial Systems Department.

Deflated by end of period CPI.

Not risk-weighted capital ratio.

State-owned commercial banks.

Source: IMF, Monetary and Financial Systems Department.

Deflated by end of period CPI.

Not risk-weighted capital ratio.

State-owned commercial banks.

In addition to financial deepening, recent credit growth in India was also partly driven by cyclical factors. Strong income growth, rapidly growing consumer demand, and decreasing borrowing costs have contributed to rising demand for credit. India is now going through an upward phase of an economic cycle, with real GDP growing at an average annual rate of about 8 percent over the last three years. IMF staff estimates using the Hodrick-Prescott filter indicate that recently credit growth has begun to outpace the cyclical upturn (Figure 6.3). In 2004, credit growth in India was 8 percent above trend, with GDP growth a much smaller 1 percent above trend.

Figure 6.3.Cyclical Components of Real Credit Growth, 1994–20041

Sources: Reserve Bank of India; and IMF staff estimates.

1 Trends are estimated using Hodrick-Prescott filter.

Indian credit growth has been relatively broad based (Table 6.2). In the year ended in March 2005, nationalized banks4 (accounting for 47 percent of total credit of the banking system) saw their credit growing fastest, at 33.6 percent, but other groups of banks were not far behind. Credit in metropolitan areas was the fastest growing (Bangalore and Mumbai witnessed the fastest growth of credit, 49 percent and 42 percent, respectively), but credit in rural areas (representing 9 percent of the total) also grew by 25 percent.

Table 6.2.Growth of Loans and Deposits by Type of Bank and by Region
Deposits MarchDeposits MarchLoans MarchLoans MarchShare in Total Credit March
Annual growth rates, in percentIn percent
By groups of banks
State Bank of India group19.715.716.126.023.1
Nationalized banks16.215.915.633.647.4
Foreign banks28.65.215.324.66.7
Regional rural banks12.
Other scheduled commercial banks23.417.823.831.920.1
All scheduled commercial banks18.715.617.330.6100.0
By population groups
By major banking centers
Source: Reserve Bank of India.
Source: Reserve Bank of India.

Priority sectors (which include agriculture and small-scale industries) were the main contributors to the growth in nonfood credit (Table 6.3). Priority sectors accounted for 40 percent of the total 28 percent growth of nonfood credit. Within the priority sectors, agriculture loans in particular were a main driver of growth with a 35 percent increase in 2004–05. This continued the trend of the last 10 years, which saw the share of industry in the total loan portfolio of commercial banks declining from 54 percent in 1995/96 to 38 percent in 2004/05.

Table 6.3.Credit Growth by Sector(Percent change)
Percent ChangeContribution to Credit Growth
Priority sector24.731.011.2
Small-scale industry9.015.6
Industry (medium and large)
Nonbanking financial companies18.910.80.2
Wholesale trade10.136.01.2
Export credit17.214.31.1
Gross nonfood bank credit17.527.927.9
Source: Reserve Bank of India.
Source: Reserve Bank of India.

Another important development over the same period was a reduction in Indian corporations’ reliance on bank loans as a source of financing. Unlike in most developing countries, Indian companies do not rely exclusively on banks for financing. The corporate bond market is fairly active,5 and companies have started to use the capital market and external borrowings more actively (although in the last few years this trend likely was driven by a fast appreciation of the Indian stock market). Between 2000 and 2005, the share of equity in total resource mobilization of the Indian corporate sector (equity and debt) increased from 4.2 percent to 26.5 percent (Sharma and Sinha, 2006). The ratio of stock market capitalization to GDP in India is significantly higher than in low-income countries and in most economies in transition, although it is still lower than in many emerging market economies in Asia and in industrial countries (Figure 6.4).

Figure 6.4.Stock Market Capitalization to GDP, End-2004

(In percent)

Source: Beck, Demirgüç-Kunt, and Levine (2000) database updated in January 2006.

Consumer credit in India is starting from a very low base, but is growing rapidly. In 2004, total household credit (which includes mortgage loans and consumer durables credit) was lower than in most emerging market economies in Asia, when measured in percent of GDP or of total credit (Table 6.4).6 However, mortgage loans were growing at a faster rate than in any other emerging market Asian economy, and credit card debt was picking up as well, albeit from very low levels.

