MacroScan - The Potential Fall-out of Basel II

The enhanced Basel guidelines, we had argued in a previous article (http://www.macroscan.org/fet/mar07/fet030307
Basel_II.htm), would lead to changes in the structure of the banking sector that would affect bank behaviour. In addition, Basel II has direct implications for bank lending. What needs to be considered therefore is the way these two factors may interact to influence bank lending. The point to note is that using external (or at a later stage, internally generated) ratings to decide the appropriate risk-weights to assesses capital adequacy, inevitably requires providing banks with a greater degree of flexibility in deciding their lending patterns based on pure profit considerations. This makes it difficult to simultaneously implement a banking policy that seeks to direct a proportion of lending to specified sectors taking into account growth and equity objectives.

The effect of changes in banking structure on bank behaviour can be illustrated by looking at the implications of the possible expansion of foreign presence. Even with the diluted regulation that currently is in place, it is clear that private banks in general and foreign banks in particular have been lax in meeting regulatory norms. Principally private and foreign banks have been unwilling to meet in full the government’s effort to direct credit to priority sectors and maintain differential interest rates that involve an element of cross-subsidization. This implies that any takeover trend led by foreign investors and banks would have adverse implications for the priority sectors, especially agriculture.

Second, an increase in foreign bank presence, by subjecting public sector banks to comparisons of ''profitability'' and ''efficiency'', would force these banks to change their lending practices as well. In fact, faced with the demands made on them by the advocates of liberalization and the effects of competition from the private sector banks, banks in the public sector are already changing their lending practices. Public sector banks that accounted for 79.5 per cent of total assets of all commercial banks in 2003 earned only 67.2 per cent of aggregate net profits, whereas the older private sector banks with 6.5 per cent of total assets earned 8.1 per cent of aggregate net profits, the new private sector banks with 6.1 per cent of assets obtained 10 per cent of the aggregate net profits and foreign banks with just 7.9 per cent of total assets garnered 14.7 per cent of aggregate net profits.

Among the factors that account for this differential in profitability, there are two that are important. One is that the operating expenses for a given volume of business tend to be higher with public sector banks. The other is that income generated out of a given volume of business tends to be lower in the case of the public sector banks. These are the two areas in which changes are being made as part of the effort of the public sector banks to ''match up'' to the performance of private domestic and foreign banks. Those efforts have increased demands for a ''level playing field'', implying the public sector banks too would like to focus on profitable rather than directed lending. The expansion of foreign presence would only accelerate this tendency.

These changes in the structure of the banking sector and the behaviour of banks, which began with liberalization, would be accelerated by Basel II. Under pressure to set aside larger volumes of regulatory capital if lending is to high-risk borrowers and/or low-rated or unrated borrowers, banks would like to redirect their resources to safe investments and credit to highly rated borrowers. This pressure would be all the greater if these banks have to go public, list their shares and be subject to shareholder pressure for higher returns. All this would have a number of implications for growth and equity.

The nature and magnitude of this impact comes through from an analysis of developments during the period of reform and the period when Basel I was being implemented. Consider for example the impact of reform, which, through its stress on reducing the pre-emption of bank assets in the form of the cash reserve ratio, the statutory liquidity ratio and directed credit programmes, was expected to substantially increase access to credit for commercial borrowers in the system.

Table 1 >>

Following the reforms, the credit deposit ratio of commercial banks as a whole declined substantially from 60.4 per cent in 1990-91 to 55.9 per cent in 2003-4, despite a substantial increase in the loanable funds base of banks through periodic reductions in the CRR and SLR by the RBI starting in 1992. There are signs of a revival more recently, driven possibly by the housing and personal finance boom. It could, of course, be argued that the earlier decline may have been the result of a decline in demand for credit from creditworthy borrowers in the system. However, three facts appear to question that argument. The first is that the decrease in the credit deposit ratio has been accompanied by a corresponding increase in the proportion of risk free government securities in the banks major earning assets i.e. loans and advances, and investments. Table 1 reveals that the investment in government securities as a percentage of total earning assets for the commercial banking system as a whole was 22.6 per cent in 1990-91. But it increased to 40.0 per cent in 2003-04. This points to the fact that lending to the commercial sector may have been displaced by investments in government securities that were offering relatively high, near risk-free returns.

