The Indian banks have had a long and bumpy ride in the last few decades. It is interesting that at one point several years ago, we did have a vibrant banking system. The Tatas, Birlas, Pais, Chettiars all ran the banks with great attention keeping the safety of their depositors money as the peg around which all strategies were evolved. Unfortunately, we then had the "stray thoughts" of Indira Gandhi in the summer of 1969. Even as the United States was climbing the heights in July that year by sending men to the moon, we were plunging to the depths by nationalising the banking system. Fourteen major banks were nationalised in 1969 with the avowed objectives of making them socially responsible. While the objective was definitely laudable all of us know what really happened. Our well-run private banks soon became big treasures for people to take a dip whenever they wanted. Enthused by the great success of this social experiment, the government undertook another dose of nationalisation and whatever was leftbehind was gobbled up in 1980.

After the reform started in 1991, we decided to open up banking for private investment. We had several new banks promoted by strong financial institutions or professionals coming into the picture. These banks have, by and large, done well. They have followed universally accepted banking techniques by keeping costs low, creating excellent systems of decision-making, bringing technology and automation etc. These banks now give the foreign banks a run for the money and are a very positive development in our financial system.

Unfortunately the past refuses to go away. A very high percentage, in excess of 75 per cent of the banking system, is still in the hands of government banks including the State Bank of India and its subsidiaries and this is where the big cracks are appearing. For one, continuous government interference at the top and corruption have meant that these banks have built up large loan portfolios which are irrecoverable. Readers would recall the fate of Indian bank where the chairman was accused of making politically motivated loans leaving the bank deep in the red. Unfortunately it was quite impossible for even the best professionals in the banks to stand up to the onslaught of government interference. When the history of Indian finance is written, the chapter on takeover of the Indian banking system and its degeneration at the hands of government control should surely be the darkest.

Not that politically inspired bad loans are the only problems of these banks. They have strong trade unions which are so powerful that they have kept costs at unacceptably high levels. While Communists all over the world are being confined to museums, in India they still continue to plague the system at various places. The strong unionism of our banks has meant that the expense base is ridiculously high as a percentage of net spreads.

One could go on and on but the bottom line is it is the consumer who pays for all these. The recent example was the credit policy. With inflation at three per cent, one would have expected interest rates to go down to stimulate capital investment but we know that cannot happen becasue of our inefficient banks. Interest spreads have to be kept very high so that customers can pick up the tabs. On one side depositors get low returns on their deposits and on the other side borrowers pay very high rates of interest.

And now driving the last nail on the coffin of the banks is disintermediation. This is an ongoing economic fact whereby the bank as an intermediary is losing out. With mutual funds offering high returns and much of it tax-free, the banks have extreme pressure on their deposit side. Once savers are able to write cheques on their mutual fund accounts, this is going to become even worse. On the loan side almost every company with a decent balance sheet takes a credit rating and accesses funds which are of longer duration and cheaper. So the banks are left with borrowers who have exhausted all options and are hence bigger risks. Hitherto the short-term debt market was the monopoly of the banks. However, even here the burgeoning commercial paper market has meant that banks are losing out.

This is a very serious situation indeed and the speed and determination, with which the government tackles this, will be watched with keen interest by one and all. The repercussions of a sick banking system are only too well known. It is now accepted wisdom that the Asian contagion was started in the banking system. Our sovereign rating would go south unless the mess is cleared up. For, a man cannot be healthy, if his heart is weak.

The author is a Delhi-based investment banker and is available at pnvijay@vsnl.com