Rakesh Mohan: Reforms, productivity and efficiency in banking: the Indian
experience
Address by Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the 21st Annual
General Meeting and Conference of the Pakistan Society of Development Economists, Islamabad, 21
December 2005.
The assistance of Abhiman Das, Saibal Ghosh and Partha Ray in the preparation of the paper is gratefully acknowledged.
The references and tables for this speech can be found on the Reserve Bank of India's website www.rbi.org.in
* * *
Let me at the outset congratulate the Pakistan Society of Development Economists for organising this
Conference. Issues of productivity and efficiency have been at the centre-stage of discussions in
recent years. Nowhere is this truer than the financial sector, which is perceived to be the 'brain' of the
economy (Stiglitz, 1998). Even within the financial sector, given the dominance of bank-based financial
systems in most emerging markets including ours and the systemic importance of banks in the
financial system, the banking sector continues to be the centre of attention for academia and
policymakers alike. Not surprisingly therefore, performance of the banking sector has repercussions
Conference
across the length and breadth of the economy. Judged thus, the theme of the immediately
appealed to me in view of its topicality and timeliness. As a central banker, the obvious topic for me to
speak on relates to productivity and efficiency in Indian banking.
The objective of reforms in general is to accelerate the growth momentum of the economy, defined in
terms of per capita income. Typically, improvements in the growth rate can be effected through three,
not necessarily mutually exclusive channels: improving productivity of capital, through investments in
human capital and raising total factor productivity (TFP).
The quality of functioning of the financial sector can be expected to affect the functioning and
productivity of all sectors of the economy. Efficient financial intermediation should help in improving
economy-wide resource allocation thereby promoting productivity growth all round. Thus discussion on
economic efficiency and productivity should involve analysis of developments in the financial sector.
Improvements in the financing of physical and human capital, both in terms of increasing magnitudes,
and in terms of allocative efficiency, should raise efficiency and productivity across the economy. This
approach justifies the choice of my topic today.
Financial intermediation is essential to the promotion of both extensive and intensive growth. The
efficient intermediation of funds from savers to users enables the application of available resources to
their most productive uses. The more efficient a financial system is in such resource generation and in
its allocation, the greater is its contribution to productivity and economic growth. As resource allocation
improves and real returns increase, savings would presumably respond and higher resource
generation should result. Thus, development of the financial system is essential to the generation of
higher productivity and economic growth.
I will structure my address along the following lines. First, I will explore in brief the impact of banking
sector productivity on the rest of the economy. This is relevant in view of the fact that any discussion
on productivity and efficiency issues in banking would need to be judged in conjunction with the level
of financial development and other country-specific features. This will be followed by a brief review of
banking sector reforms in India. The subsequent section will examine, in some detail, the trends in
productivity and efficiency in Indian banking. My concluding remarks will be in the nature of the way
ahead on areas germane to this sector at the present juncture.
2. How does productivity in banking influence the rest of the economy?
Economic history provides support for the fact that financial development makes a fundamental
contribution to growth. Financial development helped in the promotion of industrialisation in developed
countries by facilitating the mobilisation of capital for large investments. Well-functioning banks or
other financial intermediaries such as venture capital funds also spur technological innovation by
identifying and funding entrepreneurs who are perceived to have the best chances of developing new
products successfully and for implementing innovative production processes.
Recent research has provided robust evidence supporting the view that financial development
contributes to economic growth.
At the cross-country level, various measures of financial development (including measures of financial
sector assets, domestic credit to private sectors and stock market capitalization) are found to be
positively related to economic growth.
Other studies establish a positive relationship between financial development and growth at the
industry level (Rajan and Zingales, 1998).
Similarly, at the firm level, firms in countries with deeper financial development are able to obtain more
external funds and thereby enabled to grow faster (Demirgúc-Kunt and Maksimovic, 1998).
A basic indicator of financial development is the contribution of finance-related activities to GDP. The
share of real GDP originating from finance-related activities in India tripled from just around 2 per cent
during the 1970s to around 6 per cent during the 1990s and further to 7 per cent during the first half of
this decade. Within the services sector, the share of finance rose from less than 5 per cent to more
than 12 per cent over the same period.
