Modern Commercial Banking

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Copyright © 2008, New Age International (P) Ltd., Publishers

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Dedication



  

   

 

 

 

Dedication

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Since the publication of the first edition of this book five years ago several

developments covering the money market, the government securities market

and the foreign exchange market have taken place to strengthen their integration

and enhance their efficiency. Efficient settlement mechanisms, greater

transparency and best market practices are put in place, which facilitate faster

transactions and lower their costs.

Efforts have been concentrated on improving the credit delivery mechanisms.

Although the Narasimhan Committee on the Financial System (1991)

recommended the phasing out of the directed credit programme at 10 per cent of

the bank credit not only the proportion has been retained at 40% level but its

coverage has been considerably enlarged. The appropriate instrument to achieve

distributive justice is fiscal policy not credit policy. Fiscal policy ensures the

scrutiny of budget provision at various levels. Efficiency and economy in the

spending of public money are ensured by the different agencies of financial

control which include the legislature, the Estimates Committee and the Public

Accounts Committee. The audit of the government expenditure prescribed by

the Constitution is to be undertaken by the Comptroller and Auditor General. All

these agencies of control direct their control or review towards ensuring that

money is available for the purpose for which it is spent, that the manner of

expenditure conforms to the manner prescribed by the legislature and full value

is obtained for the money spent. Further, the expenditure is either tax financed

(with no quid pro quo) or by borrowing (revenue expenditure included in fiscal

deficit) with inflationary consequences. While the inflationary impact of

expenditure financed either by credit or budget is common, there are no checks

constitutional or otherwise in the end use of funds in the case of credit.

Directed credit in the name of social banking is extended out of deposits

made by public in trust with banks. While the Banking Regulation Act (BRA)

(viii)

does not envisage protection of depositors interest like the protection of investors

interest by the Securities and Exchange Board of India it requires RBI to have

due regard to the interests of depositors in enunciating banking policy from time

to time. BRA however mentions the need or equitable allocation and efficient

use of deposits. In discussions of credit policy and banking systems, the safety

of deposits which are after all placed with the bank in trust, the phrase depositors

interest does not find any mention. It is indeed perplexing that bank shares

listed on the Stock Exchange do not seen to be analysed by any maximization of

deposit holders’ interests which are used to leverage the activities of the bank

and the effect of directed credit on the erosion of deposits and profitability.

While the requirements of the priority sector lending has been retained at

40 per cent of bank credit, the categories of advances eligible for priority sector

have been expanded to provide banks increased opportunities to lend to these

sectors. The earlier definition of priority sector comprising agriculture, small

industrial units, new entrepreneurs, road and water transport operators, retail

traders, small businessmen, professionals, self-employed, weaker sections has

been extended to include venture capital (for limited time), housing and micro

credit. Under the concept of financial inclusion, pensioners, weaker sections

and groups who were excluded earlier from credit facilities are to be brought

in. The efforts of banks towards financial inclusion will be monitored and

their behaviour reinforced by a system encouragement (incentives for

conformity) and disincentives (penalisation for non conformity).

At the end of March 2005 priority sector advances outstanding were

Rs.3,45,627 crores (37.1% of gross bank credit) and advances for housing

Rs.75,173 crores (8.1%) which together constitute 45.5% of gross bank credit.

The NPAs of priority sector constitute more or less the same proportion of

total NPAs of the banking system. The NPAs of rural cooperative sector add

up to another Rs.20,000 crores. The housing loans under the priority sector

have given rise to land/real estate bubble. Prices have gone up in the last three

years by more than five times.

While financial exclusion is nobody’s case the credit requirements of

individuals/households are mainly for social purposes. Social attitudes towards

expenditures associated with birth, marriage (including dowry) and death have

not changed. People also choose to live on credit by deferring payments to

landlord for housing, milk vendor, provision stores, friends and whatever. As

it is, personal loans amounted to Rs.87,000 crores with banking system in

2003-04. How is the banking system to meet the requirements? To realize

personal loans whatever collateral has been pledged has to be liquidated. Again

loans are preferred to outright sale of collateral in the Indian society in the

hope of redeeming the collateral.

