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Banking Reform in India∗ - page 3 / 57

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that could earn large profits if they were given access to credit at the current market prices.

This paper builds on the previous work with the aim of using that evidence and evidence from other research by ourselves and others, to come to an assessment of the appropriate role of the Indian government vis a vis the banking sector. We first provide a very brief history of banking in India.

Section 3 investigate the quality of intermediation. We begin by presenting evidence that there is substantial under-lending in India. To understand what role public ownership of banks may play in underlending, we identify differences between public and private banks in the sectoral allocation of credit between public and private banks. In particular, we focus on the question of whether being nationalized has made these banks more responsive to what the Indian government wants them to do. We report results, based on work by Cole showing that on many of the declared objectives of “social banking,” the private banks were no less responsive than the comparable nationalized banks, with the exception of agricultural lending.7 Finally, the last sub-section compares the performance of public and private banks as financial intermediaries and concludes that the public banks have been less aggressive than private banks both in lending, in attracting deposits and in setting up branches, at least since 1990.

In section 4, we dig deeper into the lending processes used by the nationalized banks, in an attempt to understand under-lending. We find that official lending policy is very rigid. Moreover, loan officers do not appear to use what little flexibility they have. We argue that the evidence suggests that bankers in the public sector have a preference for what we may call passive lending. To understand why this is the case, we examine the incentives and constraints faced by public loan officers. We focus on whether vigilance activity impedes lending, and whether public sector banks prefer to lend to the government, rather than private firms.

The penultimate section compares the performance of public and private banking in two other areas. First, we examine how nationalization of banks has affected the availability of bank branches in rural areas, and find that, if anything, nationalization appears to have inhibited the growth of rural branches. Second, we try to say something about the sensitive issue of NPAs and bailouts. While the dataset we have now is rather sparse, it appears that the bailouts of the

public banks have proved more expensive for the government, but once we control for differences 7 Cole (2004).

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