Assessment of India’S Banking Sector Reforms from the Perspective of the Governance of the Banking System

Strengthening financial systems has been one of the central issues facing emerging markets and developing economies. This is because sound financial systems serve as an important channel for achieving economic growth through the mobilization of financial savings, putting them to productive use and transforming various risks (Beck, Levin and Loayza 1999; King and Levin 1993; Rajan and Zingales 1998; Demirgüç-Kunt, Asli and Maksimovic 1998; Jayaratne and Strahan 1996). Many countries adopted a series of financial sector liberalization measures in the late 1980s and early 1990s that included interest rate liberalization, entry deregulations, reduction of reserve requirements and removal of credit allocation. In many cases, the timing of financial sector liberalization coincided with that of capital account liberalization. Domestic banks were given access to cheap loans from abroad and allocated those resources to domestic production sectors. Since the Asian financial crisis of 1997-1999, the importance of balancing financial liberalization with adequate regulation and supervision prior to full capital account liberalization has been increasingly recognized. The crisis was preceded by massive, unhedged, short-term capital inflows, which then aggravated double mismatches (a currency mismatch coupled with a maturity mismatch) and undermined the soundness of the domestic financial sector. A maturity mismatch is generally inherent in the banking sector since commercial banks accept short-term deposits and convert them into relatively longer-term, often illiquid, assets. Nevertheless, massive, predomi- nantly short-term capital inflows – largely in the form of inter-bank loans – shortened banks’ liabilities, thus expanding the maturity mismatch. Further, a currency mismatch was aggravated since massive capital inflows denominated in foreign currency were converted into domestic currency in order to financethe cyclical upturn of domestic In other words, many share the view that the propersequencing of financial sector and capital accountliberalization is one of the most important policies inpreventing another Asian-type “capital account” crisis.It is now widely accepted that capital accountliberalization should follow current account anddomestic financial sector liberalization (Mckinnon1973). This sequence issue is even more important forcountries such as China and India, which have not yet launched full capital account convertibility and wherepublic-sector banks still remain dominant. In suchcountries, financial sector liberalization comes againstmore politically difficult issues than those that havealready opened up their capital account to a substantial degree since they have to first restructure predominantpublic-sector banks. This chapter focuses on India’s banking sector,which has been attracting increasing attention since1991 when a financial reform programme waslaunched. It assesses whether the reformprogramme has been successful so far inrestructuring public-sector banks and if so, whatelements of the programme have contributed. Thischapter tackles the following fundamentalquestions. In what way has the reformprogramme affected the behaviour of public-sectorbanks? To what extent have foreign and newdomestic banks contributed to the performance of thewhole banking sector? Has India’s gradual approachto the privatization of banks been successful? What policy implications can we derive fromIndia’s experience?

