Only 3.5 per cent matters

It is not that there is a shortage of expansion opportunities. 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 crore, the banking system supplies an average of Rs 2,000 crore of rural credit. More than 60 per cent 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. The main reason? Continuation of quantitative controls, that is, the inspector raj. Controls have been dismantled in industry. Importers do not have to run to the commerce ministry. But in Indian banking, a modern regulatory framework has not replaced old-style quantitative, procedural and bureaucratic restrictions.

Take the case of branch licensing. Banks have to obtain licences from the RBI for opening branches. Currently the 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 per cent, it is the cheapest source of finance for banks. The interest rate on loans up to Rs 2 lakh is still administered. Keeping rates fixed, instead 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 satisfying inspectors. Quantitative restrictions rather than risk management systems characterise the system.

A modern approach to banking regulation means 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, the US, Japan, Europe, China and so on. If yen borrowing becomes cheaper, banks will be attracted to take 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. Exempted from the requirement to disclose their exchange rate exposure, they are under no pressure to spend resources to create good risk measurement and management systems.

The difficulty with the quantitative controls mentality is this: the RBI’s response to a perceived increase in exchange rate risk exposure will be to change 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 competition, prevented potential entrepreneurs from doing business and crippled Indian industry. The shift away from controls and licences 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. Banking needs a similar shock.

Perhaps the starting point should be to do away with the bonus banks are being given through a 3.5 per cent savings account rate.

The writer is senior fellow, National Institute of Public Finance and Policy, New Delhi