Banking Sector Reforms in India and China

8/4/2019 Banking Sector Reforms in India and China

1/21

BANKING SECTOR REFORMS IN INDIA AND CHINA A COMPARATIVE PERSPECTIVEChristian Roland*This version: 8 August 2006Paper prepared for the "Harvard Project for Asian and

International Relations" 2006 Conference in SingaporeABSTRACTIndia and China have both started banking sector reforms after decades of heavy stateinvolvement. This paper takes a comparative perspective on the reforms in the two countriesby analyzing the reform progress made since the early 1990s along the lines of the policyrecommendations of transformation studies, evaluating the results using the CAMELframework, and discussing political-economy factors that may have contributed to therespective reform outcomes.The key findings are: (1) India and China have followed most of the policy recommendationsin the areas of liberalization, institution building and structural change, while privatization ofstate-owned banks has lagged in both countries; (2) India has generally proceeded faster withbanking sector reforms and outperforms China on most indicators; (3) from a politicaleconomy

perspective, a common restraining factor on the reforms are the ailing state-ownedenterprises that lack hard-budget constraints, and the influence of interest groups in areas suchas privatization and directed credit, while the political system appears to be less importantthan commonly assumed.JEL-Classification: O53, O57, P52.Key words: Banking sector reforms, CAMEL, China, India, transformation.* European Business School, Oestrich-Winkel Germany; E-Mail: [email protected]

-1-1 INTRODUCTIONChina and India have managed an impressive economic take-off since the opening of theireconomies in 1978 and 1991 respectively. Both countries have attempted to liberalize and

modernize their economies by for example lowering trade barriers, opening their countries forforeign investments and deregulating industries.Despite the impressive progress made in many parts of the economy, the banking sectors ofboth countries are not fully liberalized yet and continue to be state-dominated. In addition,both banking sectors still suffer from years of state-intervention as can be seen for example bythe comparatively high level of non-performing loans (NPLs) or the overstaffing of stateownedbanks. This can have significant implications for the overall economic performance ofthe two countries since studies have shown that a well-developed banking sector positivelyinfluences growth through the mobilization of savings and the allocation of capital to thehighest value use.1 While the benefits of a well-functioning banking sector are apparent,pursuing the necessary reforms towards this goal is not without pitfalls. From a politicaleconomy

perspective the reform of a banking sector poses major challenges due to specialinterest groups, the repercussions on the enterprise sector, and the linkage with a country'sfiscal situation.How to manage the transition from a state-directed to a market-based system is the main focusof transformation studies. The recommendations along the process elements of transformationstudies can provide a framework to evaluate the progress of banking sector reforms in Chinaand India. Knowing how the reforms have proceeded is however only the first step in anoverall evaluation since reforms are no means by themselves, but should contribute to animprovement of the economics of the banking sector. This is evaluated along the lines of the


2/21

CAMEL framework.2 To provide possible explanations for the results, relevant politicaleconomyfactors that have shaped the reforms and their outcomes are discussed.This paper contributes to the scarce comparative literature on banking sector reforms in Indiaand China in three ways: (1) it provides an evaluation along the lines of transformation studieson the reform process in the two countries, (2) performance indicators are used to provide a1 See Levine (1997), p. 720f.

2 The acronym CAMEL stands for Capital adequacy, Asset quality, Management soundness, Earnings andprofitability, and Liquidity

-2-holistic view on the relative performance of the two banking sectors, and (3) politicaleconomyfactors affecting reform outcomes are evaluated in a systematic manner.The rest of the paper is organized as follows: section 2 provides an overview of the mainelements and recommendations of transformation studies as the theoretical basis for theevaluation of the reforms. The influence of political-economy factors on the reform process inthe banking sector is discussed in section 3. In section 4 the development and major reformsin the banking sectors in India and China are presented. This is followed by a discussion insection 5 of how the recommendations of transformation studies were followed in the reform

process of both countries and which performance effects the reforms had. In section 6, theinfluence of political-economy factors on the reform process and results is discussed. Section7 concludes.

2 OVERVIEWOF TRANSFORMATION STUDIESTransformation studies3 attempt to explain the trigger, process and result of long-run systemicchanges. A transformation is frequently triggered by a political or economic crisis andinvolves a fundamental change of the underlying economic, political or cultural order, whichoften entails a redistribution of relative power and wealth.4A frequently used early blueprint for the transformation from a state-directed to a marketbasedsystem was the Washington Consensus that emphasized liberalization, stabilization andprivatization. It was at the beginning of the 1990s widely adopted in Latin America and inCentral and Eastern Europe (CEE).5 However, soon after the start of the transition in the CEE

countries, the Washington Consensus came under increasing scrutiny for offering an overlysimplistic model of transformation. The experiences in the transition countries have shownthat especially two factors have to receive more attention. First, institutions are needed toensure the functioning of the market system. Second, in most transition countries the3 There is disagreement in the literature whether a general "transformation theory" exists. Because of thecontroversy, the more neutral term "transformation studies" is used in this paper to refer to a set of hypothesisdescribing the process of transition from a state-directed to a market-based system.4 See Kloten (1991), p. 9; Wagener (1996), p. 9. According to Wagener (1996) the main difference between atransformation and a reform is the depth of the changes. While in a reform, the underlying economic order ispreserved, a transformation involves the substitution of the underlying economic order with a new one.Despite these conceptual differences the terms transformation, transition and reform are used interchangeablyin this paper.5 See Rodrik (2000), p. 86; Williamson (2004), pp. 1-10.

-3-economic structure was distorted through state interventions, which make significantstructural changes necessary. Thus, the main policy recommendations of liberalization,stabilization and privatization have to be complemented by institution building and structuralchange.6 These five elements as well as issues that relate to the timing and sequencing ofreforms are now briefly described in the context of banking sector reforms.Liberalization of the banking sector is a part of the internal liberalization of an economy. Asfor the overall economy, liberalization refers to the establishment of a market-determined


3/21

price and allocation mechanism.7 An extensive literature starting with the seminal works ofMcKinnon (1973) and Shaw (1973) argues for the reduction of repressionist policies such asinterest rate restrictions, reserve requirements and directed credit programs.8The rationale for sequencing the liberalization of interest rates is that more sophisticatedeconomic agents need a shorter adjustment period, as well as to reduce overly fiercecompetition for deposits at the start of liberalization. Thus, interest rate liberalization shouldstart with wholesale interest rates, followed by lending rates and finally deposit rates. Forinterest rate liberalization to be successful, economic agents should be subject to hard-budgetconstraints to ensure sound borrowing and lending, and banks should have a certain degree ofstability to avoid break-downs due to price competitions in liberalized markets.9Reserve requirements are a tool of monetary policy. They can however become an instrumentof financial repression, if they are used as a source of cheap funds for the budget deficit sincethey then constitute a distortionary tax on the banking sector. The policy recommendationconsequently is to only employ reserve requirements for monetary policy.10Under a directed credit program banks have to channel credit to certain priority sectors due toperceived market failures or development objectives. Should market failures exist that limitthe access to credit of certain parts of the population or the enterprise sector, measures to

ensure access to credit should be implemented before liberalization. For the abolishment of a6 See Kolodko (2004), p. 1.7 The removal of entry and exit barriers can be regarded as part of the liberalization of an economy as well.Here, these points are regarded as enablers for structural changes in a sector.8 See for example Fry (1997), McKinnon (1991), or Roubini and Sala-i-Martin (1992).9 See Caprio, Atiyas and Hanson (1994), p. 435; Mehran and Laurens (1997), p. 33f.10 See Joshi and Little (1997), p. 125.