Table 6.4.Consumer Credit in Asia, 2004
Hong Kong SARIndiaKorea1MalaysiaPhilippines1SingaporeTaiwan Province of ChinaThailand
Household credit (percent of GDP)
Household credit (percent of total credit)35.622.056.244.516.450.341.624.4
Mortgage loans (percent of total household credit)83.047.355.156.538.461.959.865.9
Credit card debt (percent of total household credit)6.43.335.437.716.135.431.726.8
Growth of mortgage loans in 2003–04−1.942.015.515.44.115.915.515.6
Growth of credit card debt in 2003–040.736.0−−0.331.129.7
Nonperforming loan (NPL) ratio for credit card debt5.46.334.
Sources: For India, Reserve Bank of India; for other countries, “The Growth of Consumer Credit in Asia,” Hong Kong Monetary Authority Quarterly Bulletin, March 2005.

For Korea and the Philippines, NPL ratio is for 2003.

Sources: For India, Reserve Bank of India; for other countries, “The Growth of Consumer Credit in Asia,” Hong Kong Monetary Authority Quarterly Bulletin, March 2005.

For Korea and the Philippines, NPL ratio is for 2003.

Retail banking is increasingly viewed by Indian banks as an attractive market segment. The expansion of the retail banking segment can be attributed to a growing middle class with high disposable income, wider choices of consumer durables, increased acceptance of credit cards, and increased demand for housing loans, spurred by attractive tax breaks. In addition, the Reserve Bank of India (RBI) has taken a number of initiatives to increase transparency and competition in the credit market, including the dissemination of information on lending rates of banks since 2002, and the creation of a credit registry.

Risks from the Recent Rapid Credit Growth

The rapid credit growth described in the previous section is a welcome development, since it is mostly a sign of increasing financial depth. However, credit growth at the speed that was recently experienced in India inevitably brings with it some potential risks, related to possible weaknesses in risk assessment by banks, as well as potential problems for capital adequacy and liquidity. The key task of the policymakers, therefore, is not to slow down the credit growth, but to minimize the risks associated with it, to make sure the credit growth is sustainable. Moreover, there is always a question of whether market mechanisms are allowed to work to allocate credit in the most efficient way. The next two sections deal with these issues in turn. This section will look at potential risks from the rapid credit growth, and the next section will analyze the remaining obstacles to efficient allocation of credit and to the financial sector development in general.

While most lending booms do not end with a banking crisis, most significant episodes of banking distress in the last 20 years were preceded by rapid credit growth (Figure 6.5). Various empirical studies estimate the likelihood of a banking crisis following a lending boom to be as high as 20 percent.7 Some countries that experienced a financial crisis in the last 20 years had a credit-to-GDP ratio at the time of the crisis as low as 40 percent, similar to the current Indian level.

Figure 6.5.Average Credit to GDP Ratio in Eight Countries That Had Financial Crisis in 1987–971

Source: Duenwald, Gueorguiev, and Schaechter (2005).

1 Finland, Indonesia, Korea, Mexico, Norway, Philippines, Sweden, and Thailand.

Fast credit growth can trigger banking distress through two channels—macroeconomic imbalances and deterioration of loan quality. At present, macroeconomic risks from fast credit growth appear to be minimal in India. Although credit growth has resulted in a reduction of banks’ holdings of government securities, this has so far led to only a modest increase in treasury bill rates. Moreover, while imports and the trade and current account deficits are rising, RBI reserves of $160 billion as of end-April 2006 are large. The key risk in the Indian case, therefore, appears to be credit risk.

In cases when rapid credit growth did lead to a banking crisis, it was usually due to a failure by banks and supervisors to maintain asset quality, properly account for risks, and ensure that adequate buffers were built in anticipation of a possible downturn. In times of rapid credit growth, the mere quantity of loan applications makes risk assessment difficult, and often results in a decreased quality of new loans. An additional source of concern in the Indian case comes from the fact that the current rapid credit growth is in part due to cyclical factors (and risk tends to be underestimated during booms and overestimated in recessions), and is accompanied by considerable exuberance in asset markets, suggesting the possibility of asset overvaluation.8

The aggregate nonperforming asset (NPA) ratio of the Indian banking system is currently low, although it may increase in the future. The aggregate nonperforming loan (NPL) ratio was 5 percent at end-March 2005, after having steadily decreased for the last five years. However, the most recent decreases in the NPL ratio are in part due to credit growth itself, as a growing share of the stock of loans is relatively new. Deterioration in asset quality typically occurs with a lag of one to two years, since a loan is classified as nonperforming only after it has not been serviced for a certain time. Furthermore, the NPA ratio is highest in public banks, which dominate the sector, and in lending to priority sectors, which is the biggest contributor to the overall credit growth (Table 6.5). While these numbers are not high enough for serious concern at the moment, they suggest that the policy of encouraging banks to increase their lending to priority sectors should at the least be conditional on appropriate credit assessment by banks.

