Transcript Diagnostics: A Snapshot (1)

India’s Banking Sector:
Balancing on the Brink?
Priya Basu
The World Bank
November 1, 2002
I. The Debate
Many observers claim that India’s banking sector is on the
brink of a full-blown crisis. They point to the sector’s:
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large and growing volume of NPLs;
weak credit culture and poor risk assessment;
poor regulation of what is a highly politicized banking system;
inefficient management of banks exacerbated by the lack of
commercial incentives.
Others take a totally contrary view:
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While accepting that India’s banking system is inefficient, they
argue that the system is somehow insulated from a systemic crisis
because government ownership ensures public confidence in the
system, making large scale deposit runs unlikely even in the face
of insolvency.
Where does the reality lie?
II. The Case for Taking a Closer Look at the
Extent of Banking Distress in India
A closer look at India’s banking system is warranted for four
principal reasons:
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First, because banking distress often takes place covertly, and in slow
motion. To use the apt expression that van Wijnbergen used to characterize
severe banking problems in the making, “banking distress…is quiet
distress”. India is surely a case in point.
– The financial saving rate is high;
– With bank accounts present the main saving vehicles, deposit liabilities are large
(50% of GDP) and growing (17.5% p.a. over the past five years);
– Net profits of the banking system are positive even if NPLs are large and growing;
– And as long as the losses are not properly recognized by the banks, and the public
continues to deposit its money, and nobody asks any questions, the problem merely
grows….
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Second, reported data tend to understate the problem, and politicians tend
to respond to a troubled banking system by cover up rather than loss
recognition and the clear attribution of losses to large public enterprises or
powerful private conglomerates.
– The politics is decidedly difficult when a government has to own up to the fact that
the accumulated assets of savers are seriously impaired.
– These problems are even more acute in a system that is largely owned by
government, as in India, where the public sector banks account for 79% of banking
system assets.
…The need for a closer look at India’s banking system(contd)
• Third, as shown by the experience of countries around the world, delays
in restructuring distressed banking systems can turn out to be very costly
to a country’s public finances, with costs ranging from 5% to over 55%
of GDP.
• Fourth, the public liabilities generated by banking distress are certainly
not all. India’s banking system inefficiencies mean that:
– finance, which is so necessary for reviving growth and reducing poverty, is
not accessible easily, widely or cheaply;
– and that financial resources cannot be put to their most productive use.
Inefficiencies constrain growth and longer term prosperity. And this is of
particular concern, given the slowdown in growth since 1997, and the
enormous challenge of poverty reduction facing India.
So India has an overarching interest in recognizing its banking problems,
and in correcting those problems, with haste.
III. The Indian Banking Problem
Banking system strengths
• The predominance of core deposits as a source of funding
contributes to systemic stability. Total deposits are at over 80% of total
liabilities, significantly higher than in most OECD countries, where
banks rely considerably more on market borrowing.
• Indian banks’ exposure to sensitive sectors (real estate, capital markets,
commodities) remains low – at about 4% of total loans.
• Off-balance sheet exposures remain low for the public sector banks and
older private sector banks.
• Banks’ exposure to the equity markets is limited (at 0.6% of total
investments) and total lending to the capital markets is also low (at
under 1% of total lending).
Banking system weaknesses: Asset Allocation
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Investments in securities: 38% of total assets, 47% of total deposits. Credit: 41% of
total assets, 50% of deposits.
Investments in G-Secs and “other approved securities”: 36% of deposits for all
banks, 36.5%for public sector banks, 28% for the new private sector banks.
Why is this a matter of concern?
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Preemption of credit (SLR=25%) -- Crowds out credit to the private sector
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But banks’ holdings of G-Secs+other approved securities exceed the SLR, and this is
particularly so for the public sector banks, reflecting:
– Risk averseness of public sector bank managers, who have become hesitant to take
commercial risks for fear that they may be held responsible for commercial decisions
that turn sour
– A dearth of quality credit demand
While G-Secs represent a relatively risk free asset in good times, large holdings by
banks of such securities raises concerns over interest rate exposure. (1%point
upward shift in the yield curve would result in a reduction in the market value of
banks’ G-Sec portfolio by about 20% of capital.