-4-directed credit program, a dual-track approach with nominal credit targets should be used sothat economic agents have time to adjust and potential reform losers are compensated.11Stabilization of the banking sector is another important reform element. In the context ofbanking sector reforms, stabilization refers especially to the recapitalization of banks that are

likely to be burdened by a legacy of non-performing loans (NPLs) and low levels of capital.To avoid moral hazard, this should be done through a "once-and-for-all" program. Preconditionsfor a successful recapitalization of banks are the correct measurement andclassification of NPLs to be able to determine the capital need, a stable macroeconomicenvironment, transparent accounting standards and a legal framework to enforce claims.12One of the main levers to create a market-based banking system is theprivatization ofstateownedbanks (SOBs). In light of the often inadequate systems of governance under stateownership, privatization is regarded as a way to enhance the performance of SOBs and avoidcostly bailouts. A successful program of bank privatization should lead to entities that areboth independent of the state and of insider control. Pre-conditions towards this goal are adisengagement of the state from direct governance of banks and the build-up of a regulatory

framework as a means of indirect control. For the disengagement of the state to be credible,banks must be able to operate independently which may make a recapitalization beforeprivatization necessary. The main policy recommendation for bank privatization is to sellstate-owned banks through a transparent bidding process to strategic partners. This shouldhelp to quickly upgrade banks' operations to best practice levels, and to fully divest thegovernment's holding to avoid continued interference. This view is however not undisputedsince large-scale sales to foreign investors might lead to a popular backlash against reforms.13The experience of the transition countries made it clear that the incentives created by


4/21

privatization and liberalization of the economy would not work in the absence of properinstitutions. In terms of necessary institutions for the banking sector, countries at least need tohave the following in place. First, accounting and disclosure rules to promote transparency foroutside stakeholders and supervisors. Second, a regulatory system to supervise marketparticipants so that consumers are protected, competition is promoted, and risk-taking is not11 For a discussion of dual-track liberalization in China see Lau, Qian and Roland (2000).

12 See Balcerowicz and Gelb (1994), p. 37f.; Sheng (1996), p. 46.13 See Bonin, Hasan and Wachtel (2005), p. 2172; Hawkins and Mihaljek (2001), p. 9; Otchere (2005), p.2090f.; Parker and Kirkpatrick (2005), p. 531.

-5-threatening the stability of the overall system. Third, capital adequacy standards following theBasel capital accord to have a cushion against losses and reduce risk-taking. These institutionshave to be embedded in the overall institutional and legal structure that includes for examplecommercial and business laws.14Managingstructural changes constitutes one of the central tasks of transition. In the contextof a banking sector, a key lever for structural changes is the entry of domestic and foreignbanks. Before new banks and especially more sophisticated foreign banks can enter themarket, it is important to have a bank supervisory agency in place. In addition, it is importantthat the incumbent banks have sufficient net worth to avoid undue risk taking in a morecompetitive environment. If these conditions are met, the general policy recommendation is toallow entry of new banks into the market. Experience has shown that the threat of entry alonecan force incumbent banks to improve and upgrade their operations, which ultimatelyenhances consumer welfare.15The successful management of the transformation process does not simply depend onexecuting the five previously described process steps, but also on managing the interactionbetween these elements. Since a transformation strategy will almost inevitably containgradual reforms, thesequencingof the policy reforms as well as the timingof theirimplementation become important considerations. Since the sequence depends at leastpartially on country specific initial conditions, it is difficult to draw general conclusions from

the experiences of other countries. There are however some generally applicablerecommendations.16 First steps in a banking sector reform program should be the creation ofmarket-based institutions and if needed the stabilization of banks. From this basis, interestrates can be liberalized in the sequence described above. The next steps are the lowering ofstatutory pre-emptions and the step-wise removal of directed credit. When the necessaryregulatory structure has been established and domestic banks are accustomed to marketmechanisms, entry barriers for domestic and foreign players can be lifted, and theprivatization of state-owned banks can start.1714 See Joshi and Little (1997), p. 115; Kormendi and Snyder (1996), p. 11; Rajan and Zingales (2003), p. 18;Rybczinski (1991), p. 34.15 See Caprio, Atiyas and Hanson (1994), p. 435; World Bank (2001), p. 169.16 See Dhanji (1991), p. 323; Funke (1993), p. 337.

17 See Gibson and Tsakalotos (1994), p. 579; McKinnon (1991), pp. 6-8; Mehran and Laurens (1997), p. 34.-6-

3 POLITICAL-ECONOMY CONSIDERATIONS FOR BANKINGSECTOR REFORMSBanking sector reforms do not occur in isolation: the transformation of the banking sectoraffects other parts of the economy, and developments in the rest of the economy in turn have aprofound influence on banking sector reforms. A further complication is that the reforms inthe banking sector affect different interest groups such as savers, borrowers, or bank


5/21

employees. Consequently, political-economy considerations are important for the successfulmanagement of banking sector reforms. Two important factors, the inter-connection ofbanking sector reforms with the enterprise sector and the fiscal situation, as well as the role ofinterest groups, are discussed in more detail.The banking sector serves as an intermediary between providers and users of capital in aneconomy. In a market-oriented banking system, banks will try to channel capital to theventures with the best risk-return trade-off in order to minimize credit losses and maximizeprofits, which will ensure an efficient allocation of capital in the economy. This may howeverchange in a system where the state has an important influence over the credit allocation of thebanking sector and enterprises face soft-budget constraints.18 If enterprises face soft-budgetconstraints, losses can either be covered by subsidies from the government budget or withfurther loans from the banking sector. The extension of loans to loss-making enterprisesadversely affects the profitability and capital base of the banking sector, which may make abailout of banks with government funds necessary. To avoid costly recapitalizations of banksdue to unsustainable lending practices, enterprises have to abide to hard budget constraints.There are two implications from these arguments for banking sector reforms. First, bankingsector reforms need to be complemented by reforms in the enterprise sector if soft budget

constraints are present. Second, the financial capability and resources of the governmentaffect the pace of banking sector reforms.While the introduction of hard-budget constraints is an important complementary element forbanking sector reforms, the extent of available financial resources has direct implications onthe transformation process in the banking sector. First, low or moderate public debt may slowdown the privatization process, because with funds available for subsidies for loss-making18 For a discussion of the soft-budget constraint see for example Kornai (1986).

-7-public enterprises and banks, there is no urgent pressure to privatize.19 Second, high budgetdeficits are likely to lead to a persistence of repressive policies in the form of interest ratecontrols and statutory pre-emptions since they constitute sources of cheap funds for thegovernment, and thus lower its financing costs. Third, higher public debt and deficits mayresult in a slower reform pace if compensation transfers have to be made.20 Fourth, highpublic debt and deficits make a "once-and-for-all" recapitalization less likely because thenecessary resources are lacking. Thus ceteris paribus, the higher the public debt and deficits,the slower the pace of banking sector reforms will be.The speed of reforms is not only influenced by the fiscal position of the government, but to amajor extent by the existence of interest groups that are affected by the reform process. Sincethe seminal work by Olson (1965) the effects of interest groups have been a recurrent topic inthe political-economy literature. The analysis of interest groups is also important in thecontext of banking sector reforms since they may profoundly affect the liberalization process.Without going into an in-depth discussion, interest groups may have ceteris paribus thefollowing effects on the transition process. First, the higher the number of veto players such as

in a coalition government or with well-organized trade unions, the less likely isprivatization.21 Second, interest rate restrictions and directed credit program provide rents tocertain interest groups, which will oppose the abolition and try to delay a full liberalization.22Third, the opening of the market for new entrants depends on the strength of incumbents toblock new entrants vis--vis the existence and degree of organization of outsiders that wouldbenefit from the reform. In general it can be assumed that incumbents are better organized andhave closer ties to relevant decision-makers, which will delay reforms.23 Fourth, interestgroups may also affect the speed of reforms. A "war of attrition" between different interest


6/21

groups, in which the group that gives in first loses more, will lead to a delay of reforms.24 In19 See Opper (2004), p. 571.20 See Roland (2002), p. 45.21 See Opper (2004), p. 569f.22 This can however be solved by using a dual-track liberalization approach in which pre-existing rents arepreserved. For a discussion see Lau, Qian and Roland (2000).23 See Abiad and Mody (2002), p. 12; Rajan and Zingales (2003), p. 20f.24 See Alesina and Drazen (1991), p. 1171.