The broad-based indicators of financial development, as culled from the flow-of-funds accounts, are
also testimony to gradual widening and deepening of the economy. Most of the commonly tracked
ratios exhibited an upward trend during the 1970s and 1980s, while moderate fluctuations in these
ratios were observed during the 1990s. What is of interest is that the Finance Ratio, a proxy for
financial deepening, witnessed remarkable improvement over this period.
When we move away from these broad-based indicators to more specific liquidity- and credit-based
indicators, a similar picture emerges. Illustratively, the ratio of aggregate deposits to GDP exceeded
50 per cent during the first half of the current decade; M3/GDP has averaged around 50 per cent since
the 1990s. At a slightly more disaggregated level, while bank credit to government has witnessed
some tapering off in the second half of the 1990s, credit to the commercial sector averaged over 30
per cent of GDP during the first half of the current decade. These observations are particularly relevant
from the standpoint of the role of banks in the intermediation process. Juxtaposed with the financial
sector reforms, this suggests that the enhanced freedom of banks since the liberalisation process has
provided them with the flexibility in resource mobilisation and deployment, which has manifested itself
in the uptrend in these ratios. Thus financial deepening has been taking place continuously in India
and is still in progress.
Studies by the Reserve Bank (RBI, 2000) on the association between finance and growth for an
extended time span from 1971-72 to 1999-2000 find that the causality between finance (proxied by
real M3 growth) and growth (proxied by real GDP growth) is bi-directional. However, in the absence of
any structural model underlying such relationships, these 'causality' estimates can only be interpreted
in terms of the predictive content of each of the variables. Subsequent research on the inter-linkage
between finance and growth in India has veered around to the view that the Indian growth process has
essentially been 'finance-led': expansion in the financial sector played an enabling role in promoting
capital accumulation, which, in turn, engendered higher growth (Bell and Rousseau, 2001). Typically
however, studies of this genre tend to be susceptible to the time period and choice of variables, so that
a different period with another set of variables could possibly lead to different conclusions. What is,
however, accepted is that finance did play a role in influencing the growth process in India, although
such observations related to financial deepening have little to say about efficiency and productivity
growth.
The aforesaid observations do not take into account the changing dynamics of the financial system.
The traditional classification of the financial system as bank- or market-based often tends to be static;
in contrast, financial systems evolve and develop over time in response to changes in the institutional
environment, legal set up and other country-specific features. This has been the case in India as well.
Many of you would be aware that, cross-country classifications of financial system have typically
classified India as a 'bank-based' system. This is not surprising, since banks have traditionally been
the dominant financial intermediaries. However, the relative share of banks in total financial sector
assets, which was nearly three-fourths in the early 1980s, came down gradually over a period of time
and has hovered around the two-thirds mark since the 1990s (Ray & Sengupta, 2004).
More importantly however, following the rapid growth of stock markets since the 1990s, the role of
'market-based' finance has been on the rise. The most commonly employed measure of financial
system orientation - the ratio of market capitalisation to bank assets - supports this observation. This
suggests that not only have financial institutions gained in terms of financial assets, but there is also
considerable potential for market financing to develop. However, the magnitude of market
capitalisation is obviously dependent on the vagaries of the stock market: it is not expected to exhibit a
consistent increase as a ratio of GDP, whereas the growth in bank assets/GDP ratio is much more
regular.
Whereas financial deepening is easier to measure, analysing productivity and efficiency changes in
banking is more complex and needs to be viewed in relation to the changing contours of the banking
industry in India.
3. Contours of Indian Banking Sector Reforms1
The transformation of the banking sector in India needs to be viewed in light of the overall economic
reforms process along with the rapid changes that have been taking place in the global environment
within which banks operate. The global forces of change include technological innovation, the
deregulation of financial services internationally, our own increasing exposure to international
competition and, equally important, changes in corporate behaviour such as growing disintermediation
and increasing emphasis on shareholder value. Recent banking crises in Asia, Latin America and
elsewhere have accentuated these pressures.
