Banks play a substantial role in mobilising savings to promote investments and growth. This function of banks is very significant with respect to the Indian economy, where in banks predominate the financial markets.
The health of financial institutions of a country is very important, since it is strongly linked with the performance of the economy, as observed by Santomero and Trester (1998). The financial sector in India is well developed with a strong banking system. The Indian banking sector was mainly in the private sector until 1969. In 1969 most of the banks were nationalized, followed by another set of nationalizations in 1980s. By 1991, most of the Indian banks were in public sector. In 1991 the financial sector was liberalized, scaling down many restraints and allowing private participation in the sector. In 1992, the Government appointed Narasimham Committee to study the banking sector. As per the recommendations of the committee, many reforms were introduced in the subsequent years.
Many committees have been constituted by the RBI and the Government of India over the years, to study the Indian banking sector. These include Luther Committee (1977), PEP Committee (1977), Sukhmoy Chakravarty Committe (1985), Pendekhar Working Groups (1982-83), Ahluwalia Committee (1985), Padmanabhan Working Group (1991), Narasimham Committe (1991, 1998) and Verma Committee (1999).
The liberalization of the sector ended the supremacy of public sector and made it a competitive industry. In order to survive in this healthy competition, banks were forced to improve their performance.
CAMELS FRAMEWORK
As per the Banking Regulation Act of 1949, the authority to inspect and supervise the commercial banks in India lies with the Reserve Bank of India (RBI). The Department of Banking Operations and Development (DBOD) was the supervisory organisation till 1993. From 1994 onwards, this function is under the jurisdiction of the Board for Financial Supervision (BFS).
The Uniform Financial Institutions Rating System (UFIRS) was developed by the regulatory agencies in 1979. Under this system, banks were rated based on their performance in five fields: the capital adequacy, the asset quality, the quality of management, the earning performance, and the sufficiency of liquidity. This rating system was known by the acronym CAMEL. A sixth component, Sensitivity to Market Risk, was added to the rating system later, making it CAMELS framework.
The banks were given a 1 through 5 rating in every field, and a composite rating for the overall performance of the bank. A rating of 1 indicates high rating, good performance and risk management, and the lowest level of supervisory concern. Whereas a rating of 5 indicates a lowest rating, poor performance and inadequate risk management, and the highest level of supervisory concern. The composite rating is not merely an arithmetic average of the component ratings, but is based on a qualitative analysis of these factors and interrelationship between the factors.
CAMELS framework is an internationally adopted model for evaluating the performance of financial institutions. This model involves analysis of six indices which reflects the health of the financial institutions. These indices are as follows:
Capital Adequacy
Asset Quality
Management Quality
Earning Performance
Liquidity
Sensitivity to Market Risk
The RBI is using CAMELS system for the supervision of Indian banks since 1997, and in 1998, RBI assessed that this model can satisfy 14 out of the 25 Basel core principles of supervision.
An empirical study by Koeva (2003) found out that, the major determinants of profitability of Indian banks are operating expenses, non-performing loans, composition of deposits and priority sector lending. Varadi et.al (2006), in their study, explained that public banks are more efficient in terms of productivity, profitability, asset quality and financial management.
Capital Adequacy
The first component of CAMELS framework is capital adequacy, which measures the efficiency of financial institutions to manage the shocks to their balance sheets. The capital requirement of a bank depends on the type and degree of risks to the bank, and the ability of banks to identify, measure, monitor and control these risks.
The RBI demands all banks to hold a minimum level of capital at all times, in order to protect the depositors from losses. The RBI uses an internationally agreed methodology, as defined in the Basel Committee on Banking Supervision's Basel Capital Accord, for setting minimum capital requirements against credit and market risk. By doing this, RBI ensures that the banks have sufficient resources to safeguard depositors against the possibility of insolvency, although such protection cannot cover all contingencies.
The major types risk faced by banks can be generally classified as follows:
Liquidity risk: this is the risk of loss arising from the failure of the bank to meet funding requirements.
Credit risk: this is the risk that companies, financial institutions, individuals and other counter-parties will be unable to meet their obligations to the bank.
Market risk: this is the risk of loss arising from adverse movements in the level of market prices, which can occur in the money, foreign exchange, equity and commodity markets.
