The number of banks in the Indian banking sector, specially the small banks, has been dwindling sharply during the last few decades. According to a study of the Evolution of Banking in India, which forms a part of the Report on Currency and Finance 2006-08 of the Reserve Bank of India, there were 1258 banks in India in 1930, registered under the Indian Companies Act 1913.

During the next three decades, by 1961, the number of scheduled banks came down to 67 and that of non-scheduled banks to 209, taking the total number of banks to 276. In the 1960s, there were numerous mergers of small banks, both voluntarily and under the direction of Reserve Bank of India. Between 1975 and 1987, as many as 196 regional rural banks were brought into the banking arena. Their number was reduced to 88 through a process of mergers introduced in 2005. As a part of the process of liberalisation and privatisation, a new breed of banks was promoted in the 1990s. Though nine banks made their appearance with a bang, three of them bowed-out after short stints.

Public sector banks also witnessed the disappearance of one among them, New Bank of India, which merged with Punjab National Bank. The inorganic growth path adopted by a few of the new generation banks has resulted in the merger of a couple of private sector banks of the old generation. As a result, the number of old generation banks in the private sector has come down to 14. Ten of them originating from the southern states have proved their durability, having been in existence for many decades, one of them being a centenarian. Four of the surviving banks in the north are in Jammu and Kashmir, Uttarakhand, Rajasthan and Maharashtra. How long will these small banks remain beautiful? This is a million dollar question.

Declining numbers

Both at home and abroad, the number of banks is declining during the last few years, for various reasons. At the global level, even the mighty banks having multinational presence are crumbling due to the financial meltdown. One omni-present bank, that allegedly ‘never sleeps,’ has its top executives now spending sleepless nights , awaiting bail-out programmes. Twenty-five banks have gone into liquidation in the United States.

Though the Indian banking sector is relatively insulated from the damages of sub-prime lending, it is witnessing a period of stresses and strains. The Reserve Bank of India is directing the banks to accelerate their lending to strategic sectors like housing and also to boost auto loans. Lending at lower interest rates is likely to affect their bottom-line during the current year. Smaller banks may face hardships in retaining the levels of their total revenue. Would there be a reduction in the number of small banks, resulting from the strategic move of any of the new generation banks acquiring one or two smaller banks, as HDFC Bank has done recently?

Size and efficiency

In the emerging liberalised banking environment, the survival of the fittest would be the order of the day. Against this background, the size and efficiency of the smaller banks may be assessed on the basis of a few efficiency ratios. Size and efficiency in the Indian banking system do not appear to be necessarily co-related. While small remains beautiful in some cases, size also influences the efficiency of some banks. Despite being in existence for a long period, most banks remain small in size compared to their counterparts in the public sector of similar age. On the efficiency plane, some of the smaller banks have shown that they are not less efficient, when measured in terms of the commonly accepted financial ratios.

Size could be measured broadly in terms of financial resources mobilised and handled; human resources developed and nurtured; and infrastructure facilities created and expanded. The total deposits mobilised and the credit outstanding, considered as the total business, is the commonly used indicator of the size of a bank. Comparison of efficiency is made through the ratio of total business to total staff, as a very simple indicator. The size of the branch network as well as the number of service points like ATMs in operation are other indicators.

Efficiency is analysed by working out the financial ratios like the return on assets, the cost of funds and the net interest margin. The volume of business per branch, profit earned per staff, and the number of customers serviced per branch are indicators of efficiency.

Quantitative and qualitative comparisons could be made subject to the ready availability of the relevant data. Banks are ranked on the basis of total business handled by them during FY2008 in Table 1.

The bank having the largest volume of business is not the one having the highest business per employee or highest profit per employee. Some private sector banks of the old generation, though small in size, have productivity ratios comparable with the bigger public sector banks. The per employee profits for Karur Vysya Bank Ltd, Tamilnad Mercantile Bank Ltd and Federal Bank Ltd for example, are higher than all nationalised banks, whose average profit per employee is only Rs.3.77 lakh.