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Also, the liquidity property of G-Secs depends upon the the proper functioning of the
G-Secs market; during a crisis, if everybody is on the same side (selling), then the
liquidity property of the asset would be very much reduced.
Banking system weaknesses: Asset Quality
Reported data on combined banking system NPLs: 928 billion, 5% of GDP
Commercial banks (100)
Banking System NPLs
NPLs
Rs. Billion
638.8
Total loans
Rs. Billion
5586.8
NPL/Total
loans (%)
11.4
93.3
155.8
59.9
195.7
55.9
139.8
27.6
75.4
21.6
15.2
1349.5
461.9
887.6
257.8
438.5
115.3
76.0
14.5
12.1
15.7
10.7
17.2
18.7
20.0
Regional rural banks (192)*
Cooperative banks **
Urban cooperative banks (1866)***
Rural cooperative banks
State coop banks (29)
Central coop banks (367)
SCARDBs (19)
PCARDBs (745)
13.1
7092.1
927.7
TOTAL
Source: Report on Trend and Progress of Banking in India 2000-01, Reserve Bank of India.
Notes:
* The total number of RRBs is 196; the data presented here is for 192 banks as of March 31, 2000.
** Data reported as of March 31, 2000.
*** The total number of UCBs is 2086; the data presented here is for the 1866 UCBs that reported
financial performance as of March 31, 2000.
…Weaknesses: Asset Quality
Reported data are believed to significantly understate portfolio quality:
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Weak application of existing loan classification norms; loans that are overdue
are often not properly classified as nonperforming, but simply rolled over.
Current classification norms for NPLs are lax. They require banks to classify as
“substandard” only those assets that have been in arrears for more than six
months (as against the international norm of three months) and as “doubtful”
after they have been in arrears for 18 months (as against the international norm
of 12 months), and giving a number of exemptions even to those figures.
Nonperforming government-guaranteed loans and some private placement
securities that are held in the investment account are not classified as NPLs.
The estimates of various private analysts suggest that if loans were
classified in accordance with internationally accepted norms, the NPL
portfolio of India’s commercial banks today would be almost twice as
high as what is reported, in the order of about Rs. 1229 billion (6.5
percent of GDP, or 22% of total loans).
…Weaknesses: Asset Quality
To be sure, commercial banks’ NPL performance shows considerable
divergence by bank groups, with public sector banks reporting much
higher NPLs (on both a gross and net basis) than the new private sector
banks or foreign banks.
Commercial Banks' Nonperforming Loans
1995/96 1996/97 1997/98 1998/99 1999/00 2000/01
Gross non-performing loans (% of outstanding loans)
Public sector banks
18
17.8
16
15.9
14
12.4
Domestic private banks
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8.5
8.7 10.58
8.2
8.5
Foreign banks
…
4.3
6.4
7.6
7
6.8
Net non-performing loans (% of outstanding loans)
Public sector banks
8.9
9.2
8.2
8.1
7.4
6.7
Domestic private banks
4.3
5.4
5.3
7.4
5.4
5.4
Foreign banks
1.3
1.9
2.3
2.9
2.4
1.9
Number of institutions with NPLs at above 10% of outstanding loans
Public sector banks
8
10
10
9
5
6
Domestic private banks
3
3
5
8
6
6
Foreign banks
1
3
9
13
10
11
Source: Report on Trend and Progress of Banking in India (various issues), Reserve Bank of India.
…Weaknesses: Asset Recovery Prospects Unclear
Recent Ordinance on Securitization and Reconstruction of Financial Assets and
Enforcement Of Security Interest allows for the creation of ARCs empowered to
recover bad assets w/o going through the lengthy/cumbersome court process.
But various factors dampen expectations about the likelihood of recovery:
• Poor quality of borrowers (65% of NPLs concentrated in “sick” industries, e.g.,
steel and textiles, featuring assets that are difficult to sell), absence of a domestic
market for bad debt, pessimism over the participation of foreign buyers.
