Not so long ago, most financial writes including myself were seriously arguing that the weak public sector banks should be made into narrow banks whereby they should only accept deposits and put all their money into gilts and triple A rates debt paper.
Today, one of the main weak banks, United Commercial Bank, and another not so strong bank, Indian Overseas Bank, have completed successful IPOs.
When they list they will certainly trade at a premium to the issue price. This is but natural considering the bullrun that public sector bank shares have been enjoying for months now.
It is easy to dismiss this as a bubble, which will go the way of all bubbles. But one of the leading rating agencies, Standard and Poor's, has also just upgraded the outlook for the Indian banking system on the basis of the reforms undertaken, leading to improvements in asset quality, profitability and capital adequacy.
Most of the Indian financial press has rubbished the poor ratings that India and Indian entities have fetched in recent times despite obvious improvements. So the upgrade should not suddenly be imbued with the insights that the downgrades did not possess.
Hence it is necessary to ask whether a key qualitative change has taken place in the health of India's public sector banks and if this can be sustained.
A recent World Bank study notes that even if you double the level of net NPAs of nationalised banks, considering the feeling that there is a good deal of 'evergreening' as a percentage of bank assets, they come to less than 7 per cent, or 4.5 per cent of GDP (2001-02).
These figures are low vis-à-vis those for East Asia and China. But the risk lies in the extent of public sector debt (over 90 per cent of GDP) and the high percentage of bank assets invested in government debt (at 28 per cent it is similar to Latin America and higher than the East Asian levels).
The study also highlights the cardinal interest rate risk. The recent rise in nationalised bank profits is largely due to trading profits made on government paper during a regime of declining interest rates. What happens when interest rates stop declining?
The picture is the same when we take into account the latest figures (2002-03). The net profit margin of public sector banks, as a percentage of total assets, rose from 0.72 per cent in 2001-02 to 0.96 per cent in 2002-03, according to a study for the Indian Bank Association by Jayasree Menon.
A big role was played in this treasury income, which rose by 65 per cent over the previous year in the last year. There is a secular rise in the share of other (non-interest) income in total income over the three-year period 2000-03, from 12 per cent to 16.5 per cent.
These large profits, mostly from treasury income, have enabled banks to make hefty provisions for non-performing assets, which have thereby fallen in absolute terms over the two-year period. Naturally net NPA, as a percentage of net advances fell appreciably from 6.1 per cent (2001-02) to 4.5 per cent in (2002-03).
While the rate of growth of interest income during 2002-03 was 6.4 per cent that of other income was 28.6 per cent. The interest rate spread, net interest income as a percentage of total assets, rose to 2.9 per cent from the previous year's 2.7 per cent.
This was aided by a sharp reduction in the rise in interest expenditure, to a mere one per cent in 2002-03 from 12 per cent in the previous year. How well the health of the banks is improving is also gauged from their control of operating expenditure, which includes staff costs. These grew by 9.4 per cent in 2002-03, compared to a fall (-5.6 per cent) in the previous year.
So is the glass half-full or half-empty? There is nothing wrong in the monetary authorities engineering a regime of declining interest rates in order to restore the health of banks by enabling them to earn hefty trading profits. The US Federal Reserve did so through the nineties.
There is scope for some further reduction in nominal interest rates in India from their present levels but not much. The process cannot go on forever. Japan has found that you cannot grow out of bad loans by continuing to lower interest rates.
The key issue is: what is the bread and butter business of banks and what are the prospects of Indian banks undertaking such business profitably? The days of safe lending to large corporates are gone; they don't need bank funds. The future of commercial banks lies in lending to small and medium enterprises, agriculturists and retail borrowers acquiring consumer durables and homes.
How well are India's public sector banks geared to undertaking these tasks profitably? A key ratio to watch is incremental NPA -- how much of hitherto good loans have turned sticky in a year.
These should definitely remain below 2 per cent. At a time when large provisioning is cleaning up balance sheets, this figure remains masked.
To lend profitably to large numbers, banks have also to adopt information technology extensively and, what is most important, re-engineer their processes. The public sector banks as a whole also have to go in for a substantial cut in staff strength made possible by the IT and process re-engineering.
There is still substantial asset-liability mismatch and the accounting and management information sysytem in place do not allow a proper assessment of risks. Without proper risk assessment and containment, the future is bleak.
There are plenty of instances of new good practices in banks. But the task ahead to stay afloat is stupendous. According to a veteran banker, the rest of the economy and the monetary authorities have engineered a "creeping improvement in health but a lot of potential for danger is still lurking."Powered by 
