Credit, Structure and Double Financial Repression: A Diagnosis of the Banking Sector(Banking, Economy)

The challenges in the Indian banking system classified into two categories:  policy and structure.

Policy challenge

Financial repression is a term that describes measures by which governments channel funds to themselves as a form of debt reduction. It means funds are channeled to the government that would otherwise flow elsewhere.
The Indian banking system is suffering from “double financial repression” i.e financial repression on the asset side as well as financial repression on the liability side .
Financial repression on the liability side
Average rate of return on deposits = weighted average return on term deposits (as per RBI) —  CPI-IW inflation rate (as per CSO).
This shows the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects.For example, let’s say your bank pays you interest of 8% per year on the funds in your term deposit account. If the inflation rate is currently 6% per year, then the real return on your savings today would be 2%.
Financial repression on liability side arose from high inflation since 2007, leading to negative real interest rates, and a sharp reduction in households’ financial savings.
Household savings continue to be the largest contributor to gross capital formation.The household savings in India can be broadly categorized into the following types:
  • Savings in physical properties =10.6 % of GDP in 2013-14
  • Savings in financial instruments = 7.2 % of GDP in 2013-14
  • Total Household savings     =17.8 % of GDP in 2013-14
Gross savings  =30.6 % of GDP in 2013-14
The contribution of physical assets to household savings has stood above 60 per cent all through the last decade because average rate of return on deposits is very low or negative.
As India exits from liability-side repression with declining inflation, the time may be appropriate for addressing its asset-side counterparts.
Financial repression on the asset side
It has 2 components – SLR & PSL
Statutory Liquidity Ratio
The Statutory Liquidity Ratio is a requirement on banks to hold a certain share of their resources in liquid assets such as cash, government bonds and gold.
SLR requirements varied from 38 per cent in the period before 1991, to about 21.5 per cent on Feb 4, 2015.
Banks typically keep more than the required SLR, the current realised SLR is in fact over 25 per cent. This is probably due to the high level of stressed assets which encourage over investment in risk free government securities to maintain a respectable risk-weighted capital adequacy ratio.
In practice, the SLR has become a means of financing (at less than market rates presumably) a bulk of the government’s fiscal deficit, suggesting that SLR cuts are related to the government’s fiscal position.
Reducing the Statutory Liquidity Ratio
The SLR is a form of financial repression where the government occupied domestic savings at the expense of the private sector.
The argument has always been that SLRs can only be reduced if the government’s fiscal situation improves.That is only partly correct because stocks rather than flows should condition SLR reform.
This opportunity to phase down the SLR in India is provided by
1. Steadily improving public debt situation that will continue to improve because of India’s growth and inflation compared to borrowing costs. Overall indebtedness (center and states) has declined from over 80 percent to 60 percent in a decade and will continue due to favorable debt dynamics( Click here to know more).  
Reducing SLR will definitely increases the cost of government’s finances but the magnitudes are likely to be small for two reasons:
  • Costs will rise only on debt that is maturing, which over the next five years is about 21.1 per cent of total outstanding debt; and
  • The macro-environment and progress in curbing the inflation favour lower real interest rates.
2. The second reason relates to the health of the banks.
As interest rates decline, SLR reductions could allow them to offload G-secs and reap the capital gains which could help recapitalise them, reducing the need for government resources, and helping them raise private resources.
3. The third reason relates to the recent experience of infrastructure financing.
PPP-based projects have been financed either by public sector banks or through foreign currency-denominated debt (ECBs), contributed to decline in corporate sector profitability especially in the infrastructure sector- investors borrowed in dollars and their revenues were predominantly in rupees so that when the rupee depreciated their profitability and balance sheets were adversely affected.
Other forms of infrastructure financing, especially through a bond market are also available. But SLRs have prevented the development of government bond markets, as government financing through SLR route is available, which in turn prevented the development of corporate bond markets. Reducing SLRs are therefore critical to finding better sources of infrastructure financing.
SLR and the Capital to risk weighted assets ratio (CRAR)should be combined into one liquidity ratio set at a desirable level depending on international norms.
Priority Sector Lending (PSL)
A key component of equality of credit in India has been the so called “priority sector lending”. All Indian banks are required to meet a 40 per cent target on priority sector lending.(All about Priority sector lending)  
Greater attention must be given to ensure that the deployed means are the most effective in achieving the desired ends. There is hence greater need for evidence-driven policy and example below illustrates this point in relation to agricultural lending.
Agricultural Credit: Scratching the Surface of Rising Numbers
  1. In nominal terms, agricultural credit has grown more than 8 times in the last 15 years compared to that agriculture’s share in GDP has remained almost constant, and significant urbanisation has occurred in this time.
  2. A sharp increase in the share of large-sized loans in agricultural credit which warrants scrutiny.
  3. A substantial increase in share of agricultural credit outstanding from urban and metropolitan areas, which is deeply puzzling.
  4. Banks possibly raise their lending activity in months , January to March, when farmers may not necessarily need it the most.
  5. A sharp decrease (70 % in 1991-92 to 40 % in 2011-12) in the share of long-term credit in total agricultural credit which means capital formation in agriculture has become small.
The implication of this evidence is that lending to agriculture may be excessive and going predominantly to large farmers. It is not being used for agricultural capital formation. Perhaps most significantly a large share of it may not be going to core agricultural activities at all.
The main lesson is that a much more careful approach needs to be applied in defining what constitutes priority sector and closer monitoring of how these funds are disbursed. This is especially important because a 40 per cent requirement absorbs a large fraction of the banks’ resources.