-8-addition, uncertainty about the distribution of gains and losses from the reforms will induceeconomic agents to prefer the status quo, which may also lead to a delay of reforms. 25It can be concluded that political-economy factors can have a profound influence on thereform process in the banking sector, and therefore can help to explain reform outcomes.Before these factors are applied to explain the reform progress in India and China, anoverview of banking sector reforms in the two countries is given.

4 DEVELOPMENT OF THE BANKING SECTORS IN INDIA ANDCHINA4.1 India

At the time of Independence in 1947, the banking system in India was fairly well developedwith over 600 commercial banks operating in the country. However, soon after Independence,the view that the banks from the colonial heritage were biased against extending credit tosmall-scale enterprises, agriculture and commoners gained prominence. To ensure bettercoverage of the banking needs of larger parts of the economy and the rural constituencies, theGovernment of India created the State Bank of India (SBI) in 1955. Despite the progress inthe 1950s and 1960s, it was felt that the creation of the SBI was not far reaching enough sincethe banking needs of small scale industries and the agricultural sector were still not coveredsufficiently. Additionally, there was a perception that banks should play a more prominentrole in India's development strategy by mobilizing resources for sectors that were seen ascrucial for economic expansion. As a consequence, in 1967 the policy of social control over

banks was announced, which aimed to cause changes in the management and distribution ofcredit by commercial banks.26In 1969 the 14 largest public banks were nationalized which raised the Public Sector Banks'(SOB) share of deposits from 31% to 86%. The two main objectives of the nationalizationswere rapid branch expansion and the channeling of credit in line with the priorities of thefiveyearplans. To achieve these goals, the newly nationalized banks received quantitative targetsfor the expansion of their branch network and for the percentage of credit they had to extend25 See Fernandez and Rodrik (1992).26 See Cygnus (2004), p. 5; ICRA (2004), p. 5; Joshi and Little (1997), p. 110f.; Kumbhakar and Sarkar (2003),p. 406f.; Reddy (2002b), p. 337f.; Shirai (2002b), p. 8.

-9-

to the so-called priority sectors, which initially stood at 33.3%. Six more banks werenationalized in 1980, which raised the public sector's share of deposits to 92%. The secondwave of nationalizations occurred because control over the banking system becameincreasingly important as a means to ensure priority sector lending, reach the poor through awidening branch network and to fund rising public deficits. In addition to the nationalizationof banks, the priority sector lending targets were raised to 40%. Besides the establishment ofpriority sector credits and the nationalization of banks, the government took further controlover banks' funds by raising the statutory liquidity ratio (SLR) and the cash reserve ratio


7/21

(CRR). From a level of 2% for the CRR and 25% for the SLR in 1960, both increased steeplyuntil 1991 to 15% and 38.5% respectively.27However, the policies that were supposed to promote a more equal distribution of funds, alsoled to inefficiencies in the Indian banking system. To alleviate the negative effects, somereforms were enacted in the second half of the 1980s. The main policy changes were theintroduction of Treasury Bills, the creation of money markets, and a partial deregulation ofinterest rates.28 Despite the reform attempts, the Indian banking sector had like the overalleconomy severe structural problems by the end of the 1980s. By international standards,Indian banks were even despite a rapid growth of deposits extremely unprofitable. In thesecond half of the 1980s, the average return on assets was about 0.15%. The capital andreserves of Indian banks stood at about 1.5% of assets, which was significantly below otherAsian countries that reached about 4-6%.29The 1991 report of the Narasimham Committee served as the basis for the subsequent bankingsector reforms. The objective of banking sector reforms was in line with the overall goals ofthe 1991 economic reforms of opening the economy, giving a greater role to markets insetting prices and allocating resources, and increasing the role of the private sector.30 In thefollowing years, reforms covered the areas of (1) liberalization including interest rate

deregulation, the reduction of statutory pre-emptions, and the easing of directed credit rules;(2) stabilization of banks; (3) partial privatization of state-owned banks; (4) changes in the27 See Arun and Turner (2002a), p. 184; Bhide, Prasad and Ghosh (2001), p. 4; Ganesan (2003), p. 14; Hanson(2001), p. 2f.; Joshi and Little (1997), p. 111f.; Kumbhakar and Sarkar (2003), p. 407; Reddy (2002b), p. 338.The SLR refers to funds that have to be kept in cash or government bonds, the CRR is a percentage of fundsthat have to be deposited with the RBI. See Joshi and Little (1997), p. 112.28 See Bhide, Prasad and Ghosh (2001), p. 5; Shirai (2002b), p. 9.29 See Joshi and Little (1997), p. 111.30 See Government of India (1991); Hanson (2001), pp. 5-7.

-10-institutional framework, and (5) entry deregulation for both domestic and foreign banks. Themain reforms are now briefly described.Interest rate liberalizationPrior to the reforms, interest rates were a tool of cross-subsidization between different sectorsof the economy. As a result the interest rate structure had grown increasingly complex withboth lending and deposit rates set by the Reserve Bank of India (RBI). The lending rate forloans in excess of Rs200,000 which account for over 90% of total advances was abolished inOctober 1994. Banks were at the same time required to announce a prime lending rate (PLR)which according to RBI guidelines had to take the cost of funds and transaction costs intoaccount. For the remaining advances up to Rs200,000 interest rates can be set freely as longas they do not exceed the PLR. On the deposit side, there has been a complete liberalizationfor the rates of all term deposits, which account for 70% of total deposits. From October 1995,interest rates for term deposits with a maturity of two years were liberalized. The minimummaturity was subsequently lowered from two years to 15 days in 1998. The term deposit rates

were fully liberalized in 1997. As of 2004, the RBI is only setting the savings and thenonresidentIndian deposit rate. For all other deposits above 15 days banks are free to set theirown interest rates.31Statutory pre-emptionsUntil 1991 the CRR had increased to its maximum legal limit of 15% from a level of around5% in the 1960s and 1970s. From its peak in 1991, it has declined gradually to a low of 4.5%in June 2003. In October 2004 it was slightly increased to 5% to counter inflationary


8/21

pressures, but the RBI remains committed to decrease the CRR to its statutory minimum of3%. The SLR has seen a similar development. The peak rate of the the SLR stood at 38.5% inFebruary 1992, just short of the upper legal limit of 40%. Since then it has been graduallylowered to the statutory minimum of 25% in October 1997.32Priority sector lendingBesides the high level of statutory pre-emptions, the priority sector advances were identifiedas one of the major reasons for the below average profitability of Indian banks. TheNarasimham Committee therefore recommended a reduction from 40% to 10%. However, this31 See Arun and Turner (2002b), p. 437; Reserve Bank of India (2004), p. 11 and 15; Shirai (2002b), p. 13f.;Singh (2005), p. 18; Varma (2002), p. 10.32 See Ghose (2000), p. 199; Reserve Bank of India (2004), p. 10.

