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The Economic Survey has prescribed a '4-D model' for the banking sector to face competition in the changed environment.
"Banking is hobbled by policy, which creates double financial repression, and by structural factors, which impede competition," the Economic Survey 2014-15, tabled in Parliament by Finance Minister Arun Jaitley, said.
"The solution lies in the 4 Ds of deregulation (addressing the statutory liquidity ratio (SLR) and priority sector lending (PSL), differentiation (within the public sector banks in relation to recapitalisation, shrinking balance sheets and ownership), diversification (of source of funding within and outside banking), and disinterring (by improving exit mechanisms)," it said.
The Survey has recommended SLR, a portion of deposits mandatorily invested in government securities, requirements can be gradually relaxed.
This will provide liquidity to the banks, depth to the government bond market, and also encourage the development of the corporate bond market, it said.
The right sequence would be to gradually reduce SLR and then provide incentives for a deeper bond market, it added.
Recently, the RBI has taken commendable and gradual steps in lowering the SLR from 25 per cent to 21.5 per cent. Earlier this month, RBI slashed the SLR by 50 basis points to 21.5 per cent.
"PSL norms can be re-assessed. There are two options: one is indirect reform, bringing more sectors into the ambit of the PSL, until in the limit every sector is a priority sector; the other is to redefine the norms to slowly make priority sector more targeted, smaller, and need-driven," it said.
The dual responsibility of building a modern economy and lifting the standard of living at the lowest percentiles of income demand creativity, including more evidence-based policy making especially in relation to PSL, it said.
The Survey further said that the analysis suggests that there is sufficient variation in the performance of public sector banks. The policy implication is that a one-size-fits-all approaches to governance reforms, public ownership, exit and recapitalisation should cede to a more selective approach.
It also suggested that more banks and more diversified ones must be encouraged.
Healthy competition from capital markets is essential too which will require policy support, it said.
Besides, better bankruptcy procedures for the future is essential.
"When the next boom and bust comes around, India needs to be better prepared to distribute pain between promoters, creditors, consumers and taxpayers. Being prepared for the clean-up is as important as the being prudent in the run-up," the Economic Survey said.
For the public sector banks in particular, which are exposed to governmental accountability and oversight, lending in a situation of NPAs is not easy because of a generic problem of caution, afflicting bureaucratic decision-making.
Bad loans in public sector banks more than tripled to about Rs 2.17 lakh crore in three years to March 2014.
NPAs (non-performing assets) of the banks have gone up during the last few years. Gross NPAs of the public sector banks increased from Rs 71,080 crore in 2011 to Rs 2,16,739 crore as on March 31, 2014.
The Survey noted that the policy challenge relates to financial repression. The Indian banking system is afflicted by what might be called "double financial repression" which reduces returns to savers and banks, and misallocates capital to investors.
Financial repression on the asset side of the balance sheet is created by the statutory liquidity ratio (SLR) requirement that forces banks to hold government securities, and priority sector lending (PSL) that forces resource deployment in less-than-fully efficient ways, it added.
Financial repression on the liability side has arisen from high inflation since 2007, it said, leading to negative real interest rates and sharp reduction in household savings.\
As India exits from liability side repression with declining inflation, the time may be appropriate for addressing its asset-side counterparts.
The structural problems relate to competition and ownership.
"First, there appears to be a lack of competition, reflected in the private sector banks' inability to increase their presence. Indeed, one of the paradoxes of recent banking history is that the share of the private sector in overall banking aggregates barely increased at a time when the country witnessed its most rapid growth and one that was fuelled by the private sector," the Survey said.
"It was an anomalous case of private sector growth without private sector bank financing. Even allowing for the over-exuberance of the PSBs that financed this investment-led growth phase, the reticence of the private sector was striking," it said.
Second, there is wide variation in the performance of the public sector banks measured in terms of prudence and profitability.
