Banking Sector's Conundrum

As we enter the last quarter of the financial year 2015-16, the Indian banking sector seems to be in a spot. On one hand there is an increasing trend in the non-performing assets (NPAs), especially of the big banks. While on the other hand there is an ever-growing number of dormant accounts, which is one of the highest in the world. There is of course the third big challenge, that is, the question of financial inclusion. All these three issues are pertinent to the growth of a vibrant banking sector and also have implications on the overall growth rate of the economy.

The issue of high NPAs has been haunting the banking sector for a couple of years now. Rating agencies have been adjusting the extent of NPAs by marginal percentage points, that is lowering the projection of gross non-performing assets for 2015-16 to 5-5.5 per cent from the earlier 5.3-5.9 per cent of the total. However, this is because banks are masking the stress on their balance sheet by restructuring long-term loans as allowed by the Reserve Bank of India. Banks have been using the the popular '5/25' scheme which allows banks to spread a project's repayment obligation to a longer period, matching the cash flow of the project, resetting the refinancing scheme every five or seven years. It is estmated that roughly Rs 35,000 crore of loans have been restructured under the scheme. Many such projects would have otherwise shown up as NPAs.

The power distribution (discom) companies' restructuring plan, UDAY,is adding another dimension to the banking sector's current woes. In the scheme, loans to discoms will get converted into bonds with a lower coupon rate than the bank loans. ICRA estmates that this conversion will bring down credit growth to the extent of 1.7-2 per cent. Public sector banks such as Central Bank of India, Punjab and Sind Bank, Vijaya Bank, Oriental Bank of Commerce and UCO Bank have the highest exposure to discoms. Public sector banks are also wrestling with the issue of slow credit growth compared to their counterparts in the private sector. While credit growth of private sector banks was 18.3 per cent over a year as on September, public sector banks (PSBs) could manage only 6.2 per cent growth.

At the other end of the spectrum, World Bank's "Global Findex Database 2014: Measuring Financial Inclusion Around the World" report finds that India has a whopping 43 per cent of dormant accounts, one of the highest in the world. This is after the government launched the Pradhan Mantri Jan Dhan Yojana scheme for comprehensive financial inclusion. Certainly the pace of financial inclusion has increased as account penetration increased from 35 percent in 2011 to 53 percent in 2014. However compared to China's 79 percent, India's account penetration is still low.

The utilization of financial institution account reveals the quality of financial inclusion achieved. Only 4 percent used an account to receive wages in India, while in lower middle-income countries in general it is 5.6 percent. In an economy, which is witnessing large scale internal migration, only 9.9 percent of the account holders used their accounts to send remittances, while in other lower middle income countries 14.2 percent used their accounts. In terms of borrowings too account holders in India lag behind. Only 6.4 percent borrowed from a financial institution. Private informal moneylender continues to be a major source with 12.6 percent borrowing from them compared to 8.5 percent in lower middle-income countries in general. Thus target oriented financial inclusion programs now have to assess the utilization pattern for making the services more beneficial. This assumes relevance as China, India, and Indonesia together account for 38 percent of the world's unbanked. India is home to 21 percent of the world's unbanked adults and about two-thirds of South Asia's. China accounts for 12 percent of the world's unbanked and Indonesia for 6 percent; together they account for three-quarters of the unbanked in East Asia and the Pacific.

The imbroglio of the banking sector is a reflection of the persistent dualism in the economy. A small dominant formal sector, which has access to formal financial institutions, seems to be utilizing it to its maximum benefit, while attempts to incorporate a large informal sector to the formal financial system appears to consistently fall short of producing desired results. The challenge is to re-orient the existing institutions to this task. Recognizing the needs and requirements of the informal sector assumes critical importance in the context of India. The assumption that the informal would eventually fade away is unfounded and sometimes undesirable as the institutional objectives and rigidities of the formal financial system is often exclusionary. Increase in NPAs point to the sluggishness of activity in the formal segment of the economy as investments and cash flows have slowed down. In such a situation the vibrancy of the informal sector is what produces the much-needed cushioning effect for the economy, which undermines the need for revitalizing the dormant accounts and reaching the unbanked.

The conundrum of the banking sector is an outcome of the typical tendency of government authorities to draw up overly ambitious targets and be in a perennial promise mode. Target-driven policies have to be tempered with reality. More importantly, assessing the success of policies solely on the magnitude of targets achieved would turnout to be shortsighted and might keep growth out of the growth strategy.