If such individuals are excluded earlier how is the banking system to include

(ix)

them now? If there is no collateral promise of a cash flow from some form of

market oriented activity has to be shown to extend credit. Financial inclusion is

going to be difficult given the risk aversion of banking personnel and delinquent

behaviour of unsecured borrowers.

Now micro credit is held out as the panacea for rural poverty. Given the

extant feudal structure of rural society the inclusion of individuals who were

earlier outside any market oriented activity in SHG/NGO is not certain. Regular

effort has to be made to locate and include them. Further mere readiness to

support NGO/SHGs is not enough. Our plans provide opportunities but the

poor cannot avail them because there is a hiatus between the provision of an

opportunity and ability to avail it. Envisaging an organisional form and readiness

to extend credit does not ensure end use by the needy. Projects or activities or

things-to-do with a market and generate cash flows have to be identified. That

requires techno-economic skills. NGOs/SHGs is only an organizational form

into which the poor have to be fitted. The members of SHGs have to be assembled

from the numbers who have not been participating in any form of production

for market. Merely counting the number of SHGs who have availed credit does

not assure that poverty has gone down by that number. With 30% population

outside the economic framework the number of SHGs and credit required would

be very large indeed.

The constitution of techno-economic team at each RRB with an interface

to SHG/NGO would ensure that micro credit is a poverty reduction measure

which augments supply of goods and services. The membership of poor in the

SHG and their involvement in projects which generate cash flows will alone

help meet the depositors interests. An efficient banking system should deliver

credit for generation of cash flow over time in the hands of poor. The rural

cooperative sector was hijacked and ruined by the politicians and their cronies

belonging to the feudal class. Micro credit should not fall prey to the

machinations and manipulations to capture micro credit. It should be saved

from the fate that has befallen rural cooperative credit system.

Visakhapatnam H.R. Machiraju

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The banking system in India has remained insulated from global developments

for almost half a century because of barriers to entry, exchange controls, public

ownership of banks (80% of the total assets of the banking system), directed

credit and pre-emption of deposit accruals for financing government expenditure.

On the other hand, there was a sea change in the nature and functioning of

banks in U.K., USA and Euro dollar market with marketisation of banking

accompanied by globalisation. There the discipline of the market in terms of

credit spreads, share price and subordinated debt is brought to bear on banks

contributing to their prudent behaviour.

Banks abroad which lost their monopoly of acceptance of deposits and

provision of payment services to non bank financial institutions assumed new

risks by undertaking securities related services, asset management and insurance

to maximise their income. Since there were no restraints on lending they financed

or undertook liquidity management. Starting in late 1960s they met the demand

for loans by borrowing or liability management. Although the mismatch between

short-term deposits and long-term loans was covered by innovations such as

rollover credit and flexi rates, the risks had to be hedged by the use of derivatives.

Risk management has come to occupy the centrestage of bank management.

Bank management became the management of balance sheet risks of assets and

liabilities and extensive resort was made to derivatives traded on both organised

and over-the-counter (OTC) markets to hedge risks. All these evolutionary

changes bypassed the banking system in India because the economy was a

closed one.

The asset liability management guidelines in India (1999) are hardly a year

old and are a response to the credit risk banks took in the accumulation of non￾performing assets. There are also guidelines for forward rate agreements and

interest rate swaps but their use would depend upon the extent of interest rate

  





(xii)

risk arising out of mismatch of banks and other participants’ sources of funds

and maturity of loans. The resort to interbank borrowing is mainly for meeting

very short-term, say, overnight, problems of liquidity and not to meet credit

demand. The problem is of non-performing assets as it is has choked credit

flow to medium and small sector.

Promoting healthy banks is a crucial prerequisite for financial stability. Banks

as well as central bank need autonomy. Banks should be subject to the discipline

of the market like firms in other industries. This trend is likely to grow as and

when the public sector banks access the market or the government disinvests.

