NPAs and the need for healthy markets for credit risk instruments

Indian Banking Sector:

India’s modern banking sector had undergone various stages of transformation starting from early years of independence facing varied challenges of an underdeveloped economy into a more liberalized, emerging and a globalizing economy.  During the decade of sixties it was felt by the policy making that banking is a public function and the banks would have to be nationalized to make banking accessible to the unbanked population of India and to appropriately direct scarce capital towards planned development. According to the RBI report on Evolution of Banking in India (2008), “the problem of lopsided distribution of banks and the lack of explicit articulation of the need to channel credit to certain priority sectors was sought to be achieved first by social control on banks and then by the nationalization of banks between 1969-80.” The economic liberalization of 1990’s ushered the new era of privatization with the entry of new private banks which used technology to transform and revitalize banking operations in India.

Since then, the banking sector has grown at a healthy pace with strong support from domestic savings, rising disposable incomes, strong economic growth, increasing formalization of Indian economy, and easy access to banking services. According to RBI’s discussion paper on Banking Structure in India – The Way Forward (2013), the size of the Indian economy in terms of GDP at market prices has increased by almost fifteen times, whereas the household financial savings have expanded by sixteen times and the gross domestic savings by almost seventeen times during the same period since 1991.

Privatization of the 90s and the rapid adoption of technology for making banking a household task led to a more rapid growth among the private banks.  This is evident from the fact that the share of public sector banks in total deposits have declined from 78.2% in 2005 to 77.5% in 2012, indicating that private banks have been capturing an increasing share of deposits. It is also evident from the growth of the asset base of the banking sector.  Public sector bank’s asset base grew at an average of 7.5%, whereas private sector expanded at a CAGR of 11.3%. Going forward, central bank is considering more licenses to private sector players to increase competition in the banking industry and improve transactional efficiency in the economy.

Marginalization of economically weaker sections and the need for improving financial access:

Historically, despite a strong growth in domestic financial savings, its channelization to fund economic activities in sectors such as agriculture, micro and small enterprises, and low income groups remained fairly low. During 1960s, the concept of social control gained importance to ensure an equitable distribution of credit keeping in view the relative priorities of developmental needs. The description of the priority sectors was formalized in 1972 with the help of the National Credit Council (NCC), set up in 1968 to assist the RBI and the Government to allocate credit according to plan priorities. It was made mandatory for banks to lend to the identified priority sectors.

Typically, priority sector lending refers to providing small value loans to the high risk category of agriculture and allied activities, micro and small enterprises, poor people for housing and other low income groups and socially weaker sections for their varied economic activities.  Added to the high risk is the mandated low cost of lending which broadens the risk reward gap to be met through income from the rest of the funds that can be lent to the non-priority sectors or to be written off as losses to be augmented by cash infusion as the deposits collected are protected.  As per the revised RBI guidelines of September 2012, domestic commercial banks and foreign banks with 20 and above branches would have to compulsorily lend 40% of Adjusted Net bank Credit (ANBC) or credit equivalent of off-balance sheet exposure, whichever is higher.  During 2005-13, total lending under PSL by scheduled commercial banks has amounted to INR 87.5 Trillion, growing at a CAGR of 20.4%.  However, the widening gap between the target and achievement above over the past few years as per Chart 3 indicates that SCBs are shying away from taking an exposure directly towards the priority sector.  PSL has been witnessing a declining trend even when the total deposits and credit of commercial banks have been growing at a healthy pace, indicating increasing avoidance of banks towards exposure to priority sectors and rather to principal protected avenues at a lower income as provided by the mandate.