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What is happening to Indian banking?

Print edition : Feb 25, 2005

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The sector is undergoing fundamental changes that have diluted its traditional role of protecting small deposits against capital and income risk and facilitating the conversion of savings into investment.

CURRENTLY, banks seem to be the prime targets of the government's reforming zeal. Having encouraged foreign acquisition, consolidation and universalisation in the banking system, the Finance Ministry's current thrust seems to be to find a host of new areas of activity for these institutions. According to unconfirmed reports, the Reserve Bank of India (RBI) has approved a proposal from the government to amend the Banking Regulation Act to permit banks to trade in commodities and commodity derivatives. This offer to banks of one more new avenue of speculative investment by removal of a prohibition on commodity trading that has been in existence for long merely furthers the fundamental changes that have been under way in India's banking sector.

These changes impinge upon the nature of the institutions, operations and instruments that constitute the sector. Institutional changes include: a rapid increase in the number of new private sector banks; a process of consolidation of banks that thus far has principally affected the private banking sector but is now being consciously promoted in the public sector as well; privatisation of equity in public sector banks; mergers of banks and other financial institutions, particularly development banking institutions; and the creation of universal banks that are in the nature of financial supermarkets, offering customers a range of products from across the financial sector such as debt products, investment opportunities in equity, debt and commodity markets and insurance products of different kinds.

Implicit in these institutional changes are changes in the operations of the increasingly "universalised" banks. The most crucial change has been an increasing reluctance of banks to play their traditional role as agents who carry risks in return for a margin defined broadly by the spread between deposit and lending rates. Traditionally, banks accepted small deposits that highly liquid investments protected against capital and income risk. They in turn made large investments in highly illiquid assets characterised by a significant degree of capital and income risk. This made banks crucial intermediaries for facilitating the conversion of savings into investment.

Given this crucial role of intermediation conventionally reserved for the banking system, the regulatory framework that had the central bank at is apex, sought to protect the banking system from possible fragility and failure. That protective framework across the globe involved regulating interest rates, providing for deposit insurance and limiting the areas of activity and the investments undertaken by the banking system. The understanding was that banks should not divert household savings placed in their care to risky investments promising high returns. In developing countries, the interventionist framework also had developmental objectives and involved measures to direct credit to what were "priority" sectors in the government's view.

IN recent years, liberalisation and "denationalisation" have changed all that and forced a change in banking practices in two ways. First, private players are unsatisfied with returns that are available within a regulated framework, so that the government and the central bank have had to dilute or dismantle regulatory measures as is happening in the case of priority lending as well as restrictions on banking activities in India. Second, even public sector banks find that as private domestic and foreign banks, particularly the latter, lure away the most lucrative banking clients because of the special services and terms they are able to offer, they have to seek new sources of finance, new activities and new avenues for investments, so that they can shore up their interest incomes as well as revenues from various fee-based activities.

In sum, the processes of liberalisation fundamentally alter the terrain of operation of the banks. Their immediate impact is visible in a shift in the focus of bank activities away from facilitating commodity production and investment to lubricating trade and promoting personal consumption. Interest rates in these areas are much higher than that which could be charged to investments in commodity production. According to a study (Consumer Outlook 2004), conducted by market research firm KSA Technopak, Indian consumers are increasingly financing purchases of their dream products with credit that is now on offer, even without collateral. "Personal credit offtake has increased from about Rs.50,000 crores in 2000 to Rs.160,000 crores in 2003, giving an unprecedented boom to high-ticket item purchases such as housing and automobiles," the study reportedly found.

But there are changes also in the areas of operation of the banks, with banking entities not only creating or linking up with insurance companies, but also entering into other "sensitive" markets such as the stock and the real estate. It should be expected that this growing exposure to non-collateralised personal debt and entry into sensitive sectors would increase bank vulnerability to default or failure. The effects on bank fragility became clear after the stock scam of the late 1990s. RBI's Monetary and Credit Policy Statement for the year 2001-2002 had noted: "The recent experience in equity markets, and its aftermath, have thrown up new challenges for the regulatory system as well as for the conduct of monetary policy. It has become evident that certain banks in the cooperative sector did not adhere to their prudential norms nor to the well-defined regulatory guidelines for asset-liability management nor even to the requirement of meeting their inter-bank payment obligations. Even though such behaviour was confined to a few relatively small banks, by national standards, in two or three locations, it caused losses to some correspondent banks in addition to severe problems for depositors."