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Since 1991, India has been engaged in banking sector reforms aimed at increasing the profitability and efficiency of the then 27 public-sector banks that controlled about 90 per cent of all deposits, assets and credit. The reforms were initiated in the middle of a “current account” crisis that occurred in early 1991. The crisis was caused by poor macroeconomic performance, characterized by a public deficit of 10 per cent of GDP, a current account deficit of 3 per cent of GDP, an inflation rate of 10 per cent, and growing domestic and foreign debt, and was triggered by a temporary oil price boom following the Iraqi invasion of Kuwait in 1990. Prior to the reforms, India’s financial sector had long been characterized as highly regulated and financially repressed. The prevalence of reserve requirements, interest rate controls, and allocation of financial resources to priority sectors increased the degree of financial repression and adversely affected the country’s financial resource mobilization and allocation. After Independence in 1947, the government took the view that loans extended by colonial banks were biased toward working capital for trade and large firms (Joshi and Little 1996). Moreover, it was perceived that banks should be utilized to assist India’s planned development strategy by mobilizing financial resources to strategically important sectors. Reflecting these views, all large private banks were nationalized in two stages: the first in 1969 and the second in 1980. Subsequently, quantitative loan targets were imposed on these banks to expand their networks in rural areas and they were directed to extend credit to priority sectors. These nationalized banks were then increasingly used to finance fiscal deficits. Although non-nationalized private banks and foreign banks were allowed to coexist with public-sector banks at that time, their activities were highly restricted through entry regulations and strict branch licensing policies. Thus, their activities remained negligible. In the period 1969-1991, the number of banks increased slightly, but savings were successfully mobilized in part because relatively low inflation kept negative real interest rates at a mild level and in part because the number of branches was encouraged to expand rapidly. Nevertheless, many banks remained unprofitable, inefficient, and unsound owing to their poor lending strategy and lack of internal risk management under government ownership. Joshi and Little (1996) have reported that the average return on assets in the second half of the 1980s was onlyabout 0.15 per cent, while capital and reservesaveraged about 1.5 per cent of assets. Given thatglobal accounting standards were not applied, eventhese indicators are likely to have exaggerated thebanks’ true performance. Further, in 1992/93, non-performing assets (NPAs) of 27 public-sector banksamounted to 24 per cent of total credit, only 15 public-sector banks achieved a net profit, and half of thepublic-sector banks faced negative net worth. The major factors that contributed to deterioratingbank performance included (a) too stringentregulatory requirements (i.e., a cash reserverequirement [CRR] and statutory liquidity requirement[SLR] that required banks to hold a certain amount ofgovernment and eligible securities); (b) low interestrates charged on government bonds (as comparedwith those on commercial advances); (c) directedand concessional lending; (d) administered interestrates; and (e) lack of competition. These factors notonly reduced incentives to operate properly, but alsoundermined regulators’ incentives to prevent banksfrom taking risks via incentive-compatible prudentialregulations and protect depositors with a well-designeddeposit insurance system. While governmentinvolvement in the financial sector can be justified at the initial stage of economic development, theprolonged presence of excessively large public-sector banks often results in inefficient resourceallocation and concentration of power in a few banks.Further, once entry deregulation takes place, it will put newly established private banks as well as foreignbanks in an extremely disadvantageous position. Against this background, the first wave of financialliberalization took place in the second half of the1980s, mainly taking the form of interest ratederegulation. Prior to this period, almost all interest rates were administered and influenced by budgetaryconcerns and the degree of concessionality of directed loans. To preserve some profitability, interest ratemargins were kept sufficiently large by keeping deposit rates low and non-concessional lending rates high.Based on the 1985 report of the ChakravartyCommittee, coupon rates on government bondswere gradually increased to reflect demand andsupply conditions. Following the 1991 report of the NarasimhamCommittee, more comprehensive reforms took placethat same year. The reforms consisted of (a) ashift of banking sector supervision from intrusive micro-level intervention over credit decisions towardprudential regulations and supervision; (b) a reductionof the CRR and SLR; (c) interest rate and entry

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deregulation; and (d) adoption of prudential norms. Further, in 1992, the Reserve Bank of India issued guidelines for income recognition, asset classification and provisioning, and also adopted the Basle Accord capital adequacy standards. The government also established the Board of Financial Supervision in the Reserve Bank of India and recapitalized public-sector banks in order to give banks sufficient financial strength and to enable them to gain access to capital markets. In 1993, the Reserve Bank of India permitted private entry into the banking sector, provided that new banks were well capitalized and technologically advanced, and at the same time prohibited cross-holding practices with industrial groups. The Reserve Bank of India also imposed some restrictions on new banks with respect to opening branches, with a view to maintaining the franchise value of existing banks. As a result of the reforms, the number of banks increased rapidly. In 1991, there were 27 public-sector banks and 26 domestic private banks with 60,000 branches, 24 foreign banks with 140 branches, and 20 foreign banks with a representative office. The workforce diversity emerged mainly to further the availability equal opportunities in the workplace. This equal opportunity philosophy is aimed at ensuring that organizations make the most out of the difference from a diverse workforce rather than losing talent which might assist the organization to be more efficient and effective. The increased mobility and interaction of people from diverse backgrounds as a result of improved economic and political systems and the recognition of human rights by all nations has put most organizations under pressure to embrace diversity at the work place. Diversity brings with it the heterogeneity that needs to be nurtured, cultivated and appreciated as means of increasing organizational effectiveness in this competitive world. Between January 1993 and March 1998, 24 new private banks (nine domestic and 15 foreign) entered the market; the total number of scheduled commercial banks, excluding specialized banks such as the Regional Rural Banks rose from 75 in 1991/92 to 99 in 1997/98. Entry deregulation was accompanied by progressive deregulation of interest rates on deposits and advances. From October 1994, interest rates were deregulated in a phased manner and by October 1997, banks were allowed to set interest rates on all term deposits of maturity of more than 30 days and on all advances exceeding Rs 200,000. While the CRR and SLR, interest rate policy, and prudential norms have always been applied uniformly to all commercial banks, the Reserve Bank of India treated foreign banks differently with respect to the regulation that requires a portion of credit to be allocated to priority sectors. In 1993, foreign banks– which