-11-recommendation has not been implemented and the targets of 40% of net bank credit fordomestic banks and 32% for foreign banks have remained the same. While the nominaltargets have remained unchanged, the effective burden of priority sector advances has beenreduced by expanding the definition of priority sector lending to include for exampleinformation technology companies.33

StabilizationDue to directed lending practices and poor risk management skills, India's banks had accrueda significant level of NPLs. Prior to any privatization, the balance sheets of SOBs had to becleaned up through capital injections. In the fiscal years 1991/92 and 1992/93 alone, theIndian government provided almost Rs40 billion to clean up the balance sheets of SOBs.Between 1993 and 1999 another Rs120 billion were injected in the nationalized banks. Intotal, the recapitalization amounted to 2% of GDP.34PrivatizationDespite the suggestion of the Narasimham Committee to rationalize SOBs, the Government ofIndia decided against liquidation, which would have involved significant losses accruing toeither the government or depositors. It opted instead to maintain and improve operations toallow banks to create a starting basis before a possible privatization. In 1993 partial private

shareholding of the SBI was allowed, which made it the first SOB to raise equity in the capitalmarkets. After the 1994 amendment of the Banking Regulation Act, SOBs were allowed tooffer up to 49% of their equity to the public. This led to the partial privatization of anadditional eleven SOBs. Despite those partial privatizations, the government is committed tokeep the public character of these banks by for exampling maintaining strong administrativecontrols.35Institution buildingThe report of the Narasimham Committee was the basis for the strengthening of prudentialnorms and the supervisory framework. Starting with the guidelines on income recognition,asset classification, provisioning and capital adequacy the RBI issued in 1992/93, there havebeen continuous efforts to enhance the transparency and accountability of the banking sector.33 See Ganesan (2003), p. 15; Hanson (2001), p. 8; Reserve Bank of India (2004), p. 16.34 See Deolalkar (1999), p. 66f.; Reddy (2002a), p. 359; Reserve Bank of India (2001), p. 26.35 See Ahluwalia (2002), p. 82; Arun and Turner (2002b), pp. 436-442; CASI (2004), p. 33; Reddy (2002a), p.358f.; Shirai (2002b), p. 26.

-12-The improvements of the prudential and supervisory framework were accompanied by aparadigm shift from micro-regulation of the banking sector to a strategy of macromanagement.36

The Basle Accord capital standards were adopted in April 1992. The 8% capital adequacy


9/21

ratio had to be met by foreign banks operating in India by the end of March 1993, Indianbanks with a foreign presence had to reach the 8% by the end of March 1994 while purelydomestically operating banks had until the end of March 1996 to implement the requirement.Significant changes where also made concerning NPLs since banks can no longer treat theputative 'income' from them as income. Additionally, the rules guiding their recognition weretightened. Even though these changes mark a significant improvement, the accounting normsfor recognizing NPLs are less stringent than in developed countries where a loan is considerednonperforming after one quarter of outstanding interest payments compared to two quarters inIndia.37Structural changesBefore the start of the 1991 reforms, there was little effective competition in the Indianbanking system due to strict entry restrictions for new banks, which effectively shielded theincumbents from competition. Over 30 new banks both domestic and foreign have enteredthe market since 1994. By March 2005, the new private sector banks and the foreign bankshad a combined share of almost 20% of total assets.384.2 ChinaLike in other countries the development of the banking sector in China has been strongly

influenced by the pre-dominant political philosophies. Since the foundation of the People'sRepublic of China (PRC) the Chinese banking sector has undergone several distinct policychanges. Before the reforms conducted after 1994 are described in more detail, the earlierdevelopments in the banking sector are briefly described.The banking system of the Soviet Union in the 1930s served as a blueprint for the Chinesesystem after the declaration of the PRC in 1949. The People's Bank of China (PBC) stood at36 See Reserve Bank of India (2004), p. 24f; Shirai (2002b), p. 21.37 See Joshi and Little (1997), p. 117; Madgavkar, Puri and Sengupta (2001), p. 114; Shirai (2002b), p. 21f.38 See Reserve Bank of India (2005b), pp. 231-233 and p. 258f.

-13-the center of a virtual mono-banking system since it had the main responsibility for cash,credit and settlements. Even though at the beginning of the 1950s other banks and rural

cooperatives existed, they de-facto functioned as extensions of the PBC, and were eventuallymerged into the PBC system in 1955. As the de-facto mono-bank, the PBC combined centralbanking and commercial banking functions, and served as a tool for the implementation of theFive-Year Plans. As such, the PBC did not have any degrees of freedom in its lendingdecision size, term and interest rates of loans were all administratively set.39In 1979 China established a two-tier banking system with the foundation of three state-ownedbanks. These were the Agricultural Bank of China (ABC), the Bank of China (BOC) and thePeople's Construction Bank of China (PCBC). The ABC was charged with the task ofproviding banking services to rural areas and townships, the BOC which was separated fromthe PBC was supposed to act as an urban bank providing different banking services, while thePCBC took responsibility for financing large capital intensive projects. This was an important

first step in creating a more diversified and specialized banking system. In 1984, the Industrialand Commercial Bank of China (ICBC) was established and complemented the three otherstate-owned commercial banks by taking over the commercial banking functions and the vastbranch network of the PBC. In 1984 the PBC became the official central bank after ICBC hadtaken over its commercial banking functions.40Several important steps were taken to further commercialize the banking system between1985 and 1994. Among them was the replacement of direct grants with interest-bearing loansto harden the budget constraints of state-owned enterprises (SOEs), the granting of formalresponsibility for the PBC in 1986 over monetary policy and the supervision of the financial


10/21

system, and the formulation of a credit plan that instituted an aggregate credit ceiling for eachPBC branch. Within those credit ceilings, the branches gained increasing autonomy to makecredit decisions. In 1993 the State Council initiated further reform steps that included thetransformation of the PBC into a modern central bank with responsibility for monetary policyand financial system supervision, and the decision to separate policy and commercial lending39 See Lo (2001), p. 16; Nanto and Sinha (2002), p. 472; Wolken (1990), p. 54; Yang (2004), p. 2. Under the

central planning system, enterprises had two sources of funds: the state budget and the banking system.Companies received most of their funds through the official state budget. The remainder of the funds primarily for working capital was provided by the PBC based on a national credit plan that was prepared bythe State Planning Commission of the State Council. See Wolken (1990), p. 55.40 See Chen and Thomas (1999), p. 17; Lardy (1998), p. 64; Lowinski and Terberger (2001), p. 5f.; Nanto andSinha (2002), p. 472; Wolken (1990), p. 57.

-14-which was the basis for the transformation of the state banks into commercial banks. Inaddition to the foundation of the policy banks, major reforms in the areas of reserverequirements, interest rate deregulation, reduction of directed lending, entry deregulation,improvement of prudential regulation, and NPL management have been started since 1994.41These reforms are now described in more detail.

Interest rate liberalizationThe initial attempts to liberalize interest rates started in the late 1980s, when Chinese banksreceived the flexibility to adjust interest rates for lending within a certain range around theadministered rate. Further progress was made in 1998 and 1999 when attempts were made toincrease the flow of credit to SMEs by first increasing the interest ceiling on loans to SMEs to20% in 1998 and then to 30% in the following year. From 2002, banks received moreflexibility in setting their interest rates on loans since they could charge up to 1.3 times thecentral lending rate. This was in 2004 raised to 1.7 times the central lending rate. Despite theprogress made on the lending side, deposit rates continue to be largely set by the state.42Statutory pre-emptionsAttempts have been made to ease the burden of statutory pre-emptions. After an increase ofreserve requirements from 13% to 20% in 1992, they were lowered to 8% in 1998 and to 6%in 1999. The statutory reserves are remunerated by the PBC.43Priority sector lendingThe main instrument for directed lending in China has been the credit plan. An important steptowards a more market-based allocation of credit came with the Commercial Banking Law of1995, in which the four SOBs were given responsibility to operate as commercial entities withaccountability for profits and losses. Besides the establishment of the policy banks, thismarked an important step to ensure the extension of loans based on economic and not politicalcriteria. The credit plan for working capital loans and fixed investment loans was in 1998replaced with an indicative, non-binding target. Today, even though banks are in general able41 See Shirai (2002a), p. 21f.; Lo (2001), p. 20; World Bank (1996), p. 27.42 See Garcia-Herrero and Santabarbara (2004), p. 19; Shirai (2002a), p. 23; The Economist (2004), p. 18.43 See Garcia-Herrero and Santabarbara (2004), p. 19; Shirai (2002a), p. 23.