Operational risk: this is inherent in all businesses and represents the potential for financial and reputational loss arising from failures in internal controls, operational processes or the systems that support them.
The level of capital required by the banks above the regulatory minimum depends on the nature and intensity of these risks. Adequate capital levels will safeguard the banks against the potential adverse effects of these risks. The capital adequacy of a bank is dependent on several factors like the quantity and quality of capital, the overall financial health of the bank, the type and volume of problem assets, the earning strength of the bank, ability of the management to raise additional capital, the level of various risks associated with its activities, the risk exposure due to off-balance sheet activities, and the access to capital markets and other sources of capital.
Measures of Capital Adequacy
For the purpose of calculating a bank's capital for supervisory purposes, the bank will identify three types of capital-Tier 1, Tier 2 and Tier 3. Tier 1 capital forms a bank's core capital and this includes permanent share capital comprising of ordinary shares and perpetual non-cumulative preference shares, reserves and retained profit; but a bank is required to deduct all holdings of its own shares, current year's net losses, and goodwill and other intangible assets.
Tier 2 capital forms the supplementary capital of a bank, and this comprises of reserves arising from the revaluation of tangible fixed assets and fixed asset investments, general provisions up to 1.25 percent of risk weighted assets, hybrid capital instruments like perpetual subordinated debt and cumulative preference shares, and dated capital instruments with a maturity of at least five years, such as term subordinated debt and dated preference shares. Tier 3 capital is more short term than Tier 2 capital (but must have a minimum maturity of two years) and is used to support market risk.
Under current supervisory rules, the Capital Adequacy Ratio (CAR) or Risk Asset Ratio (RAR) is defined as the ratio of a bank's capital to its risk weighted assets. Risk weighted asset represents a bank's assets which are weighted according to its credit risk. The RBI is bound to set a minimum CAR of no less than 8% as per the Basel Accord. As per the recommendations of the Basel Accord, the core capital of a bank should equal or exceed 4% of its risk weighted assets. It is also recommended that the supplementary capital should not exceed core capital, and the total capital must be greater than 8% of the risk weighted assets of the bank (Saunders & Cornett, 2004). But, as per the recommendations of the Narasimham Committee 1998, the RBI later raised the required CAR to 9% for scheduled commercial banks, 10% for new private sector banks and 15% for local area banks (RBI, 2001).
Leverage ratio is also an indicator of capital adequacy of a bank. It is defined as the ratio of core capital of a bank to its assets. This was a widely used method in the early 1980s. But, during the 1990s, banks preferred risky off-balance sheet transactions rather than investing in high-liquidity, low return assets. So, many nations adopted the risk based capital standards that were originated during the period.
Optimal Capital Structure
There are many factors which influence the capital structure of a bank. Managerial risk aversion is such a factor. Managers have proportionately more investment in their banks than most of the shareholders, in the form of human capital, and so there is a high probability that they may opt for minimal risk exposure and higher capital levels (Shrieves & Dahl, 1992).
An empirical study by Jackson and Fethi on Turkish banks, found that capital adequacy ratio has an adverse effect on the performance of banks. But, the study by Gupta et.al (2008), suggested that capital adequacy ratio is one of the parameters which determines the efficiency of banks. His study revealed that, there is an optimal level of CAR beyond which it do not have any effect on the efficiency of banks. Berger et.al (1993), in his study, pointed out that higher CAR reduces the risk through better risk management, and produce higher earnings.
ASSET QUALITY
Credit risk is one of the major threats which affect the functioning of a bank. The degree of credit risk depends on the quality of assets held by the bank, which in turn depends on the financial health of the borrowers (especially the corporate borrowers), exposure to specific risks and trends in non-performing loans. The various measures of asset quality include gross non-performing assets (Gross NPA) ratio, net non-performing assets (Net NPA) ratio, asset growth rate, loan loss ratio and loan loss provision ratio.
NPA is a variable, which can be used to assess the risk management efficiency of the banking system. Kirkpatrick, Murinde and Tefula (2008) pointed out that, one of the major reasons for the inefficiency of banks is bad loans.
Several empirical researches have been done regarding the usefulness of these accounting ratios used to evaluate the asset quality of banks. A study by Gupta (1983), on ICICI Bank, revealed that these accounting ratios are good indicators of the financial health of a bank. Studies by Bhatia (1988) and Sahoo, Mishra, and Soothpathy (1996) also disclosed the same results.
