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Friday, Apr 08, 2005

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Basel norms & bank restructuring

By Sunanda Sen

Implementing Basel II norms on capital adequacy will further accentuate the trend of moving credit away from the deserving industrial units in the small sector.

OF LATE, the new Basel norms for capital adequacy have been drawing a lot of attention in India, not just in banking circles but also among the general public and the media. Much of this revived interest is due to the changes likely to come about with the introduction of Basel II in 2006. In this discourse one observes an over-emphasis on financial stability as a goal in itself, even when it goes contrary to distributional norms as well as growth potentials of the economy, which are no less relevant.

The history of the Basel International codes and Standards (BIS) relating to minimum capital adequacy for banks goes back to the developed countries' initiative in 1988 to protect the Organisation for Economic Cooperation and Development (OECD) banks from the financial crises common during the 1980s. According to the norm, the BIS-reporting banks were to protect the depositors' money by raising capital from the market up to at least eight per cent of the risk-weighted bank assets. The assets, consisting of advances and securities, were attributed a three-tiered credit-risk ranging from zero to 100 per cent. Generally, government-held debt (securities) carried a zero risk while bank borrowings and other loans were respectively at 20 per cent and 100 per cent.

With securities overpowering the global market for bank credits by the 1990s, the notion of risk was no longer confined to credit alone. Risk today includes the possibilities of capital losses due to movements in prices or interest rates or even exchange rates in the market, in addition to operational risks.

To counter these potential risks from market volatility, Basel II recommends a new model of risk-weighted capital adequacy for banks, to be initiated in stages. Risk-content of bank assets, as recommended, is judged either by an external agency in terms of the standardised approach or by banks themselves through an internal rating based (IRB) model. The market thus aims to bring in, via the regulators, financial discipline for banks, expecting a greater degree of financial stability.

As in many other developing countries, the Indian monetary authorities implemented Basel I by 1999. The Scheduled Commercial Banks (SCBs) in the country experienced, as a direct consequence, a noticeable drop in their non-performing assets (NPAs), from 8.1 per cent to 2.9 per cent of net bank credits (NBCs) between 1997-98 and 2003-04. There was even an absolute decline in these NPAs during the 2003-04 financial year. Encouraged by the performance of banks under the Basel I regime, the Reserve Bank of India as well as the major commercial banks in the country are already preparing the road map for Basel II.

On retrospection, the improvement in the NPA performance of banks can be related to several developments, including a demonstrated preference on the part of the SCBs to hold the risk-free government securities far in excess of the stipulated SLRs. Holding government securities also enabled banks to avoid the capital adequacy requirements while providing opportunities for reaping trading gains with declining yields and rising prices of government bonds in a soft-interest rate regime.

The improved NPA of banks was also made possible by the higher provisioning in respect of NPAs as warranted by Basel I. With the switchover from the earlier 180-day to the 90-day NPA norms by the RBI in accordance with international practice, the SCBs perforce raised provisions towards NPAs by as much as 40 per cent in 2003-04. By the end of 2003-04, the cumulative provisions of the SCBs accounted for 56.6 per cent of the gross NPA.

It, however, needs to be pointed out that the restructuring of the banking sector with the Basel norms has implications that go far beyond the performance criteria of banks, such as the reduced NPAs. One needs to look at the changes in the composition of bank assets, which have a strong bearing on the distribution of bank credit. While the demonstrated preference on part of the banks for government securities pre-empts the sum available for other advances, the priority sector in India still enjoys the 40 per cent mandatory minimum of net bank credit.

Social commitments in terms of priorities for credit, however, have of late been grossly violated with more than two-fifths of the priority sector credit offered to cover the "others segment." This segment typically comprises small business, retail trade, small transport operators, professional and self-employed persons, housing, education loans, micro credit, housing, etc. Small loans not exceeding Rs.10 lakh for housing have seen a steep jump over the last four years. Agriculture and small-scale industry (SSI), the remaining items on priority, have received the rest.

Judged by the relative size of the net NPAs on net advances it is not correct to say that loans to SSIs have been less credit-worthy as compared with the other priority and non-priority sector loans. Nor have loans to SSIs been less profitable in terms of yield or interest rate spreads in recent years.

No amount of "rationality" on the part of the banks can explain the shrinking size of bank credit to the small sector including the SSIs, which fell from 17.3 per cent of net bank credit from PSBs in 1999-2000 to seven per cent in 2003-04.

No sub-target has been specified for the SSIs in the priority package, a fact which turns the flow as a residual after meeting the respective sub-targets of 19 per cent for agriculture and 10 per cent for the poor. Of the sum lent to the SSIs, 40 per cent is earmarked as advances to the `tiny' units (defined as those with investments less than Rs.50 lakh), at interest rates that cannot exceed the PLR.

However, the interest rates on all other SSI units as well as those on "other loans" in the priority category have been liberalised since 1992. It is today openly admitted by bankers that banks lend short to small and medium enterprises at a higher interest rate and that they are also heavily collaterised. According to the Third Census of Small industries, held recently, shortage of working capital remains a major factor behind sickness in the SSI sector.

Much of the so-called risk-aversion of banks with regard to loans to the small and medium industries have their origin in the quick adoption of the Basel-approved credit risk adjusted ratios (CRAR) for capital. Implementing Basel II will further accentuate the ongoing trend by moving credit away from the deserving industrial units in the small sector.

Let us not forget the basic fact that employment generated by the organised sector of the manufacturing industry is only 14 per cent compared with 86 per cent by the unorganised sector of which small and medium enterprises remain the major component.

Labour intensity of output for major undertakings in the organised big industries are alarmingly in the downtrend, both with technological upgradings and the adoption of labour market flexibility. Moreover, small and medium enterprises, which include the SSIs, currently contribute 40 per cent of the total industrial production and over 34 per cent of national exports for the country.

One observes, with serious concern, the limitations of the guiding principle of the Basel norms for banking industry in a country like India where credit needs to be re-directed to units which are deserving, not only in terms of productive contribution but also in terms of social priorities.

With financial assets held in stock markets more lucrative compared to assets with productive capacity, policymakers today need to offer and administer wiser counsel to the profit-hungry corporates in the banking sector.

(Sunanda Sen is a former professor of economics at Jawaharlal Nehru University and currently a Visiting Professor at Jamia Millia Islamia, New Delhi.)

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