While India’s financial reforms have been comprehensiveand in line with global trends, one unique feature is that,unlike with other former planned economies such asHungary and Poland, the Indian Government did notengage in a drastic privatization of public-sector banks.Rather, it chose a gradual approach toward restructuringthese banks by enhancing competition through entryderegulation of foreign and domestic banks. This reflectsthe view of the Narasimham Committee that ensuring theintegrity and autonomy of public-sector banks is the morerelevant issue and that they could improve profitabilityand efficiency without changing their ownership ifcompetition were enhanced. Since this approach was introduced, some criticismshave been expressed (Joshi and Little 1996). First,public-sector banks continue to be dominant thanks to theirbetter branch coverage, customer base, and knowledge ofthe market compared with newcomers. Second, public-sector banks would find it more difficult to reducepersonnel expenditure because of the strong trade unions.Third, the government would find it difficult to acceptgenuine competition within public-sector banks. Inresponse to these concerns, the government decided togradually expand private-sector equity holdings in public-sector banks, but still avoided the transformation of theirownership. The 1994 amendment of the Banking Actallowed banks to raise private equity up to 49 per cent ofpaid-up capital. Consequently, public-sector banks, whichused to be fully owned by the government prior to thereform, were now allowed to increase non- governmentownership. So far, only eight public-sector banks out of 27have diversified ownership. Meanwhile, a consensus is emerging that stateownership of banks is bad for financial sectordevelopment and growth (World Bank 2001). Based ondata from the 10 largest commercial and developmentbanks in 92 countries for 1970-1995, La Porta and others(2000) have found that greater state ownership of banksin 1970 was associated with less financial sectordevelopment, lower growth, lower productivity, and thatthese effects were greater at lower levels of income. Barthand others (2001a, 2001b) have shown that greater stateownership of banks tends to be associated with higherinterest rate spreads, less private credit, less activityon the stock exchange, and less non-bank credit, evenafter taking into account other factors that could influencefinancial development. This suggests that greater stateownership tends to be anti-competitive, reducing

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competition from both banks and non-banks. Barth and others have also noted that applications for bank licences are more often rejected and there are fewer foreign banks when state ownership is greater. Moreover, Caprio and Martinez-Peria (2000) have shown that greater state ownership at the start of 1980 was associated with a greater probability of a banking crisis and higher fiscal costs. With respect to privatizing banks, moreover, the World Bank (2001) takes the view that privatization can yield real benefits to economies provided that an appropriate accounting, legal and regulatory infrastructure is in place. It should be noted that premature privatization may give rise to banking crises. Clarke and Cull (1998) have demonstrated that Argentina promoted the privatization of public-sector banks in a reasonably developed regulatory and infrastructure environment, and thus privatized banks improved productivity remarkably. Considering the implications derived from the above studies, this chapter examines whether India’s gradual approach has been successful so far by examining whether public-sector (commercial) banks have improved their performance (profitability, efficiency and soundness) in the reform period. Two hypotheses have been adopted in this regard. The first hypothesis is that the degree of concentration in the banking sector has been declining in the reform period. The second hypothesis is that the performance of public-sector banks may have deteriorated initially during the adjustment period, but performance improved later on. Three types of performance indicators have been used: (a) profitability, (b) cost efficiency, and (c) earnings efficiency. It tests this hypothesis by analyzing trend patterns and empirically testing the performance of public-sector banks.

The second unique feature of India’s banking sector is that the Reserve Bank of India has permitted commercial banks to engage in diverse activities such as securities- related transactions (for example, underwriting, dealing and brokerage), foreign exchange transactions and leasing activities. The 1991 reforms lowered the CRR and SLR, enabling banks to diversify their activities. Diversification of banks’ activities can be justified for at least five reasons. First, entry deregulation and the resulting intensified competition may leave banks with no choice but to engage in risk-taking activities in the fight for their market share or profit margins. As a result, risk-taking would reduce the value of banks’ future earnings and associated incentives to avoid bankruptcy (Allen and Gale 2000). Second, banks need to obtain implicit rents in orderto provide discretionary, repetitive and flexible loans.6In addition, banks attempt to reduce the extent ofinformation asymmetry by processing inside information ontheir clients and monitoring their performance. Such roles are unique to the banking system and importantparticularly for SMEs since information on them tendsto be highly idiosyncratic. Without sufficient rents,however, banks are likely to cease providing theseservices and the implication for SMEs and economicdevelopment can be enormous. Thus, it is important forbank regulators to ensure adequate implicit rents tobanks in order to encourage them to provide suchunique services. Moreover, banks may lose anopportunity to collect implicit rents if their clients switch tocapital markets once they become larger and profitable. Diversification of banking activities helps banks tomitigate the two problems raised above by providingthem with an opportunity to gain non-interest income andthereby sustain profitability. This enables banks tomaintain long-term relationships with clients throughouttheir life cycles and gives them an incentive to processinside information and monitor their clients. Third, banks can stabilize their income by engaging inactivities whose returns are imperfectly correlated, therebyreducing the costs of funds and thus lending andunderwriting costs. Fourth, diversification promotes efficiency by allowingbanks to utilize inside information arising out of long-termlending relationships.8 Thanks to this advantage, banksare able to underwrite securities at lower costs thannon-bank underwriters. Firms may also obtain higherprices on their securities underwritten by banks because oftheir perceived monitoring advantages. Further, bankscan exploit economies of scope from the production ofvarious financial services since they can spread fixedphysical (i.e., branches and distribution channels) andhuman capital costs (Steinherr and Huveneers 1990). Fifth, diversification may improve bank performance bydiluting the impact of direct lending (through requiringbanks to allocate credit to priority sectors). Direct lendingreduces the banks’ incentives to conduct informationprocessing and monitoring functions. As a result, this notonly lowers banks’ profitability by limiting financialresources available to more productive usages, but alsoresults in a deterioration of efficiency and soundness bydiscouraging banks from functioning properly. These five advantages, however, can be offset by thefollowing disadvantages. First, public-sector banks’engagement in the securities business may promote aconcentration of power in the banking sector since the

