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The Indian banking industry has emerged into a complex multi-tier structure with a range of big and small Banks and FIs operating. Way back in 1951, the need to form state sponsored institutions to increase flow of credit to the rural areas led to the formation of the State Bank of India by an act of Parliament passed in May 1955. In 1959, State Bank of India took over the eight former state-associated banks as its subsidiaries. A major turning point in the industry was in 1969 with the nationalisation of 14 major banks, which led to considerable reorientation of bank lending to meet social objectives. In 1980, eight more banks were nationalised. In 1976, the Regional Rural Banks Act came into being that allowed the opening of specialised banks exclusively to meet the credit requirements in the rural areas. These banks were set up jointly by the central government, commercial banks and the respective state governments. Apart from these, there was a large network of cooperative banks and a few private banks. Thus, till around the 1980s, a large portion of the banking industry was state-controlled; that was recognised to be better adapted to meet the needs of economic planning and aiding the otherwise neglected sectors like agriculture and small scale industries.

The period following nationalisation was characterised by rapid rise in banking business and helped in mobilising national savings. Savings rate in the country leapfrogged from 10-12% of GDP in the two decades of 1950-70 to about 25% by 1980. Aggregate deposits which registered annual growth in the range of 10% to 12% in the 1960s rose to over 20% in the 1980s. Growth of bank credit increased from an average annual growth of 13% in the 1960s to about 19% in the 1970s and 1980s. Branch network expanded significantly leading to increase in banking coverage, especially in the rural areas..

Indian banking, which experienced rapid growth following nationalisation, began to face pressures on asset quality by the 1980s. Simultaneously, the banking world everywhere was gearing towards meeting new prudential norms and operational standards pertaining to capital adequacy, accounting and risk management, transparency and disclosure etc. In the early 1990s, India embarked on an ambitious economic reform programme in which the banking sector reforms formed a major part. The Committee on Financial System (1991) more popularly known as the Narasimham Committee I prepared the blue print for the reforms. Few of the major aspects of the reforms process included (a) moving towards international norms in income recognition and provisioning and other related aspects of accounting; (b) liberalisation of entry and exit norms leading to the establishment of several New Private Sector Banks and entry of a number of new Foreign Banks; (c) freeing of deposit and lending rates (except the saving deposit rate); (d) allowing Public Sector Banks access to public equity markets for raising capital and diluting the government stake; (e) greater transparency and disclosure standards in financial reporting; (f ) suitable adoption of Basel Accord on capital adequacy; (g) adoption of technology in banking operations, etc.

The reforms led to major changes in the approach of banks towards issues such as competition, profitability and productivity and the need for adopting global best practices. Today, the business of banking in India has undergone a sea change with fee-based income overtaking net interest margin, relationship banking being replaced with transaction banking. Revenue streams for banks have shifted from the traditional lending model to fee-based wholesale and retail banking, technologybased banking, advisory services, bond-derivative products, insurance and institutional investments. Use of technology has become a key-differentiator for banks in driving growth, though investment in technology is still sub-optimal.

Structure of the Indian Banking Industry

The Indian banking system has undergone significant changes in the post reforms period, with the introduction of new banks, new instruments, growing opportunities and new avenues to increase income streams. Accompanying this has been rising competition and risk factors. In this rapidly evolving milieu is a set of 183 commercial banks are now operating in India. Scheduled Commercial Banks (SCBs) in India are categorised in five different groups according to their ownership and/or nature of operation. As of end Mar 07, the bank groups operating were State Bank of India and its associates numbering 8, Nationalised Banks (20, including IDBI), Regional Rural Banks (96), Private sector Banks (26) and Foreign Banks (29). All Scheduled Banks comprise Schedule Commercial and Scheduled Co-operative Banks. Scheduled Cooperative banks consist of Scheduled State Co-operative Banks and Scheduled Urban Cooperative Banks. The cooperative sector as a whole, including urban and rural, has approximately 3,000 entities operating.

By FY07, the number of scheduled commercial banks functioning in India was 183. The 83 scheduled commercial banks (excluding RRBs) accounted for over 80% of the financial sector; cooperative banks accounted for 11% of the market, and RRBs 3%. There were over 73,000 bank offices spread across the country, of which 43% were located in rural areas, 22% in semi-urban areas, 18% in urban areas and the rest 17 % in the metropolitan areas.

Indian Banking at a Glance

Source: RBI, Statistical Tables Relating to Banks in India

Performance of public sector banks has improved significantly over the years and is comparable with other domestic banks in terms of products and services offered. The new private banks and foreign banks have been significant drivers to growth in the banking sector, and currently hold a combined share of 25% in total assets as of Mar 07.