Second, under pressure to restructure their asset base by reducing non-performing assets, public sector banks may have been reluctant to take on even slightly risky private sector exposure that could damage their restructuring effort. This has encouraged the Scheduled Commercial Banks to hold risk-free government securities far in excess of that stipulated under Statutory Liquidity Ratios. The share of public sector banks in 2002-3 in total investments in government securities of the scheduled commercial banks was very high (79.17 per cent), when compared with other sub-groups like Indian private banks (13.41 per cent), foreign banks (5.7 per cent) and RRBs (1.74 per cent). Holding government securities enabled banks to avoid the capital adequacy requirements.

Thus the increased attraction of government securities in comparison to loans and advances in the reform period points to the growing risk-aversion on the part of banks, which might have resulted from the increasingly stringent prudential regulations such as income recognition, asset classification, provisioning, capital adequacy norm, etc. that have been implemented since the adoption of Basel I norms. It needs to be noted here that government securities were classified as risk-free and thus did not carry any provisioning requirements.

In the event, the experience of implementing even Basel 1 has not been positive from the point of view of credit delivery. This would worsen after Basel II. The preference of banks for government securities and the increased risk-aversion of banks following the adoption of Basel II would adversely affect credit to agriculture and small scale industries.

Banking Reform and Priority Sector Credit

In fact, past experience indicates that changing bank behaviour in the wake of institutional and regulatory reform has in particular affected credit delivery to the priority sectors. The process of directing credit to what were ''priority'' sectors in the government’s view was facilitated by the nationalization of leading banks, since it would have been difficult to convince private players with a choice of investing in more lucrative activities to take to a risky activity like banking where returns were regulated. Nationalization was therefore in keeping with a banking policy that implied pre-empting banking resources for the government through mechanisms like the statutory liquidity ratio (SLR), which defined the proportion of deposits that need to be diverted to holding specified government securities, as well as for priority sectors through the imposition of lending targets. An obvious corollary is that if the government gradually denationalizes the banking system, its ability to continue with socially-motivated and inclusive banking and with policies such as directed credit and differential interest rates would be substantially undermined.

''Denationalization'', which takes the form of both easing the entry of domestic and foreign players as well as the disinvestment of equity in private sector banks, forces a change in banking practices in two ways. First, private players would be unsatisfied with returns that are available within a regulated framework, so that the government and the central bank would have to dilute or dismantle these regulatory measures as is happening in the case of priority lending as well as restrictions on banking activities in India. Second, even public sector banks find that as private domestic and foreign banks, particularly the latter, lure away the most lucrative banking clients because of the special services and terms they are able to offer, they have to seek new sources of finance, new activities and new avenues for investments, so that they can shore up their interest incomes as well as revenues from various fee-based activities.

As a result, since 1991 there has been a reversal of the trends in the ratio of directed credit to total bank credit and the proportion thereof going to the agricultural sector, even though there has been no known formal decision by government on this score. At the same time, attempts have been made in recent years to dilute the norms of whatever remains of priority sector bank lending. Thus, while the authorities have allowed the target for priority sector lending to remain untouched, they have widened its coverage. At the same time, shortfalls relative to targets have been overlooked.

In agriculture, both direct and indirect advances to agriculture were clubbed together for meeting the agricultural sub-target of 18 per cent in 1993, subject to the stipulation however that "indirect" lending to agriculture must not exceed one-fourth of that lending sub-target or 4.5 per cent of net bank credit. It was also decided to include indirect agricultural advances exceeding 4.5 per cent of net bank credit into the overall target of 40 per cent. The definition of priority sector itself was also widened to include financing of distribution of inputs for agriculture and allied sectors with the ceiling raised to Rs. 5 lakh initially and Rs. 15 lakh subsequently. Further, financing of distribution of inputs for allied activities such as dairy, poultry and piggery up to Rs. 5 lakh were also made eligible for treatment as indirect agricultural advances. Finally, the scope of direct agricultural advances under priority sector lending was widened to include all short-term advances to traditional plantations including tea, coffee, rubber, and spices, irrespective of the size of the holdings.

