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India's
post-Budget stock market collapse is still taking its toll in the banking
sector. After the Madhavpura Mercantile Cooperative Bank (MMCB) and
Global Trust Bank (GTB), the most recent bank to come under a cloud
and lose its chief executive is the small, but relatively high profile
Nedungadi Bank from the South. These banks were till recently considered
leaders in their league, with a reputation for dynamism and good management.
Unfortunately, the very factors that gave them this reputation, namely
their abilities to innovatively exploit the opportunities offered by
a liberalized financial order, were also responsible for their fall
from grace. This is the principal lesson emerging from the evolving
story of financial fragility being unraveled by the regulators and the
financial media. But the full story begins with financial liberalization
itself.
Financial
reform or liberalisation, is an omnibus concept that is not easily delimited.
In India, for example, such liberalisation has involved various measures
that touch on diverse aspects of the financial sector's functioning.
In the banking sector, which dominates India's financial system,
the reform has involved three major sets of initiatives. First, those
aimed at increasing the credit creating capacity of banks through reductions
in the Statutory Liquidity and Cash Reserve Ratio, while offering them
greater leeway in using the resulting liquidity by drastically pruning
priority sector lending targets. This was combined with greater flexibility
in determining the structure of interest rates on both deposits and
loans.
The second was to increase competition through structural changes in the financial
sector. While the existing nationalised banks, including the State Bank
of India, were permitted to sell equity to the private sector, private
investors were permitted to enter the banking area. Further, foreign
banks were given greater access to the domestic market, both as subsidiaries
and branches, subject to the maintenance of a minimum assigned capital
and being subject to the same rule as domestic banks. Finally, a degree
of "broadbanding" of financial services was permitted, with
development finance institutions being allowed to set up mutual funds
and commercial banks, and banks themselves permitted to diversify their
activity into a host of related areas. The broad trend is towards a
form of universal banking.
Thirdly, to render this competition effective in influencing bank functioning,
banks have been provided with greater freedom in determining their asset
portfolios. They were permitted to cross the firewall that separated
the banking sector from the stock market and invest in equities, provide
advances against equity provided as collateral and offer guarantees
to the broking community.
All these initiatives, had an immediate impact on the functioning of banks,
with banks choosing to modify their credit portfolio and diversify out
of their overwhelmingly dominant role as credit-providing intermediaries.
To start with, non-food credit itself was increasingly being diverted
away from the priority sectors (such as agriculture and the small scale
sector), industry and the wholesale trade, to other areas such as provision
of loans to individuals for purchases of consumer durables and investment
in housing and towards lending against real estate and commodities (Chart
3). While this shift increased the interest incomes that could be garnered
by the banks, it also increased their exposure to the euphemistically-termed
‘sensitive' sectors, where speculation is rife and returns
volatile.
Chart 1 >>
Chart 2 >>
Chart 3 >>
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