Table 6.5.Nonperforming Assets (NPAs), March 2005
Public BanksPrivate BanksForeign BanksAll Banks
NPAs to gross loans5.
Provisioning ratio61.350.062.859.7
Net NPAs to capital13.69.54.511.7
NPA ratios in
Priority sectors7.
Small-scale industry11.611.12.711.3
Consumer loans2.
Mortgage loans2.
Credit card debt25.
Source: Reserve Bank of India.
Source: Reserve Bank of India.

Rapid credit growth also puts pressure on banks’ capital. New loans to the private sector increase risk-weighted assets, making it more difficult for banks to satisfy the capital adequacy requirement. So far, however, capital adequacy of the system appears sound. The aggregate capital adequacy ratio (CAR) was at 12.8 percent as of end-March 2005, and only two banks out of 87 were violating the RBI requirement of 9 percent. Nevertheless, there are indications that some banks may have started to feel pressure on their capital. At end-March 2005, seven banks had a CAR between 9 percent and 10 percent (against only one bank a year before), and there were reports of some banks issuing significant amounts of subordinated debt to shore up their Tier II capital.

Stress Tests

Stress tests can be used to assess the vulnerability of the Indian banking system to credit risk. Three scenarios were considered by the IMF staff: (1) an increase in provisioning to the levels consistent with international best practices;9 (2) an increase in NPLs by 25 percent; and (3) an increase in NPLs due to a portion of the “new” loans becoming nonperforming. In the third scenario, we assume that all loans made in the last two years are currently performing. Then, we assess the effect of these “new” loans becoming nonperforming at the same NPL rate that the “old” loans currently have. Assuming that the NPL ratio of the “old” loans reflects the average quality of risk assessment mechanisms currently in place and the average riskiness of lending in India, this is a fairly realistic scenario.

The results of the stress tests indicate that the Indian banking system as a whole is resilient to the tightening of provisioning requirements and to the deterioration in credit quality that typically accompanies periods of rapid credit growth (Table 6.6). No group of banks would experience serious capitalization problems as a result of increased provisioning or a 25 percent increase in NPLs. In the third scenario, which has the biggest effect on banks’ capitalization, most groups of banks still remain above or very close to the capital adequacy requirement of 9 percent. The only exception are old private banks, whose aggregate CAR falls to 6 percent, but these banks together account for less than 6 percent of the market. Capital adequacy of all of the six largest banks in the country remains above 8 percent in this scenario. However, the next four banks (accounting for 12 percent of the system’s assets) would see their capital adequacy fall to the levels of 4–7 percent. While this is a significant reduction compared with their current levels of capitalization, it need not present a systemic risk for the banking sector, and the affected banks should be able to restore their capital adequacy relatively quickly through new capital injections, consolidation, or other means.

Table 6.6.Stress Tests: Capital Adequacy Ratio Under Various Scenarios
All BanksPublic BanksOld Private BanksNew Private BanksForeign BanksTen Largest Banks
Actual at end-March 200512.812.812.512.114.112.7
Stress tests scenarios
Increased provisioning12.011.910.711.713.811.8
NPLs increase by 25 percent10.410.07.511.113.210.1
New loans become NPLs at the same rate as old loans9.
Memorandum item:
Market share (assets)
Sources: Reserve Bank of India; and IMF staff estimates.
Sources: Reserve Bank of India; and IMF staff estimates.

The analysis above suggests that, while the recent rapid credit growth does present some risks, at the moment those risks do not appear to be significant. There are currently no signs of serious asset quality problems in the banking system, the aggregate ratio of credit to deposits is still moderate, capital adequacy ratios are sufficiently high, and the NPA ratios are low. Nevertheless, credit developments need to be closely monitored, to ensure that potential risks do not materialize.

Sound financial policies (including prudential rules and regulations) play a crucial role in allowing the level of stress in the financial system to be contained (Das and others, 2005). The RBI has already taken several steps to respond to potential risks. In 2004 and 2005, it increased the risk weights on consumer and housing loans, and on commercial real estate and capital market exposures.10 It also tightened loan classification rules in line with the international best practices, by requiring that a loan be classified as nonperforming after it has not been serviced for 90 days, instead of the previous 180 days. More recently, general provisioning for nonpriority sector loans was increased from 0.25 percent to 0.4 percent.