Structural challenge

The answers to certain questions would make the picture clear. The questions are :
Is India credit-addled and over-banked?
India has witnessed a credit boom over the last decade, with the share of credit-GDP increasing from 35.5 percent in 2000 to 51 percent in 2013, with the bulk accounted for by bank lending. As countries become richer, they tend on average to see a rise in credit. For India it indicates that for its level of development, credit levels are reasonable.
Whether India is over-banked?
Banking should shrink in size over the course of development relative to other sources of funding such as capital markets. Here too, India is well placed. India is neither over-banked nor are capital markets too small at this stage of development.
Whether the Indian banking and financial system has been especially irresponsible and imprudent in the growth phase?
India’s credit bubble was not worse than the experience of countries during comparable times. Other countries such as Japan and China saw faster credit growth during boom years. Thus, even in the last phase of rapid credit growth during the 2000s, the Indian financial system was no more irrationally elated than those around the world.

What then is the problem on the structural side?

Is there adequate competition?
There is lack of sufficient internal competition. India’s approach was not privatisation of public sector banks, rather it was based on allowing entry of new private banks. This strategy worked reasonably well in the telecommunication and civil aviation sectors but in banking the results have been mixed.India saw a steady rise in the size of private sector banks till 2007. Thereafter, the process slowed down.
So, It was a case of private sector led growth without private sector bank financing.
Level of competition with respect to other sources of funding ,as capital markets, is similar to other countries at same level of development.
Of course, over time, if India grows at 8 percent a year for the next twenty years, a rapid shift in the composition of India’s financial sector away from banking is desirable. This shift will encourage transparency and better pricing of corporate risk.
Are Public Sector Banks uniform in performance?
there is a lot of variation within the public sector banks.
  • the leverage ratio for the best bank is about 1.7 times more than for the worst, and
  • the Gross NPAs plus restructured assets are 4 times more for the worst bank than the best.
  • It is also important to note that the best amongst the public sector banks are often performing less than the private sector average, although this fact should be seen against the greater social obligations imposed on the PSBs.
Hence , the structural problems relate to competition and ownership.
  1. there appears to be a lack of competition, reflected in the private sector banks’ inability to increase their presence.
  2. the share of the private sector in overall banking aggregates barely increased at a time when the country witnessed its most rapid growth and one that was fuelled by the private sector. It was an anomalous case of private sector growth without private sector bank financing.
  3. Finally viewing public sector banks as one homogenous block would be a mistake.
Two other observations are:
  1. First, the variation in the Leverage Ratio is much more than in CRAR.
  2. second the return on assets has declined and stressed assets loans have increased to worrying levels with substantial variation across banks.
As presented below, especially for India, using the leverage ratios to measure, test, and monitor financial stability is more important than the CRAR ratio.