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asset size of banks expands. This is partly because banks have a natural tendency to promote lending over securities, thereby indirectly deterring the development of capital markets. Further, the reputation and informational advantages enjoyed by public-sector banks put them in an even more favourable position, preventing other banks and investment firms from competing on a level playing field. Second, the engagement of banks in underwriting services may lead to conflicts of interest between banks and investors. Banks may decide to underwrite securities for troubled borrowers so that the proceeds of the issue of securities can be used to pay off these banks’ own claims to the companies. Banks may dump into the trust accounts they manage the unsold part of the securities they underwrite. Further, banks may impose tie-in deals on customers by using their lending relationships with firms to pressure them to purchase their underwriting services (for example, using the threat of increased credit costs or non-renewal of credit lines). Banks may also use the confidential inside information that they possess when they underwrite firms’ securities in a way that the firms do not contemplate, such as disclosing the information directly or indirectly to the firms’ competitors. Third, diversification may expose banks to various new risks. For example, banks may end up buying the securities they underwrite. They may also face greater market risks as they increase their share of securities holdings and market-making activities. Further, derivatives involve higher speed and greater complexity, which may reduce the solvency and transparency of banking operations. The presence of these three potential disadvantages suggests that measures are needed to balance the advantages and disadvantages. The Reserve Bank of India tries to cope with the disadvantages by encouraging banks to engage in securities business through subsidiaries, thereby putting in place firewalls between traditional banking and securities services. The Reserve Bank of India also prohibits cross-holdings with industrial groups to minimize “connected lending” – one of the causes of the East Asian crisis. To assess the overall impact of banks’ activities, this chapter examines whether diversification improves bank performance. In particular, the impact of disadvantages can be assessed indirectly by examining how soundness is associated with diversification. It is also important to examine whether diversification has led to even greater dominance of public-sector banks by examining whether banks’ asset portfolios differ between public-sector and private banks.

One interesting feature of India’s banking sector is thatsome large public-sector banks appear to have beenperforming reasonably well in the post-reform period. Thiscould be attributed to (a) the import of better riskmanagement skills from foreign and private domesticbanks, (b) intensified competition, (c) the diversificationeffect described above, (d) reorganization (for example,mergers and acquisitions), and (e) goodwill. In India,however, given the virtual absence of an exit policy, large-scale mergers and acquisitions among problematic bankshave not occurred so far. It is generally thought that the entry of well-capitalizednew banks is likely to improve the quality and variety ofservices, efficiency of bank management, andprudential supervisory capacity (Levine 1996; Walter andGray 1983; Gelb and Sagari 1990). The entry of foreignbanks tends to lower interest margins, profitability, and theoverall expenses of domestic banks (Clarke, Cull,D’Amato, and Molinari 2000; Claessens, Demirgüç-Kuntand Huizinga 2000). Further, Claessens, Demirgüç-Kunt and Huizinga have reported that the number ofentrants matters compared with their market share,indicating that foreign banks affect local bank competitionupon entry rather than after they have gained asubstantial market share. Moreover, these banksmay be able to provide a source of new capital forenterprises and thus reduce government restructuringcosts, especially when the domestic banking sector isdevastated in the aftermath of a crisis. Some studies alsofind that foreign banks tend to go for higher interestmargins and profitability than domestic banks indeveloping countries, while the opposite is true indeveloped countries (Claessens, Demirgüç-Kunt andHuizinga 2000). On the other hand, premature deregulation and foreignentry may cause some downside effects. First, they mayincrease the risk of a banking crisis if there ismacroeconomic or regulatory weakness, as wasexperienced in Argentina, Brazil and Chile in the 1970s(Demirgüç-Kunt, Asli and Detragiache 1998). Second,foreign banks may exhibit a home country bias, leadingthem to retreat promptly and massively at the first sign ofdifficulty. In the East Asian crisis, for example, it is widelybelieved that foreign banks, such as Citibank, played amajor role in supporting the capital outflow withoutconsideration as to the national damage caused. This chapter assesses whether their performanceshows statistically different results from that of public-sector banks through three steps: (a) analysing trendpatterns, (b) testing the hypotheses that the average levelof each indicator is the same between public-sector andforeign and private domestic banks, and (c) using ordinaryleast squares regression. The sixth hypothesis is that

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foreign and private domestic banks have performed better than public-sector banks, and thus have contributed to an improvement in overall banking sector performance. The seventh hypothesis is that new banks perform better.

