How India’s banking model has changed

How India’s banking model has changed

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One of the top settled conclusions is that when any economy shows signs of trouble, the trick is to cut interest rates and to do it fast.

This is something that has been playing out in India over the last few years, particularly in the aftermath of covid-19, where the Reserve Bank of India (RBI) has driven down the interest rates in the financial system by cutting the repo rate, the cash reserve ratio (CRR) and by printing money, among other things.

Repo rate is the interest rate at which RBI lends to the banks. CRR is the portion of deposits that banks need to maintain with the RBI. When the CRR is cut, banks need to deposit less money with the RBI. Hence, the total amount of money which banks can lend goes up. This drives down interest rates.

Of course, one of the hopes behind all of these measures was that companies will borrow and expand, and in the process create more jobs. People who get these jobs will also earn and spend money. And all this will help in perking up economic growth.

The trouble is what sounds good in theory doesn’t always work out in practice. In the last few years, the lending by banks to corporates has been more or less flat, which basically means that net-net barely any new industrial lending has happened.

This stems from the fact that the profits made by corporates as a proportion of their total income has been falling over the years, giving them lesser incentive to borrow and expand.

Also, as we shall see, this trend has also changed the business model of Indian banks—from being banks which primarily lent money to industry, they are in the process of becoming retail banks. The difference between bank lending to industry and bank lending to retail is now down to a few basis points.

Overall lending to industry

Silent shift

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Silent shift

As can be seen from Chart 1, industrial lending by banks has remained flat for a while now. As of February 2021, the total bank lending to industry stood at 27.86 trillion. It was at 27.93 trillion as of February 2020. If we take a two-year period into account, as of February 2019, the bank lending to industry was a more-or-less-similar 27.74 trillion.

Over a period of 24 months, banks have increased their lending to industry by just 11,945 crore or 0.4%. During the same period, the interest rates on fresh rupee loans given by banks came down from 9.81% to 8.19%, a fall of 162 basis points. One basis point is one hundredth of a percentage.

Of course, one can attribute this lack of lending partly to the pandemic and the economic destruction that it has unleashed. Nevertheless, what is true over the last two years is also true over a period of the last five years. As of February 2016, the total bank lending to industry had stood at 27.45 trillion.

Over a period of 5 years, the net bank lending to industry has gone up by a minuscule 40,731 crore or just 1.5%. The interest rate on fresh rupee loans given out by banks during the same period has fallen from 10.54% to 8.19%, a fall of 235 basis points.

In fact, industrial lending has remained flat across different sizes of industry. If we look at large industries, which form a bulk of the industrial lending, the total lending as of February 2021 stood at 22.79 trillion. This isn’t very different from the overall lending to large industries of 22.55 trillion as of February 2016.

When it comes to lending to micro industries, the total lending as of February 2021 stood at 3.77 trillion, almost the same as the overall lending of 3.76 trillion as of February 2016. When it comes to medium industries, the overall lending has gone up from 1.14 trillion to 1.30 trillion over the last five years. Hence, when it comes to industrial lending, banks haven’t differentiated on industrial size.

What this data clearly tells us is that falling interest rates don’t necessarily lead to higher lending. There can be multiple reasons for it. First and foremost, corporates are not in the mood to borrow—simply because they don’t have enough confidence in the future purchasing power of the consumers whom they cater to. Or that the expansion they could carry out by borrowing will necessarily generate a decent rate of return that is higher than the cost of borrowing.

Corporate honchos keep talking about the RBI having to cut interest rates in order to encourage borrowing and investing. But then, that’s just talk.

The proof of the pudding is in the eating. Companies don’t necessarily have to always borrow in order to expand their operation of course. They can use profits which were made in earlier years and not distributed as dividends to do the same. A good proportion of this money is saved with banks in the form of deposits. And this is where the difference between the talk of corporate honchos and their revealed preference or what they are actually doing comes to the fore.

The total amount of deposits of private non-financial corporates with the banks has gone up by 48.2% between March 2016 and March 2020 to 15.79 trillion. There is no real reason for this to have changed during 2020-21. This tells us that, on the whole, corporates are happy to earn the rate of return offered by banks on deposits than invest that money in any expansion because they don’t have enough confidence in the future.