As many of you would be aware, India embarked on a strategy of economic reforms in the wake of a
serious balance-of-payments crisis in 1991; a central plank of the reforms was reform in the financial
sector and, with banks being the mainstay of financial intermediation, the banking sector. The
objective of the banking sector reforms was to promote a diversified, efficient and competitive financial
system with the ultimate objective of improving the allocative efficiency of resources through
operational flexibility, improved financial viability and institutional strengthening. A summary profile of
the banking industry over the last 15 years is presented in Table 5.
As you are aware, the financial system in India by the late 1980s was characterized by dominant
government ownership of banks and financial institutions, widespread use of administered and
variegated interest rates, and financial repression through forced financing of government fiscal
deficits by banks and through monetisation. Thus, although a great degree of financial deepening had
indeed taken place and financial savings had increased continuously, financial markets were not really
functioning, and there was little price discovery in terms of the cost of money, i.e., interest rates. The
efficiency and productivity enhancing function of the financial system was severely handicapped.
Hence, a widespread financial sector reform effort has been underway since 1991.
Let me briefly sum up the major areas of banking sector reforms2:
• Financial repression through statutory pre-emptions has been reduced, while stepping up
prudential regulations at the same time.
•
Interest rates have been progressively deregulated on both the deposit and lending sides (Box
I).
Restoration of the health of the banking system has involved:
•
Restoration of public sector banks' net worth achieved through recapitalisation where needed
(total cost less than one per cent of GDP).
•
Competition increased through entry of new private sector banks and foreign banks.
•
Higher levels and standards of disclosure achieved to enhance market transparency.
•
Bank regulation and supervision strengthened towards international best practice.
• Micro prudential measures instituted.
•
Supervision process streamlined with combination of on-site and off-site surveillance along
with external auditing.
•
Risk based supervision introduced.
•
Process of structured and discretionary intervention introduced for problem banks through a
prompt corrective action mechanism.
• Ownership of public sector banks has been broadened through disinvestment up to 49 per
cent, and banks have been listed.
•
Mechanism for greater regulatory coordination instituted for regulation and supervision of
financial conglomerates.
•
Measures taken to strengthen creditor rights (still in process).
Box I
Interest Rate Deregulation
Deposit Rate Deregulation
April 1992: (a) interest rates freed between 46 days and 3 years and over, but ceiling prescribed,
(b) October 1995 : Ceiling removed for deposits over 2 years
July 1996: Ceiling removed for deposits over 1 year
October 1997: Interest Rates on Term Deposits Completely Deregulated
2004: Minimum maturity for term deposits reduced to 7 days
Lending Rate Deregulation
1992-93: Six categories of lending rates
5 slabs for below Rs.2 lakh
Minimum lending rate above Rs.2 lakh
October 1994: Lending Rate freed for Loans above Rs.2 lakh & Minimum Rate Abolished
October 1996: Banks to specify maximum spread over PLR
1997-98: Separate PLRs permitted for cash credit/demand loans and term loans above 3 years.
Floating Rate permitted.
1998-99: PLR made ceiling for loans upto Rs.2 lakh
1999-00: Tenor linked PLR Introduced
2001-02: PLR made benchmark rate; sub PLR permitted for loans above Rs.2 lakh
2002-03: Bank-wise PLRs made transparent on RBI website
2003-04: Computation of Benchmark PLR rationalized tenor linked PLRs abolished
As the banking system has been liberalised and become increasingly market-oriented and financial
markets have developed concurrently, the conduct of monetary policy has also been tailored to take
into account the realities of the changing environment (switch from direct to indirect instruments).
This macro approach to financial monitoring has enabled policy makers to fine-tune their regulatory
stance in consonance with the changing market and institutional dynamics so as to balance growth
and stability concerns. For instance, despite the gradual tightening of prudential norms, the ratio of
non-performing loans (NPL) to total loans, which was at a high of 15.7 per cent for scheduled
commercial banks (SCBs) at end-March 1997, has declined by more than two thirds to 5.2 per cent at
end-March 2005. Net NPLs also witnessed a significant decline, driven by the improvements in loan
loss provisioning and improved recovery management, which comprises over half of the total
provisions and contingencies. Capital adequacy of the banking sector also recorded a marked
improvement and reached 12.8 per cent at end-March 2005, well above the stipulated level of 9 per
cent. Banks have also been sensitised to develop robust risk management systems for credit and
operational risks and focus on their asset-liability maturity profile to withstand adverse movements in
market risk parameters such as interest rates and take corrective measures.