Centenarian small bank, City Union Bank Ltd, has a profit ratio higher than that of another centenarian, but much bigger, public sector bank, Canara Bank. Two of the smaller banks, Lakshmi Vilas Bank Ltd and Catholic Syrian Bank Ltd, have the lowest profit per employee. The average figure of private sector banks is higher than that of the nationalised banks, because of the inclusion of the data relating to the new generation private sector banks.

Resource mobilisation

Cost of funds and the yield on advances have a direct impact on the financial results of banks. In the past, most of these banks were making concerted efforts to reduce their cost of funds by canvassing more of savings bank accounts, targeting the salary earners and middle income groups. They were entertaining small savings bank accounts very efficiently. Through this process, they were having a large number of such accounts. In order to attract small savers from different occupational groups, banks were observing special weeks, where the professionals from each group would be approached for opening their savings bank accounts.

This was a successful experiment in the case of many south-based banks. Even in small towns, they were able to gather deposits of a cross-section of the society through savings bank accounts. Only after the introduction of financial sector reforms, the bankers became status-conscious, and began to discourage the small savers in blind imitation of the foreign banks. Entry-level minimum deposit was raised gradually, to keep out the small savers.

The cost-conscious banker now finds that the cost of funds would be lower for those banks, which have a higher component of savings bank deposits. The interest paid to the savings bank depositors is a paltry 3.5 per cent. With computerisation of banking operations, it should be possible for these banks to handle large number of savings accounts, if proper spadework is made to canvass such accounts. The new generation banks in the private sector are more adaptive in their marketing strategies aimed at wooing the small savers.

Smaller banks do not appear to have an edge over bigger banks in the cost of funds they mobilise. Their cost of funds is higher than that of the nationalised banks, with a few exceptions. The smallest bank, having the lowest volume of deposits has the lowest cost of funds.

Health of financial assets

Concerted efforts have been made by all the banks in the recent years to peg down non-performing assets (NPA) ratio. While all public sector banks have been able to bring it down to less than one per cent, two of the private sector banks operate with net NPA ratios above one per cent: Lakshmi Vilas Bank Ltd at 1.55 per cent, and Catholic Syrian Bank Ltd at 1.61 per cent.

Karur Vysya Bank Ltd has a better record of performance of having the lowest NPA ratio of 0.18 per cent. It is closely followed by Federal Bank Ltd at 0.23 per cent. It is not readily ascertainable as to how far these banks have availed the services of the Assets Reconstruction Corporations for controlling the volume of NPAs. Successful management of NPA ratio looks to be size-neutral.

Return on assets (ROA) ratio is a commonly used measure of the efficiency of assets utilisation. Six private sector banks have this ratio above one per cent. A small bank among them, Dhanalakshmi Bank Ltd, has its ROA as low as 0.76 per cent. It may be noted that it is equally low at 0.75 per cent for Vijaya Bank, a medium size public sector bank. Similarly, if the highest ratio for public sector bank is 1.64 per cent, (Indian Bank), for the private sector bank also the highest is 1.63 per cent (Karur Vysya Bank Ltd). While these ratios are scattered within a narrow range, no conclusion can be drawn about the comparative efficiency of small versus big banks or between public and private sector banks.

The data relating to ROA, corrected for the cost of funds, also do not enable one to draw definite conclusions on the relationship between the size of the bank and the efficiency of credit management. For the public sector banks, the range is from 2.83 per cent to 4.71 per cent and for the private sector banks, it is from 3.30 to 5.15 per cent. Two private sector banks have ROA above 5.0 per cent. The range within which the ROA ratios are scattered is wider compared to the range of variations in return on assets.

It may be noted that correlation between efficiency and size of banks cannot be judged on the basis of the data pertaining to a single year. It has to be necessarily based on time series data and a much deeper analysis of various parameters has to be made.

However, the simple inference that could be drawn from the above analysis is that size and ownership alone cannot determine the efficiency of the banks studied. Their efficiency ratios vary within a narrow range, indicating the absence of significant differences in their operating efficiencies. Smaller banks per se are not less efficient than the bigger banks.

