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A crisis-proof banking sector

He subprime crisis peaked in September 2008 following the collapse of Lehman Brothers.Many forecast that 2009-10 would be the year of reckoning

for the Indian economy and for Indian banking, both of which had successfully weathered thecrisis until then. I disagreed. I said that banking would be a bright spot in the economy given thestrengths inherent in the sector.

The pessimists have been proved wrong about the Indian economy the economy isprojected to grow at more than 7% in 2009-10 . They are going to be proved even more wrongabout the banking sector. The Bankex has outperformed the Sensex during April-December2009. It rose by 123% while the Sensex rose by 73%. In 2008-09 , the Bankex had declined by40%, a little more than the decline of 37% in the Sensex.

We have to await the details of financial performance for 2009-10 but the RBIs Report onTrend and Progress in Banking (2008-09 ) tells us what happened last year and gives us cluesto what we might expect this year. It is indeed a revelation. In the midst of the worst financialcrisis of the century and when banks in the industrial world were falling apart, the Indianbanking sector fared as well as in the boom years.

Banks managed a return on assets of 1% in both 2007-08 and 2008-09 , slightly higher than the0.9% return of 2006-07 . This should place the Indian banking sector amongst the mostprofitable in the world today . Banks elsewhere saw their capital eroded and required infusionsof capital from governments. In India, capital adequacy actually improved in 2008-09 . Whatbetter indicators of banking soundness do you need than world-class profitability and improvedcapital in the midst of devastation in the banking sector worldwide?

After the Lehman collapse, pundits forecast that the moment of reckoning for Indian banks hadarrived following years of commercial credit growth of around 30%. They said banks would facea mountain of nonperforming assets (NPAs) as Indian companies and the housing sector feltthe impact of the global crisis. There are models that predict that a sustained credit boom leads

to bank failures and even a banking crisis. This did not happen in 2008-09 and is unlikely tohappen in 2009-10 either.

Bad times for the economy spell lower credit growth. In 2007-08 , commercial credit growthslowed to 22%. It slowed further to 18% in 2008-09 . But banks maintained their return onassets in 2008-09 at the same level as in the preceding boom years of 2004-08 . This is trulyastonishing . It suggests that no matter what the ups and downs of the economy, the Indianbanking sector can deliver a return of 1% on assets, a benchmark of good performance inbanking. India today seems to have a crisis-proof banking sector.

What explains this phenomenon? One, banks ability to sustain spreads return on advancesminus cost of funds at all times. Volume growth slowed down in the last two years. But thespread on loans actually increased in 2008-09 . A key factor driving large spreads in Indian

banking is the high proportion of current and savings account (Casa) deposits. These accountfor a more a third of all deposits in Indian banking. Banks pay zero interest on current accountsand 3.5% on savings accounts.

Secondly, banks have woken up to the potential for fee income. Apart from conventionalproducts that generate fees such as letters of credit, guarantees and mortgage products, banksnow generate fee income from sale of mutual fund and insurance products.

Thirdly, falling interest rates in a slowdown lead to a surge in treasury profits on banksinvestment in government securities. By the same token, rising interest rates in boom periods

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should cause these profits to decline. They do, but there have been other offsetting factors:gains on equities and foreign exchange products.

Fourthly, the slowdown that we have seen in the past two years has not caused any increase inprovisions on account of rising NPAs. That is because a deceleration from 9% to 7% may meanlower growth in earnings but it hardly spells disaster for companies. Besides, companiesentered the crisis with sound balance-sheets after five boom years. There was a large increasein housing prices before the slowdown but this does not appear to be a bubble. It is based ongenuine demand and increased affordability.

Experts told us that Indias antiquated banking sector was constraining growth. Reforms in thefinancial sector would deliver another two percentage points of growth. We have since foundthat the banking sector can support economic growth of 9%.

Banks, of course, need to do more. We need more sophisticated products. There is thechallenge of financial inclusion. But those who urge banking sector reforms need to tell us whatexactly needs fixing in a system that aint broke.

Web exclusive: Inclusive growth in the financial sector

There is unanimity in thinking among the intelligentsia that if India is to become an economicpower, growth has to be inclusive and touch the lives of millions of people living in rural India. Itis heartening to note that the Government is conscious of the fact and has taken unique stepsto which will go a long way in alleviating the sufferings of poor people.