-15-to extend loans based on commercial considerations within the framework of the existingregulations, the government is still able to intervene to some extent in credit decisions.44StabilizationStabilization of state-owned banks is one of the foremost issues in the Chinese bankingsystem. The need to stabilize the SOBs arises from a combination of a large stock of NPLsand low equity capital that could serve as a cushion for loan losses. Despite rapid creditgrowth over recent years, the stock of NPLs has not declined sufficiently so that even today


11/21

NPLs stand at around 15-20% of total loans, which implies that the banking sector istechnically insolvent. The Chinese government has tried to solve the problem byrecapitalizing the Big Four banks with almost USD 260 bn in three successive rounds ofrecapitalization since the late 1990s and by shifting NPLs to asset management companies.45PrivatizationPrivatization of state-owned banks in China has not proceeded beyond the selling of minoritystakes. The first partial privatization of a Big Four bank was the global initial public offeringof China Construction Bank in October 2005, which was followed by the listing of Bank ofChina in June 2006. Besides that foreign investors have taken ownership stakes in second-tierbanks starting in December 2001 with HSBC's purchase of an 8% stake of the Bank ofShanghai, a local joint-stock commercial bank.46Institution buildingImportant upgrades to the institutional infrastructure of the Chinese banking sector were madebetween 1995 and 2002. The Commercial Banking Law included provisions that requiredbanks to focus on efficiency and liquidity in their operations, as well as to make inquiries intothe creditworthiness of their customers. In addition, the Commercial Banking Law requiredbanks to maintain an 8% equity cushion and to adopt a classification system for NPLs. The

loan classification system was further upgraded in 2002 with the introduction of a five-tiersystem which all banks had to adopt by the end of 2005. Important progress in the area ofregulation and supervision was made in 2003 with the establishment of the China BankingRegulatory Commission (CBRC) that took over these responsibilities from the PBC. The44 See Mo (1999), p. 99; Shirai (2002a), p. 24. For example according to the Commercial Banking Law statebanks have to provide credit for projects approved by the state council. See Shirai (2002a), p. 2445 See Bremner (2005), p. 24; Garcia-Herrero and Santabarbara (2004), p. 17; The Economist (2004), p. 18f.46 See Bremner (2005), p. 26; Bremner (2006), p. 1.

-16-current main priorities of the CBRC are the reduction of NPLs, ensuring sufficient levels ofbank capital and the upgrading of banks' internal indicators to international standards. 47Structural changes

Starting in the second half of the 1990s, the SOBs saw an increase in competition through theestablishment of new commercial banks whose shares were owned by public authorities, andat times by individuals. These new commercial banks include for example ShenzhenDevelopment Bank, Guangdong Development Bank and Everbright Bank. Under China'sWTO commitment, the banking sector has to be opened successively between 2002 and 2006in terms of business reach and geography. Until 2002 foreign banks were only allowed toserve foreign companies and foreign individuals. This was extended to Chinese domesticcompanies in 2005, with the commitment to lift all restrictions in 2006, so that services can beoffered to Chinese individuals as well. In geographic terms, the liberalization also proceeds ina phased manner with 2006 being the deadline for lifting all geographic restrictions forforeign banks' business in China.48

5 COMPARATIVE PERSPECTIVE ON BANKING SECTORREFORMSAs the overview of the reform progress in table 1 shows, there is a remarkably high degree ofsimilarity between India and China despite the different starting points for both countries anddifferent reform environments. Both countries have followed the general recommendationsfor interest rate liberalization, the lowering of reserve requirements, and the enabling ofstructural changes through the entry of new players. Institution-building is a somewhat specialcase, because both countries have upgraded their institutions and relevant regulations.


12/21

However, the enforcement of these rules seems to have been particularly in China, at leastuntil recently, an issue. In the areas of directed credit and privatization both countries havemade relatively little progress towards a market-oriented banking system. In the area ofstabilization both countries have not followed the recommendation of a "one-time"recapitalization of banks. It is interesting to note that in all areas with the exception of47 See Chen (2003), p. 321; Deutsche Bank Research (2004), p. 8; Garcia-Herrero and Santabarbara (2004), p.

22f.; Lardy (2000), p. 8f.; Lowinski and Terberger (2001), p. 10; Nanto and Sinha (2002), p. 472f.48 See Deutsche Bank Research (2004), p. 2; Nanto and Sinha (2002), p. 473f.; Wong and Wong (2001), p. 19.

-17-directed credit, India has started in general 5-10 years earlier with reforms than China. Whilethis can to a certain extent be attributed to China's mono-bank legacy and fragility of itsbanking sector, this marks an important deviation to the overall reforms where China is ingeneral perceived to be the first-mover.Concerning the timing and sequencing of reforms, both countries have followed like for therest of their reforms a gradual reform path. The generally proposed sequence of reforms hasbeen followed quite well by both countries with only some smaller deviations. For examplethe initial partial privatizations were conducted quite early in the reform process in India. The

selling of minority stakes should however be interpreted more as a means to generate funds,and not to cede control. China started with institution building relatively late, which again canbe attributed to the legacy of the mono-banking system, which first required the build up of atwo-tier banking system. It is interesting to note that both countries have despite their gradualand cautious reform not always had all the necessary pre-conditions in place.Overall it can be concluded that India and China followed the policy recommendations fairlywell. It is noteworthy that reform progress has been limited in the contentious areas ofdirected credit, privatization and stabilization, which would be expected from a politicaleconomystandpoint since these are the reforms that most likely affect various interest groups,and are intricately linked to enterprise reforms and the fiscal situation of the government.Banking sector reforms are no means by themselves, but should contribute to a betterfunctioning of the sector. Therefore, it is necessary not only to evaluate the reform process,

but also the performance effects of banking sector liberalization. This is done with theindicators of the CAMEL framework that analyzes capital adequacy, asset quality,management soundness, earnings and profitability, and liquidity.49 To provide a more holisticview of the reforms, indicators for financial development and sectoral concentration areincluded in the analysis.49 See International Monetary Fund (2000), p. 4. Sensitivity to market risks is sometimes used as an additionalfactor. Due to lack of data it is however not included here.

-18-Capital Adequacy: India's banking sector has on average a higher capital basis than theChinese as measured by the ratio of capital to risk-adjusted assets and the equity share (Figure1). The Chinese banking sector has however shown some improvements in recent yearsfollowing the recapitalization of the SOBs.50Asset Quality: Both countries have started the reform process with a huge burden of NPLs.India has however so far more successfully managed to gradually reduce the burden of NPLsand to introduce hard-budget constraints. In China the ratio of NPLs has despite capitalinjections and strong loan growth not declined significantly (Figure 2).Management Soundness: The cost-income ratio is lower in China. India has since 1992 showna steady improvement and has lowered the CIR from 90% to 70% (Figure 3)50 The aggregate capital adequacy ratio in India has since 1996 exceeded 10%. For China, data is not availablefor all years, but the level is likely significantly below the 8% threshold of the Basel capital standards.


13/21

-19-Earnings and Profitability: With the exception of the immediate aftermath of the balance-ofpaymentcrisis, India's banks have been consistently more profitable than China's banks asmeasured by the return on assets (Figure 4). While the profitability of China's banks has

improved somewhat, it remains low by international standards.Liquidity: Credit from monetary authorities to deposit money banks was not of greatimportance in India (Figure 5). However in China it was an important tool for refinancing andcapitalization of banks. The importance has however declined in the last years as well. Onepossible reason for the high share is the former mono-bank system were no distinctionbetween the central bank and commercial banks was made.Other indicators: Two further indicators to evaluate the reforms are liquid liabilities to GDPand the M-4 concentration ratio. Liquid liabilities to GDP is an indicator of the depth of thefinancial system. China by far exceeds India in this respect (Figure 6). The M-4 concentrationratio is the sum of the market shares of the four largest banks in the market. Due to the largerinstitutional diversity in the Indian banking sector in the pre-reform period, the concentrationof the banking sector is significantly lower compared to China, which should result in more

intense competition that benefits banks' customers (Figure 7).Thus, it can be concluded that on a sectoral level the Indian banking sector outperforms theChinese with the exception of the cost-income ratio. The relatively weak performance of theChinese banking sector as measured for example by the equity share or NPLs is exacerbatedby the great importance of the Chinese banking sector for the overall economy as indicated bythe high ratio of liquid liabilities to GDP.Possible factors that may explain the better performance of the Indian banking sector are anearlier start of reforms, a less difficult institutional legacy since India had no mono-bankingsystem, and a lower concentration, which may lead to a higher degree of competition.