The RBI uses Gross NPA ratio and Net NPA ratio as the indicators of asset quality of Indian commercial banks. Loans form a major portion of the assets of a bank, but at the same time it carries greater potential risks to the bank. The norms regarding the asset classification was introduced for the first time by the RBI in 1992-93. As defined by the norms, a non-performing asset is one, which does not generate any income for the bank. An asset can be identified as NPA if the income from it is suspended for a period of more than 90 days. The assets of a bank are classified into sub-standard assets, doubtful assets and loss assets, based on the period for which it has remained as NPA. Commercial banks are required to make a minimum general provision of 0.4% on standard assets, 20% for sub-standard assets, 50% for doubtful assets, and 100% for loss assets.
There have been considerable improvements in the financial health of Indian commercial banks with respect to the asset quality. Both Gross NPAs and Net NPAs have been slumping over the years. These ratios were very high in the past, when compared to the international levels. The absence of strict prudential norms and legal impediments were responsible for this situation.
Higher NPA levels will have a deterrent effect on the profitability of banks. Rajaraman and Vasishtha (2002), in an empirical study, established that non-performing loans are an indicator of operational efficiency of Indian banks. The NPA levels are dependent on the lending policy of the bank (Reddy, 2004). A study by Mohan (2003) also provided the same results, and he put forward the concept of 'lazy banking' signalling the poor investment portfolio and lending policy of banks. Their studies about the Indian banking sector has an international perspective, since their results coincides with many studies across the globe. Studies by McGoven (1993) and Bloem and Gorters (2001) also established that the lending policy of banks is the main driver of NPAs. McGoven (1993), in his study of US banks pointed out that, the 'character' of the banks is a determinant of its lending policy. Sergio (1996) also signalized the effect of bank-firm relationship on the lending policy of the bank. But, his study emphasised that, this relationship do not have any effect on the levels of NPAs, because even though it helps in reducing the information asymmetry, it recoups some appraisal rules. Bloem and Gorter (2001) also suggested that the NPA levels depend on the economic conditions in the country, and also on unexpected changes like natural calamities. In a country like India, where natural calamities like floods and drought are very common, it is not surprising that the levels of non-performing loans are high.
The competition within the industry is also a reason for the deteriorating asset quality. With the entry of more private banks and foreign banks, banks were forced to reduce the quality of borrowers, which in turn contributed to an increase in their NPAs (Bhattacharya, 2001). Priority sector lending is also a reason for the higher NPA levels in the country. As per the RBI regulations, the commercial banks in India are required to lend at least 40% of their advances to the priority sector. Low interest rates were charged for this lending, and the viability of the institutions were often neglected to meet the prescribed standards.
A regular and efficient follow through to prevent any defalcation and diversion of funds is the best method to control the levels of non-performing loans of a bank. Proper assessment of credit history of the borrowers, and establishment of a healthy relationship between the bank and the borrowers are key steps in the management of NPA.
Asset reconstruction or Recovery mechanism is a globally practised method to mitigate the levels of NPA. It is successfully practised in countries like China, Korea, Taiwan and Japan. Here, the bad assets of banks are sold to an Asset Reconstruction Company (ARC) at an agreed price. The Narasimham Committee have already recommended the service of ARC in the country; but it is still in its emerging stage. The RBI is also using Compromise Settlement Schemes to help the recovery of NPAs.
EARNING PERFORMANCE
Profitability is very essential for the sustenance of every financial institution. The different indicators which can be used as a measure of this earning capacity of a bank are Return on Assets (ROA), Return on Equity (ROE), operating profit margin, net profit margin and gross margin.
The indicators of earning performance used in this study are ROE, Net Interest Margin (NIM) and Expense Ratio (EXP). ROE is calculated by dividing a bank's earnings by its share capital and reserves; whereas NIM is the ratio of the bank's net interest income to its loans and advances. The ratio of operating expenses to net revenue gives the expense ratio of a bank.
The emergence of new private sector banks and foreign banks, have fortified the competition within the banking sector, and the banks are shifting from the socialistic approach to a profit oriented approach. This competition has improved the professionalism in the industry.
