BANKING SECTOR REFORMS IN INDIA

The commonalities provide opportunities for Pakistan and India to learn a lot from experience of each other

By SHABBIR H. KAZMI
May 30 - June 05, 2005

Dr. Y. V. Reddy, Governor, Reserve Bank of India recently came to Pakistan to attend a meeting of Asian Clearing Union. Taking advantage of his presence, Dr. Ishrat Husain, Governor, State Bank of Pakistan invited him to deliver a talk on banking sector reforms in India. His presentation was keenly attended by a large number of bankers and executives from other financial institutions. Following are the excerpts from his very comprehensive presentation.

The Indian financial system, prior to commencement of reforms in the early nineties, was essentially catering to the needs of planned development on a mixed economy framework where the public sector plays a dominant role in the economic activities. The strategy required huge development expenditure, which was met through government's dominance of ownership of banks, automatic monetization of the fiscal deficit and subjecting banking sector to large preemptions. There was a complex structure of administered interest rates guided by the social concerns and cross-subsidization.

The reforms measures were initialized and sequenced to create an enabling environment for banks to overcome the external constraints. Sequencing of interest rate deregulation was an important component of the reform process. The process was gradual and predicated upon the institution of prudential regulation for the banking system, market behavior, financial opening, and above all, the underlying macroeconomic conditions.

As part of the reforms program, initially there was infusion of capital by the government in public sector banks, which was followed by expanding the capital base with equity participation by the private investors. Diversification of ownership led to greater market accountability and improved efficiency.

One of the major objectives of banking sector reforms has been to enhance efficiency through competition. Since 1993, twelve new private sector banks have been set up. Foreign direct investment in the private banks is now allowed up to 74%, subject to conformity with the guidelines issues from time to time.

Consolidation in the banking sector has been another feature of the reform process. This also encompassed DFIs, which have been providers of long-term finance while the distinction between short-term and long-term finance provider has increasingly become blurred over time. The complexities involved in harmonizing the role and operations of DFIs were examined and Reserve Bank of India enabled the merger of a large DFI with its commercial banking subsidiary.

In 1994, a Board for Financial Supervision (BFS) was constituted. It comprised of selected members of the RBI Board with a variety of professional expertise to exercise 'undivided attention to supervision'. The BFS also ensure an integrated approach to the supervision of commercial banks, DFIs, non-banking finance companies, urban cooperative banks and primary dealers.

While the regulatory framework and supervisory practices have almost converged with the best practices elsewhere in the world, two points are noteworthy. The minimum capital to risk assets ratio has been kept at 9% and banks are required maintain separate Investment Fluctuation Reserve out of profit at 5% of their investment portfolio under the categories 'held for trading' and 'available for sale'.

In order to ensure timely and effective implementation of the measures, RBI has been adopting a consultative approach. Suitable mechanisms have been instituted to deliberate upon various issues so that the benefits of financial efficiency and stability percolate to the common person and the services of the Indian financial system can be benchmarked against international best standards in a transparent manner.

The banking reforms have had major impact on the overall efficiency and stability of the banking system in India. The present capital adequacy of Indian banks is comparable to those at international level. There has been a marked improvement in the asset quality. The reform measures have also resulted in an improvement in the profitability of banks and return on assets of bank has also improved.

Considerable emphasis is on appropriate mix between elements of continuity and change in the process of reform, but the dynamic elements in the mix are determined by the context. While there is usually a consensus on the broad direction, relative emphasis on various elements of the process of reform keeps changing, depending on the evolving circumstances.

Banks are constantly pushing the frontiers of risk management. Compulsions arising out of increasing competition are inducing banks to explore new avenues to augment revenues along with trimming costs. Consolidation, competition and risk management are critical to the future of banking, but governance and financial inclusion would also emerge as key issues for a country like India, at this stage of socio-economic development.

After hearing Dr. Reddy one tends to arrive at the conclusion that there is great similarity between the banking sectors and the reforms initiated by Pakistan and India. The only difference is in the size and the level of conservatism. The positive point about Pakistan is that smaller size makes Pakistani banking sector easy to manage and the attitude of sponsors towards following global standards also makes the reform process easier to manage. However, there is no room for complacency as lot more remains to be done that too at a faster pace. Pakistani banks have been able to contain the level of non-performing loans, which was one of the reasons for the fragile state of banks, when they were operating under the state control.