The RBI is also working on reducing potential risks from the expansion of consumer credit. Consumer credit is still at low levels in India, and the NPL ratios are low (2.2 percent for all retail loans, 1.9 percent for housing loans, and 7.9 percent for credit card debt). However, the rapid rise in credit card debt (36 percent in 2004/05), as well as the already sizable share of nonperforming loans and reports of unfair market practices, point to the possibility of future problems. Experience of other countries (notably Korea) shows that developments in this area need to be closely monitored, especially in an environment where the concept of consumer credit is new for most borrowers. The RBI has recently issued a set of guidelines for credit card operations, aimed at raising consumer awareness and punishing unfair market practices.

Nevertheless, additional prudential steps could be considered, especially if rapid credit growth continues. Experience of other countries that had periods of high credit growth can be useful. Hilbers and others (2005) explored the policy options that are available to counter and reduce the risks resulting from fast credit growth. The Indian authorities have indicated that they are considering the scope for additional steps, including the further tightening of loan classification norms and the introduction of “special mention” loans that would require provisions (International Monetary Fund, 2006).

Remaining Obstacles to Financial Development

The improving financial soundness of the banking sector and the absence of major risks provide an opportunity to devote more attention to developmental issues, and to accelerate banking reforms.

Despite all the remarkable progress of the last decades, India still lags behind the major industrial countries in financial sector development. The ratio of private sector credit to GDP grew from 33 percent in 2002 to around 40 percent in 2005—a level that may be impressive by developing countries standards but that is significantly lower than the levels in many other Asian countries, Western Europe, or North America (Figure 6.6). Many types of credit—in particular retail credit—still remain at very low levels, as banks in India have tended to invest a large share of their deposits in government securities. Government securities still account for 31 percent of banking system assets, while net loans account for about 50 percent. Although growing rapidly, retail loans (which include housing loans, consumer durables, credit card receivables, and other personal loans) are still small at about 7 percent of GDP.

Figure 6.6.Banks’ Credit to the Private Sector, 2004

(In percent of GDP)

Source: IMF, International Financial Statistics.

1Data for India are for end-March 2005.

Furthermore, although Indian banking has become more inclusive over the years, the majority of rural population (including large farmers) still does not have access to finance from a formal source (Srivastava, 2004; and Basu, 2005) (Figure 6.7). This happens in spite of the fact that Indian banks typically exceed the government’s target for the loan growth in priority sectors. The demographic branch penetration in India (6.3 branches per 100,000 people) is also lower than the developing Asia average of 7.5 (Beck, Demirgüç-Kunt, and Martinez Peria, 2005). This leads rural households to rely heavily on informal finance, where the interests charged averaged 48 percent a year in 2003.

Figure 6.7.Access of Indian Households to Formal Finance1

(In percent)

Source: Srivastava (2004).

1 Marginal farming households are those with landholding of less than one acre; small with one to four acres; large with four or more acres. Commercial households are with or without land, but with income from nonfarm sources exceeding half of total household income.

To compensate for the lack of finance from the formal banks, some new innovative microfinance approaches have been developed, including the self-help group (SHG) bank linkage, which received strong support from the government. However, the reach of microfinance institutions has been modest, and in any case microfinance cannot substitute for the efficient formal financial sector (Basu, 2005; and Basu and Srivastava, 2005).

Another potential source of finance for rural households are rural cooperative banks. However, many of them are in financial distress, with NPAs reaching 35 percent in some banks. More than a third of rural cooperatives are undercapitalized, and about a fourth are unprofitable. These banks also present a significant regulatory burden, given their large number and a number of differences in the regulatory frameworks for cooperatives and scheduled commercial banks.

Priority Sector Lending

One of the reasons for the continued failure of the Indian financial system to provide finance to the underprivileged population is the continued reliance on priority sector lending as a means to provide finance to rural areas. A recent World Bank report (Srivastava, 2004) noted that the directed lending norms that require banks to allocate 40 percent of their lending to the “priority sectors” have not generated the intended results, as access to finance of the rural households, as well as of the small and medium-sized enterprises (SMEs), remains at a very low level.