Though relatively smaller size of the capital and reserves is a common factor among these banks, they are complying with the stipulations relating to the capital adequacy ratio (CAR). This can be observed from Table 2, where the banks are listed according to their net profit in FY2008.

Nine banks out of 14 could earn a net profit above Rs.100 crore and the smallest four have their bottom lines below Rs.30 crore. Banks earning higher incomes invariably have larger capital base, a major exception being that of Ratnakar Bank Ltd.
Dhanalakshmi Bank is the only bank having CAR below 10 per cent as on March 2008, though it is well above the minimum stipulated level of 9 per cent. It has subsequently raised this ratio to 15.56 per cent as on 30 September, 2008 by increasing the paid up capital from Rs.32.06 crore to Rs.64.12 crore during the first half of the financial year. Except Bank of Rajasthan, all banks have ensured to reward their shareholders with reasonable rates of dividend. Jammu and Kashmir Bank Ltd stands first followed by Karur Vysya Bank Ltd during FY2008.

Capital participation from non-resident investors

A review of the shareholding pattern of these banks reveals that barring two banks, Karnataka Bank Ltd and Nainital Bank Ltd, all other banks have capital participation by non-resident investors. Nainital Bank is a wholly-owned subsidiary of Bank of Baroda. In the case of Jammu and Kashmir Bank Ltd, about 55 per cent of the capital is owned by the state government and its exposure to foreign investors is 34 per cent.

ING Vysya Bank Ltd has the highest exposure to foreign investors. Resident corporate investment in Bank of Rajasthan Ltd is to the extent of 65 per cent. Non-resident financial investors have a fairly large share in Federal Bank Ltd at 53 per cent followed by South Indian Bank Ltd at 46 per cent.

From available information, Life Insurance Corporation of India emerges as one of the financial institutions having minor shareholdings in a number of banks. While it has a major stake in the capital of one of the public sector banks, Corporation Bank, it has minor interest in the yogakshema of four private sector banks: City Union Bank (4.69 per cent); Bank of Rajasthan (2.03 per cent); Lakshmi Vilas Bank (2.01 per cent); and South Indian Bank (1.77 per cent).

A review of the shareholding pattern of all the 14 banks reveals that a few of them own a small percentage of the shares of other banks. Federal Bank holds 4.99 per cent of the shares in both South Indian Bank and Lakshmi Vilas Bank. Karur Vysya Bank's share in the paid up capital of Lakshmi Vilas Bank is 1.69 per cent while Indian Bank has a 3.80 per cent stake in this bank. Canara Bank's shareholding in City Union Bank is 1.48 per cent as on 30 September, 2008.

To what extent the foreign capital participation is beneficial to the local banks cannot be easily comprehended. For complying with Basel II requirements, all banks have to raise their capital base within a prescribed time frame. The reliance on non-resident capital participation may increase, if the banks are unable to raise the required capital from the domestic investors. It would be desirable to seek larger participation from the domestic investors. Bank employees, one of the important stakeholders, have to consider the need for subscribing to the capital of the banks, which they serve. Though bank shares are not likely to become the darlings of the stock market, reasonable appreciation in these shares should not be difficult.

According to the time-frame prescribed by the Reserve Bank of India for the smaller banks to migrate to the Basel II norms is from March 2009. This would be a very challenging task as conceded by the Reserve Bank of India in its chapter on Perspectives in the Report on Trend and Progress of Banking in India: 2007-08.

RBI has observed, “The full implementation of the Basel II accord, even under the basic/ standardised approaches, would remain a major challenge for some time to come, for both the banks and the Reserve Bank, as the banking supervisor. At the banks’ level, the implementation would require, inter alia, upgradation of the bank-wide information system through better branch-connectivity, which would entail cost and may also raise some IT-security issues. The implementation of Basel II also raises several issues relating to development of human resource skills and database management. The banks which require higher amount of capital under the Basel II framework would also need to explore various capital raising options.”

(to be continued in the March 2009 issue of Industrial Economist)