Only 3.5 percent matters

Indian Express, 28 March 2007

Despite rising interest rates, the savings deposit rates remain fixed at 3.5 percent. Why is this bounty being given to banks? Why are banking intermediation costs higher in India than in most parts of the world? Instead of reaching out to more consumers, why do banks in India prefer to raise rates?

It is not due to shortage of opportunities to expand. Today, there are no more than 30,000 bank branches in the 600,000 villages of India. More than 500 million people do not have bank accounts. Against an estimated annual demand of Rs 45,000 crores, the banking system supplies an average of Rs 2,000 crores of rural credit. More than 60 percent of India is still deprived of access to financial services.

Despite the visible introduction of technology, entry of new private and foreign banks, sharp rise in retail lending and a new range of customer services, the low reach of financial services to the bulk of India's population has not changed significantly even after the 1991 reforms. One of the main factors behind the problems in banking has been the continuation of quantitative controls and the licence permit raj in Indian banking. While the licence raj has been dismantled in industry, while importers do not have to run to the commerce ministry, this is not the case in Indian banking. A modern regulatory framework has not replaced old style quantitative, procedural and bureaucratic restrictions on banks.

Take the case of branch licencing. Banks have to obtain licences from the RBI for opening branches. Currently RBI is reported to be objecting even to the opening of ATMs by private sector banks on the grounds that they perform the function of bank branches. Media reports often indicate that applications from private banks for branches are pending. Competition in the banking sector is discouraged, not encouraged.

Restrictions are imposed not merely on expanding business, they extend to interest rates on loans and deposits. An example of quantitative controls are the RBI restrictions on export credit. The latest circular on export credit says, "in respect of pre-shipment credit up to 180 days and post-shipment credit up to 90 days, the ceiling rate applicable is 2.5 percentage points below the relevant PLR."

The interest rate on savings deposits continues to be administered by the RBI. Today at 3.5 percent, it is the cheapest source of finance for banks. The interest rate on loans upto Rs 2 lakh is still administered . Keeping rates fixed, intead of letting them vary with differences in the risk profile of the loan, reduces the incentive of banks to give small loans. The fact that Small and Medium Enterprises (SMEs) are not receiving adequate funds from banks is one of the consequences of such a policy.

Even though the regulatory framework has to soon move towards Basle II, the approach to monitoring risk in the system is based on requiring banks to follow fixed procedures and satifying inspectors. Quantitative restrictions, rather than risk management systems characterise the system.

A modern approach to banking regulation entails a change in the philosophy of the regulator. This would essentially mean a shift to the monitoring of outcomes achieved through proper public disclosures. The role of the regulator would be to assess the competency of bank managers to be able to develop and implement such systems. The pressure of making proper disclosures would mean that banks would have to develop capabilities to assess risk. It would require them to constantly assess their own business and publicly reveal how shocks to commodity prices, interest rates or exchange rates will impact their balance sheets. In contrast, the present framework of regulation by circulars tries to handle one problem after another, but only after it has arisen.

Take the example of foreign borrowing by banks. This would depend on changes in interest rates and exchange rates in India, US, Japan, Europe, China and so on. If yen borrowing becomes cheaper, banks will be attracted to take on more yen loans. Under the present regulatory structure, disclosure requirements do not make it necessary for them to say what would be the impact of a sharp change in the exchange rate of the yen on their balance sheets. All they have to do is to publish a statement of their foreign currency borrowing and its maturity profile. Deprived of the requirement to disclose their exchange rate exposure, they are under no pressure to spend resources creating good risk measurement and management systems. The difficulty with the quantitative controls mentality is that RBI's response to a perceived increase in exchange rate risk exposure of the banking system, will be to make changes to NRI interest rates, prevent banks from opening branches abroad, or impose ceilings on foreign borrowings for all banks. Why would one bank try to do things differently when it is also going to be penalised along with all other banks?

But how would a change in the regulatory framework make banks reach out to new customers? Because banks are not regulated in a sophisticated manner, they stay within their "comfort zones" and do not re-engineer themselves. For all the shiny ATMs, they pursue the most obvious businesses of corporate banking, up-market retail banking and trading in the financial markets. If banks were required to disclose information on risk adjusted return on capital, they would have the incentive to pursue new markets and un-banked customers.

In the pre-1991 period in the name of protecting industry, the control raj in India had killed competetion, prevented potential entrepreneurs from doing business and cripped Indian industry. The shift away from controls and licenses in Indian industry pushed firms out of their comfort zones. This yielded huge benefits to Indian consumers. Products that were out of reach of most consumers in the pre-reform period are commonplace today. Today competition needs to be ushered into the banking sector in a similar fashion. Perhaps the starting point should be to do away with the bonus banks are being given to banks through a 3.5 percent saving deposit interest rate.

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