Understanding the credit market behaviour of Indian banks  

In developing countries, the type of ownership of a bank is often considered the greatest influence on its credit market behaviour. In high-risk environments, however, other factors may play a more important part. Governments can do much to reduce risk for banks in order to encourage credit delivery.

Traditional analysis of banksin emerging markets has focused on the relationship between ownership andfinancial performance. Private banks, often considered more dynamic andefficient than public banks, have been encouraged as part of economicliberalisation in many developing countries. But experience has shown that inhigh-risk environments, banks are reluctant to lend, regardless of theirownership structures.

A paper from the Centre for EconomicDevelopment and Institutions at BrunelUniversity, UK and King’s College, London uses evidence from India to explore factors other than ownership that affectbank behaviour in emerging markets. Indian banks, private or public, tend toavoid risk. The evidence suggests that the proportion of credit distributed by wayof (largely short-term) corporate securities, which involve less risk, wasparticularly high during the economic uncertainty of 1998-2000.

The Indian banking sector hasa diverse ownership structure (27 public sector banks, 32 domestic privatesector banks and more than 30 foreign banks), and liberalisation since 1990 hasgranted operational autonomy to all. These banks compete with each other andthere has been a noticeable convergence in their financial performance sinceearly nineties, but little is known about their behaviour in the credit market.As in most developing countries, Indian banks are faced with the choice of investingin ‘safe’ government bonds, or offering ‘risky’ commercial credit. They are alsosubjected to many regulations on the pre-emption of deposits for mandatoryinvestment in government securities, distribution of credit across sectors andtreatment of non-performing assets (NPAs).

The authors find that the creditmarket behaviour of Indian banks is largely determined by:

• past trends
• the diversity of the bank’s potential borrowerpool
• regulations about the treatment of NPAs
• lending restrictions imposed by the Reserve Bank of India.

Regulatory and institutionalchanges can make it easier for banks to distribute credit. The reforms in Indiathat helped banks enforce debt covenants and clear NPAs from their balancesheets, for instance, were notably effective. They also had a positive effecton credit distribution.

The authors offer a keypolicy recommendation to the Government of India:

• prioritise the development of a market for corporatesecurities (for example lending by commercial paper), as this involves lessliquidity and hence less overall risk than conventional lending.

By developing the market forcorporate securities, particularly in ways that reduce liquidity risk evenfurther, the Government can offer a relatively low-risk way for Indian banks todeliver credit to the economy.