Major Components of Balance Sheets of Scheduled Commercial Banks - Bank Group-wise

Source: RBI Trends and Progress in Banking 2006-07,

Operations of SCBs

Growth in the Indian banking industry has been achieved with the least instability, as against those experienced by several East Asian and Latin American countries. The reforms period saw a significant improvement in the capital position of commercial banks. As of end-March 2007, SCBs operating in India maintained a capital to risk-weighted asset ratio (CRAR - which is also an indicator of the capacity of the banking system to absorb losses) at 12.3% as of Mar 07, way above the stipulated minimum of 9% and the Basel I norm of 8%. Though improvements in capitalisation of public sector banks was initially brought through infusion of funds by the government as a move to recapitalise these banks, subsequently they were allowed to raise funds from the market through equity issues, along with maintaining a public ownership of 51%. This has resulted in substantial diversification in ownership of public sector banks.

Credit growth picked up significantly since 2003 largely on account of robust growth in the economy and excess liquidity in the banking system. The growth remained broad based thus reducing credit concentration risks. The principal driver to credit growth though was retail loans, which grew by over 35% annually. Retail loans as a percentage of gross advances increased from 22% in Mar 04 to 25.5% in Mar 06. Within the retail credit segment, commercial real estate and housing were frontrunners. However, despite the sharp rise in credit, NPA levels have declined not only in proportions but also in absolute levels.

Since the mid-1990s, non-performing loans of banks have consistently declined. Asset quality has improved significantly as reflected by the decline in the ratio of gross NPLs to gross advances from 16% in FY97 to 2.4% in FY07. The ratio of net NPLs to net advances at 1.0% is comparable with that of several advanced countries. Some of the key factors that enabled this significant reduction in nonperforming assets include a rapidly expanding economy, improvement in the credit appraisal process, greater provisioning and write-offs of NPAs and SARFAESI Act that enabled resolution of NPLs.

Till the initiation of reforms, the Indian banking system was saddled with very high reserve requirements (Cash Reserve Ratio and Statutory Liquidity Ratio) mainly to accommodate the high fiscal deficit in the economy and its monetisation. These have been lowered substantially over the years – the CRR has come down from a peak 15% in 1992 to 7.5% currently and SLR from 38.5% to 25%. Regulatory norms in terms of capital adequacy, income recognition, asset classification and provisioning are gradually moving towards converging with international best practices. These measures have, in turn, infused transparency and accountability in the functioning of banks. Apart from sub-standard assets, provisioning has also been introduced for the standard assets.

As of FY07, the position of Indian banks based on various financial indicators were as follows:

Deposits/Advances/Investments/Assets of Bank Groups in India

Source: RBI

Today, significant changes are perceptible in the strength and sustainability of Indian banking. Apart from a growing domestic spread, Indian banks have also expanded operations abroad. As of Oct 07, sixteen Indian banks, including 11 public sector and 5 private sector banks, were operating a network of 192 offices. Indian banks have experienced sharp growth in profitability, greater emphasis on prudential norms with higher provisioning levels, reduction in non-performing assets and surge in capital adequacy. The Indian banking industry is preparing to meet two major requirements: compliance to Basel II norms, and a smooth transition towards more intense competition arising from further liberalisation of the banking sector from 2009.

The Issue of NPAs in Indian Banking

The problem of NPAs has been a concern to the Indian Banking industry since long, which became pronoumced in the 1980s, largely arising out of priority sector lending targets and the “provide & hold” strategy. The Narasimham Committee I in 1991 had recommended the creation of an Asset Creation Fund to which public sector banks would transfer their non-performing assets with certain safeguards. However, the recommendation was not accepted, and banks were internally dealing with their NPAs. Debt Recovery Tribunals (DRTs) were established consequent to the passing of the RDDBFI Act, 1993. A Scheme of Corporate Debt Restructuring (CDR) was introduced in 2001 outside the purview of BIFR. The SARFAESI Act was passed in 2002 paving way for the creation of Asset Reconstruction Companies. Guidelines on debt restructuring of viable or potentially viable small and medium enterprises were issued in September 2005. These recent measures have all enabled banks to address the “flow” and not just the stock of NPAs.

These institutional measures, accompanied with high economic growth and asset base diversification has helped banks to improve the quality of assets despite the tightening of prudential norms in terms of classification of non-performing assets. NPAs have been consistently on a decline since the mid-1990s. However the scenario of NPA management considerably improved since the passing of the SARFAESI Act. Among the various recovery channels available to Banks, the DRTs and SARFAESI have been the most effective in terms of amount recovered, though the number of cases referred to Lok Adalats is the highest.

