Economic Context of Banking - Essay Example

?Economic context of Banking Table of Content Executive Summary 2 Introduction 3 Indian Banking sector and the role of government in increasing competition, stability and efficiency in Indian banking sector 3 Performance of the Indian Banking System 6 What should be done to enhance stability, competition and efficiency of Indian banking system 9 Conclusion 11 References 12 Executive summary India has a very active and a very interesting banking sector where public, private and foreign banks have their own importance and operate simultaneously. This paper will look at the role that the Indian government does play in increasing competition, stability and efficiency in Indian banking sector. The Indian financial field is made of a large network of commercial banks, financial institutes, stock exchanges and financial instruments. There has been revolutionary structural reformation after financial liberalization in 1990s. The Reserve Bank of India (RBI) made its firm role as the administrative agency of supervision and banking. The structure of the banking sector has undergone a significant transformation wherein the public sector banks have been observed in losing their relative importance which resulted to have more domestic private banks and more foreign banks. Even if a number of measures have been taken by the government to ensure higher stability, competition and efficiency, there still exist some problems in with the banking system, for example profitability of public sector banks has not been increased, and foreign banks are not performing at their desired level and so on. The overall performance of the banking sector has improved over time, but desired level of performance has not been reached. Hence the paper also provides my opinions regarding some recommendations. Introduction In many countries government plays an important role in maintaining competition, efficiency and stability in the operation of banking system. However, it would be quite interesting to consider a particular country and examine to what extent government supports the banking system in enhancing competition, stability and efficiency. For this purpose, the banking system of India will be chosen in this paper as India has a very active and a very interesting banking sector where public, private and foreign banks have their own importance and operate simultaneously. This paper will first look at the banking system of India and the role that the Indian government does play in increasing competition, stability and efficiency in Indian banking sector. Thus it will go on analyzing the extent to which the governmental efforts have been able to enhance the performance of the banks. Finally, some recommendations would be forwarded on how to effectively increase competition, stability and efficiency of banking sector. Indian Banking sector and the role of government in increasing competition, stability and efficiency in Indian banking sector The Government of India when nationalizing all the popular Indian banks in 1969 sought that banking was "inspired by a larger social purpose" and should attend national importance and goals such as rapid development in agriculture, small scale industry and exports. Now a day a body of direct and indirect proof is there to show that credit markets in developing countries frequently fail to make credit where its social product might be the highest. (Agarwal, 2003) Nationalization of Indian banks has helped in meeting social needs of the country. Earlier, the banks only concentrated on lending their money to big industrial houses. But after nationalization, the banks extend their loans to small scale industrialists, peasants and other individuals also. Nationalization has also helped in expansion of banking network to the rural areas as well. Peasants and small scale industrialized are also getting loans at lower interest rates. All these have helped in the growth and development of relatively poor segment of the population. (Agarwal, 2003; Mohan, 2005) However, nationalization has put various regulations on the operation of the banking sector of the country that reduces profitability of the public sector banks. Looking at the lower rate of profitability government allowed more private banks to enter into the market. The period of 1969 to 1980, the numerous private banks showed up more than public banks and on 1st of April, 1980, they accounted an approximate count of 17.5 percent of bank branches in India. (Agarwal, 2003) In order to improve performance of the banking sector high-end competition is needed. Indian government has allowed for larger entry by private banks for increasing competition in this banking industry. Competetion is required for maximization of social welfare and subsistence of Pareto power. In direct terms, in a competitive market setting, there is also allocative and fruitful efficiency as dynamic efficiency. For other industries, contest in banking system is needed as well for efficiency and optimum increment of social welfare. Nevertheless, banking field has specific characteristics that make it is important to the economy and properties that may differentiate it from other industries. To an economic growth banks play the most important