Lending in rural areas and to the SMEs remains a high-risk and high-cost proposition for banks. Uncertainty about the borrowers’ ability to repay, in the absence of credit information (and of proper accounting in the case of SMEs), drives up default risk. In addition, transaction costs are high, due to the small loan size, high frequency of transactions, large geographical spread, and widespread illiteracy (Srivastava, 2004). As a result, most banks prefer to get around the priority lending requirement by subscribing to other eligible instruments. Similar programs of directed lending in other countries were also typically shown to be unsuccessful in improving access to credit for the targeted groups.

A substantial impact on financial sector development could be achieved by a shift from the heavy reliance on priority sector lending to removing roadblocks to lending, such as remaining difficulties in recovering assets, lack of well-developed credit registries, and weak accounting practices in SMEs. The passage of the new Securitization and Debt Recovery legislation in 2002 and 2004,11 and the creation of the new credit registry in 2005, were both significant positive developments, but collateral requirements and limits on microfinance continue to constrain potential.

Dominance of Public Sector Banks

Another major obstacle to faster financial sector development in India is the continued dominance of public sector banks. Public banks account for 75 percent of banking system assets, 78 percent of deposits, and 67 percent of capital. Public banks have also played the major role in recent rapid growth in domestic credit. In contrast, foreign banks currently account for about 7 percent of total assets of the banking system, 5 percent of deposits, and 11 percent of capital.

The public sector also accounts for a significant share of banking sector credit, reflecting the important role public enterprises play in the Indian economy. Bank credit to the public sector in India accounts for nearly 40 percent of total banking sector credit, or slightly over 20 percent of GDP, which is higher than in many other Asian emerging market countries.12

A recent study argues that large public sector borrowing from the banking system may slow financial deepening, by affecting structural characteristics of the banking system (Hauner, 2006). In particular, it finds that high levels of public sector borrowing have a negative effect on standard indicators of financial sector depth, and that banks lending mainly to the public sector tend to be more profitable but less efficient.

Other recent studies (La Porta, Lopez-de-Silanes, and Shleifer, 2002) found that government ownership in banks tends to be significant in countries with low levels of per capita income, underdeveloped financial systems, interventionist and inefficient governments, and poor protection of property rights. They also found that government ownership of banks is associated with slower subsequent financial development and lower subsequent growth in per capita income, in particular with slower growth of productivity. These findings seem to support the view that government control of financial institutions tends to politicize resource allocation, soften budget constraints, and lower economic efficiency (Kornai, 1979; and Shleifer and Vishny, 1994), and stands in sharp contrast with the “development” view of government ownership (Gerschenkron, 1962; and Myrdal, 1968). Public banks can have a different objective function than private banks. As a result, they tend to provide credit based on considerations such as economic development needs, without efficiency considerations or sufficient assessment of risks.

The relatively slow pace of financial development in India and the lack of success in providing access to finance to poor and rural communities seem to support the pessimistic view of effects of government ownership in the banking sector. Furthermore, key financial soundness indicators of public banks in India tend to be worse than those of foreign and domestic private banks (Table 6.7). Efficiency indicators (such as the ratio of personnel expenses to total income) are also much stronger in domestic private and foreign banks than in public banks.

Table 6.7.Key Financial Soundness Indicators by Bank Ownership, End-March 2005(In percent)
All BanksState BanksDomestic Private BanksForeign Banks
Market share (in assets)100.074.418.86.8
Capital to risk-weighted assets12.812.912.214.0
Tier I capital to risk-weighted assets8.48.08.511.2
Gross NPLs to gross loans5.
Net NPLs to capital11.713.69.54.5
Personnel expenses to total income15.317.29.010.3
Return on assets0.
Return on equity13.614.711.710.8
Source: Reserve Bank of India.
Source: Reserve Bank of India.

The authorities are well aware of the need to further deregulate the banking sector, and are taking steps in that direction. In early 2005, the RBI announced a series of banking reforms, designed to give public banks greater autonomy and to provide guidelines for foreign bank expansion. The RBI sees it as a new step in the continuing process of financial market liberalization. The intention of the reforms is to increase public banks’ efficiency, while providing them breathing space by keeping some restrictions on foreign competition until 2009. From 2005, foreign banks are allowed to establish wholly owned subsidiaries (previously only branches were allowed). In addition, the RBI plans to amend legislation to eliminate the 10 percent cap on the voting rights of foreign banks. However, any acquisition of 5 percent or more by a foreign bank will still require RBI approval, and foreign direct investment (FDI) is limited to private banks identified for restructuring, with a limit of 74 percent. Full national treatment for wholly owned subsidiaries of foreign banks and the expansion of FDI to nondistressed banks is not envisaged until 2009.