India’s financial market has been gradually developing, but still remains bank-dominated in the reform period. The extent of financial deepening measured by total deposits in GDP has risen only modestly from 30 per cent in 1991 to 38 per cent in 1999. Capital market development has also been quite sluggish. Outstanding government and corporate bonds as a share of GDP rose from 14 per cent in 1991 to 18 per cent in 1999 and from only 0.7 per cent in 1996 to 2 per cent in 1998, respectively, while equity market capitalization dropped from 37 per cent in 1995 to 28 per cent in 1999. Nevertheless, the government’s commitment on restructuring the highly regulated banking sector appears strong. Since financial reforms were launched in 1991 and particularly when the entry of new banks was permitted in 1993, public-sector banks appear to have become more conscious of the need for greater profitability and efficiency, suggesting that the reform has had a favourable impact on India’s financial market. According to an analysis of the overall performance of state-owned, domestic and foreign banks based on trend patterns in 1993-2000, the overall performance of public- sector banks appears comparable with foreign and private domestic banks (table 1). In general, foreign banks performed better than domestic banks (public-sector and private domestic banks) in terms of cost, earnings efficiency and soundness. However, domestic banks overtook foreign banks in terms of profitability in 1999-2000. Moreover, all banks are comparable in terms of the scale of medium- to long-term credit and liquidity. The results are summarized below.

Foreign banks’ profitability (defined as the ratio of profits after tax to average assets [ROAA]) exceeded that of private domestic and public-sector banks in 1993-1997, despite a declining trend.11 However, private domestic banks have become more profitable than foreign banks in 1999-2000. IMF (2001) has also reported that foreign and new private domestic banks maintained higher profitability (about 1-2 per cent) than public-sector and old private domestic banks (0.6-0.8 per cent) during the period 1995/96-1999/2000. Profits from securities and foreign transactions, and brokerage/ commission services have also increasingly contributed to profitability for all banks, suggesting that the diversification effect is positive.

Foreign and private domestic banks are generally morecost-efficient than public- sector banks.12 The ratio ofoperating expenditure to operating income (COST) in 2000was 72 per cent for foreign banks, 80-85 per cent fordomestic banks, and 84 per cent for public-sector banks.While foreign banks are more cost-efficient, their efficiencylevel has somewhat deteriorated. Instead, domestic andpublic-sector banks improved efficiency over the sampleperiod. As for earning capacity, foreign banks are generally betterperformers. The earning indicator proxied by the ratioof income to assets (INCOME1) shows that foreignbanks have consistently performed better than privatedomestic and public- sector banks. However, foreignbanks’ income-generating capacity deteriorated somewhatfrom 14.5 per cent in 1993 to 12.5 per cent in 2000, whilethe two other types of banks maintained their performanceat a level of about 11 per cent. The inferior performanceof domestic banks relative to foreign banks can beattributed to (a) the larger share of credit extended to thepublic-sector, (b) more stringent requirements imposedon direct lending, (c) a lesser degree of diversification,and (d) lower interest rate margins. Implicit interest rate spread (defined as the differencebetween implicit lending and deposit rates [INCOME2])has been shrinking for all banks over the sample period.While foreign banks have received higher interest ratespreads than private domestic banks and public-sectorbanks, their margins have become comparable in 2000.An alternative indicator (the difference between interestincome and expenditure) shows that while all types ofbanks reduced interest rate margins over the sample

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period, those of public-sector and private domestic banks have generally remained negative and recently even worsened. This suggests that domestic banks must obtain income from other activities to maintain profitability and thus extend credit to the private sector.