• Developing country experience suggests recovery rates in the range of 8 to 10 cents
in the dollar, and at best, 30 cents in the dollar.
Expected low recovery raises the question of whether banks would be able to absorb
the “hit”, when the loan/collateral cannot be sold at par. And whether, in the
current regulatory environment, where banks are neither forced to value their
assets accurately nor to provision adequately, banks would decide simply to hold on
to NPLs rather than make any attempts at recovery.
Moreover, while the Ordinance marks a key step in dealing with the “stock” of NPLs,
important “flow” problems remain. NPLs will continue to grow until the incentives
for sound lending and risk management improve. This requires better governance
and management of banks, and enhanced regulation to impose the necessary credit
discipline.
…Weaknesses: Capital Adequacy
The risk-weighted capital asset ratio (CAR) of the public sector banks,
domestic private banks and foreign banks, respectively, is above 9%; most
banks, including the systemically important banks, satisfy the required CAR. A
few banks do not meet the regulatory minimum, some by a wide margin, but
they collectively account for a small percentage of bank assets
However, these figures need to be taken with some caution, and banks—
particularly the public sector banks—are less well-protected against risks
than reported data might suggest.
• Gearing is high because of large holdings of low-risk weighted G-Secs (Tier I
capital for the public sector banks is only 3.4 percent of total non-risk
weighted assets.
• Loan classification standards are lax.
• The current provisioning by public sector banks, at about 50% of gross NPLs,
may not reflect the true likelihood of recovery. Substandard loans are subject
to a flat provisioning requirement of 10% (compared to the international norm
of 20%, while provisions for doubtful loans which comprise about 60% of
NPLs at present, are phased in. Indeed, foreign banks on average provision at a
rate of 75% (which includes an element of higher discretionary provisioning).
Stress test results (for public sector banks)
The stress tests for the public sector banks indicate that:
1. Without correcting for the reported NPL numbers, if banks were to
increase the average provisioning rate from 50% to the same average
rate (75%) as foreign banks, their average CAR would decline by 3
percentage points to 8 percent, generating additional capital needs of
Rs 90 billion (under half a percent of GDP)
2. If banks were to provision fully against all nonperforming loans the
CAR would decline to 5 percent, with additional capital needs of Rs
226 billion (about 1%of GDP)
3. If, as independent analysts suggest, public sector banks’ gross NPLs
were in fact double the amount reported—and this is not a far fetched
assumption–and assuming average provisioning at the same rate as
foreign banks, this would make the public sector banking system
insolvent, generating the need for additional capital of Rs 500 billion
(almost 2.5% of GDP).
The public sector banks are not a uniform group, and some stronger banks
may generate sufficient profits to attract private capital. But many
may not be able to do so.
…Weaknesses: Profitability
• Strong improvements in bank profitability during 2001/02 were
primarily from trading in G-Secs in a declining interest rate
environment.
• But such gains from treasury operations are typically one-off. Rough
calculations suggest that the gains from treasury operations in 2001/02
would neutralize with a rise in interest rates on G-Secs by over 1%.
• Meanwhile, banks continue to suffer from key underlying problems
that constrain profitability, including:
– Some remaining elements of interest rate controls for small loans.
Close to a quarter of the public sector banks’ total loans are smaller than
Rs. 200,000, with lending rates subject to the PLR ceiling.(In the foreign
banks, which lend more to large borrowers, only 12.5 percent of the loans
are under Rs. 200,000).
– Deep operational inefficiencies. The cost to income ratios of the public
sector banks (67%) are much higher than private banks (52%) and foreign
banks (50%). (A C/Y ratio of 60% is considered as the minimum
efficiency standard in the OECD countries).
• Public sector banks function at about 20% of the productivity of their
newer private sector counterparts.
IV. Benchmarking India’s Banking Distress:
How do India’s banking problems compare with countries that have
suffered systemic banking crises?
Systemic crises around the world
A systemic crisis is typically defined as a situation when much or all of a banking
system’s capital is wiped out. Since the 1970s, over 100 episodes of such crises
have occurred in some 93 countries.
