Taking the road less traveled

Special address by Finance Minister P Chidambaram at the Bankers' Conference, Vigyan Bhawan, New Delhi, November 11, 2004

One of the major threats to the health of Indian banking comes from the high level of nonperforming assets (NPAs). Although the situation has improved over time, this is largely in terms of net NPAs. The Indian banking industry has, fortunately, had a sufficiently long period of soft interest rate regimes. With large investments in government securities, banks were able to make substantial profits without much effort. This helped them to make large provisions and show impressive figures in terms of NPAs.

Another reason for lower NPAs has been the reluctance on the part of public sector banks to recognise bad loans as NPAs. Instead, in many cases, they have resorted to restructuring, or "ever-greening", which makes recovery an extremely difficult task.

The problem of NPAs is more complex than it appears, and needs to be tackled on several fronts. First, banks will need to improve credit quality. This calls for better skills, better risk management systems, and improvement in monitoring and follow-up. There are reports of poor documentation and, consequently, difficulties in enforcing loan contracts. On the whole, the system of supervision and accountability within public sector banks and many old private sector banks needs to be improved.

These are issues that have to be tackled by bank managements themselves. They need to compare their own systems to those of the global banks, in which the quality of credit appraisals is far superior, supervision is strict, and penalties for serious mistakes instantaneous.

Information is vital for improving the quality of credit appraisals. Availability of required information on borrowers will, in course of time, reduce their harassment. This will help banks make speedy appraisals and credit decisions. A well-established system of credit information should also minimise financial frauds that can become problematic for certain categories of loans, like housing loans. Given the importance of information for improving the credit climate, we propose to bring about a law to provide legal sanction for collection, sharing and regulated dissemination of credit information and setting up credit information companies. This initiative should enable our banks to benefit from access to credit information, like banks in the USA, the UK, Australia, New Zealand, France, Germany and Sri Lanka.

A related issue, however, is that of lenders' liability. While developing the database of credit histories of individual borrowers, banks may intrude upon citizens' privacy. They have, therefore, an equal obligation to ensure proper customer service. Banks need to follow certain norms in considering, appraising and deciding on proposals for credit. They also need to disclose all the information that the borrowers should have. When in genuine difficulty, the honest borrower needs to be given timely help. In many countries of the world, banks are mandated by law to respect the rights and interests of lenders, depositors and other customers.

There is a demand for a similar law in India, and the Supreme Court in the judgment upholding the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act has made a reference to the lender's liability. So far, we have agreed to achieve this objective through an advisory or guidelines, and the Reserve Bank of India (RBI) has circulated a Fair Practice Code. If Indian banks aspire to be global players, they will have to display greater respect for the Fair Practice Code. If they fail to show sufficient concern for customers, there will soon be clamour for enacting a law. It may be difficult to deny such a demand, indefinitely.

Since banks are "special" and particularly vulnerable to systemic crises, there is a need to gradually approach competition. The policy for opening the Indian banking sector will, thus, have to follow a dual-track approach. While providing a roadmap for opening up to global competition fully, we will have to simultaneously strengthen national banks so that they are fully prepared to face any competition. While Indian banks aspire to become truly global players, they should also be prepared to face the full force of global competition on their home ground.

Preparing for global competition will mean greater attention to regulation. It will be necessary to enhance regulatory capacity to ensure proper surveillance, enforce rules and develop the capacity to block banks and close them down, before they become insolvent and make claims on the tax-payers' money. From the task of protecting weak banks at the cost of public money, regulation will need to refocus on such issues.

For Indian banks to become globally competitive, it is necessary to adopt the best international practices in corporate governance. The government has formulated certain guidelines regarding eligibility criteria for appointment of non-official directors on boards of public sector banks. The objective of these guidelines is to ensure that they bring about a distinct qualitative improvement in corporate governance and help banks meet competitive challenges and the risk associated with the rapidly changing environment. However, the goal of vastly-improved corporate governance will not be achieved by selecting good non-official directors alone. The management of banks will need to adopt better systems and practices, and to provide necessary information and material to their boards for making sound decisions.

With globalisation, Indian public sector banks have to compete with new-generation private and foreign banks. International trends suggest that consolidation has reduced the chances of credit risks. There is a near consensus on the issue that to attain global aspirations and provide greater banking services to rural and hitherto unbanked areas, banks have to consolidate. However, the consolidation has to be addressed not merely to create large behemoths but to benefit from the synergy created by mergers.

The footprints of our banks should cover the most interior rural areas and provide support to far flung sectors, which at present face enormous difficulty, as small banks find such remote branches at rural areas unviable. Large banks would be in a position to set up branches in hitherto unknown areas even if these were not totally viable, as these banks would have the long-term financial sustainability to be able to cross-subsidise. Such large banks would also be able to meet Basel II norms, providing comfort to clients and stakeholders.

The strategy should, thus, be for public sector banks to analyse consolidation with entities, maximise synergies and create larger banking entities, able to compete globally. The entire process should be market-driven and based purely on commercial and economic considerations. Regional and ethnic considerations must also be built into any proposal for consolidation.

The profitability performance of Indian banks in recent years compares well with that of the global benchmark banks, primarily because of the higher share of profit on the sale of investments, higher leverage and higher net interest margins of Indian banks. However, many of these drivers of higher profits of Indian banks may not be sustainable. To ensure long-term profitability, Indian banks need to focus on the following parameters:

• Ensure that loans are diversified across several customer segments
• Introduce robust risk-scoring techniques to ensure better quality of loans, as well as enable better risk-adjusted returns at the portfolio level
• Improve the quality of credit-monitoring systems so that slippage in asset quality is minimised
• Raise the share of non-fund income by increasing product offerings wherever necessary by better use of technology
• Reduce operating expenses by upgrading banking technology
• Improve the management of market risks
• Reduce the impact of operational risks by putting in place appropriate frameworks to measure risks, mitigate them or insure them.

Indian banks must, over the years, look and behave like global banks.

A global bank has to have modern frameworks for handling credit risk. It does not mechanically use ratings from credit rating agencies, but uses models for evaluating credit risk. It does marking to market of the loan/bond portfolio, based on a prospective view of the net present value (NPV) of the assets. It routinely buys/sells components of the credit portfolio. It intensively uses credit derivatives. None of these features are found in Indian banks today. These are skills and practices that Indian banks will need to think about to become global.

In order to be successful, even a global bank has to be relevant to local needs. It should not only understand the local economy, its opportunities and challenges, but also be sensitive to its culture and customs. Indian banks having global aspirations would need to do the same. That is, indeed, a daunting challenge. But before an attempt is made to understand the needs of the Western economy, or that of East Asia or the Gulf countries, we need to fully tap the emerging opportunities in our own country. Unless our banks effectively tap these opportunities, their aspirations for success abroad may not be realised.

Huge opportunities lie within India in agriculture, agri-businesses, small and medium enterprises, non-farm activities and infrastructure, self-help groups and micro-finance borrowers. We need to tap these opportunities, be proactive; and research and develop appropriate skill sets and systems. We must not always walk down the trodden path; we must sometimes take a road less travelled, while taking precautions to manage these risks.