Leverage Ratio

Almost all stress tests formerly were based on ratio of a risk weighted measure of capital to the total assets.
In India, CRAR- Capital to Risk (Weighted) Assets Ratio- has been the used. 
There is however growing international discontent with the measure because CRAR failed to capture risk appetite before the financial crises in the US and in Europe. For this reason the focus is shifting to giving more weight to the Leverage Ratio.
What is leverage ratio?
RBI : the ratio of total assets to total capital,
BIS : the ratio of “capital” to “assets”. It is inverse of RBI definition.
Correlation between leverage ratio (as defined by BIS) and CRAR
These two measures were highly correlated in the 1990s but the correlation between them broke down in the early 2000s for the largest banks. Leverage ratios of large European banks fell between 2000 and 2007, and – Tier 1 capital to risk-weighted assets (CAR) – remained relatively stable.
In Europe, the correlation has steadily became negative for the last few years.By 2012, the correlation had turned strongly negative.
Hence leverage ratio is better indicator of risk appetite of banks.
For the public sector banks in India, the correlation of the average of last three years of CRAR and Leverage Ratio is positive. But, the average of Leverage Ratios for public sector banks varies from 7.8 to 4.5.
It is important to note that if a bank has a moderate-low leverage ratio, and excellent return on assets and negligible NPAs, the leverage ratio is less of a concern. But, this changes dramatically when there is a substantial quantity of toxic loans on its books.
Why we should focus on the leverage ratio in India?
  1. First, the CRAR can be a very poor indicator of stability, especially in adverse situations when risk weights loose meaning and value.
  2. More important, given weak governance systems within banks and the difficulty of regulating them from the outside, it is difficult to know how the risk weights are being assigned. This becomes more important because of the size of stressed assets.
Indian regulators and policymakers should therefore elevate the role of the leverage ratio in financial stability and soundness assessments.

Policy Implications

Four key policy recommendations which we call the four Ds:
1. Deregulate (in relation to financial repression)
  • As the banking sector exits the financial repression on the liability side, aided by the fall in inflation, this is a perfect opportunity to relax asset-side repression which can be done by:
  • Gradually relaxing SLR requirements. This will provide liquidity to the banks, depth to the government bond market, and encourage the development of the corporate bond market. The right sequence would be to gradually reduce SLR and then provide incentives for a deeper bond market.
  • PSL norms can be re-assessed. There are two options: one is indirect reform, bringing more sectors into the ambit of the PSL, until in the limit every sector is a priority sector; the other is to redefine the norms to slowly make priority sector more targeted, smaller, and need-driven.
2. Differentiate (within the PSBs)
There is sufficient variation in the performance of public sector banks. The policy implication is that a one- size-fits-all approaches to governance reforms, public ownership, exit and recapitalisation should cede to a more selective approach.
3. Diversify within and outside the banking system
More banks and more kinds of banks must be encouraged. Healthy competition from capital markets is essential too which will require policy support.
4. Disinter (to create more efficient exit)
  • Better bankruptcy procedures for the future is essential.
  • Debt Recovery Tribunals are over-burdened and under- resourced, leading to delayed turnaround times and delayed justice.
  • The ownership structure of Asset Restructuring Companies in which banks themselves have significant stakes creates misaligned incentives.
  • The SARFAESI act seems to work more against the smallest borrowers and medium sector enterprises.
  • Distressed assets require creative solution such as an Independent Renegotiation Commission with political authority and reputational integrity to resolve some of the big and difficult cases.
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