Some of these crises have been overt and sudden, characterized by a wide scale run on
banks, typically triggered by a macroeconomic shock (exchange rate shock,
interest rate shock, credit shock, or a combination of these). Indonesia, Korea and
Thailand (1997), Turkey (2001), and most recently, Argentina.
– E.g., an exchange rate devaluation could drive under water a banking system
that is highly exposed to other currencies, either because loan customers in
other funding suffer dramatic losses or the banks themselves, having borrowed
offshore in unhedged forex positions, experience a funding shock that wipes
out the capital base. Or, if the cost of funding suddenly rises while loan rates
are locked in, losses are made and disintermediation forces banks into high
cost short maturity funding at a loss. Or, a sudden economic downturn can
bring systemic defaults on the portfolio.
But other crises have taken place more quietly, over a protracted period (as in China or
Japan over the last decade), resulting in a steady erosion of bank capital, and often
over a lasting recession. The exact date of the onset of such quiet crises is not
always clear.
Benchmarking India’s financial distress
Macroeconomic indicators
India’s banking system appears to be sheltered from a crisis triggered by an external
macroeconomic shock of the type suffered by the East Asian countries, because:
• India’s exchange rate regime is flexible,
• foreign exchange reserves are high,
• there is not yet full capital account convertibility,
• and the foreign exchange exposure of India’s banks and their customers is limited.
In contrast, the East Asian economies, prior to 1997, were characterized by inflexible
exchange rate regimes that complicated macroeconomic management and increased
vulnerability and rapid credit expansion, fuelled by capital inflows, reflecting direct
borrowing by banks (Korea and Thailand) or corporations (Indonesia)—that led to asset
price inflation and excessive risk taking.
Structural/Financial Sector Related indicators
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Reported NPL ratio of India’s commercial banks is currently worse than in any
of the east Asian countries pre-1997.
Lending practices in India (as in East Asia) tend to rely on collateral rather
than credit assessment and cash flow analysis.
Directed lending (as in Korea), high exposure to individual clients, excessive
sectoral concentration of loans.
…Benchmarking India’s financial distress
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Prudential regulations do not meet up to international standards; loan
classification and provisioning norms in India are more lax than in at least four
of the east Asian countries on the eve of their crisis.
Lack of full autonomy of the financial sector regulators/supervisors—regular
waiver of prescribed limits, forbearance, & “lifeboat” schemes for nonviable
institutions
Accounting and disclosure practices.
Regulatory architecture—multiple regulators, lack of autonomy, gaps in
supervision.
Close links between government and financial institutions—directed lending
circumvents the need for thorough risk assessment and management by banks,
makes government co-responsible for the quality of assets, and provides an
implicit guarantee on banks’ liabilities.
Slow and inefficient judicial framework.
Lack of financial diversification means that companies are highly leveraged
and poorly governed (India’s stock market cap is lower than Malaysia,
Philippines or Thailand pre-1997).
V. Conclusions
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India’s banking system is probably not about to succumb to a vast bank run
resulting in an open crisis. But that is not a test of the quality of the banking
system nor a cause for complacency.
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Banking distress in India is significant, both in absolute terms and also when
compared with the distress faced by many of the East Asian countries on the eve
of their crisis. Critical banking sector indicators— notably, NPLs— are much
worse for India than for some East Asian countries on the eve of their banking
crises, and in fact are comparable to “peak” NPLs in many crisis countries. India’s
banking system today is plagued by a weak credit culture, poor risk assessment
and management, supervision and regulation that is not fully in line with
international standards, and an inefficient legal and judicial framework.
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That large deposit runs are unlikely should not be used as an excuse for
postponing reforms. The system needs deep and early reforms so that finance can
make a fuller contribution to growth, and so that banks cease to act as a drain on
scarce fiscal resources.
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Delays in addressing the banking problem could result in an escalation of bail-out
costs for the Government, which would mean a growing public finance liability
that would be borne ultimately by future generations of India’s taxpayers. And if
the banking problem is allowed to grow unchecked, it would become ever more
difficult to revive sustainable growth and achieve longer term prosperity.