Improving Indian Banks’ Performance by James A. Hanson

Overview India liberalized credit markets to support the real reforms/more credit for the private sector. Benefits but increasingly limited by Crowding out from public debt and deficits Weak Incentives for debt service, related to weak judicial, informational and institutional incentives Weak incentives in public banks, not generating enough capital for growth, especially of private credit. Need to focus on incentives for principal agents (banks) Regulators face New Challenges Resolution of problems more urgent now that other sources of private sector finance drying up.

India Started bank liberalization in 1992 Focus on Markets: price, alloc., competition Reduced directed credit allocation (SLR) Gradually liberalized interest rates, even on priority credit Increased competition Let clients switch banks, Reduced RBI lending control Licensed new private, quasi-private and foreign banks Non-bank intermediaries grew until the 1997 crisis Liberalized the capital market Allowed offshore borrowing and capital inflow. Strengthened regulation and supervision, unlike most liberalizing countries Liberalization largely completed by 1997-98

Reforms Restarted Dep. Growth

Other Sources of Private Credit Grew NBFCs Equity—easier rules and entry of foreign players Bonds and Private Placements Offshore borrowing. But NBFCs have declined since 1997 crisis New inflows and demand for offshore funds drying up. India’s capital market is one of largest but it is down India is still bank dominated: Banks assets more than double market capitalization. Banks are critical

Private credit growth, bank performance were not up to expectations Private credit growth, bank performance were not up to expectations. Why? Crowding out by Government Debt Large Role of Public Sector Banks Large NPLs Weak judicial and informational framework Public banks lack incentives Profit Squeeze on Banks limits internal capital generation, raises risks.

Crowding out: Gov. debt absorbed much of bank growth, reflecting its large deficit; credit grew slowly

Gov. Debt/Dep. , 2000, Percent (IFS)

Gov. Debt is attractive but it must held even if it weren’t attractive Gov. Debt has low risk, low capital weight, no priority sector obligation, making it attractive But macroeconomic constraints mean that Gov. debt has to be held, if not by banks, then by the public, meaning less deposits, so still crowding out Crowding out is now by interest rates, not by fiat, but it is still crowding out. Attractiveness of Gov. debt simply determines interest differential between public and private debt.

Large Public Sector Bank Role

Large Public Sector Bank presence associated with slower financial and economic development, worldwide Weak incentives for sound lending and collection Credit Misallocation (bad lending & collection processes) Borrowers develop culture of non-payment. Weak Governance: Multiple Conflicting Goals Political Interference Lack of clear incentives to staff, who become an interest group. Weak Information/non transparency Lower effective lending rates crowd out private banks Difficulties in Regulation & Supervision Result is often costly “skeletons” for governments

Credit Misallocation: Banks’ Gross NPLs High by International Standards Note DFIs are worse.

NPLs represent misallocation Either borrowers are getting credit they cannot repay—poor selection of borrowers Or Defaults mean someone must bear the cost, other borrowers (higher rates), depositors (lower rates), or taxpayers (bailout).

Q. Why are NPLs High? A. Poor Incentives. Weak legal (judicial) framework Slow Judicial Proceedings, BIFR Debt Tribunals have not been enough Will new ordinance become law and make a difference? Poor information on borrowing 1. And 2. Mean Poor incentives: Why pay? No credit record to maintain. Courts work slowly. In 1999 an estimated 1.4 million debt recovery cases pending.

Why are NPLs high (cont.)? Public sector banks have NPL problems worldwide. In India worse than even “old” private banks, which have similar clientele. In Public sector banks, what are incentives To choose borrowers well? To collect promptly? To use good contracts? Have been at least 20% worse until this year. Even now, npls on priority loans are 25% higher in public banks compared to old private banks.

Competition has pushed down bank margins Competition within the banks, but more from capital markets, and foreign lenders. Actually getting riskier!!!!!

Public Sector banks face a squeeze from competition, poor lending, and high costs Note provisions in public banks meet regs. But regs. Are below best practices. And all other bank groups provision much more.

Profits have fallen

Need more profits to Write-off bad loans Keep pace with growth More private lending Stronger regulation and supervision Best Practices Basel II Privatize?

More Profits require: Better lending Lower costs Or Larger spreads (lenders pay more, depositors get less) Or Gov. will have to add capital

Prerequisite to more private credit Reduce Crowding Out

Better Performance(1): Better Legal & Judicial Framework Better incentives to service debt New bankruptcy law will help/BIFR revamping. Debt tribunals need more support, faster deliberations, and penalties for willful default and delay New ordinance: will it work?

Better Performance (2) : Better Information Framework Improve incentives to service debt, select borrowers better. Credit registry who will manage it? include non-banks and small borrowers. Public banks can be restrained from lending to defaulters. Improve supervision

Better information improves Access Small have asset: good credit rating But system must go down to small loans Which institutions can best provide access? Currently, priority sector loans getting bigger, and rates constrain small lending.

Better Performance (3) Cutting Costs in Public Banks VRS will help, but needs to be managed Computerization needed, but funds are lacking. Why can’t India export banking services? Reducing or selling branches Mergers Needed: An Exit Policy for Banks

Better Performance(4) Better Incentives for Better Lending Public banks need to improve incentives for Selection of sound borrowers Collection of debt service Privatization: Few examples of public banks that work well. But low profits and lack of interest by foreign investors may make privatization difficult.

Challenges to Reg & Supervision Private Banks and Moral Hazard Deposit Insurance levels Strengthening of Regulation & Supervision to Best International Practices For example, exposure limits, connected lending, income recognition, provisioning, and prompt corrective action. Particularly important for private banks without a reputation to protect.