Another heartening development in banks' balance sheets, driven by the twin forces of international
accounting irregularities and regulatory initiatives has been the increasing focus on corporate
governance. As part of their Annual Report, banks presently disclose, under the head 'Report on
corporate governance', details of their boards of directors, number of board meetings attended by
members, details of the various sub-committees of the boards and provided the banks are listed,
information on their stock price movements. This is complemented with the banks' philosophy on
corporate governance and the enabling mechanisms undertaken by the banks to achieve their
philosophy. As you would be aware, such listing is an important component of the process of 'market
discipline', which complements the regulatory initiatives undertaken by the authorities. To take the
governance process in banks a step further, we had some time back issued guidelines laying down
transparent criteria for determining the 'fit and proper' status of owners and directors in private banks.
Given our focus on a consultative approach to policy formulation, the document was posted on the RBI
website for encouraging a debate on this issue. Based on the feedback received, the draft is being
reviewed before final guidelines can be issued to banks.
The whole policy reform process has been designed to make the banking system more market
oriented to enable efficient price discovery and to induce greater internal efficiency in the resource
allocation process. Thus, whereas the efforts in the 1960s, 1970s and 1980s were essentially devoted
to financial deepening, the focus of reforms in the past decade and a half has been engendering
greater efficiency and productivity in the banking system in particular, and in the financial sector as a
whole. How well have we succeeded?
4. Efficiency and productivity analysis in banking
In recent times, a significant body of literature has evolved which explores the performance of financial
institutions in the wake of financial liberalisation. These studies are essentially micro-economic in
nature and seek to analyse the efficiency and productivity of banking systems. Such analysis is of
relevance from the policy standpoint, because as the finance-growth literature suggests, if banks
become better-functioning entities, this is expected to be reflected in safety and soundness of the
financial system and ultimately, lead to increases in the rate of economic growth. More importantly,
such analysis is useful in enabling policymakers to identify the success or failure of policy initiatives or,
alternatively, highlight different strategies undertaken by banking firms which contribute to their
successes.
A priori, deregulation is expected to unleash competitive forces. Such competition would, in turn,
enable banks to alter their input and output mix, which when combined with technological
developments facilitates increase in output that raises overall bank productivity and efficiency. Second,
de novo
liberal entry of private and foreign banks as a part of the deregulation process is expected to
raise bank efficiency, productivity and technology levels, because de novo private/foreign banks are
associated with superior management practices and technology, which can be fruitfully imbibed by
those which are not. A third strand of thinking, borrowing from the public choice framework, contends
that different ownership structures may engender different efficiency levels. The theoretical argument
is straightforward: lack of capital market discipline weakens owners' control over management,
enabling the latter to pursue their own interests, and provides fewer incentives for them to be efficient.
Finally, as banking in the current world is technology driven and technological progress itself is scale
augmenting, the relationship between bank size and efficiency becomes important. Skeptics, on the
contrary, argue that deregulation is, in general, accompanied by an increase in banks' operational cost
and could induce financial fragility due to over-expansion of banking activity. Thus, productivity gains
after deregulation could be temporary and not sustainable in the long run. As a result, evidence in
support of a unidirectional relationship between deregulation and efficiency/productivity is not
conclusive.
Besides various methods of estimation, the efficiency and productivity studies in banking are
constrained by the absence of precise definitions of inputs and outputs of banks. As a result, several
approaches exist and the appropriateness of each approach varies according to the circumstances
(Box II).
Box II
Inputs and outputs of commercial banks
Banks are typically multi-input and multi-output firms. As a result, defining what constitutes 'input'
and 'output' is fraught with difficulties, since many of the financial services are jointly produced
and prices are typically assigned to a bundle of financial services. Additionally, banks may not be
homogeneous with respect to the types of outputs actually produced. In view of these
complexities, four approaches have come to dominate the literature on banking output: the
production approach, the intermediation approach, the operating (income-based) approach and
modern
more recently, the approach.
Under the production approach, banks are primarily viewed as providers of services to
customers. The input set under this approach includes physical variables (e.g., labour, material,
space or information systems) and the outputs represent the services provided to customers and
are best measured by the number of deposit and loan accounts.
