The Indian banking journey: Logic & cure

In part 1 of a series, the author traces the compulsions behind bank nationalisation and the effects of liberalisation on the banking sector

I believe there are three discernible phases in Indian banking post nationalisation till 2018. The 1969-91 post-nationalisation phase; 1992-2012 post-liberalisation phase; and 2013-18 failed clean-up phase.

1969-91: The political brilliance of bank nationalisation for consolidating Indira Gandhi’s socialist credentials is well understood. What is not commented on as well was its strong economic requirem­e­nt. By 1969 the lustre of the freedom mo­v­ement had worn off. Indian political le­a­ders were faced with the demands of fu­ll adult franchise with a poor, third wo­r­­ld, resource-starved economy. India was co­nsidered a global basket case with en­d­­emic hunger and poverty. External bo­r­r­owings were scarce; poor tax po­­licy wi­t­h extremely high tax rates on a small ba­­­se led to widespread evasion and poor co­­­llections. India had no money to deal wi­­th the democratic demands of its people.

At this time the Indian depositor saved both Indian democracy and the Indian economy. Bank nationalisation allowed the government to access the Indian depositor. A rapid thrust to increase reach led to the spurt in opening rural and semi-urban branches (R&SU) and government ownership took out any risk in depositing money with nationalised banks. Between 1969 and 1975, bank branches more than doubled from 8,000 branches (of which 4,780 were in R&SU areas) to 18,730 (of which 12,405 were in R&SU areas). By 1990, India had almost 60,000 branches (of which 46,115 were in R&SU areas), raising Rs 314,823 crore of bank deposits. The deposits so collected were available to the government through approved securities banks had to buy to meet the statutory liquidity ratio (SLR) requirements. At its peak, SLR and cash reserve ratio (CRR) together touched 50 per cent of bank deposits. Credit was disbursed to lobby groups by mandating that 40 per cent of all advances went to important priority sectors and the remaining credit to industry was allocated on the basis of Tandon & Chore Committee norms by a credit authorisation scheme.  

Foreign banks were marginal but operated in profitable niches — foreign exchange, overseas syndication, structured products, transaction banking, and simple mass affluent banking. They did not really use their balance sheet but the American banks — Citi and Bank America — made very high returns and offered bright Indians a great career. The Imperial Bank had previously been nationalised into the State Bank of India and subsequently so were its associate banks. By 1980 there were 28 banks in the public sector with over a million employees of relatively high calibre to do the government’s bidding. Capital projects were funded by development finance institutions (DFI) — IDBI, IFCI, and ICICI — which had access to concessional funds and on lent them for permitted capital projects.  

What was not explicitly mentioned was that bank deposits, routed as loans to industry, also funded political parties. Due to shallow capital markets Indian industry also lacked capital and was dependent on bank credit. Indian entrepreneurs were of two kinds — capital starved “actual industrialists” who managed by intelligent accounting to avoid putting own equity but built excellent plants and grew businesses; but also the “robbers” who essentially diverted depositor money to create private wealth and rotten industries (they had the highest market share in bank NPAs). The latter have gotten the greatest attention in movies, media and were the regular whipping boys at election time tarnishing all Indian capitalists.  

The government used the public sector banking system as a milch cow and would pillage it for as long as it could before it collapsed in a regular boom and bust cycle of failing every 8 to 12 years — 1977, 1985, 1992 (and to be discussed later 1999 and 2012). When it failed, the government would nurse it back to adequate fitness so that it could continue thereafter to support unfunded government mandates. By 1991 the largely controlled socialist Indian economic model together with its intellectual justification had collapsed. India approached the IMF in 1992 for a bailout and smart domestic reformers managed the accompanying structural adjustment programme sensibly, liberating the economy of draconian controls and changing India’s growth trajectory thereafter.  

1992-2012 post-liberalisation phase: The banking reforms initiated with liberalisation had five major legs: 1. New private sector banks were given licences with the hope they would increase competition and inject efficiency into the sector; 2. Public Sector banks were encouraged to list to raise capital and face market pressure on performance; 3. India agreed to comply with Basel Committee risk norms putting a focus on NPAs; 4. Public sector banks were encouraged to use core banking technology solutions that brought transparency to their portfolios and were also encouraged to seek external help to restructure their operations; 5. Sadly, by 2000 DFIs were killed by starving them of concessional financing and forcing them to convert into universal banks.

Yet liberalisation post 1992 brought with it reduced tariffs and increased competition created a major strain in the health of the protected Indian industry. By 2000 the consequential NPAs led the financial system again to crisis. Intelligent coordinated action by the Reserve Bank of India and the government allowed the banks to get back to health in three years. RBI cut interest rate by I per cent a year for three years, forced banks to use the accompanying treasury profits for provisioning, announced a non-discretionary hair-cut regime for bankers and industrialists (taking out individual risk for bank managers) and spurred robust credit growth (including retail credit) bringing net NPAs down below 2 per cent of the bigger bank balance sheets and restored bank profitability. 

By 2007, a healthy banking system again tempted the government to use PSB balance sheets in the eleventh five year plan (2007-12) to fund infrastructure. I shall trace the origins of the current crisis in Indian banking and the commencement of the third banking phase — the 2013-18 failed clean-up phase — together with a reform agenda for Indian banking in my next piece. 

(Tomorrow: Rescuing the financial sector)

The author is chairman, BCG India. Views are personal