-20-The comparison of the reform experiences has shown that India and China have largely followed

the same reform path, with India being ahead in most reform areas. This has also led to anoverallbetter performance of the Indian banking sector. Looking at the reforms, it appears that bothcountries followed the general policy recommendations where they found little opposition frominterest groups such as the lowering of reserve requirements or the introduction of capitaladequacy standards, while reforms in areas that could likely affected larger constituencies suchasprivatization, credible stabilization or directed credit where not implemented as suggested by thegeneral policy recommendations. Possible reasons for these outcomes are discussed in the nextsection.

6 DISCUSSION OF REFORM RESULTSThe political-economy factors discussed in section 3 are now used to interpret and explain the

experiences of India and China with banking sector reforms. In both countries the reformoutcomeshave been influenced by the interaction of fiscal constraints, the performance in the enterprisesector and the influence of interest groups.Contrary to expectations the relatively weak fiscal situation in both countries appears to have hadno major influence on the reform process: despite the relatively high debt levels in bothcountries,privatization of state-owned banks has not proceeded far, while statutory pre-emptions as well as


14/21

interest rate restrictions have been lowered more than expected.51 In these areas interest groupsappear to have played a more influential role. The same is true for stabilization of banks. Theinability to pursue a "once-and-for-all" stabilization program appears to have been influencedmoreby the lack of political will to do so than by the budgetary situation. 52The pace of reform in the enterprise sector appears to have had some influence on the reformprocess in the banking sector, especially due to the linkage between state-owned banks andstateownedenterprises. In both countries, banks were and to some extent still are burdened bylegacy NPLs from SOEs. Since it was politically not feasible to directly introduce hard budgetconstraints in the enterprise sector at the start of the reforms due to the likelihood of large job51 India has annual budget deficits of around 10% of GDP and government debt of around 80% of GDP. China has arelatively moderate official deficit and debt levels of 3-4% of GDP and about 40% of GDP respectively. However,China has relatively high contingent liabilities from the bad loans that are accumulated in the banking sector, whichare estimated to stand at 30% of GDP. See Mukherji (2005), p. 64f.; The Economist (2004), p. 18f.52 As discussed above, India's bank recapitalization program in the 1990s for example amounted to a relativelymodest2% of GDP; China appears to have sufficient foreign currency reserves to pay for a recapitalization.

-23-losses, banks had to extend further loans to non-viable SOEs, which in turn adversely affectedthequality of banks' loan portfolios.53 Since the respective governments were not prepared to letlargeSOEs and SOBs go bankrupt, credible stabilization of banks was not possible, and privatizationdifficult at best since banks did not fully operate according to commercial principles.While the fiscal situation has not had the expected effect in shaping reform outcomes, interestgroups had a major influence. Especially in India, there has been strong opposition by interestgroups against privatization of SOBs and the reduction of directed credit; a situation that hasbeenexacerbated by relatively weak coalition governments that are particularly vulnerable to a loss ofvoters' support. An important interest group against the opening of the banking sector to newcompetitors in both India and China were the ailing SOBs themselves, which at least at thebeginning of the reform process were not in a position to compete with best-practice players.These factors are more likely to have slowed down the reform process than a "war of attrition"between different interest groups, or uncertainty about the distribution of gains and losses frombanking sector reforms.A surprising feature of the banking sector reforms in both countries is the similarity of the reformprocess despite a different political, economic and institutional situation in both countries. This isespecially striking in terms of the political system since the general assumption is that China as aone-party authoritarian system is in a position to pursue faster reforms than the Indian multi-party

democracy. The comparison of the reforms in the banking sector and the faster reform pace inIndia provide some evidence that the political system has less importance on the reform processand outcome than commonly assumed.54

7 CONCLUSIONThe goal of this paper was to evaluate the recent banking sector reforms in India and China alongthe lines of transformation studies and to discuss political-economy factors that have shapedreform outcomes. The analysis showed that the reforms in both countries have proceeded quitefar


15/21

and that many of the general policy recommendations have been followed. There were howeverimportant deviations in areas such as stabilization, directed credit and privatization. A likelyreason53 The distribution of bank loans in China shows that this pattern continues: private enterprises received only 27%ofbank loans in 2003, but accounted for 52% of GDP. See McKinsey Global Institute (2006), p. 11.

54 As reported by Saez and Yang (2001) this not only appears to be the case in the banking sector, but also in theelectricity and telecommunications sector. See Saez and Yang (2001), p. 90.

-24-is higher pressure from interest groups in these areas, and the close connections between theailingSOEs and state-owned banks. In terms of performance, the Indian banking sector is on mostindicators ahead of the Chinese banking sector.Several implications for policy makers arise from the reform experiences in India and China.First,banking sector reforms are closely intertwined with the real sector of an economy. Therefore,hardbudgetconstraints in the enterprise sector are an important pre-condition for further reforms in the

banking sector in India and China. Second, interest groups can have a profound influence on thereform process especially in "visible" areas such as privatization and directed credit. Thus goingforward it is necessary to either incorporate the concerns of diverse stakeholder groups in thereform strategies, or to design compensation mechanisms for potential reform losers to ensuretheirbuy in. The dual-track approach for price liberalization in China for example is a mechanism thatcould also be applied in the banking sector. Third, the political system of a country is likely lessimportant for successful reforms than the management of interest groups.There are two areas that warrant further research. First, political-economy factors have only beendiscussed qualitatively in this paper. An econometric analysis would help to yield further insightsinto which factors have a significant influence on the reform process. Second, the timing of the

banking sector reforms showed that most reforms started in the mid-1990s after the growthacceleration in the two countries. The relationship between banking sector reforms and economicgrowth in the two countries is therefore a topic that deserves further investigation.

REFERENCESAbiad, Abdul/ Mody, Ashoka (2002): Status QuoBias in Financial Reform, in: IMF Working Paper, pp.1-38.Ahluwalia, Montek S. (2002): Economic reforms inIndia since 1991: Has Gradualism worked?, in:Journal of Economic Perspectives, 16 (3), pp. 67-88.Alesina, Alberto/ Drazen, Allan (1991): Why areStabilizations Delayed?, in: The American EconomicReview, 81 (5), pp. 1170-1188.

Arun, T.G./ Turner, J.D. (2002a): Financialliberalisation in India, in: Journal of InternationalBanking Regulation, 4 (2), pp. 183-188.Arun, T.G./ Turner, J.D. (2002b): Financial SectorReforms in Developing Countries: The IndianExperience, in: World Economy, 25 (3), pp. 429-445.Balcerowicz, Leszek/ Gelb, Alan (1994):Macropolicies in Transition to a Market Economy: AThree-Year Perspective, in: Bruno, Michael/Pleskovic, Boris (ed.), Paper prepared for the Annual


16/21

World Bank Conference on Development Economics1994, Washington D.C., pp. 21-44.BankScope (2006): Accessed: July 2006.Bhide, M. G./ Prasad, A./ Ghosh, Saibal (2001):Emerging Challenges in Indian Banking, in: WorkingPaper Stanford University, No. 103, pp. 1-61.