Several empirical studies have revealed that, the ownership of banks will have a significant effect on the earning performance of banks in developing countries. Demirguc-Kunt and Huizinga (1998) studied the bank data from 80 countries, and stated that foreign banks are more profitable than the domestic banks in developing countries. Later, a study by Barth and others (2001) demonstrated that, the low profitability of state owned banks is due to the high intermediation costs associated with these banks. But, the empirical studies about Indian banking sector have produced conflicting reports. Sarkar, Sarkar and Bhaumik (1998) found out that, the gap in the performance of Indian public sector banks and private sector banks is not significant. A research by Shirai (2002) confirmed the above result, and he established that, even though the private sector banks had performed better in the past, public sector banks have diminished this gap by improving their profitability and cost efficiency. But, the study by Sathye (2005) produced a contradictory result. He studied the effects of privatization on the performance of banks using financial ratios, and concluded that the performance of private sector banks were better than fully public sector banks. The study of 70 banks by Bhattacharya et.al (1997) suggested that public sector banks were more efficient than foreign banks, which in turn were more efficient than private sector banks. Study by Ram Mohan and Ray (2003) also produced the same results.
LIQUIDITY
The regulatory capital is a tool is a tool for financial regulators to protect the interests of deposit holders and the integrity of the financial system. It is an absolute minimum amount of capital that could be held by an authorised bank. It does not give an indication of the actual amount of capital needed to run the business.
Like all other companies, banks need capital to run their businesses, and to protect themselves from unforeseen risks that might arise from a number of different directions. Additionally, banks require capital to reduce systemic risk to the financial system; and they have to maintain the confidence and trust of depositors and the general public. Banks must also hold sufficient capital to protect the interests of shareholders and to finance future growth of the business. So, usually banks would always have more capital than the regulatory minimum. Otherwise, it would decrease its competitiveness in the market and increase its cost of borrowing. It would also make its share prices more volatile and increase its cost of equity. Regulatory capital is actually intended to measure the credit risk associated with lending, although it also measures market and some other risks as well. But now, it is considered by financial regulators as an inaccurate and inadequate measure, even for the purpose for which it was intended.
It is very vital to ensure that the capital base is managed actively to ensure that it do not hold excess capital, while at the same time ensuring that it has sufficient capital to meet its ongoing needs.
Financial liberalization of Indian banks has brought about significant changes in the banking sector. Reserve requirements of the banks were cut down over the years. The Cash Reserve Ratio (CRR) was reduced from 15% to its present value of x%. The Statutory Liquidity Requirement (SLR) has fallen from 38.5% for domestic liabilities and 30% for non-resident liabilities to x%.
METHODOLOGY
In India, a total of 171 commercial banks are in operation. This includes 27 public sector banks, 22 private sector banks, 32 foreign banks, 86 regional rural banks, and 4 non-scheduled banks (RBI, 2009). For the purpose of the study, 20 commercial banks were selected (10 public sector and 10 private sector) randomly.
The study is based on the data collected from the annual reports of these commercial banks and the historical data published by the RBI. The main RBI publications used for the study are the Statistical Tables relating to Banks in India, A Profile of Banks, and the Report on Trend and Progress of Banking in India. These publications provide data on balance sheet and profit and loss account of banks, and ratios like CAR and NPA. The study covers the last ten fiscal years- from FY 2000/01 to FY 2009/10. The method used for the study is based on the CAMELS framework. As mentioned in the literature review, the CAMELS framework covers six aspects of a financial institution namely capital adequacy, asset quality, management soundness, earning performance, liquidity and sensitivity to market. However, the last component has been left out due to the complexities involved. So, CAMEL framework will be used instead to assess the financial health of Indian commercial banks.
DATA ANALYSIS
Analysis of Financial Health of Banks
Capital Adequacy
Capital adequacy is the ratio of a bank's capital to its risk weighted assets. As per the RBI regulations, the banks in India are required to maintain a minimum Tier 1 CAR of 4% and a total CAR of 9%. But, usually the banks maintain a capital in excess of this requirement. The total CAR of commercial banks in India over the last 10 years is plotted in the graph below:
The graphs depict that the banks normally maintain a CAR of 11-13% which is well above the minimum requirement. The ratio showed an upward trend till 2005, which was followed by a slight decline for the next two years. As of now, the ratio stands above 13%.