Under the intermediation approach, financial institutions are viewed as intermediating funds
between savers and investors. Banks produce intermediation services through the collection of
deposits and other liabilities and their application in interest-earning assets, such as loans,
securities and other investments. This approach includes both operating and interest expenses
as inputs, whereas loans and other major assets count as outputs. In principle, there are three
asset user cost
variant of intermediation approach, viz., the approach, the approach and
valueadded approach. The asset approach is a reduced form modelling of the banking activity,
focusing exclusively on the role of banks as financial intermediaries between depositors and final
uses of bank assets. Deposits and other liabilities, together with real resources (labor and
physical capital) are defined as inputs, whereas the output set includes earning assets such as
loans and investments. The user cost approach determines whether a financial product is an
input or an output on the basis of its net contribution to bank revenue. If the financial returns on
an asset exceed the opportunity cost of the funds or alternately, if the financial costs of a liability
are less than the opportunity cost, they are considered as outputs; otherwise, they are considered
as inputs. The value-added approach identifies major categories of produced deposits and loans
as outputs because they form a significant proportion of value added.
The operating approach (or income-based approach) views banks as business units with the final
objective of generating revenue from the total cost incurred for running the business. Accordingly,
it defines banks' output as the total revenue (interest and non-interest) and inputs as the total
expenses (interest and operating expenses).
Finally, the modern approach seeks to integrate some measure for risk, agency costs and quality
of bank services. In this approach, the individual components of CAMEL3 are derived from the
financial tables of the banks and are used as variables in the performance analysis.
Source: Adapted from Berger and Humphrey (1992) and Frexias and Rochet (1997)
Competition and profitability of Indian banks
Beginning from 1992, Indian banks were gradually exposed to the rigours of domestic and
international competition. Newly opened banks from the private sector and entry and expansion of
several foreign banks resulted in greater competition in both deposit and credit markets. Consequent
to these developments, there has been a consistent decline in the share of public sector banks in total
assets of commercial banks. The evidence of competitive pressure is well supported from the
declining trend of Herfindahl's concentration index.4 Notwithstanding such transformation, the public
sector banks still remain the mainstay, accounting for nearly three-fourths of assets and income. It is
also important to note that public sector banks have responded to the new challenges of competition,
as reflected in the increase in the share of these banks in the overall profit of the banking sector. From
the position of net loss in the mid-1990s, in recent years the share of public sector banks in the profit
of the commercial banking system has become broadly commensurate with their share in assets,
indicating a broad convergence of profitability across various bank groups. This suggests that, with
operational flexibility, public sector banks are competing relatively effectively with private sector and
foreign banks. The 'market discipline' imposed by the listing of most public sector banks has also
probably contributed to this improved performance. Public sector bank managements are now
probably more attuned to the market consequences of their activities (Mohan, 2005).
Since the late1990s, in line with the benign interest rate regime, both interest income and interest
expenditure of banks as proportions of total assets have declined. However, interest expenditure
declined faster than interest income, resulting in an increase in net interest income. However,
noninterest income, which emanates mostly from fee-based activities, has been increasing consistently in
the post-reform period. For example, non-interest income as a proportion of total assets of the banking
sector increased from 1.2 per cent in 1993 to more than 2 per cent in 2004 (Table 9). In this context, it
is also appropriate to mention that Indian banks, in particular the public sector banks, are yet to
catchup fully with their foreign counterparts.
Efficiency of Indian banks
inter
Improvements in efficiency of the banking system are expected to be reflected, alia, in a
reduction in operating expenditure, interest spread and cost of intermediation in general. Several
indicators have been employed in the literature to compare banking production costs across time.
Illustratively, intermediation cost, defined as the ratio of operating expense to total assets, witnessed a
gradual reduction in the post reform period across various bank groups barring foreign banks. This
decline in intermediation cost needs to be weighed against the large expenditures incurred in
upgradation of information technology and institution of 'core banking' solutions. Admittedly,
intermediation costs of banks in India still tend to be higher than those in developed banking markets.
