1. World Bank - IMF - Brookings Conference, April 26-27, 2004 Urjit R. Patel Infrastructure Development Finance Company Ltd. ROLE OF STATE-OWNED FINANCIAL INSTITUTIONS IN INDIA: SHOULD THE GOVERNMENT “DO” OR “LEAD”? World Bank – IMF – Brookings Institution Conference on Role of State-Owned Financial Institutions Washington, D.C., April 26-27, 2004

2. World Bank - IMF - Brookings Conference, April 26-27, 2004 1 MUSINGS “The crucial issue … is whether Corporate Governance is compatible with public ownership, which makes the system accountable to political institutions and not to the economic institutions or even regulators. Could we have public ownership without Government or political control …? ” - Governor, RBI, Pune, Jan 2002. “The Agricultural Infrastructure and Credit Fund, the Small and Medium Enterprise Fund, and the Industrial Infrastructure Fund will be operational shortly. All the three funds will, without compromising the norms of financial prudence, provide credit at highly competitive rates, which is expected to be 2 percentage points below the Prime Lending Rate (PLR)” - Union Interim Budget, 2004-05.

3. World Bank - IMF - Brookings Conference, April 26-27, 2004 2 STRUCTURE OF PRESENTATION  Status and changing profile of the financial sector  Involvement of govt. and other public institutions in intermediation  Consequences of continued govt. presence in intermediation  The incentives story  An examination of government’s role in the current financial sector environment  The way forward and conclusions

4. World Bank - IMF - Brookings Conference, April 26-27, 2004 3 STATUS OF INTERMEDIATION IN INDIA  Financial markets have deepened  M3/GDP ratio is now 70%; bank branches increased eightfold  Banks are the largest intermediaries  Deposits have been 40% of financial savings p.a. on average  Other deposit taking institutions (DTIs) are much smaller  The role of Development Financial Institutions (DFIs) is diminishing …  ICICI is now a bank, IDBI is in the process of becoming one, IFCI is being merged  … but some Systemically Important Financial Institutions (SIFIs) are becoming a cause for concern  Investible funds of LIC were 11.9% of GDP in 2002-03; of the Employee Provident Fund Organisation (EPFO), 5.6% of GDP

5. World Bank - IMF - Brookings Conference, April 26-27, 2004 4 GOVT. INVOLVEMENT IN INTERMEDIATION  Dominance of government owned institutions in most segments of intermediation  Banking, mutual funds, insurance  Central bank performs multiple tasks besides oversight of intermediaries  Owner of some intermediaries, investment banker for government’s borrowing program  Impedes its interest rate management function  Govt. involvement is, furthermore, larger than mere ownership  Pre-emption of resources  Directed credit  Implicit guarantee of bailouts

6. World Bank - IMF - Brookings Conference, April 26-27, 2004 5 INDEX OF GOVT. INVOLVEMENT IN FINANCIAL INTERMEDIATION (IDGI-F) Political forbearance lead to distorted incentives!

7. World Bank - IMF - Brookings Conference, April 26-27, 2004 6 DISTORTIVE EFFECTS ON INCENTIVES  Implicit “comfort and support” engenders moral hazard for both depositors and lenders  Vitiates commercial discipline  Declining investment efficiency of non-commercially oriented loan portfolios  Regulatory forbearance  Non closure of unviable intermediaries and lax enforcement of project completion norms  Risk weighting of govt. securities kept low  Extra-commercial oversight by government agencies  Accountability to agencies like CVC, CAG, etc. deter “good” risks by Public Sector Bank (PSB) loan officers Result: “Bad risk” pushes out “good risk”

8. World Bank - IMF - Brookings Conference, April 26-27, 2004 7 OUTCOME: “LAZY BANKING”! Credit creation role of banks is squeezed Quarter-wise cumulative investment (SLR securities) – deposit ratio