The balance sheets of foreign banks appear to be more structurally sound than those of domestic and public-sector banks based on the following criteria: capital adequacy, asset quality, management and liquidity. First, on the capital adequacy ratio proxied by equity plus reserves over total liabilities or total assets (EQUITY), the ratio of foreign banks increased from 7 per cent in 1993 to 20 per cent in 2000. While the ratios increased moderately for domestic banks, it still remains small. This suggests that foreign banks have greater incentives to lend prudently and remain well capitalized than the two other kinds of banks. This reflects the fact that foreign banks steadily reduced their deposit dependence ratio from 67percent of liability in 1993 to 47 per centin 2000,while the twoother types maintained their dependence ratio at about 85 per cent throughout the sample period. Nevertheless, the IMF report (2001) indicates that the risk-weighted capital ratio has been comparable among all banks and has improved from 1996/97 to 1999/2000: from 10.4 per cent to 11.9 per cent for foreign banks, from 11.7 per cent to 12.4 per cent for old private domestic banks, and from 10 per cent to 10.7 per cent for public- sector banks, while that of new private domestic banks declined from 15.3 per cent to 13.4 per cent. Second, by contrast, the assessment on asset quality based on (a) the ratio of contingent liabilities to assets, (b) asset growth, (c) the ratio of investment in securities to assets, (d) the ratio of provisions for NPA to assets (PROV), and (e) the ratio of medium- and long-term credit to assets reveal mixed results. The first indicator reports that the ratio of foreign banks (at around 25-30 per cent) has been greater than that of domestic banks and public-sector banks. While this indicates that foreign banks are more exposed to high potential losses in cases of default, this outcome may simply show that foreign banks provide more complex and sophisticated services than the two other types of banks, given that their activities are concentrated on urban areas, wholesale markets and large clients. The second indicator reports that foreign and private domestic banks faced rapid credit growth in 1993-1997, signalling some kind of risk-taking behaviour. However,this may be explained simply by their early stage ofestablishment. The third indicator shows that all threebanks invested about 30-40 per cent of assets insecurities in response to the SLR, indicating that all ofthem have a large cushion against NPAs. In particular,public-sector and private domestic banks increased theirshare of investment in government bonds in assets in1993-2000 from 21 per cent to 23 per cent and from 21 percent to 27 per cent, respectively. This may be due to theirpreference for more liquid, safe assets as the BasleAccord was applied. The fourth indicator reports that foreign banks generallyallocated greater provisions for NPAs. Given that morestringent accounting and auditing standards of their mothercountries are applied to foreign banks, the foreign banksare more resilient to adverse shocks. IMF (2001) hasreported that foreign and new private domestic banksmaintained small NPA ratios (about 2-4 per cent) duringthe period 1995-2000 – below the level of public-sectorand old domestic banks, with the former declining from 9.2per cent in 1996/95 to 7.4 per cent in 1999/2000 and thelatter remaining at around 7 per cent. The final indicatorreports that foreign and private domestic banks increasedmedium- to long-term credit in 1993-2000 from 7.5 percent to 17 per cent and from 10 per cent to 13 per cent,respectively, suggesting their increased confidence inIndia’s financial market. Public-sector banks maintainedthe same level of exposure throughout the sample period. Third, management performance is assessed based ontwo indicators: (a) the ratio of credit to deposits; and (b)the ratio of equity and reserves to debt (inverse ofleverage). The first indicator reports that foreign banksattempt to improve their income by expanding theirlending operations as compared with other domesticbanks. The ratio of foreign banks surged from 56 per centin 1993 to 94 per cent in 2000, while the two other types ofbanks maintained the ratio at about 40 per cent over thesame period. Given that foreign banks’ ratio of credit toassets is similar to other domestic banks (about 35 percent of assets), however, this simply suggests that foreignbanks lowered the deposit dependence ratio. Based on thesecond indicator, foreign banks are generally lessleveraged than domestic and public-sector banks. Fourth, all three types of banks maintain a similar liquidityposition, accounting for about 15 per cent in terms ofcash and balances with banks; and about 50 per cent interms of the sum of cash, balances with banks, andinvestment. This reflects the CRR and SLR.

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As a second step, a statistical test was conducted to see whether the average levels of the following indicators are the same for public-sector, foreign, and private domestic banks: ROAA, COST, INCOME1, INCOME2, PROV, and EQUITY. The results show that foreign banks have generally performed better than public-sector banks in terms of all indicators (table 2). A similar pattern is observed for private domestic banks against public-sector banks. However, such differences were more pronounced in the earlier period compared with later periods. This may suggest that public-sector banks have made greater efforts to improve their performance as reforms have progressed.

This section assesses the extent of concentration in the banking sector and conducts empirical estimation to test seven hypotheses.

