Uphill battle

The Global Trust Bank (GTB) episode raises a large number of issues relating to banking practices, and banks' ability to manage and weather risks.

While all these are significant, there is one question lurking in the background, which it is important to address if enduring solutions to banks' problems are to be found.

Commercial banks in India, like pretty much everywhere else, have grown by catering for the short-term funding requirements of industry. Risks were addressed by using the borrower's tangible assets""raw material and finished goods inventories for the most part""as collateral. If there was a default, the bank simply took possession of those assets.

In this business model, growth in banking obviously depended on growth in industrial activity. A look at the structure of the Indian economy as it has evolved over the last 20 years, immediately suggests that there are macroeconomic reasons for the problems that banks face, which result in periodic collapses.

In the early 1980s, industry accounted for about 22 per cent of GDP and agriculture for close to 40 per cent, leaving around 38 per cent for services.

Two decades later, agriculture has shrunk to about 22 per cent, while services have expanded to 52 per cent. Industry has stagnated around the one-quarter mark. Banks have, therefore, either been forced to work within the constraints of the sluggishness of industry or look for new lending opportunities.

Retail finance has come to the rescue of the banking sector as a whole, growing at 30 per cent or more per year over the past five or six years. But this is a highly competitive market and imposes many infrastructure and logistics requirements on banks.

Volume growth comes at the expense of margins, a trade-off that many of the smaller players are simply not able to afford. So what does a bank management do? Typically, it looks around for other, unconventional lending opportunities which, while offering higher returns, also bring with them higher levels of risk.

GTB's current problems are perceived by many to have begun with its inordinate exposure to the stock market, whose volatility it simply did not have the capacity to guard against.

Of course, it is the regulator's responsibility to ensure the integrity of both the bank's portfolio and its risk management practices but, time and again, and not just in India, desperate banks have proved to be far smarter than regulators. It is only when the collapse takes place that the degree of window dressing is revealed.

The RBI's announcement a few weeks ago, limiting individual stakes in private banks, is essentially an admission that regulating aggressive private banks is difficult. There is some safety and assurance in the way in which publicly-owned banks carry out their business, with the occasional exception.

But this is only firefighting; in the long term, banks will flourish only if industry breaks out of its stagnation or they redesign their lending models to tap into the fast-growing services sector.