Essays on bank, financial intermediation and economic growth in India

Abstract

The key objective of this thesis is to analyse certain aspects of financial intermediary development and its role in economic growth in India during last three decades. Since Indian financial system is mainly bank-based, we focus only on the role of commercial banks in financial intermediation process. Moreover, we carry out the analysis at sub-national level in India. In India, since independence, economists and policy makers have been more concerned about regional disparities in the context of economic growth. Emphasis is placed on the issues of convergence (or divergence) of per capita incomes. However, there is a general consensus that growth across Indian states has been unbalanced. Most of the studies reveal that Indian states diverge in terms of per capita state domestic product (SDP) due to reasons such as inter-state variations in size, infrastructure etc. However, the role of financial development in growth process at sub-national level across states has not been adequately focused. It is likely that level of financial development would be different across states and would exert differential impact on growth. The thesis looks into the role of financial development on economic growth across states in India during last three decades which encompasses both pre-liberalisation as well as post-liberalisation periods. Broadly, the thesis, first, looks into quantity aspects of financial intermediary development by looking into alternative measures of financial intermediation across states in India and then, we make an analysis of quality aspect of financial intermediation by looking into the relationship between non-performing assets, credit growth and risk-based capital requirements across Indian banks and make certain predictions of its effect on growth. We, first, examine the long-term equilibrium relationship and causality between financial development and economic growth across Indian states in order to understand whether finance-growth relationship follow demand following hypothesis or supply leading hypothesis or whether there are feedback effects. However, predictions on the causality and cointegration relationships between financial development and economic growth at more disaggregated level such as states are likely to be different in the presence of cross-sectional dependence that may arise due to certain factors such as common monetary and fiscal policies etc. The thesis takes care of this issue of cross-sectional dependence while scrutinising causality and cointegration. Findings based on cointegration test provide evidence of long-term stable equilibrium relationship between financial development and growth. However, with cross-sectional dependence, cointegrating relationship sustains only between credit per capita and per capita income. Panel Granger causality results in the absence of cross-sectional dependence provide support for both demand following as well as supply leading hypotheses. However, in the presence of cross-sectional dependence, we find evidence of finance-led economic growth. We also examine the effect of financial development and economic growth across Indian states using alternate indicators of financial development along with other statespecific factors. In this analysis, we take care of cross-sectional heterogeneity as well as endogeneity issues while scrutinizing the role of financial development in economic growth. We find that effect of financial development on growth is positive and significant with alternative indicators of financial development. Our findings also reveal that bank branch expansion across states played a pivotal role in financial intermediation during last three decades. Probable channels through which financial development boosts economic growth, may arise from reduced transaction cost, increased savings through greater deposits mobilisation and credit disbursement. The thesis also explores the inter-relationship among structural changes, financial intermediation and growth across states. In particular, we examine how changing composition of bank credit across different sectors of the economy relates to structural changes during last three decades. We find that since mid-2000, credit disbursement to various sectors has experienced a sharp upward trend. Service sector credit and personal credit, in particular, witnessed the biggest spurt in growth. Growth of services sector during post-reform period has also been higher and relatively stable compared to that in agriculture and industrial sector. The study reveals that service sector credit, agriculture credit and personal credit exert positive and significant effect on aggregate growth only in the decade of 2000. We also find that during 1980s, 1990s, agricultural credit hardly had any impact on agricultural growth. In the decade of 2000, we find significant influence of agricultural credit and service sector credit on sectoral growth. However, we find that industrial credit hardly had impact on industrial sector growth in various sub-periods. Finally, the thesis focuses on quality aspects of financial intermediation. Specifically, we analyse how financial intermediation may receive a setback in view of the deterioration of asset quality of banks by looking into the implications of effects of credit growth and regulatory instruments such as capital to risk weighted asset ratio (CRAR) on non-performing assets in Indian context. We consider credit growth and CRAR as regime dependent variables and all other bank-specific variables are considered as regime independent. Our findings reveal that above the critical threshold of credit growth, there is significant and negative effect on NPAs which seems to be favourable for financial intermediation. High credit growth is not only crucial in terms of reduction of NPAs and increased profitability but also bears positive implications for the economy as commercial banks constitute the major source of external financing in developing country banking system such as India. However, very high growth of credit may also act a signal towards ever-greening of bad loans as it typically happens in developing country banking systems such as India. We also observe that banks maintaining capital adequacy ratio in excess of threshold reduces NPAs which appears to be good for bank’s health as well as the economy as whole.