9. World Bank - IMF - Brookings Conference, April 26-27, 2004 8 IS GOVT. NEEDED IN INTERMEDIATION?  Indian banks now have performance standards that are prima facie comparable to world yardsticks  Systems and regulatory frameworks, to a large extent, in place  Most banks adhere to RBI prudential norms; NPAs under control  India unlikely to suffer a full-blown financial crisis  SARFAESI Act bestows significant foreclosure powers to banks and financial institutions  Institutions needed for market “completion” might, however, have to be reinforced  Facilitating transactions  Creating specialised markets  Promoting “development” and social objectives

10. World Bank - IMF - Brookings Conference, April 26-27, 2004 9 FACILITATING TRANSACTIONS  Efficient capital markets are critical for imposing commercial discipline on intermediaries  Speed and complexity of capital markets transactions have increased  Counterparty risks increase with non-govt. entities  Three pivots for efficiency of capital markets: Trading, Settlement and Delivery  Screen based trading introduced by NSE  Resulting spot benchmarks helped catalyse derivatives markets  STCI, CCIL, etc., have helped deepen govt. securities markets  NSDL has changed equity delivery formats ROLE OF GOVT.

11. World Bank - IMF - Brookings Conference, April 26-27, 2004 10 CATALYSING SPECIALISED MARKETS  Commercially oriented activities in areas hitherto state dominated entails a new set of risks  Many infrastructure segments continue to retain “public good” characteristics  Requires a novel approach to financing  Role of specialised intermediaries (like IDFC) in “leading private capital to commercially viable projects”  Developing innovative financial products and deepening capital markets  Take-out financing, risk participation facilities, “annuity” financing  Stimulating external trade  Filling trade financing gaps that private intermediaries are unable or unwilling to assume (Exim Bank) ROLE OF GOVT.

12. World Bank - IMF - Brookings Conference, April 26-27, 2004 11 ADVANCING “SOCIAL” OBJECTIVES  Attempts to mix “development” with commercial objectives  Extending the reach of intermediation into rural areas  Advancing industrial development objectives  Alternative delivery systems likely to be more cost effective  Specialised lending institutions for rural and small industries exist, but ineffective in their mandate  Revamping post office network is likely to be more cost effective  Using intermediaries to provide social security nets  Artificially high rates of interest to maintain pensioners’ purchasing power  EPFO’s solvency needs to be critically assessed ROLE OF GOVT.

13. World Bank - IMF - Brookings Conference, April 26-27, 2004 12 WAY FORWARD  The government should not be directly intermediating resources  Merely aggravates moral hazard  “Social contract” with intermediaries and depositors  Root cause of persistent unease with the financial system in India  Need to shift reform focus from individual intermediaries to a system level  Privatisation of intermediaries is a necessary condition  Make appropriate deposit insurance the anchor of public confidence in the banking system  Despite regulatory oversight mechanisms and a degree of macroeconomic prudence, insurance for bank deposits is relatively liberal  Introduce co-insurance and risk-based premia

14. World Bank - IMF - Brookings Conference, April 26-27, 2004 13 SUMMING UP  (Justifiable) reasons for erstwhile govt. presence in intermediation no longer exist  Unfortunately, a tendency to confuse outcomes with processes still persists Return to a dirigiste mode? Interim Budget announcement of lending at 2% below PLR Various funds have been proposed to increase funds flow  Entire banking sector becoming narrow  Measures earlier proposed for individual weak banks now becoming an endogenous reality for the sector!

15. World Bank - IMF - Brookings Conference, April 26-27, 2004 14 SHARES OF INTERMEDIARIES 1990-911998-992002-03 Gross Domestic Savings 1,3013,9325,500 (24.3)(22.3)(24.0) Bank deposits outstanding 2,0787,14013,043 (38.2)(40.5)(50.1) Small Savings deposit outstanding 1,0713,3333,810 (20.0)(19.1)(15.4) Mutual Funds assets 2538581,093 (4.7)(4.9)(4.2) NBFC deposits 174204178 (2.4)(1.2)(0.7) Total borrowings by DFIs (outstanding) --2108901* (12.0)(3.5) Figures are in Rupees billions Numbers in parentheses are percentages of GDP * Excludes ICICI Bank

