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Banking Reform in India∗ - page 6 / 57





6 / 57

commencement of financial reforms. While we believe both of these types of banks deserve study, our focus here is on the older private sector, and nationalized banks, since they represent the overwhelming majority of banking activity in India.

The Indian banking sector has historically suffered from high intermediation costs, due in no small part to the staffing at public sector banks: as of March 2002, there were 1.17 crores of deposits per employee in nationalized banks, compared to 2.05 crores per employee in private sector banks. As with other government-run enterprises, corruption is a problem for public sector banks: in 1999, there were 1,916 cases which attracted attention from the Central Vigilance Commission. While not all of these represent crimes, the investigations themselves may have a harmful effect, if bank officers fear that approving any risky loan will inevitably lead to scrutiny. Advocates for privatization also criticize public sector banking as unresponsive to credit needs.

In the rest of the paper, we use recent evidence on banking in India to shed light on the relative costs and benefits of nationalized banks. Throughout this exercise, it is important to bear in mind that the Indian banking sector is going through something like a transformation. Thus, it is potentially a dangerous time to evaluate its performance using historical data. Nevertheless, data from the past is all we have, and we believe things are not changing so quickly that the lessons learned are not useful.


Quality of Intermediation

    • 3.1

      Is there under-lending?

      • 3.1.1

        Identifying under-lending

A firm is getting too little credit if the marginal product of capital in the firm is higher than the rate of interest the firm is paying on its marginal rupee of borrowing. Under-lending therefore is a characteristic of the entire financial system: the firm has not been able to raise enough capital from the market as a whole. In other words, while we will focus on the clients of a public sector bank, if these firms are getting too little credit from that bank, they should in theory have the option of going elsewhere for more credit. If they do not or cannot exercise this option, the market cannot be doing what, in its idealized form, we would have expected it to do.

However, we know that the Indian financial system does not function as the ideal credit


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