Comparative Analysis of India and Chinas Banking SystemPage 1 of 3

KEY STATISTICS 1US$ in bnParticulars India ChinaDeposits 326 2,661Loans 183 2,050Savings/ GDP ratio 88% 57%

PERFORMANCE INDICATORS 2IndiaAll figures in % for the year 2001Particulars Nationalised banks State Bank of IndiaGroupTotal privatesector banks

Net interest income as a % of total assets 2 .90 2 .76 2 .33Return on assets 0 .33 0 .55 0 .71Return on stockholders equity 6 .36 1 2.74 13.41Total assets/ total stockholders equity (leverage) 1 9.28 2 3.16 18.41Capital adequacy ratio 1 0.98 1 2.43 12.36Gross NPLs/ Gross advances (Official estimates) 1 2.19 1 2.73 8 .48Allowances/ Total assets 2 .50 2 .77 1 .44ChinaAll figures in % for the year 2000Particulars Wholly ownedcommercial banksOther commercialbanks

Net interest income/ average assets 1.80 2.20Return on average assets 0 .20 0 .60Return on average equity 3 .10 1 1.30Equity/ Total assets 5 .30 5 .30

NPLs/ Total loan portfolioLoan loss reserves/ Loans 1 .00 1 .40~ 19%

REFORM PROCESS IN THE BANKING SYSTEMIndiaIn 1991, the Indian economy went through a process of economic liberalization. Recognizing that thesuccess of economic reforms was contingent on the success of financial sector reform as well, thegovernment initiated a fundamental banking sector reform package in 1992. The banking reform

package was based on the recommendations proposed by the Narsimhan Committee Report (1992)that advocated a move to a more market oriented banking system, which would operate in anenvironment of prudential regulation and transparent accounting. One of the primary motives behindthis drive was to introduce an element of market discipline into the regulatory process that wouldreinforce the supervisory effort of the Reserve Bank of India (RBI). This was particularly critical

since market discipline, especially in the financial liberalization phase, reinforces regulatory andsupervisory efforts and provides a strong incentive to banks to conduct their business in a prudent andefficient manner and to maintain adequate capital as a cushion against risk exposures.1 Source: Presentation by Liu Mingkang, Chairman, China Banking Regulatory Commission dated May 14, 20042 Sources: Reserve Bank of India, Report titled Indian Banking Sector Reform and Liberalisation: Pain or Panacea? by

Niranjan Chipalkatti and Meenakshi Rishi, Study titled Banking Sector Reforms in the Peoples Republic of China Progress and Constraints

Comparative Analysis of India and Chinas Banking SystemPage 2 of 3

From a central banks perspective, such high-quality disclosures help the early detection of problembanks by the market and reduce the severity of market disruptions. Consequently, the RBI as part and


17/21

parcel of the financial sector deregulation, attempted to enhance the transparency of the annual reportsof Indian banks by, among other things, introducing stricter income recognition and assetclassification rules, enhancing the capital adequacy norms, and by requiring a number of additionaldisclosures sought by investors to make better cash flow and risk assessments.ChinaThe Chinese government has embarked on a series of financial reform programmes since 1979. The

programmes initially focused on institutional reforms to the banking system in the 1980s, especiallythe establishment of a two-tier banking system that comprised primarily a central bank and fourspecialized banks that are owned fully by the central government. Once the two-tier banking systemwas formed, the government launched the second wave of financial reforms, consisting of two major

parts: further institutional-building and the management of NPLs. Institutional-building focused onthe commercialization of specialized banks and a separation between policy and commercial lendingactivities.Other reform measures include an attempt to reduce local government intervention, the removal ofcredit allocation, a narrowing of the scope of business, interest rate and entry deregulation (albeit to alimited extent), and a gradual tightening of accounting and prudential regulations. Measures toimprove management of NPLs include the recapitalization of wholly state-owned commercial banks(WSCBs), the disposal of NPLs held by WSCBs, and the merger and closure of problematic banks,the transformation of urban credit cooperatives into city banks, and the promotion of debt-equityswaps.STATE OF THE BANKING SYSTEM AFTER REFORMIndiaThe functioning of the markets disciplining mechanism and also the effectiveness of the supervisory

process is hindered by weak accounting and legal systems, and inadequate transparency of accountingdisclosures. The law makers are still to provide banks with a powerful law to deal effectively with the

problem of willful defaulters. However, attempts are being made with the current budget seeking tomake changes to the Securitization Act.ChinaThe banking sector has remained dominated by the four wholly-owned state commercial banks(WSCB) in the reform period since 1994. Competition has emerged, but only at the lower end.Further, the impact of the financial reforms has not had a noticeable impact so far on the performanceof WSCBs. Their profitability and cost-efficiency have deteriorated while the level of non-performingloans is still alarmingly high.Perhaps the greatest risk to the Chinese economy is the state of the financial system. For many years,state-owned banks have been lending money to loss-making state-owned companies. Rather than lendon the basis of creditworthiness, banks have yielded to political pressure and extended credit to theleast creditworthy in order to keep them in business, especially the State-owned Enterprises (SOE).The result has been NPLs in the range of 21% to 40% of total loan portfolios at Chinas four majorstate-owned banks (depending on the source of information).Comparative Analysis of India and Chinas Banking System

Page 3 of 3

ASSET SECURITIZATION MARKETIndiaThe market for securitizing loans including NPLs is still in its nascent stage. The effort is currentlyled by ICICI Bank, State Bank of India and other commercial banks. Asset reconstruction companieslike Asset Reconstruction Company of India Limited (ARCIL) have purchased loan portfolios from

commercial banks. But the size of these deals is not comparable with those being undertaken by banksin China.ChinaIn 1999, four asset management companies (AMC) were established to transfer the non-performingassets from the banks. The AMCs planned to repackage the NPLs into viable assets and sell them offto the investors. A total of 1.4 trillion yuan (US$168 billion) worth of NPLs have been transferred intothe four AMCs, which are expected to dispose of these NPL portfolios by 2009. But the disposal ofthe bad assets has remained slow since then.In February 2001, Huarong Asset Management Corporation signed a contract for advice and trading


18/21

services with Ernst & Young with respect to the bidding process. In November 2001, Huarong thenannounced that it had agreed to sell NPLs with a book value of Y10.8 billion to an international

bidding team (consisting of seven overseas investors and domestic enterprises) headed by MorganStanley the first case of any of the four AMCs offering NPLs to international investors through the

public bidding system. In November 2001, further, Cinda Asset Management Company signed anagreement with Goldman Sachs on the establishment of a joint venture to dispose of bad assets. In the

same month, Great Wall Asset Management Company announced a plan to organize in December thelargest auction of NPLs, to be conducted in different places.China's four AMCs have sold 509.4 billion yuan (US$61.56 billion) of bad loans by the end of 2003,according to the China Banking Regulatory Commission. A consortium led by Morgan Stanley hasrecently purchased 2.85 billion yuan (US$344 million) of two NPL pools from the China ConstructionBank (CCB). In April 2004, Citigroup, agreed to buy 2 billion yuan (US$242 million) worth of NPLsfrom Great Wall Asset Management Corporation

Indian banksThe pendulum swings again

Chinas banking system is not a good model

for IndiaJun 9th 2011 | MUMBAI| from the print edition

DURING Indias long experiment with socialist economics after gaining independence in 1947,many big industrial houses managed to survive as recognisably private firms. Banking, though,got it in the neck. Major banks should be not only socially controlled, but publicly owned,Indira Gandhi, the then prime minister, announced on All India Radio in 1969. Nationalisationfollowed.


19/21

Today, after 20 years of liberalisation, state-run banks can sometimes look like they are interminal decline. Some branches are literally rotten, their concrete walls covered in slime andwindow bars rusted. Yet the reality is quite different. The state sector still controls three-quartersof deposits, and since the financial crisis its share has crept up (see chart).

In 2008 and 2009 foreign banks, burned by bad consumer loans and shaken by events elsewhere,withdrew credit. Some private Indian banks slammed the brakes on, too, including the largest,ICICI, which faced rumours of insolvencyscurrilous, as it turned out, but gleefully repeated byat least one state-bank boss at the time. The public banks, meanwhile, and in particular StateBank of India (SBI), which has a fifth of the market, had an influx of deposits and undertook alending splurge. SBIs balance-sheet doubled between March 2007 and March 2011.