16. World Bank - IMF - Brookings Conference, April 26-27, 2004 15 STATE PRESENCE IN FINANCIAL SEGMENTS Public (%) Private (%) Total (Rs. Bn) Scheduled Commercial Banks 75.624.4 16,989 Mutual Funds 48.251.8 1,093 Life Insurance 99.9 Negligible 2,296 Bank and mutual fund data are for 2002-03; Insurance data for 2001-02 Share definitions: Bank assets, net assets of MFs, life insurance liabilities Sources: RBI, SEBI, IRDA

17. World Bank - IMF - Brookings Conference, April 26-27, 2004 16 GOVT. INVOLVEMENT IN INTERMEDIATION  Share of public sector banks and financial institutions in total financial intermediation.  Share in resource mobilisation (as a sum of the following):  Net domestic and time liabilities in banks (as % of financial savings).  Resources mobilised by FIs through bond issues (as % of financial savings).  Premia of LIC / Amounts mobilised by UTI (as % of financial savings).  Lending practices and use of funds.  Investments in government securities by banks and financial institutions.  Excess deposits deployed by PSBs in priority sectors (relative to minimum prescribed norms).  Government’s pre-emption of financial resources.  Share of public investment in overall investment.  Public sector saving – investment gap.  Public sector fiscal / resource gap (a proxy for PSBR).  Outstanding contingent liabilities (guarantees and other off-balance sheet items) of the (central and state) governments.

18. World Bank - IMF - Brookings Conference, April 26-27, 2004 17 INTERNATIONAL BENCHMARKING Source: BCG presentation, CII summit, 2003 Data pertinent to 2002 or 2003 Parameters (in %) (March ’03) SBI Best International Banks Return On Assets0.86>1 Return On Equity18.05>18 Capital Adequacy Ratio 13.5011-12 Gross NPAs9.34<3 Net NPAs4.500 Expense Ratio50.53<50 Other Income to Operating Income 36.52>40 Net Interest Margin2.95>3.5 Transaction Costs1.80<1 Source: SBI Investor presentation, 2003

19. World Bank - IMF - Brookings Conference, April 26-27, 2004 18 INSTITUTIONS TO ENABLE MARKETS INSTITUTIONS’ ROLE OBJECTIVETRANSLATION TO THE INDIAN FINANCIAL CONTEXT Market creationEnabling property rights and contract enforcement Facilitating transactions Catalysing specialised markets Market legitimisation Social protection; conflict management; market access Ensuring systemic stability Facilitating intermediation in rural areas Designing appropriate social security nets Market completion “Spanning states of nature” resulting from non-existent markets Developing institutions to mitigate (specific) market making risks Develop pension safety nets

20. World Bank - IMF - Brookings Conference, April 26-27, 2004 19 GEOGRAPHIC SPREAD OF BANKING Shares No. of bank branches DepositsCreditC-D Ratio (%) Urban centres29%67%79%70% Metro centres 13%45%62%83% Top 100 centres 23%61%75%74% Non-Urban centres71%23%21%38% Semi urban centres 22%19%11%35% Rural centres 49%14%10%42% Scheduled Commercial Banks (at end-March 2003) Source: RBI Banking Statistics – Quarterly Handout, March 2003

21. World Bank - IMF - Brookings Conference, April 26-27, 2004 20 DEPOSIT INSURANCE Coverage Ratio (Limit / Per Capita GDP) Co- insurance Permanent Fund Annual Premium (% insured deposits) India 6NY0.05 Argentina3NY(Risk-based) 0.4-0.7 Brazil4NY0.3 Chile1YN0 Mexico In full (till 2005)NY 0.3 IndonesiaBlanket GuaranteeNY0 JapanIn full (till March ’01)NY0.04 Korea In fullNY 0.05 TurkeyIn fullNY(Risk-based) 1.0-1.2 UK1YNOn demand USA3NY(Risk-based) 0.27 Switzerland1NNOn demand Source: Demirguc-Kunt & Kane, World Bank Economic Review, 2001.