role by playing an inter mediating role between borrowers and lenders and providing financial assets to other industries so also production. Banking system is also of great importance as it can destabilize the whole economy. So a good functioning banking system is said to be the cornerstone of the economy. The Indian policymakers have attempted to ensure that the banking system is stabile and that it is competitive and efficient. The Indian financial field is made of a large network of commercial banks, financial institutes, stock exchanges and financial instruments. There has been revolutionary structural reformation after financial liberalization in 1990s. Before that, from mid 1960s to early 1990', the Indian financial system was counted as an instrument of civil finance (Agarwal, 2003). Indian financial sector in the post independent period evolved in three phases. In the first period (1947-68), the Reserve Bank of India (RBI) made its firm role as the administrative agency of supervision and banking (Sen & Vaidya, 1997). Before 1960s the neo-Keynesian perspective dominated and neo-Keynesian economists used to argue that interest rates should be kept low in order to promote capital accumulation (Sen & Vaidya, 1997). In that period Indian financial sector was known by nationalization of banks, directed credit and administered interest rates (Lawrence & Longjam, 2003). The next phase (1969 - mid 1980s) is called the period of financial repression. Performance of the Indian Banking System The financial inhibition started in 1969 when 14 commercial banks were nationalized. Due to this reason, control over the interest rate, directed credit programmes had a very high impact. During the mid 1980 onwards, which was known as the Third Period, has been recognized as the period of consolidation, diversification and liberalization. Though during early 1990s, the Government of India initiated a more comprehensive liberalization programme. This particular programme involves decontrolled interest rates, reduced reserve ratios, and lesser control on banking operations by the government, when they established framework to regulate the market. (Bhattacharya, Lovell and Sahay, 1997) The main focus of the financial liberalization is to enhance the overall performance of the Indian financial sector in order to make the financial institutions more efficient and competent. As we know from earlier analysis that financial sector consists of commercial banks, stock exchanges and other financial institutions. Though, the Indian financial system will continue being a financial system which is based on bank where the banking sector plays the key role in mobilizing all the resources. The banking sector acts as the principle source of resource for majority households, enterprises irrespective of its size and financial services. Besides the major role which the banking sector underplay, there were other reforms which were introduced as financial reforms, in order to motivate the Indian Banking sector to better their performances in every way possible. (Bhattacharya, Lovell and Sahay, 1997) The banks in the public sector has dominated the Indian banking sector in a huge way in terms of number and asset share. The banking sector consists of 28 banks in the public sector with majority government ownership, 23 private banks and 27 foreign banks. It has been observed over the last three decades that the number of public sector commercial banks has remained almost the same. Also, in terms of asset share, 70 percent of the total commercial banking asset has been owned by the public sector banks. But here the most important point needs to be noted is that the asset share of the public sector banks has fallen down widely in the year 1980 from 90 percent to 68 percent in the year 2007. Since 1980s, although the number of domestic private banks have decreased to a large extent but still their asset share have shown a significant mark of increase to about 20 percent in 2007. While on the other hand, the foreign banks could not show such an increase in asset share. (Bhattacharya, Lovell and Sahay, 1997) The structure of the banking sector has undergone a significant transformation wherein the public sector banks have been observed in losing their relative importance which resulted to have more domestic private banks and more foreign banks. The fall in the share of public sector banks and consequent rise in the share of private banks has been significantly in terms of asset, deposit and credit share implying a declining concentration and an increase in the competition. The indicators of profitability reveal that all bank groups have recorded an increase in the profit rate and it has been noticed that the foreign banks had a wide margin of profit as compared to banks in the public sector and private banks in the domestic sector. The X-efficiency result shows that there has been no major change in the efficiency level of the public sector banks. While in the post reform period, there has a marginal decline in the efficiency of the public sector banks. The post reform period analysis shows that the efficiency of the domestic private banks are increasing day by day. Their efficiency level was noticed to be higher than the foreign as well as the