SBI insists that its expansion did not reflect a Chinese-style, government-directed effort to offset

the global slump. Yet although they remain tiny compared with Chinese giants like ICBC andChina Construction Bank, there is often more than a whiff of Beijing about the Indian statelenders. Their loan books are skewed towards more socially worthy projects; their bosses pay ismodest; and they have a hybrid status as firms that are listed but have the state as a majorityshareholder.

The crisis led to a reddening of attitudes across the industry. The requirement that banks musthold up to about a quarter of their deposits in government bonds was no longer denounced as aracket to help fund the budget deficit but instead hailed as an enlightened form of liquiditymanagement. The Reserve Bank of India (RBI), the central bank which regulates banking as wellas setting interest rates, made clear its view that Indias approach was superior to the discreditedWestern models that it had long been told to adopt. It seemed as if Indias state-dominated

system might not be a staging-post towards full liberalisation but instead the end destination.

Yet recently things have shifted again. In May SBIs new chairman announced dire results, withlower lending margins, provisions for pensions and extra charges taken against its loans. The hit,including forfeited profits, was some $2.5 billion, equivalent to over a tenth of the banks equity.Since its capital ratios are too low to support fast growth, SBI needs to raise more equity. Thatmeans persuading the government, which does not want its 59% stake diluted, to stump up: notan easy task.


20/21

With rates rising and the economy slowing, some fear more bad debts could emerge at the statebanks that lent freely during the downturn. Meanwhile the private banks seem perkier, with theirshare of loans beginning to rise. ICICIs chief executive, Chanda Kochhar, says that after twoyears of building more branches to suck in sticky deposits, the bank is in a happy situation andready to start increasing credit again. Aditya Puri, the boss of HDFC Bank, which remains thedarling of investors thanks to its metronomic performance, plans to keep expanding quickly, too.Other financial firms with banking licences, such as Kotak Mahindra, have been shifting towardsthe lending business and away from capital markets where profitability has fallen, partly thanksto a rush of foreign investment banks into India.

Two reforms being flirted with by the RBI could make things more competitive. The first wouldoffer foreign banks a deal by which they create proper subsidiaries in India (which should beeasier to regulate) and direct more lending to priority areas such as agriculture. In return theywill be allowed more branches. One foreign-bank boss reckons that India, much like China, willnever allow foreign firms more than a 10% market share, but that would still be almost doublecurrent levels. Another is more optimistic, saying that the RBIs stance is a huge step.

The RBI is also considering granting new banking licences to Indian-owned firms. There is some

scepticism about the process. One Mumbai financial bigwig jokes that two licences will begrantedone, by the RBI, on the basis of competence, and the other by politicians in Delhi onthe basis of bribe size. Still, the result should be an increase in the number of banks. India couldend up allowing industrial conglomerates to own banks. That would put it at odds with mostcountries, where mixing business and banking is considered toxic, but would mean new entrantswith financial muscle (although the butchest conglomerate of them all, Reliance Industries, saidon June 3rd that it would not seek a licence).

Over the next year private banks will almost certainly win back market share. Farther out, theBeijing model of banking is in any case probably beyond the capacity of the cash-strappedIndian state. Loans are only about a third of Indias GDP compared with over 100% in China.The private sector will be needed to provide the capital to support more credit. Nor can India seal

off its financial system to the same extent as China. Its businesses are internationalising faster,and its persistent current-account deficit and bad infrastructure mean it badly needs foreigninvestment.

As a matter of both preference and necessity, then, Indians banking system will become morelinked with the world. Its resilience during the crisis partly reflected its competence, but also itsinsularity and underdevelopment. But if Indias economy is to rival Chinas by size, its financialsector needs to become less, not more, like the Middle Kingdoms.

from the print edition | Finance and Economics

2009

Top of Form

Home Archive

Contact

Log in

Search

>
http://www.igatepatni.com/blogs/http://www.igatepatni.com/blogs/archive.aspxhttp://www.igatepatni.com/blogs/contact.aspxhttp://www.igatepatni.com/blogs/login.aspxhttp://www.igatepatni.com/blogs/post/emerging-cloud-frameworks.aspxhttp://www.igatepatni.com/blogs/post/SaaS-versus-iTOPS.aspxhttp://www.igatepatni.com/blogs/archive.aspxhttp://www.igatepatni.com/blogs/contact.aspxhttp://www.igatepatni.com/blogs/login.aspxhttp://www.igatepatni.com/blogs/post/emerging-cloud-frameworks.aspxhttp://www.igatepatni.com/blogs/post/SaaS-versus-iTOPS.aspxhttp://www.igatepatni.com/blogs/


21/21

Home > Banking, Financial Services

Who has a better Banking system India or China?7. October 2009

Comments (0)

China celebrating its 60th anniversary of communist rule, with its booming economy staking itsclaim to be the largest economy by 2025 is also having one of the largest Banking sector in theworld. Compared to China, India a front runner in economic growth for the last decade is laggingfar behind the mighty neighbor on size and scale of its Banking. Let us have a comparison ofBanking system of the both the countries to have an understanding on the depth of this gap andquality of the system between these two emerging giants.

Industrial and Commercial Bank of China Ltd. (ICBC) is Chinas largest bank and the largestbank in the world by market capitalization. ICBC is also the largest bank in the world in terms ofmarket value, deposit size and is also the most profitable Bank in the world. It is one of Chinas

Big Four state-owned commercial banks (the other three being the Bank of China, AgriculturalBank of China and China Construction Bank.

As of 2009, it had assets of US$1.6 trillion compared to which State Bank of India, largest Bankin India has a asset size of US$ 200 billion. In terms of size State Bank of India stands at 93rd.Top four Banks in China which hold the top slots among Asian banks have Tier 1 capital of US$95 billion which is 3 times of the entire Indian Banking industry. Similarly there asset size is 3times of the entire Indian Banking industry.

Even though Indian banks are beaten on size on quality parameters they are far ahead of theChinese counterparts. In Return of Assets (ROA) a parameter which denotes efficiency IndianBanks ranges between, .90% to 1.50% on par or better than global standards, while top rankingChine banks ROA is ranging between .05 to .90%.

Another indicator of banking industries health and efficiency is its level of Non PerformingLoans (NPL), the ratio of Non Performing Loans to total Assets. Here also Indian Banks are farahead of Chinese banks and is thriving to meet the NPL levels of Developed countries. Theofficial data on Chinas banks on NPA levels are not reliable, but most independent analystsbelieve that the banks there have a staggering bad loan problem. The estimates vary, rangingfrom 30 to 50 per cent of total loans. So, even if we go by the lower estimate, a third of all themoney lent out by Chinas banks has been frittered away which compared to India Banks netNPL levels of 4 to 4.5%.

So it would be good to modify the terms of the popular comparison between the financialsystems of India and China. India has the stronger system while China has the bigger one. Thiswill definitely change in the years ahead. Indias savings rate has started climbing. It touched an

all-time high of 28.1 per cent last year. That will automatically mean more money flowing intothe banking system and China too will close the efficiency lead that India has over it.
http://www.igatepatni.com/blogs/http://www.igatepatni.com/blogs/category/Banking.aspxhttp://www.igatepatni.com/blogs/category/Financial-Services.aspxhttp://www.igatepatni.com/blogs/post/Who-has-a-better-Banking-system-India-or-China.aspxhttp://www.igatepatni.com/blogs/http://www.igatepatni.com/blogs/category/Banking.aspxhttp://www.igatepatni.com/blogs/category/Financial-Services.aspxhttp://www.igatepatni.com/blogs/post/Who-has-a-better-Banking-system-India-or-China.aspx

Documents

Banking Sector Reforms in India and China