The pattern of growth in the financial sector that is gradually being opened up for privateparticipation also follows the model of inclusive growth. However the policy guidelines differ fromone constituent to the other in the financial service sector which is rather inexplicable.

It is the informal financial sector which added to the plight of rural poor by not only by notproviding financial help at the time of need but also exploiting them to their personal advantage. Itwas rightly expected that the financial sector in its new avatar would provide succour to the rural

poor. While efforts have been made in this direction an overall policy is sadly out of place.In the case of banks, the Reserve Bank has adopted a two pronged strategy to ensure banksparticipate in the economic revival of all sections of society by controlling distribution and bymaking lending to priority sectors mandatory. Distribution is managed by granting license foropening new branches with a stipulation that for every three branches opened in rural and semiurban areas one new branch is allowed to be opened in city area which are more profitable.

This ensures that more branches are opened in non urban centres. As per RBI data as of 31stMarch 2008, as many as 48,633 commercial bank branches were operating in the rural/semiurban areas compared with 29,140 in urban areas. On the lending side 40 per cent of advanceshave to be made in the priority sector of which 18% are earmarked for agricultural lending andbalance 22 per cent for others including housing, education SME etc. In the agricultural sector 25per cent of total loans have to be for direct lending for agriculture. These mandated provisionshave certainly been responsible for flow of credit to rural poor and other less financially affluentsections of society. Banks have done a commendable job in this direction.

In case of Insurance, the regulator IRDA has set equally challenging targets for the industry. Theyhave not mandated opening of offices in rural/semi urban areas like Banks. But companies arerequired to do minimum amount of rural business and cover certain minimum number of livesfrom the social sector comprising of unorganized sector and groups from socially weak andvulnerable sections.

In the case of life insurance it starts from first year of operations and from 6th year onwardscompanies have to compulsorily sell at least 18% of policies in the rural sector and cover at least

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25000 lives annually(as on 31st day of March) from social sector. Most companies have compliedwith these requirements. The number of life policies sold in the last two years in rural areas were12.6 million in 2007-08 and 15.6 million in 2008-09.Similarly 25,000 lives from the social sectorhave been covered. To achieve this life insurance companies had to open more than two-thirds of11,700 branches in rural and semi-urban areas without any statutory intervention.

In the case of general insurance companies 5 per cent policies are required to be underwritten in

rural areas. Compliance is strictly monitored by IRDA and in case of noncompliance companieshave been fined.

Sebi has not prescribed any minimum stipulation for mutual funds to distribute products in ruralareas or cover people in the social sector. There is also no stipulation like in case of banks thatcertain minimum branches will be opened in non city and non metro areas. This has lead toconcentration of mutual fund branches in urban areas with 75 % of the turnover arising from 16major towns.

One can only guess the reasons for this. One argument can be that equity investments arespeculative in nature and it will not be desirable to expose investors in non metro centres to theserisks. But if one looks at the responses to some of the large IPOs and the data about number ofsub brokers being added in the stock exchanges and the number of demat accounts beingopened in non-metro areas, the argument for not making mutual fund industry participate ininclusive growth can hardly be convincing. Notwithstanding the above the bulk of funds with theindustry are debt funds. Certainly people in rural and semi urban areas need to be encouraged tosave under these secure schemes rather than allow them fall to the temptation of entrusting theirsavings to informal sector and lose their hard earned money. This business may not be asprofitable as in the major cities but is in tandem with the road map for growth envisaged by ourGovernment. The regulatory indulgence is quite surprising.

The new NPS is of recent origin. It is too early for any mandated rural foray. But it will beadvisable to lay a long term inclusive growth pattern and to make it mandatory at some futurepoint of time. Merely hoping that various POPs in the rural or semi urban areas will get somebusiness may lead the beneficiaries under the scheme to be confined to cities and urban areasas in case of mutual funds.

While some major initiatives have been taken in ensuring that financial sector touches all sectionsin the country there is inconsistency in approach. It is high time that a composite policy is put in

place to ensure that all participants in the financial sector contribute to the inclusive growth of theeconomy.