At a more disaggregated level, it is evident that5 Indian banks have improved their efficiency in the
post reform period as evidenced from the declining trend in per unit cost of output, irrespective of the
choice of outputs. The operating cost per unit of earning assets declined from 2.1 per cent in 1992 to
1.8 per cent in 2004; similarly, operating cost per unit of total volume of business declined from 3.4 per
cent to 2.6 per cent during the same period. Among the components of operating expenses, employee
cost per unit of output witnessed a noticeable decline in the post-reform period. This decline is
discernible across all bank groups, and especially for public sector banks in the post 2001 period
consequent to the voluntary retirement scheme across several nationalised banks. On the other hand,
the change in physical capital cost per unit of output has been marginal, reflecting the fact that Indian
banks maintained a steady flow of investments towards physical capital formation, especially on
automation and information technology.
From the efficiency standpoint, the intermediation cost needs to be viewed in conjunction with
noninterest income. Till 2001, the burden (the excess of non-interest expenditure over non-interest income
as a percentage to total assets) of commercial banks hovered around 1 to 1.5 per cent. This gap
between intermediation cost and income from fee-based activities has narrowed considerably in recent
years. For example, the burden of Indian commercial banks declined from 1.2 per cent in 1992 to 0.2
per cent in 2004. Moreover, there has been a lowering of the burden across bank groups in recent
years. The improvement in respect of Indian private banks has been remarkable; their non-interest
income in recent years has surpassed their intermediation cost and has resulted in a negative burden.
The cost income-ratio (defined as the ratio of operating expenses to total income less interest
expense) of Indian banks showed a declining trend during the post reform period. For example, Indian
banks paid roughly 45 per cent of their net income towards managing labour and physical capital in
2004 as against nearly 72 per cent in 1993. In other words, 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 world's largest banks varied markedly from a low of 48 per
cent to a high of 116 percent and the ratio around 60 per cent is an indicative benchmark (RBI, 2005).
In that respect, the cost-income ratio of Indian banks is now comparable internationally. Among
various ownership patterns, public sector banks have tended to have relatively higher cost-income
ratio as against private banks and foreign banks.
This explanation needs to be viewed in conjunction with the differential ownership profile of banks.
et
Early studies (Sarkar al., 1998) found somewhat weak evidence to suggest that ownership was an
important determinant of performance. More recent studies exhibit mixed evidence: while certain
studies (Keova, 2003) suggest ownership to have some effect on bank performance, others (e.g.,
Bhaumik and Dimova, 2004) veer around the view that competition induced public sector banks to
eliminate the performance gap that existed between them and both domestic and foreign and private
sector banks. More recent research reported differences in the efficiency of Indian commercial banks
with different ownership status, level of non-performing loans, size and asset quality (Das and Ghosh,
2006). More importantly, their study uncovered evidence that public sector banks (PSBs) recorded
higher efficiency gains in the post-reform period. Clearly, the evidence here is not conclusive, because
comparisons are beset with several difficulties. Given the size and variety of PSBs, it is possible to find
banks that could equal the good private sector banks as well as bad ones. In addition, PSBs have to
reckon with 'legacy' problems, such as many of the non-performing assets that they have been
saddled with. Some PSBs operate in relatively backward areas with limited discretion to pull out from
such areas. The question still remains: whether there is a better payoff in enabling PSBs to improve
their performance while promoting private sector banks, as compared with an alternative policy that
provides for transfer of ownership and control from the public to the private sector. Will greater scope
for mergers and acquisitions within and between public and private sector add to greater efficiency?
Another important indicator of efficiency of banks is net interest margin (NIM), defined as the excess of
interest income over interest expense, scaled by total bank assets. Broadly speaking, this ratio reflects
the allocative efficiency of financial intermediation, a lower ratio being indicative of higher efficiency. It
is quite reasonable to believe that the decline in deposit rates ushered by the deregulation process will
be manifested in the lending behaviour of banks. In practice, however, lending rates have tended to be
sticky downwards and seem to operate with a time lag. Historically the NIM of Indian banks is rather
high. Around the onset of the reform process in 1992, the NIM of Indian banks was about 3.3 percent.
Thereafter, it recorded a relatively modest decline to around 3 per cent in recent years. And
traditionally, it is the foreign banks, which by