These measures are a welcome step. While presence of foreign banks will not by itself solve all the problems of financial development,13 larger foreign bank presence should enhance the competitiveness of the banking sector, and widen access of qualified borrowers to financing (Mathieson, Schinasi, and Claessens, 2000; and Moreno and Villar, 2005). Currently, although foreign banks can engage in all financial sector activities, foreign presence in the Indian banking system (as captured by balance sheet data) is lower than in some other Asian emerging market countries, and significantly lower than in Latin America and Eastern Europe.14 Bringing forward the target dates for lifting remaining restrictions on foreign ownership from 2009 could therefore help to improve efficiency of the banking system.

More generally, however, efficiency gains could be achieved by increasing private involvement in the banking sector, domestic as well as foreign. An important step here would be allowing some public banks to reduce their government share below 51 percent. In addition to efficiency considerations, this step should make it easier for public banks to deal with the rapid credit growth and the need to meet Basel II capital norms, which Indian banks will be required to implement from end-March 2007. Fast credit growth is already putting pressure on capital adequacy of some banks, and it is expected that a number of public banks with government ownership close to the 51 percent floor would need additional capital to satisfy the Basel II requirements. Without access to new private capital, banks would have to resort to the new instruments approved by the RBI in 2006 (such as perpetual preferential nonvoting shares), which may not necessarily be the most efficient way to raise capital.

To conclude, India is currently in a fortunate position where a relatively sound financial system provides the opportunity to take a significant step toward increasing the efficiency of the financial sector. Prudential issues remain important, as recent rapid credit growth poses a number of potential risks, that need to be closely monitored. But the soundness of the banking sector combined with its resilience to potential shocks present a unique opportunity to accelerate the banking sector reforms. The key steps here would be to reduce reliance on priority sector lending targets as a way to provide finance to rural areas and SMEs, and to allow more private ownership in the banking system, domestic as well as foreign.


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The remaining restrictions on interest rates include a cap for small loans (under Rs 200,000) at the prime lending rate, and a floor on short-term deposit rates.


Public banks in India comprise the State Bank of India group and banks that were nationalized in the late 1970s and early 1980s.


In 2004/05, total resources raised from the debt markets were Rs 2.051 billion (6.6 percent of GDP). The corporate sector accounted for 29 percent of that amount, with the remaining 71 percent taken by the government. About 93 percent of corporate debt in 2004/05 was raised through private placements (Sharma and Sinha, 2006).


In central and southeastern Europe, which also experienced a period of rapid growth of consumer loans from a low base, consumer loans at end-2004 were equal to 12.4 percent and 11.9 percent of GDP, respectively.


Real estate prices in major metropolitan areas (such as Bangalore, Kolkata, and Mumbai) have increased at an annual rate of about 20 percent since 2003, with prices accelerating in the second half of 2004. Until the end of 2005, the Indian stock market had been growing at an annual rate of about 37 percent since early 2004.


Current regulations require provisioning of 20 percent on all substandard loans (defined as 3–12 months overdue), gradually increasing to 100 percent for loans that are more than three years overdue. In the stress tests, we test the effect of introducing a more stringent requirement of 25 percent provisioning on all substandard loans, and 100 percent provisioning on all loans that are overdue for more than 12 months.


Risk weights on housing loans went up from 50 percent to 75 percent, and weights on consumer credit and capital market and commercial real estate exposures were raised from 100 percent to 125 percent, above those recommended in the Basel Capital Accord.


The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act was passed in 2002. The Act confers powers on secured creditors to take possession and sell assets kept as security if a default is committed by the borrower in repaying secured debt. The Act also aims to regulate securitization, reconstruct financial assets, and enforce security interests. Some minor amendments to the Act were later made in the Enforcement of Security Interest and Recovery of Debts Laws (Amendment) Act in 2004.


Bank credit to the public sector accounts for about 50 percent of total banking sector credit in Indonesia, 6 percent in Malaysia, 33 percent in Pakistan and the Philippines, 23 percent in Sri Lanka, and 8 percent in Thailand.


Many recent studies on the role of foreign banks in developing countries find that foreign banks help improve risk management and increase technical know-how and efficiency. Others, however, suggest that foreign banks contribute little to financial deepening, preferring to “cherry pick” borrowers and generally shying away from providing credit to small and medium-sized enterprises (Detragiache, Gupta, and Tressel, 2005; and Gormley, 2005).


In contrast, foreign shareholders account for 21 percent of total trading in the Indian stock market—a level similar to other Asian countries.

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