Reform works

It is often asked what good reforms have done. The story of what has happened to the productivity of Indian manufacturing, especially in the private sector, is well-known. But what has happened to banking as result of reforms is not. The speech made by Rakesh Mohan, deputy governor of the RBI, at the Pakistan Society of Development Economists last month provides a more or less complete picture. The wonder is why the RBI has been so reticent about it. The short point is that thanks to the reforms, productivity has improved.

The ratio of non-performing loans to total loans used to be around 16 per cent about ten years ago. It is now down to about 5 per cent. Capital adequacy has improved and is now around 13 per cent, which is well above the required 9 per cent. Although public sector banks still account for nearly 75 per cent of assets and income, their share of assets has come down, which means private banks have become more active. But the share of public sector banks in overall profit has gone up. Listing has been an important factor in achieving this. Net income from interest has increased, as has fee-based income. In the end, though, what matters is reduction in the cost of intermediation, which is what banks do. This cost is defined as the ratio of operating expense to total assets and it has "witnessed a gradual reduction in the post-reform period across various bank groups barring foreign banks". That this decline has taken place when large investments have been in technology and the start of the so-called "core banking" solutions is creditable.

Mohan also points to the declining trend in the unit cost of output, which has come down from 2.1 per cent in 1992 to 1.8 per cent in 2004. The operating cost per unit of total volume of business has declined from 3.4 to 2.6 per cent. The employee cost per unit of output has also come down, largely due to voluntary retirement schemes in the public sector banks. Overall, then the trend is clear: Indian banking has become far more efficient in the last decade and a half. The excess of interest income over interest expense, which reflects allocative efficiency, has also come down from about 3.3 per cent in the early 1990s to around 3 per cent now. The international norm is 2 per cent. Oddly, the foreign banks, which usually do well in this respect, have been outdone by Indian private sector banks. On the whole, though, the main beneficiaries of reform have been the public sector banks. They appear to have shed their drooping image acquired during the 1970s and 1980s of complacent, large and loathsome bureaucracies. Little wonder then that Mohan is able to boast that "Indian banks recorded a net cost saving of nearly 27 per cent of their net income during the post-reform period. According to the data reported in The Banker 2004, the cost-income ratio of the world's largest banks varied markedly from a low of 48 per cent to a high of 116 per cent and the ratio around 60 per cent is an indicative benchmark. In that respect, the cost-income ratio of Indian banks is now comparable internationally." That said, Mohan admits a little ruefully that things could be better. Compared to banks in the developed countries, Indian banks still have high costs. Moral: more, not less reform.