The marketisation of banking and shareholder demands together would constrain

the banks to maximise the return on capital. They need however autonomy to

manage risks in their balance sheet. Despite the review of the financial system

and its component the banking sector in 1991 and 1998, respectively, little has

changed. Pre-emptions of deposit accruals continue with the need to finance

fiscal deficit which has gone up from 9% in 1990-91 (the crisis year before

reforms) to 11% in 2000-01. Financial stability which demands the maintenance

of stability in the domestic and international value of the rupee has to be

buttressed by granting autonomy of action to central bank and reining in fiscal

deficit. The conflict of objectives arising out of the dual role of RBI of debt

management and monetary policy functions has to be eliminated.

Commercial banks may be encouraged to offer gold denominated deposits

like the State Bank of India has done. But SBI scheme has failed to attract

deposits. Unlike the SBI scheme gold in the form of jewellry should be retained

in the form and shape deposited and returned on demand. This would eliminate

the loss on melting and cost of remaking jewellry which are acting as

disincentives. This would encourage temples also to deposit gold jewellery.

Interest rate on gold deposit should be based on time or lock-in period say 5%

p.a. for 3 years and 8% p.a. for 5 years lock-in period. Gold deposits may be

insured up to Rs.10 crores or 20 kg. Once the gold deposits are mobilised a

central issue of Indian Gold Depository Receipts in the international capital

market may be organised. With appropriate accounting methods securitisation

of gold deposits may be undertaken. The hoards are estimated at $100 billion

and represent genuine saving. Foreign exchange flows in the form of NRI

deposits and FII investment accounting for two thirds of our forex reserves of

$33 billion are fair weather investors. The reserve position can be strengthened

by mobilising gold.

Risk management requires the setting up of institutions/ exchanges for futures

and options trading. NGOs may be encouraged to frame rules and accounting

methods for over-the-counter instruments such as swaps. It is necessary that

we have the institutional framework in place as well as over-the-counter market

to hedge various risks banks face in managing their assets and liabilities. It

(xiii)

would also get the economy ready to add foreign currency hedging instruments

as and when capital account convertibility is adopted. Most of the risk

management techniques would remain esoteric unless we take in hand the

promotion of institutions for the purpose.

The attitude to take risk of bank executives is a key factor influencing

bank’s income. The question of management of risk arises only when banks

undertake risk to maximise income. This requires that banks be given autonomy

to deal in their funds within the guidelines of their boards in regard to exposure

and select staff who can evaluate and undertake risk within the exposure norms.

As a nation we are highly risk averse and bank executives are no exception.

The banking system did not make any demands on risk taking ability of the

executives as long as the emphasis was on deposit mobilisation to fill the

borrowing needs of the government. Even now banks prefer to park surplus

funds in government securities rather than lend. Suitable behavioural testing

before recruitment and training after induction have to be devised. Provisioning

norms should take care of any losses that arise in the normal execution of duties

rather than by personal accountability which cramps the style of bank executives.

Banking is business and like any other the return on capital and maximisation

of share value have to be pursued within the overall framework of prudential

regulations.

Banking system in India has been put to inappropriate use for far too long

as a social instrument to eradicate poverty and to take care of organised labor

within the banks. Depositors funds are to be held in trust to earn a return.

Demands of organised labor should be linked to gains in productivity rather

than behaviour of price which can be held stable if fiscal deficit is reined in.

The principle of neutralisation of price rise when viewed over a long period

has gone quite beyond the protection of real wages and contributed to the wide

differential in reward to workers in the banking industry and others with

comparable skills in other industries and activities. The key to strengthening

the banking system is to close the captive market for government securities and

reducing the allocation to priority sector to 10% as was originally suggested by

the Committee on Financial System in 1991. Our banking system is fragile and

unless we reform it in the real sense we cannot join the global banking system

as an equal partner. National interest rather than political interest should govern

the decisions in regard to the economy, its growth and financial stability. Our

record so far is that we are prisoners of political compulsions rather than free

modern decision-makers to build a strong modern India with a modern

commercial banking system that is second to none in the world.

Visakhapatnam H. R. Machiraju

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