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The problems in Indian banking system lie into policy and structure

If India grows at 8 percent a year for the next twenty years, a rapid shift in the composition of India’s financial sector away from banking may be necessary and desirable

If India grows at 8 percent a year for the next twenty years, a rapid shift in the composition of India’s financial sector away from banking may be necessary and desirable

New Delhi: June 3, 2017

Banking is hobbled by policy, which creates double financial repression, and by structural factors, which impede competition. The solution lies in the 4 Ds of deregulation (addressing the statutory liquidity ratio (SLR) and priority sector lending (PSL)), differentiation (within the public sector banks in relation to recapitalisation, shrinking balance sheets, and ownership), diversification (of source of funding within and outside banking), and disinterring (by improving exit mechanisms).

Discussions of banking in India have recently focused on the problem of stressed and restructured assets, the challenges in acquiring the resources to meet the looming Basel III requirements on capital adequacy, including the
respective contributions of the government and markets, and the need for governance reform reflected in the 2013 Nayak Committee Report. Stepping back from these proximate issues allows a deeper analytical diagnosis of the problems of Indian banking which in turn provide the basis for more calibrated solutions.

A first question that arises is whether India is creditaddled and overbanked. One way to assess this is to see whether Indian banks were unusually imprudent in the boom phase. While the boom years of the last decade both spawned and were fed by a credit boom, originating in the public sector nbanks, irrationally exuberant behaviour was not out of line with similar experiences in other countries. Indian credit grew no more rapidly than elsewhere. For example, the Japanese and Chinese financial systems lent much more during their takeoff years.

If India grows at 8 percent a year for the next twenty years, a rapid shift in the composition of India’s financial sector away from banking may
be necessary and desirable.

Where then does the problem lie? The problems in the Indian banking system lie elsewhere and fall into two categories: policy and structure. The policy challenge relates to financial repression. The Indian banking system is afflicted by what might be called “double financial repression” which reduces returns to savers and banks, and misallocates capital to investors.

Financial repression on the asset side of the balance sheet is created by the statutory liquidity ratio (SLR) requirement that forces banks to hold government securities, and priority sector lending (PSL) that forces resource deployment in less-than-fully efficient ways. Financial repression on the liability side has arisen from high inflation since 2007, leading to negative real interest rates, and a sharp reduction in household savings. As India exits from liabilityside repression with declining inflation, the time may be appropriate for addressing its asset-side counterparts.
The structural problems relate to competition and ownership. First, there appears to be a lack of competition, reflected in the private sector banks’ inability to increase their presence. Indeed, one of the paradoxes of recent banking history is that the share of the private sector in overall banking aggregates barely increased at a time when the country witnessed its most rapid growth and one
that was fuelled by the private sector.
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