Banking on diversity

Diversity lends strength to any ecosystem — a monoculture tends to be fragile, especially in the financial sector, where following each other’s strategies builds risks. So even though public sector bank ownership is often attacked as a weakness, a diversified banking system may be a source of strength.

Freer post-reform entry resulted in an even split in ownership by 2009-10: 27 public sector banks (PSBs) with majority government ownership, 22 private sector banks, and 32 foreign banks. PSBs, however, still dominated, with 75 per cent of the assets of the banking system. But this was less than their 1991 share of a little over 90 per cent. With diverse ownership in place, policy now aims to diversify by activity-type.

Changes in relative competitiveness illustrate the benefits from diversity. The public sector did unexpectedly well after the reforms of the 1990s, and even overtook private banks on some parameters. It also outperformed them during
and immediately after the global financial crisis.

Reforms reduced excessive government ownership. A new philosophy of regulation shifted from micro intervention to a strategy of macro management. High growth and legal reform that made debt recovery easier also contributed to non-performing assets (NPAs) falling to historic lows. As a ratio to gross advances, NPAs fell to 2.4 per cent in 2009-10 from 12.8 per cent in 1991. There were structural improvements in the health of Indian banks.

Systemic failures were also avoided. The Basel Accord capital standards were implemented as part of the reforms, but a standardised version was followed. Given diverse capabilities, banks were allowed learning time to migrate to internal risk rating-based capital buffers. It was feared that the lack of historical data for wholesale and retail, together with the absence of industry benchmarks to be used in the calculation of internal parameters, could distort risk-based pricing. Indian capital adequacy norms were kept higher than the Basel norms to make sure risky exposures were not undercapitalised, despite the difference in approach. Additional prudential (safety) norms included risk weights and provisioning requirements that effectively moderated sectoral booms. Simpler regulation based on broad patterns was used partly because the skills for complex risk-based regulation were missing, but turned out to have good stability-enhancing incentives. A risk assessment methodology not based wholly on self-assessment was protective.

Features such as high leverage, short-term market-based funding, risky endogenous expansion of balance sheets and exposure to cross-border risks, which had led to massive bank failures in the West, were limited. Most banks followed a retail business model. Loans dominated market investments on bank balance sheets. But this varied by bank type. In 2010-11, contingent liabilities as a percentage of the group’s total liabilities were 41.4 per cent for PSBs, 167.9 per cent for private banks and 1,892.7 per cent for foreign banks. Although technology and skills improved, PSBs lagged behind private banks in systems, fee-based services and use of sophisticated products and derivatives. Or perhaps this reflects the choice of a different business model. Business contracted for private banks after the global financial crisis, and some were in trouble.

PSBs heeded the government’s post-crisis call and participated much more than private banks in infrastructure financing. Meanwhile, private banks concentrated on retail. They used their more flexible hiring patterns to design effective services for the growing middle class, overtaking foreign banks concentrating on high-net worth accounts. The paralysis in many large infrastructure projects and interest rate hikes hit PSBs. A loan-based system is highly sensitive to a rise in interest rates. But again, regulations, such as position and sectoral exposure limits, were protective. In 2011, banks had reached the exposure limit in financing infrastructure.

NPAs are not expected to rise above 4 per cent, and may come down as the economy revives and projects start moving. While some PSBs may have made non-commercial decisions, external shocks were also responsible for outcomes. Errors are always possible, but stronger boards and improved governance mechanisms can ensure that independent decisions are made on purely commercial grounds. Disincentives from taxpayer support are not limited to PSBs, since no large bank is allowed to fail for fear of systemic spillovers.

Diversity helped again, since private banks did well in this period. In 2011, the market capitalisation of 24 listed public sector banks, still controlling 73 per cent of bank deposits, fell below that of the 15 listed private sector banks for the first time. The latter also tended to have more foreign investment.

The recent emphasis on technology-driven financial inclusion and mobile banking may again lead to some surprise reversals. The SBI has the highest number of mobile banking accounts, more than double those of ICICI, which is in second place. PSBs tend to follow government directions, but this need not be harmful so long as social purposes are consistent with viable business decisions.

The Jan Dhan Yojana may not lead to a rise in NPAs down the road, since it aims for a basket of financial services meeting the needs of its target group. Along with lower transaction costs and supporting technological advances, these accounts may actually be used to generate revenue. A large under-banked population implies a huge potential market for a well-designed set of banking services. Proposed diversity in types of banks and easier entry may lead to a new phase of beneficial competition. Whatever the type of bank that leads next, the people should gain.

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