WP No. 6/2020 EGROW WORKING PAPER Future of Indian Banking from Public Policy Perspective By Subhash Chandra Pandey IAAS, Special Secretary, GoI November, 2020 EGROW Foundation Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in EGROW Working Papers are those of the author(s) and do not necessarily represent the views of the EGROW Foundation, Executive Board, or EGROW Foundation management. 1 Future of Indian Banking from Public Policy Perspective By Subhash Chandra Pandey* November, 2020 Abstract Technology and social control on banks has helped in achieving a high degree of financial inclusion but the contribution of banks in channelizing financial savings to productive sectors has been sub- optimal due to large public sector debt and decline in financial savings in an increasingly consumption-driven economy. Desktop analysis of the annual reports of the Reserve Bank of India shows that the institutional development in banking sector has followed a punctuated equilibrium path to develop significant endogenous capabilities in Indian banks of reforms and modernization. The banks have responded well to external stimuli and regulations but there are significant challenges at present and plenty of dark fibre to tap. Policy, regulatory and technological measures are needed to correct the risk aversion stance of banks and erosion of profitability in recent years. Institutional reengineering is needed to curb regulatory arbitrage by entities directly competing with banks in raising deposits and lending - including treasury banking through small savings schemes. Credit information systems and systems of record keeping of titles to property and charges thereon need significant improvement. Excessive regulations due to delinquency by a few are against the expectations and interests of the vast majority of compliant stakeholders. Rather blunt macro- prudential regulations need to be supplemented by fine-tuned RegTech/SupTech/FinTech enabled micro regulations and business practices to create appropriate incentives/disincentives at operational levels. Block chain technology deserves special mention to create smart contracts and verifiable transaction trails. Bank account portability is needed to spur competition. Banks need to get disentangled from long-term project finance to refocus on short and medium term credit. Formalisation requires ease of doing business, nay ease of living. Technology-enabled efficient services and white label business correspondents are needed to ease the access and reduce the cost of adoption of formal financial services JEL Codes: G21 G28 H63 O16 Keywords: Financial inclusion, competition, assets, liabilities, bank credit, bank deposits, consumption, savings, investment, NPA, NBFC, RegTech, SupTech, FinTech, Blockchain, regulatory sandbox, Bank Account Portability, Bank Regulation Email: [email protected] * The Working Paper was prepared for the first Conference on Banking organized by the EGROW Foundation on February 22, 2019. Author would like to thank Arvind Virmani, Ashok Vishandass, Charan Singh, Rattan Chand for and all participants of Conference. 2 Introduction 1. This is an attempt to review the growth and spread of banking system in India and to identify its current strengths and weaknesses. Recommendations are made for the Government of India and the Reserve Bank of India to steer the banking system into making bigger contribution to economic growth. Considering the dominance of public sector banks and a large stock of debt owed by governments and quasi-government agencies, the governments carry a higher responsibility. Our analysis shows that social control on banking institutions has served the goal of financial inclusion well but an increasingly government and consumption-driven economy, the financial inclusion has not been able to formalize/channelize financial savings. Indian banks are risk averse and have responded more to external stimuli and regulations than endogenous reforms and modernization. However, credit expansion is not commensurate with the size and needs of the economy and so far the focus of technology up-gradation by banks has been on the customer-end service delivery. In order to enhance lending capacity of banks, technology infusion is required by the banks in pre-sanction due diligence and post-disbursement monitoring of borrower performance and state of underlying securities. Technology-enabled institutional support for banks’ commercial decisions will in turn enhance scope and capability of the central bank to deploy technology for risk-based supervision, resulting in rationalisation of traditional, blunter tools of supervision. 2. Some basic objectives of a prudential public policy towards banking sector are postulated in Section I. Section II on Financial Inclusion reviews the trend of expanding network of bank branches, ATMs, and cashless modes of banking services. Section III reviews trends in mobilisation of deposits and their deployment by way of credit and investments. Section IV provides a perspective on the size of banking sector vis-à-vis total (formal) financial sector to see whether its significance remains intact. The Central government is performing banking functions of raising deposits and lending through Small savings Schemes. Section V highlights issues connected with this ‘treasury banking’. Section VI highlights trends in key indicators of profitability of banks like net interest margin and return on assets/equity. As growth of Non-Performing Assets in last decade has been a major source of steep decline in bank profitability, some generic/specific suggestions are given in Section VII for improving the management of NPAs by improving due diligence both at loan sanction and loan implementation stages. Section VIII contains a suggestion to consider appropriate amendments in the corporate law so that exposure norms are 3 supplemented with statutory leverage limits on companies and groups of related companies. Section IX discusses the case for a differentiated regulation approach with both incentives and exceptional relaxations for well-behaved banks and their clients. Section X takes a synoptic view of both actual use and potential of information technology for better profitability and customer service. 3. Data has been sourced from Annual Budgets of the Government of India (https://www.indiabudget.gov.in/); the website of the Reserve Bank of India (https://www.rbi.org.in/ ), especially the Annual Reports on Trends and Progress of Banking in India and Half-Yearly Financial Stability Reports; and CRISIL’s Yearbook on Indian Debt Market. (CRISIL, 2018). I. Basic objectives of a prudential public policy towards banking sector 4. Following is an attempt to articulate the guiding principles and policy objectives for development, regulation and reform of the banking industry:- (i) Improving financial inclusion, formalization and financialization of savings: Improved channelization of financial savings and generation of credit demand based on acceptable credit-worthiness for productive economic activities is a key prerequisite to boost inclusive economic growth. Hence, the foremost objective of policy should continue to be the expansion in the access points for availing to financial services in general and banking in particular. (ii) Protecting and enhancing shareholder value: Bankers are trustees of depositors besides normal accountability to their shareholders. Banking is not philanthropy. Globally, it is a low margin, high-volume business, very heavily regulated due to the interests of a large number of small savers and savings aggregators involved in it. Hence, the importance of improving profitability and efficiency (without compromising quality of services to the customers), improving safeguards against bad lending, improving asset quality can hardly be over- emphasized. (iii) Improving customer service: Like any other business, the business of financial services is also under the oversight of policy makers to ensure that the bankers and other service providers do not abuse their dominant position to vis-à-vis their customers to trample upon their rights to quality service at reasonable price. Policy would also be concerned about misuse of market dominance by any single player or group of players acting in concert through anti-competitive collusion. II. Financial Inclusion: Expanding the reach of Banking Services 4 5. Money lending activity in India could be traced back to the Vedic period. Use of various types of credit instruments like loan deeds and pay orders (called Rinapatra, Adesha, Dastawez, Hundis) is centuries old. ‘Arthashastra’, Kautilya’s treatise on statecraft and law in Mauryan Empire (400 BC) details law of contracts including ‘Adesha’ an order on a banker desiring him to pay the money of the note to a third person, which corresponds to the definition of a bill of exchange as understood today. (Reserve Bank of India, 1998) These financial services were provided by merchants acting individually or through guilds and partnerships. Stipulations for borrowers going bankrupt provided that the debts owed to the State had priority over other creditors. Modern banking based on the idea of a joint stock company is distinctly a European import. The creation of an abstract legal person having the rights to sue and be sued, to borrow and lend, and to own various properties all protected by law allowed pooling of finances and risks to take up more risky