INTERESTINGLY, this increase in financial fragility has been accompanied by the emergence of new instruments in the banking sector. Derivatives of different kinds are now traded in the Indian financial system including, crucially, credit derivatives. Most derivatives, financial instruments whose value is based on or derived from the value of something else, are linked to interest rates or currencies. Credit derivatives are based on the value of loans, bonds or other lending instruments.

A working group of the RBI had recommended in 2003 that scheduled commercial banks may initially be permitted to use credit derivatives only for managing their credit risks. But banks were not permitted to take long or short credit derivative positions with a trading intent. Credit derivatives were seen as helping banks manage the risk arising from adverse movements in the quality of their loans, advances, and investments by transferring that risk to a protection seller. Using credit derivatives, banks can (1) transfer credit risk and, hence, free up capital, which can be used in other opportunities; (2) diversify credit risk; (3) maintain client relationships, and (4) construct and manage a credit risk portfolio as per their risk preference.

Banks in India have quickly responded to this opportunity. For example, soon after the introduction of interest rate futures in India, Citigroup concluded three securitisation deals worth Rs.570 crores ($126.6 billion), where yields on government securities or the call money rate, were used as the benchmark for pricing floating rate payments for investors. The underlying receivables arise from a large number of fixed rate loan contracts made for financing commercial vehicles and construction equipment. The risk here is being shared with mutual funds, who are reportedly the major investors.

Even the conservative State Bank of India (SBI) has taken a plunge into the credit derivatives market to cope with the risk arising from its growing loan portfolio. The bank had recorded a growth of almost Rs.36,000 crores or 25 per cent in its loan portfolio on a year-on-year basis until September 2004, starting from a total loan assets position of Rs.135,000 crores in the corresponding period of the previous year. Of this credit growth, more than 40 per cent had been contributed by retail assets. Credit derivatives offered an opportunity to hedge against the risks being accumulated in this manner.

It should be clear that credit derivatives are an industry response to the increasing fragility that comes with the changed nature of banking practices. Derivatives of this kind permit the socialisation of the risks associated with the liberalisation-induced transformation of banking. These trends are in keeping with changes in the international banking industry as well. As The Economist, London, put it: "The world's leading banks decided some years ago that lending is a mugs' game. They began to get rid of their loans, repackaging them and selling them off as securities, or getting others to re-insure their risk."

From the point of view of the banks this effort has been extremely fruitful. Thus, when there was a major melt down in corporate America, as a result of financial fraud and accounting malpractice, leading to the closure of giants like Enron and WorldCom, leading banks that had lent large sums to them appeared unaffected. According to one estimate, loans totalling $34 billion were wiped out through these bankruptcies. But far less amounts showed up as losses in the bank's accounts and, in the second quarter of 2003, Citigroup reported a 12 per cent increase in profits and J.P. Morgan Chase a 78 per cent increase.

It should be clear that these losses have to show up somewhere in the accounts of the financial system, but as the Bank of International Settlements (BIS) argued, its not easy to trace them. "The markets lack transparency about the ultimate distribution of credit risks," it declared. One reason could be that these losses were being borne by insurance companies, which would be treating them like any other casualty loss so that they are not identifiable. The BIS sees this conundrum as being the result of the substantial growth of the practice of credit-risk transfer - the shifting of risk from banks on to the buyers of securities and loans, and on to the sellers of credit insurance.

IN sum, the traditional image of the great banks with armoured vaults has little to do with the banks of today. The latter appear to make loans and then pass them on as quickly as possible, pocketing the margin. That allows them to take bigger risks in trading securities, derivatives, and foreign exchange. But these risks do not go away. At the end of 2002, though non-bank entities accounted for just 10 per cent of the syndicated loan market in the United States, they held 22.6 per cent of the bad or doubtful loans. The same is now happening in India, increasing the fragility of a host of non-bank financial institutions, such as pension funds, mutual funds and life-insurance companies. Unfortunately, rather than recognise this danger, the Finance Ministry is keen on ensuring changes of the kind described above through a state-directed process of financial engineering. The full implications of the resulting changes would be revealed only in the days to come. But the experience elsewhere provides cause for concern.

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