This chapter tests this hypothesis by adopting two approaches: (a) the m-bank concentration ratio adopted by Sarkar and Bhaumik (1998) and (b) the Herfindahl Index adopted by Juan-Ramon and others (2001). The m-bank concentration measures (a) one-bank concentration ratio (market share of the largest bank or the State Bank of India, (b) five-bank ratio, and (c) 10-bank ratio. Deposits are used to estimate the m-bank concentration indicator. The Herfindahl Index is defined as 100 x i=1i=Nki2 where ki=Ki/i=1i=NKi and N=number of banks during the period under consideration. This indicator can be calculated for the whole banking sector as well as for public- sector, foreign, and private domestic banks, respectively. The higher the indicator, the greater the concentration of the banking sector. The lower limit of this indicator is obtained as 100 divided by N and the upper limit is 100. The m-bank concentration indicator reveals that the degree of concentration in the banking sector has barely changed during the period 1993-1999 (table 3). Since most of these large banks are public-sector banks, this indicates that public-sector banks continue to be dominant and enjoy scale advantages over new banks. On the other hand, the Herfindahl Index shows that the degree of concentration has declined consistently in the whole banking sector, more or less in line with the first hypothesis. In addition, the concentration has declined even within foreign banks, private domestic banks, and public-sector banks. Since the lower limit (100/N) has also declined, this suggests that a number of new banks have entered the market and exerted some competition at the lower end.

There are two studies that assess the impact of India’sreform programme. Based on data from 1993/94 and1994/95, Sarkar, Sarkar and Bhaumik (1998) have shownthat foreign banks are more profitable than public-sectorbanks, based on two indicators (profits divided by averageassets and operating profits divided by average assets).The profitability of private domestic banks is similar to thatof foreign banks, but private domestic banks spendmore resources on provisions for NPAs. Second,foreign banks are more efficient than private domestic andpublic-sector banks, based on two measures (net interestrate margins and operating cost divided by averageassets).

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Based on data from the period 1980-1997/98, Sarkar and Bhaumik (1998) have concluded that foreign banks, despite the superior quality of services they offer, have not been a competitive threat in Delhi, West Bengal and Maharashtra, where their presence is greatest. This shows that competition has emerged only at the fringe, since the entry of new banks has been at the lower end. Domestic private banks have gained some market share in these regions, but the impact on public-sector banks was small and gained at the expense of foreign banks. In Uttar Pradesh, Madhya Pradesh, Bihar, Orissa, Gujarat and Punjab, public-sector banks have been predominant before and since the reforms, thus no apparent impact from new entries was observed. In Tamilnadu, Kerala, Andhra Pradesh, Karnataka, Jammu and Kashmir and Rajasthan, private domestic banks have been more concentrated than in other regions and have experienced an increase in market share at the expense of public-sector banks. But the presence of foreign banks was small. The progress of India’s financial reforms has been investigated via two steps. In the first step, the overall impact of the financial reforms on public-sector banks has been assessed by using pooled data. The performance measures adopted are ROAA, COST and INCOME1. Some of these indicators were employed from Claessens, and others [2000]; Demirgüç-Kunt and Huizinga [1997]; Sarkar Sarkar and Bhaumik [1998]; and Sarkar and Bhaumik [1998]. The time dummy (TIME) has been introduced to capture time differences in the sample. Five control variables account for banks’ specific features and behaviour: (a) diversification (proxied by the sum of profits from securities and foreign exchange transactions and brokerage and commissions/assets [DIVERSE]), (b) investment in government securities/assets (GBOND), (c) lending to priority sectors (proxied by lending to priority sectors/assets [PRIORITY]), (d) lending to the public sector (proxied by lending to the public sector/assets [PUBLIC]), and (e) size of the bank (proxied by the log of each bank’s asset size [SIZE]). This analysis uses data from the Prowess database for 1993-2000 compiled by the Centre for Monitoring Indian Economy Pvt. Ltd., which includes most of the major banks in India. The results from this estimation are reported in table 4. A significant coefficient of the time dummy variable would indicate that the particular year was different, which could be due to numerous factors, including regulatory changes, if any, that happened during that year. First, the time effect on ROAA (and COST) given in columns 1 and 2 was negative (positive) and statistically significant initially. Since many of the regulatory changes took place during the earlier period of reforms, the significance of the time effect could reflect the initial negative impact of thereform, which has disappeared in the later period. Basedon these outcomes, the financial reforms appear to havehad a non-negligible impact on the overall performance ofpublic-sector banks. While the reforms lowered theirprofitability and cost efficiency at the initial stage, thisnegative effect disappeared later on as they adjusted to anew environment, supporting the second hypothesis. Second, DIVERSE has exerted a statistically positive(negative) contribution to ROAA and INCOME1(COST), indicating that the diversification effect on theperformance of public-sector banks is favourable andthus the third hypothesis is supported. The statisticallysignificant and negative (positive) impact of GBOND onROAA (COST) is present. This suggests that investmentin government bonds limits banks in the diversification oftheir asset portfolios and thus the fourth hypothesis issupported. On the other hand, PRIORITY has made astatistically significant and positive (negative) impact onROAA (COST), contrary to the fifth hypothesis. This implies that while lending to priority sectors isgenerally regarded as the cause of NPAs, somelending activities have generated high income and haveallowed banks to improve cost efficiency. As a next step, the analysis examines the overall impact ofthe whole banking sector by using pooled data of allcommercial banks for 1993-2000. In addition to theapproach adopted above, ownership dummy variables([FOREIGN] and [PRIVATE]) have been used to capturedifferences in ownership. FOREIGN (PRIVATE) equals 1if the bank is foreign (domestic)-owned and equals 0otherwise. Moreover, the age dummy (AGE) hasbeen used to capture the differences between new and oldbanks. AGE is equal to 0 if the bank existed before 1991and equals 1 otherwise.

