HOW BANKING HAS CHANGED

I wrote this in the Calcutta Telegraph of 28 July 2009. I watched the banking industry closely while I was in the finance ministry; my interest continued after my exit. Bank nationalization was one of Indira Gandhi's worst mistakes. We have to live with it; much can be done even with government banks if the government tried out some experiments in management - for instance, promote people with a more entrepreneurial bent of mind. THE BANKS’ JOURNEY

Many almonds were eaten and glasses of soft drinks emptied on Monday last week, when government-owned banks celebrated 40 years of their nationalization. It would have been fitter if the government had instead published a report of what banks had achieved in those 40 years. It might have given self-congratulatory figures of how many scheduled-caste families below poverty line were given credit. But quite accidentally, it might have unveiled some interesting facts too. Here are a few examples. At the time of nationalization, 56 per cent of bank deposits were in savings accounts; the remaining 44 per cent were in current accounts. In the next 10 years, the proportion of savings deposits rose to 80 per cent, and it has stayed close to that level since. During the early years after nationalization, banks were made to give generous loans; their lending created so much money that the idle balances they generated came to be parked in savings accounts. Since banks pay interest on savings accounts (and not on current accounts), the average cost of funds to them went up. But they did not care because they earned much more on their loans than they paid on deposits. There was no competition amongst them, and their margins were fat. So they were tempted to give more loans. There was no risk to them in giving loans, for if the loans turned bad, the government would bail out the banks. So nationalization led to more rapid credit expansion. According to orthodox theory, this should have led to higher inflation. But it also led to higher real growth; its rise from the Hindu rate of three-and-a-half per cent to five-and-a-half per cent coincides almost exactly with the rise in the growth rate of loans and deposits. So nationalization led to faster monetary expansion, but also to faster growth. The banks were nationalized to take credit to the government’s favourite sectors — agriculture and small industry. They were not, however, the banks’ favourite sectors. So the government forced banks to lend to them — 40 per cent of their credit had to go to these sectors. They did lend that much to priority sectors well into the 1980s; that was one reason why both agricultural and industrial growth accelerated then. But it would look as if banks ran out of creditworthy borrowers in these sectors, for they began to lend a rising proportion of their funds to other sectors. Surprisingly, it was not their traditional borrowers in industry and trade to whom they lent more; they sought out new borrowers, such as exporters, transporters, and more recently, buyers of real estate. Banks have followed the diversification of the economy into services; conversely, India’s shift to services and neglect of industry may well have been encouraged by banks’ lending policies. The finance minister may keep giving banks homilies about lending to politically desirable candidates. But even though his government owns them, banks have followed their own noses to find profitable clients. These clients were in the normal manufacturing industries till the 1990s. But in the last 10 years, banks have begun seriously to lend to infrastructure industries — power, telecommunications, roads and ports. These would not have been considered fit industries for bank finance under traditional rules, which required banks to lend short-term against liquid collateral. But almost a quarter of their credit now goes to these unconventional industries. In normal capitalist economies, these industries would have turned to the capital market; its lack of development in India has led to the banks taking over its function. The government had created special institutions to provide long-term finance — IDBI, ICICI and UTI. But banks encroached into their business, so much so that they had to turn themselves into banks. Whether banks have taken on undue risk by giving long-term credit to infrastructure will become evident only later; if they have, many will go bankrupt, and since they are owned by the government, it will bail them out. Until then, however, ministers and officials will keep making self-congratulatory statements claiming how their wise management has saved banks from the global meltdown. Banks were heavily concentrated in metros and big cities; after nationalization, they were required to expand into small towns and villages, and so they did. But that does not mean that they did a higher proportion of their business in smaller places. They did increase their proportion of rural depositors; but their share of banks’ total deposits actually fell. The number of their depositors in metros went up about as much as the total number; but the proportion of their deposits coming from metros went up. In other words, as banks spread to villages, they simultaneously intensified their urban coverage and attracted a higher proportion of the urban population; and they persuaded city-dwellers to deposit more money with them. Whatever the government’s intention, banks did at least as much to spread the habit of banking in cities as they did in villages. Although banks found more depositors in smaller places, they certainly did not lend more there. They became more choosy about rural borrowers, identified more credit-worthy ones, and gave them relatively larger loans. But their basic strategy was to find more borrowers in big cities. Earlier they had concentrated on big borrowers; progressively, they lent to smaller borrowers, and gave relatively smaller loans. Their branching out into retail mortgages is a part of this strategy. After early experimentation, banks decided that city-dwellers were better borrowers. By taking deposits from more city-dwellers, they got to know them better, and used the knowledge to turn the depositors into borrowers. So while the government’s efforts have perhaps succeeded in making banks open branches and draw in depositors in small places, they have certainly failed in making banks divert credit to small places. Banks’ bad debts have gone down to negligible levels after the write-offs and subsidies of the early years of this century. But in the mid-1990s they were high — almost a twelfth of all advances. One might think that old banks would have captured the best clients, that new banks would have to scrounge amongst less good borrowers, and would therefore have higher bad debts. The truth is just the opposite: new banks (and foreign banks) have had consistently lower bad debts than old banks. One might think that government banks would be worse managed and would have higher bad debts; but this also is not true. Old private banks were just as bad as old government banks. It would therefore appear that bad debts depend on techniques of selecting borrowers, servicing them and following them up — techniques which new banks have mastered better than old ones. My findings are based on a cursory analysis of easily available banking statistics. So much more could be inferred from the masses of statistics accumulated by the Reserve Bank of India. All it needs is a good, elementary economist. The RBI employs economists by the hundreds; the finance ministry gives generous grants to many more. But their minds are focused on higher matters; looking at easily available figures and calculating simple ratios would not occur to them. So we continue to have one of the world’s best documented and least analysed banking systems.