The indicator of capital adequacy used in this study is the Leverage ratio. It is the ratio of core capital of a bank to its total assets. Assets are not risk adjusted for this method. Normally, a bank with a leverage ratio of 5 is considered as well capitalized. The leverage ratio of most public sector banks (with the exception of Oriental Bank of Commerce and Corporation Bank) was below 5% till 2004. But, the banks other than Central Bank of India improved their leverage ratio in the subsequent years. The ratio of Central Bank of India was less than 5% during the whole 10 year period.
The capital adequacy of private sector banks was much better when compared to the public sector banks. All banks with the exception of Axis Bank and Federal Bank were well capitalized with a ratio higher than 5%, during the whole study period. Axis Bank and Federal Bank also recorded a substantial increase in their leverage ratios in the years following 2004. The achievement of ICICI Bank is outstanding as the bank increased its leverage ratio from 6% in 2001 to 14% in 2010, which is the highest within the sector.
As of now, Central Bank of India is the only bank with inadequate capital adequacy. While most banks improved their capital adequacy over the years, banks like Corporation Bank, Oriental Bank of Commerce and Karur Vysya Bank registered a decline in their leverage ratios in the last few years. It is a contradiction that Corporation Bank and Karur Vysya Bank were the best capitalized banks in the first half of the study period. Even though Corporation Bank maintains the minimum requirement of 5%, its ratio is the least second only to Central Bank of India.
Asset Quality
Net NPA ratio was used in the study to analyse the asset quality of the banks. The results revealed that the asset quality of Indian banks have improved considerably over the years. The Gross NPA ratio, which was 11.45% in 2001 reduced drastically to nearly 2% by 2010. The Net NPA ratio also showed a sharp decline from 6.17% in 2001 to 1% in 2010. The gap between the Gross NPA and Net NPA has also reduced over the years (from 5% in 2001 to 1% in 2010). The average NPA ratio of Indian commercial banks over the years is depicted in the graph below:
The results in the late 2000s are encouraging, and they do demonstrate the strength and resilience of the banking sector, since these results have been achieved notwithstanding the dismal economic situation of the banking sector throughout the world. Conditions have been extremely difficult for almost every sector of industry and commerce, with particularly severe difficulties persisting in property, housing and retailing. These results show the great efforts made in the credit appraisal process, which helped in ensuring a minimum level of non-performing assets, even when the banks remain firmly committed to the policy of lending.
The higher NPA ratios in the early years were mainly because of the inefficient credit recovery system and poor legislations. Improvements in the credit assessment procedure and new steps from the Government and the RBI (such as the enactment of Securitizations and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002, debt recovery tribunals and Lok Adalats) played a significant role in reducing the levels of non-performing assets.
Among the banks selected for the study, most show the general decreasing trend of NPA. All the public sector banks selected for study showed a sudden decline in their Net NPA during the period 2001 to 2007. In the subsequent years, banks like Indian Overseas Bank, Union Bank of India, and Bank of India recorded a slight increase in their Net NPA ratios; whereas, State Bank of India, Canara Bank, and Corporation Bank almost maintained a constant NPA ratio.
All private banks, with the exception of ICICI Bank and ING Vysya Bank recorded a continuously declining graph with respect to the Net NPA ratio. The figures of ICICI Bank were constantly increasing since 2006, and it will be a concern for their management. The performance of HDFC Bank deserves special mention, because the bank was able to maintain a ratio less than 1% during the whole ten year period.
Central Bank of India and Dhanalakshmi Bank were the least performers among the public sector banks and private sector banks respectively; whereas, Corporation Bank and HDFC Bank outperformed their peers by a huge margin.
Earnings
Liquidity
RESULTS
Expense ratio and Net interest margin are the major determinants of profitability in the Indian banking sector. The expense ratio, defined as a ratio of operating expenses to net revenue, is a key explanatory variable for bank profitability in India. Banks with higher operating costs have significantly low profitability.
Another variable which has significant effect on the profitability of banks is Net interest margin.
A surprising finding is that capital adequacy and non-performing loans do not have any significant effect on the profitability of Indian banks; but there exists a negative and significant relationship between the two.