This stems from the fact that corporate profits as a percentage of total income has been coming down over the years. If we look at listed corporates, data from the Centre of Monitoring Indian Economy (CMIE) points out that the profit after tax as a percentage of total income peaked at 10.21% in 2007-08. It fell to 5.44% in 2015-16 and fell further to 2.88% in 2019-20. Profits in 2020-21 have been better but that is more on account of cost cutting than a sustainable increase in income.

CMIE also provides data for corporates as a whole (both listed and unlisted). As per this data, corporate profits as a percentage of total income peaked at 7.86% in 2007-08. They fell to 2.89% in 2015-16 and fell further to 2.61% in 2018-19. As of now, complete data for 2019-20 is not available.

From the data for 12,775 companies that is currently available, the corporate profits as a percentage of total income stood at 2.81%.

With such low rates of return, it is not surprising that the average Indian corporate isn’t interested in borrowing money and expanding. One reason for this lies in the fact that the debt of Indian corporates has expanded at a faster rate than their income, pushing up interest payments and pushing down profits in the process.

Reluctance to lend

As we know, interest rates on deposits have crashed over the last few years. Hence, the corporates are probably earning a very low rate of return on these deposits. But they seem to be happy even with that rather than reinvest this money in expanding the business.

Of course, there is no denying that a part of the problem might lie in the reluctance of the banks to advance new loans. Over the years, the banks, in particular public sector banks, have ended up accumulating a lot of bad loans, particularly on their lending to corporates. Bad loans are loans which haven’t been repaid for a period of 90 days or more.

The overall bad loans of banks peaked at 10.36 trillion as of March 2018. They have come down since then but still stand at 7.57 trillion as of December 2020. When it comes to public sector banks, the bad loans have come down from 8.96 trillion to 6.78 trillion during the same period. It needs to be mentioned here that the latest bad loans numbers don’t include loans which turned bad post 31 August, 2020, thanks to an interim order of the Supreme Court.

Hence, actual bad loans as of December 2020 are likely to be more than 7.57 trillion, discouraging banks to carry out further industrial lending.

Further, one might also argue that many new age startups have access to funding from venture capitalists. Hence, they don’t need loans from banks. While that is true, the kind of business models that many of these startups have—where they are happy to face losses in order to build scale—isn’t exactly the kind of business that banks would lend to in any case. Not now and not in the past.

The bigger businesses have access to foreign currency loans, which are available at lower interest rates. And that might be another reason for a slowdown in industrial lending by banks.

What all of this tells us is that there is much more to corporates borrowing money and investing in the economy than just lower interest rates, which, when it is too low, has a ripple effect on savers.

Retail banking push

The lack of industrial lending by banks has also more or less changed the business model of Indian banks. Take a look at Chart 2, which plots industrial lending and retail lending by banks as a proportion of non-food credit over the years. Banks lend money to the Food Corporation of India and other state procurement agencies to buy rice and wheat directly from farmers. This is referred to as food credit. Once this is subtracted from the overall lending, what remains is non-food credit which spurs economic activity. It forms a bulk of the bank loans. As of February 2021, non-food credit made up 99.2% of the overall loans.

Industrial lending has always been more than the retail lending carried out by Indian banks. Industrial lending as a proportion of non-food credit peaked at 46.13% in February 2013. At this point of time, retail lending as a proportion of non-food credit was 18.45%.

Industrial lending as a proportion of non-food credit has been falling over the years. At the same time, retail lending has been going up. In February 2021, the two curves in Chart 2 almost touched each other.

Industrial lending now forms 29.35% of non-food credit. Retail lending forms 29.22% of non-food credit, which is just 12 basis points lower. One basis point is one hundredth of a percentage.

The difference between industrial lending and retail lending has never been so low. In fact, just two years back in February 2019, the difference had stood at 736 basis points. Clearly, over the years, the business model of Indian banks has changed dramatically. From banks which used to lend majorly to industry, they are gradually in the process of becoming retail banks.

This has also been accompanied by the rise of private sector banks and the fall of public sector banks. Private sector banks prefer to give out more retail loans than industrial ones. This way, they can control their bad loans in a much better manner.

Clearly, the indirect effect of the lack of industrial lending has been that Indian banks are gradually turning into retail banks. In fact, when the data for March 2021 comes out, it may not be a surprise to see that retail lending might have overtaken industrial lending.

Vivek Kaul is the author of Bad Money

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