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The estimation results reported in table 5 are summarized as follows. First, if the entry of foreign and private domestic banks brings in more skilled banks, the profitability and efficiency of the banking sector is expected to be higher. The results reported in columns 1-3 indicate that the coefficients of FOREIGN and PRIVATE in the ROAA equation were statistically significant and positive, although their coefficients were not significant in the COST equation. Further, coefficients of FOREIGN are positive and statistically significant in the INCOME1 equation. These results suggest particularly that foreign banks perform better than domestic banks, and that ownership matters, thus supporting the sixth hypothesis. Second, the coefficient of TIME is negative (but statistically insignificant) initially in the ROAA equation of the whole banking sector, but is positive and statistically significant in 1995 and 1997. The TIME coefficient was also positive and statistically significant in the INCOME1 equation. Third, DIVERSE has improved profitability and the cost and earnings efficiency of the whole banking sector, in line with the third hypothesis. The coefficient of DIVERSE shows that the diversification impact on ROAA and INCOME1 (and COST) was positive (negative) and statistically significant.

Fourth, GBOND helps banks to increase holdings of safe, liquid assets, and thus improve their liquidity position. At the same time, however, it reduces the opportunity to allocate limited financial resources toward more needed sectors and hence profit-ability and cost and earnings efficiency. The results indicate that the coefficients of GBOND on ROAA (and COST) were negative (positive)and statistically significant, supporting the fourthhypothesis. Contrary to our expectations, however, theimpact of GBOND on INCOME1 was positive andstatistically significant. Fifth, lending to priority sectors and the public sectorwould be expected to lower the profitability and earningsefficiency of the whole banking sector, reflecting that thistype of lending is characterized by direct lending. Despitethe share of credit extended to priority sectors accountingfor more than 20 per cent of their total credit, thecoefficients of PRIORITY and PUBLIC with respect toROAA turn out to be insignificant, contrary to the fifthhypothesis. Moreover, the coefficient of PRIORITY onCOST was negative and statistically significant, implyingthat some types of those credits have enhanced costefficiency. However, the coefficient of PUBLIC onINCOME1 was negative and statistically significant,suggesting that such lending lowers banks’ incomeearnings capacity. Sixth, the coefficient of AGE with respect to ROAA andINCOME1 was negative but statistically insignificant.

Since the financial reforms of 1991, there have beensignificant favourable changes in India’s highlyregulated banking sector. This chapter hasassessed the impact of the reforms by examining sevenhypotheses. It concludes that the financial reforms havehad a moderately positive impact on reducing theconcentration of the banking sector (at the lower end) andimproving performance. The empirical estimation showed that regulation (capturedby the time variable) lowered the profitability and costefficiency of public-sector banks at the initial stage of thereforms, but such a negative impact disappeared oncethey adjusted to the new environment. In line with theseresults, tables 1 and 2 show that profitability turnedpositive in 1997-2000, cost efficiency steadily improvedover the reform period, and the gap in performancecompared with foreign banks has diminished. Moreover, allowing banks to engage in non-traditionalactivities has contributed to improved profitability and costand earnings efficiency of the whole banking sector,including public-sector banks. By contrast, investment ingovernment securities has lowered the profitability andcost efficiency of the whole banking sector, includingpublic-sector banks. Lending to priority sectors and thepublic-sector has not had a negative effect on profitabilityand cost efficiency, contrary to our expectations.

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Further, foreign banks (and private domestic banks in some cases) have generally performed better than other banks in terms of profitability and income efficiency. This suggests that ownership matters and foreign entry has a positive impact on banking sector restructuring. The above results suggest that the current policy of restructuring the banking sector through encouraging the entry of new banks has so far produced some positive results. However, the fact that competition has occurred only at the lower end suggests that bank regulators should conduct a more thorough restructuring of public-sector banks. Given that public-sector banks have scale advantages, the current approach of improving their performance without rationalizing them may not produce further benefits for India’s banking sector. As 10 years have passed since the reforms were initiated and public-sector banks have been exposed to the new regulatory environment, it may be time for the government to take a further step by promoting mergers and acquisitions and closing unviable banks. A further reduction of SLR and more encouragement for non-traditional activities (under the bank subsidiary form) may also make the banking sector more resilient to various adverse shocks.

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