Banking reforms - barking up the wrong tree?

Banking reforms has been on top of the mind of the government, media and in general the commentariat over the last 3 years, gaining decibel in line with deteriorating balance sheets of banks. A recent op-ed piece by Prof Ajay Shah in Business Standard encapsulated the commonly thought of issues with banking, and the roadmap of what is popularly believed to be “reforms”. Prof Shah essentially makes the following points.

1. There isn’t enough competition in banking, and we haven’t got enough new entrants coming through. This is affecting service delivery, both quality and quantity.
2. Banks dominate the credit markets, lack of a developed corporate bond market is crowding out bank credit to SME (unlike in “mature” markets).
3. Lack of a developed bond-currency-derivative market is preventing efficient transmission of policy rate movements.

Unfortunately, all the three identified issues (and their putative reformative solutions) are either misdirected (ie, not linked to revitalisation of the banking system), or completely wrong in its premise per se. Given that these are the Generally Accepted Banking Solutions (GABS!) of the "liberal" commentariat, it is important to put the hypotheses through some basic rationality tests.

Competition - too little, or too much?
First, on the question of competition. We don’t have enough banks, and too few new ones are coming through in scale. 

Data simply doesn’t bear the hypothesis out. There are ~100 commercial banks (Publicsector, private sector and foreign banks), a few dozen Regional Rural Banks(RRB), and hundreds of Cooperative banks (of various types). Very few countries (outside of US) have such proliferation in sheer numbers of banks. Ergo, lack of competition isn’t the most burning issue plaguing the industry.

Far from not having enough banks, India has an issue of far too many banks. So is the issue of regulatory walls creating a few large oligopolistic banks while the industry has a long tail of small banks? Far from it. Barring State Bank of India with a marketshare of ~20% and ICICI Bank (with a shade lower than 10%), all other banks have marketshares in low single digits.  The big issue therefore being that very few of whom have scale economies to drive down intermediation costs and offer competitive services to customers.

From a “reform” perspective therefore, the key imperative isn’t new banking licenses or more foreign banks coming into India, but a more enabling M&A framework that would enable consolidation of banks into large, scalable entities.

Prof Shah’s favoured exemplar industry, telecoms, had exactly the same enabling consolidation roadmap for penetration and costs.

Corporate Bond market - "crowding out" small borrowers?

Second, in absence of a well developed corporate bond market, most of corporate credit is financed by banks, thereby “depriving” SMEs of banking credit. To start with, the hypothesis is again incorrect. 

Loans above 100 crores contribute only around 31% of totaloutstanding banking credit. Ergo, ~70% of credit is going to medium and small sized enterprises and individuals.

Moving on, the premise itself is incorrect. Most large corporates in India do have access to a corporate bond market, both onshore as well as offshore.

As seen in the chart above, the corporate bond market in India is actually quite in line with Asian peers, accounting for ~30% of all outstanding bonds. Above all, the share of banking credit to overall credit outstanding in the economy too is in line with relevant Asia peers.

There is a structural issue with the savings market in India . Simply put, savers in India prefer banks over anything else to deploy their savings (bank deposits account for ~50% of all household financial savings).

With banks having access to the largest pool of savings, its but natural that they will have the largest share in credit, tautologically!

Net net, while access to credit is always a work in progress, lack of corporate bond market isn’t the elephant in the room. 


Lack of Bond-Currency-Derivative market preventing monetary policy transmission?
Third, lack of a bond-currency-derivative market prevents effective transmission of rates. While as a structural issue, lack of a derivative market in bonds (CDS) and a liquid enough market in Currency (more INR trading happens in the offshore NDF market than in India) are constraints, the immediate issue on rate transmission is a lot more quotidian.

Simply put, PSU banks (that are 70% of the banking system) have ~12-13% of assets classified as stressed. As a result, all of them are stretched on capital (remember Tier1+Tier2 capital on an average would be 10-11% for these banks). Given the lack of "free capital", the banks are unable to grow their loan books. Now if they repriced existing good loans downwards, it will only have one impact, ie, a drop in Net Interest Margin (NIM) and hence profits. In a more normal environment, the banks would compensate through growth in their loan books. But in absence of balance sheet/capital space to do so, there would be only one outcome, ie, a drop in profits. A drop in profits would mean a further reduction in retained earnings, further reduction of Tier1 (equity) capital. Ergo, its a vicious cycle. It is thus very normal and rationally explained why policy rate cuts are being transmitted through the system so anemically. No amount of market development in products would solve an issue primarily linked to capital adequacy.


Its the (banking) capital, stupid!:)
So what is the way out of the current problem? While silver bullets are never available outside of blue TV channels, the US TARP (Troubled Assets Relief Program) launched to rescue banks after the 2008 meltdown offers interesting cues. The issues with US banks in 2008 were somewhat similar to Indian banks today.

1. Concentration of bad assets in the loan portfolio (it was CDO/MBS there, corporate loans for us in India).
2. Extreme capital inadequacy to clean up the bad assets and resume normal business growth.
3. Sharp reduction in valuations/share prices, cutting off reasonable access to capital markets.

The solutions under TARP were a mix of infusion of government equity, sovereign guarantees on liabilities and an aggressive clean-up of bad assets by using the fresh capital. The program was a resounding success. While there were philosophical questions raised about using taxpayer money to bail out private banks, the government of the US earned a handsome profit out of the exercise.

The solutions for India would have to be on similar lines. A problem of banking capital has to be resolved through infusion of capital. Once confidence is restored around the health of the banks, the latter can access capital markets to raise fresh capital at reasonable terms. That will enable the banks to resume normal business. It is that which would make the systemic impulses more efficient to transmission of policy signals down the chain. That would also be a better time to take stock of and decide upon questions of privatisation, mergers and so on.