Cases Referred under various schemes by Banks

*One-time settlement scheme for SME by PSBs
#No. of Notices issued under SARFAESI Act
Source: RBI

An Assessment of NPAs

In FY07, the asset quality of SCBs as a whole had improved, judged by the decline in gross and net NPAs as a percentage of loans & advances, although in absolute terms net NPAs grew. As regards to sector -wise break-up, NPAs from priority sector has been rising since FY06 and especially for the public sector banks. The share of priority sector NPAs in total NPAs was at 54.1% in FY07, of which NPAs other than agriculture and SSI constituted almost a quarter of total NPAs. In terms of bank groups, gross NPAs of nationalised banks and old private sector banks declined, while those of new private sector banks, SBI Group and foreign banks showed an increase during the year. By loan asset categories, asset quality of SCBs improved, with share of standard assets in total advances increasing to 97.5%. The share of sub-standard loans remained stable at a low 1%. The share of “doubtful” and “loss” categories declined in proportion as well as absolute terms.

It was observed for the last four years, from FY04 to FY06, that on an average around Rs 230 bn or USD 5.7 bn worth of NPAs is added by SCBs to the Indian financial system. During FY07, NPAs worth Rs 262 bn were added by SCBs, which was approximately 1.3% of total advances by SCBs. The annual addition of NPAs as a percentage of outstanding advances has declined substantially though in the last four years from 2.8% in FY04 to 1.3% in FY07.

Outstanding NPAs in the Indian Financial Sector

*Net NPA value for UCBs, # only for UCBs
$ NPAs in FY07 dipped as the total number of FIs reduced by one to 7, lending was restricted and above all IFCI showed zero NPAs as it was written off as
part of its restructuring.
Source: RBI

At an aggregate level, total outstanding Net NPAs in the banking sector, including SCBs, FIs, NBFCs, Co-operatives, put together was Rs 264 bn. Gross NPAs for FY07 stood at Rs 647 bn (excluding rural cooperatives). In FY06, gross NPAs accounted for 2.8% of GDP. These figures are also understated in a sense as data for NPAs for financial corporations likes State Finance Corporations, Mutual Fund and Insurance Industry is not easily available. Nevertheless, FY07 saw a very clear increase in NPAs only among SCBs, and this is likely to worsen in FY08 due to the rise in interest rates witnessed during the year.

Distressed Assets

A more appropriate way of assessing stressed asset is by tracing the changing profile of aggregate distressed or non performing assets in the Indian financial system.

To gauge the extent of distressed assets prevailing in the banking system, one has to look at the stressed assets of all financing/lending institutions including SCBs, FIs, NBFCs and Cooperative banks. Similarly, corporate loans restructured under CDR scheme, structured loans other then corporate debt and the write-off of bad loans should also be considered. The level of under-performing loans saw a significant dip in the last four years. As a percentage of GDP, the assets declined from 4.9% in FY04 to 3.2% in FY06. The recapitalisation and restructuring of RRBs, that is being pursued based on recommendations of Vaidyanathan Committee since 2006, will significantly bring down the NPAs in the co-operative sector.

Distressed Assets in the Financial System

Source: RBI, D&B Research
# only for UCBs

The quantum of loans restructured in FY04 was relatively high, with Rs 34 bn worth loan being under restructuring. This has shown a gradual fall with only Rs 10 bn worth loan assets restructured in FY07. This could be partly attributed to the various means deployed by Banks/FIs for NPA recovery discussed later.

* Does not include NPAs for RCBs Source: RBI, D&B Research

Provisions for NPAs

Cumulative provisions as on end-Mar 07 were lower compared to the year ago level across all bank groups, except among new private sector banks and foreign banks. Although gross NPAs in absolute terms declined, net NPAs increased reflecting the higher write back of excess provisioning than the fresh provisioning for the year.

Over the last few years, provisioning for NPAs by SCBs has come down which in turn has raised net profits for these banks. The stricter provisioning norms set by RBI has compelled banks to let go the “provide and hold” strategy and find ways to recover the bad loans or write off the loss ones. However, banks have also been instructed to have more recoveries than write-offs in a particular year.

Source: RBI, D&B Resereach

The ratio of provisioning to NPAs reflects the ability of a bank to withstand losses in asset value. The vulnerability of a bank’s balance sheet is mitigated to the extent non-performing loans are covered by loan loss provisions. A low ratio of provisioning to NPAs makes the banking system vulnerable to shocks. Indian SCBs maintained provisioning of 56.1% of gross NPAs as on end-Mar 07, which was comparable with global standards

Provisions for NPA as a % of Gross NPAs across Countries

Note: Ratios for Japan, Canada & Australia pertains to 2006; Ratios for South Africa & UK pertains to 2005
Source: Global Financial Stability Report, IMF, 2007