So far as small scale industries were concerned, the coverage for priority sector lending was extended by re-defining the sector in terms of the level of investments in plant and machinery together with an increase in working capital limits. Initially, the SSI sector included those industries whose investment and machinery did not exceed Rs. 35 lakh. In the case of ancillary units, the investment limit was Rs. 45 lakh. In May, 1994, these limits were raised to Rs. 60 lakh and Rs. 70 lakh respectively. This has gone up to Rs. 3 crore in some cases. All advances to SSIs as per the revised definition were to be treated as priority sector advances which indirectly encouraged term finance loans.

It is in the light of this that the trends in priority sector lending during the post liberalisation period of 1991-2004 needs to be understood. Priority sector lending as a proportion of net bank credit, after reaching the target of 40 per cent in 1991, had been continuously falling short of target till 1996. It has subsequently been in excess of the target for the reasons specified above, and stood at 44 per cent in 2004, which was mainly due to the inclusion of funds provided to RRBs by their sponsoring banks that were eligible to be treated as priority sector advances. Advances to agriculture on the other hand declined from 16.4 per cent of net bank credit in 1991 to 15.4 per cent in 2004, well below the target of 18 per cent of net bank credit. Within the category of agricultural advances, the growth of indirect finance has been much faster than direct finance to agriculturists. Indirect finance to agriculture includes lending to various intermediary agencies assisting the farmers as also investment in special bonds issued by NABARD and the Rural Electrification Corporation (REC). It also includes deposits placed by banks in RIDF.

In sum, the principal mechanism of directed credit to the priority sector that aimed at using the banking system as an instrument for development is increasingly proving to be a casualty of the reform effort. And methods are being found to conceal this trend by window-dressing the evidence of achievement with regard to priority sector lending.

The functioning of the system of credit delivery by scheduled commercial banks, the largest component of the financial sector in India, is a good example of the extent and nature of the neglect of agriculture, small-scale industries and small borrowers, the correction of which is most crucial. According to a study undertaken by the EPW Research Foundation the share of agriculture in total bank credit had steadily increased under impulse of bank nationalization and reached 18 per cent towards the end of the 1980s, but thereafter the achievement has been almost completely reversed and the share of the agricultural sector in credit has dipped to less than 10 per cent in the late 1990s-a ratio that had prevailed in the early 1970s. Even the number of farm loan accounts with scheduled commercials banks has declined in absolute terms from 27.74 million in March 1992 to 20.84 million in March 2003.

Further, overall credit to the small sector including the SSIs fell from 17.3 percent of net bank credit from PSBs in 1999-2000 to 7 percent in 2003-04. Of the sum lent to the SSIs, 40 percent is earmarked as advances to 'Tiny’ units (those which has investment less than Rs 50 lakhs), at below-PLR interest rates. However, interest rates on all other SSI units as well as those on 'other loans 'in the priority category have been liberalized since 1992. It is known that banks lend to SMEs at a higher interest rate and that these loans are heavily collaterised. Not surprisingly, the Third Census of Small industries conducted recently revealed that shortage of working capital was a major factor accounting for closure of industrial units in the SSI sector.

Unfortunately the decision to continue with liberalization and institutionalizing it through the adoption of the more stringent norms would only encourage the diversion of credit to higher rated corporates and the retail lending sector, aggravating the adverse consequences of past financial reform and the adoption of Basel I. Much of the so-called risk-aversion of banks which goes against loans to the small and medium industries have their origin in the quick adoption of the Basel approved credit risk adjusted ratios (CRAR) for capital. Implementing Basel II will further accentuate the ongoing trend by moving credit away from agriculture and industrial units in the small sector.

In addition to all of this, it is known that implementation of Basel II norms would introduce pro-cyclical elements into developing economies. Critics have argued that the drive for riskweights to more accurately reflect probability of default (PD) is inherently pro-cyclical in that, during an upturn, average PD will fall, reducing incentives to lend. Conversely, during a downturn, average PD will increase (due to more difficult economic circumstances) and, in consequence, a credit crunch may develop with all but the most highly rated borrowers having difficulty attracting funds.