RBI is wrong, our banks are efficient

Recently, the RBI Deputy Governor K. C. Chakraborty lamented that banks were not passing on the benefit of lowered policy rates to customers.

He attributed this to the operational inefficiency of banks in general, and called upon banks to improve their performance.

It’s worth looking at whether Indian banks are indeed inefficient. Operational efficiency can be seen in various ways. For a customer, it would mean prompt and hassle-free services at minimum cost, and quick redressal of grievances. For a borrower, lower turnaround time, cheaper interest rates and swiftness in extending non-fund-based facilities would matter. For the regulator, the interest margin that banks enjoy is an indicator of operating efficiency. The issue of operational efficiency can be examined from each of these perspectives — but what is RBI’s stand on banks’ performance?

NIM and service charge

The central bank is concerned that banks in India enjoy higher interest margins than their peers in the Western world. From a cross-country perspective, the NIMs enjoyed by Indian banks are higher than the levels in US and China, but lower than in Brazil and Russia.

The banks’ contention in this context is that lower NIMs are compensated by higher non-interest income. In fact, banks in the US and Brazil have a much higher ‘other operating income’ as a proportion of average assets, compared with India. In Russia, this ratio is comparable to that prevailing in India, and for Chinese banks it is much lower than that for Indian banks.

Banks in India argue that, in India, many banking services are provided free of cost, or at a minimal charge. Thus, higher NIMs help them to protect their bottomline. If in the overall analysis, banks were enjoying both higher margins and imposing a competitive service charge, their RoA, an indicator of overall profitability, would have been much higher than their peers in the developed world.

Indian banks are found to be just as profitable as those in US and China. Brazilian and Russian banks have a much higher profitability ratio. Hence, there is some merit in the banks’ argument.

The RBI is applying moral suasion to banks to pass on a part of their interest margin to the customers. The merit of such moral suasion has to be seen in the larger context in which banks do business. When the DG remarks that banks should improve operational efficiency, is he amenable to the idea that banks levy higher service charges to compensate for the reduction in interest margins?

Operating Efficiency

The regulator’s stance is that banks enjoy high net interest margins. The issue is whether high NIMs are reflective of operational inefficiency.

The Indian banking system consists of public sector banks (nationalised banks, or NBs and the SBI), new private banks (NPBs), old private banks (OPBs) and foreign banks. The NPBs consistently enjoy better NIM, compared with their nationalised peers. The SBI in the past two years has also enjoyed better NIMs.

What underlies the differing NIMs across bank groups? We find that for NPBs, it is the tilt towards the retail portfolio which has led to better margins.

For SBI, it is the high proportion of low-cost deposits which keeps their funding cost low. The NBs are a diversified lot with varying degrees of low-cost deposits and a higher tilt towards bulk business, which involves low margins. Higher NIMs, thus, are more on account of the composition of business than a reluctance to pass on a portion of NIM to customers in the form of lower interest rates.

Cost-to-Income Ratio

A standard indicator of operational efficiency is cost-to-income ratio obtained by dividing the operational expenses by the sum of net interest income and other income. Compared with banks in the US, Brazil and Russia, Indian banks have a much lower cost-to-income ratio. At a disaggregated level, we find that NPBs have consistently shown lower operating efficiency, compared with public sector banks.

Public sector banks have a better operating efficiency, because they pay their employees poorly, compared with their NPB peers. In the 1980s, a public sector bank job was one of the better-paying occupations in this country, attracting talent from other sectors. With the passage of time, compensation to PSB employees has turned out to be the least competitive.

The NPBs, in contrast, pay competitive salaries to attract the best talent, and have been able to grab a sizable proportion of the market share in a short period. Underlying the better operating efficiency of PSBs is a worrying trend of staff demoralisation on account of low pay, coupled with a competitive market.

Some initiatives to improve HR practices in NBs were mooted by the Khandelwal committee. The RBI should take the lead in persuading the banks to implement some of its proposals, in order to strike a balance between operating efficiency and profitability of NBs.

The RBI acknowledges in different forums that Indian banking has undergone a paradigm shift in terms of increased competition after the introduction of financial sector reforms in the early 1990s. The introduction of new generation private sector banks in the mid 1990s has contributed significantly to the unleashing of market forces in terms of pricing and product offering.

Yet, the DG’s observation suggests that banks in India, in general, are operationally inefficient. That seems like quite a sweeping statement.

(The author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)