private banks where the foreign banks were recognized to be the least efficient banks in India. (Bhattacharya, Lovell and Sahay, 1997; Button and Weyman-Jones, 1994.) What should be done to enhance stability, competition and efficiency of Indian banking system? On the basis of the discussions and findings from a number of theoretical and empirical researches on efficiency, stability and competition of banking sectors in different nations(Abbasoglu, Aysan and Gunes, 2007; Akmal, M and Saleem, M. 2008; Altunbas et al. 2001; Carbo et al. 2002), it would be possible to develop some personal opinions regarding some effective measuresthat should be undertaken by the Indian government to improve the performance of Indian banking sector. In my opinion, the desired measures to be undertaken in order to have a uniform stability in the banking sector are as follows: Risk calibration of capital as well as the level and quality of capital and liquidity in the banking sector should be enhanced. This is because unless the capital is incapable of being invested in high risk projects, it would not be possible to extend loans to risky ventures that are very often required for the growth of the country. Even if the banks extend the capital with lower risk calibration to highly risky ventures, then the bank will make loses. In addition, the government should explore the market mechanisms. It is necessary to increase the center clearing counter parties which might have developed as a circuit breaker in between banks. In business, competition in banking services is important so as to have a wide range of financial products and services, therefore reducing the risk of choice constraint in terms of competitive prices. In order to have a healthy, well functioning and competitive banking sector, it is very important to keep a very good mutual understanding between banks and their respective customers. Also it is very vital to rebuild the trust between bank and its customers. In my opinion some measures to increase further competition and reduce barriers. Can be as follows: Improved infrastructure will help a wide range of branches of a bank to deliver transactions and execute them widely among their customers. Non-bank finance should be encouraged in a diversified way. It would help in increasing customer base. Small business entities should have enough support in terms of mentoring, identifying and understanding a wide range of financial products and services and also make sure that they can be of use at the right time and in the right place. In order to have a better transparency in the pricing of bank products and services, competition among varied suppliers should be cut down so as to make varied choices from a wide range of suppliers. Finance supply should be sufficient enough to determine the shape and strength of the economic recovery and hence a private sector growth can be secured. Conclusion On the basis of the above discussion, it can be said that Indian government plays a crucial role in maintaining competition, stability and efficiency of the banking sector. Major importance is generally placed on efficiency and competition and hence more and more privatization is taking place in the country. However, focus on stability is relatively less and hence the banking sector some times fails to provide desired performance. Government needs to be more careful about its reform measures and rules and regulations relating to the banking industry of the country. Some well-thought and systematic efforts should be undertaken to enhance the performance over long run and in a consistent way. References 1. Abbasoglu, O. F., Aysan, A. F. and Gunes, A. 2007. “Concentration, Competition, Efficiency and Profitability of the Turkish Banking Sector in the Post- Crises Period”, MPRA Paper No. 5494. 2. Agarwal, R. N 2003. “Capital Market Development, Corporate Financing Pattern and Economic Growth in India”, Asian Economic Review, Vol. 45, No.1, April 2003, Pp. 23- 34. 3. Akmal, M and Saleem, M. 2008, “Technical Efficiency of the Banking Sector in Pakistan”, SBP Research Bulletin, Volume 4, Number 1, November, 2008, pp. 61-80. 4. Altunbas, Y; Gardener, E.P.M.; Molyneux, P. and Moore, B. 2001. “ Efficiency in European Banking”, European Economic Review, 45, pp. 1931-1955. 5. Bhattacharya, A., Lovell, C.A.K., and Sahay, P. 1997. “The impact of liberalization on the productive efficiency of Indian commercial banks”, European Journal of Operational Research, 98, 332-345. 6. Button, K. J. and Weyman-Jones, T. G. 1994. “ X-Efficiency and Technical Efficiency”, Public Choice, Vol. 80, No. 1/2 (1994), pp. 83-104. 7. Carbo, S., Gardener, E.P.M. and Williams, J. 2002. “Efficiency in Banking: Empirical Evidence from the Savings Banks Sector”, Econ Papers, 2002, vol. 70, issue 2, pages 204-28. 8. Lawrence, P. and Longjam, I. 2003. “Financial Liberalization in India: Measuring Relative Progress”, Keele Economics Research Paper No. 2003/8, Kele University. www.keele.ac.uk/depts/ec/kerp. 9. Sen, K. & Vaidya , R. 1997. “The Process of Financial Liberalization in India”, Oxford University Press, Delhi. 10. Mohan, R. 2005. “Reforms, Productivity and Efficiency in Banking: The Indian Experience”, Pakistan Development Review, Vol. 44, No. 4, Pp. 505-538. Read More