All it took to bring the banking sector out of its complacent cocoon was one rude jolt. Buoyed by a declining interest rate regime, strong demographics and positive growth, the sector had lulled itself into the belief it had put the worst behind it. By most commonly accepted measures-profitability, capital adequacy and level of non-performing assets-2002-03 was a record year for it, with the good run continuing into the first few months of 2004.

What reinforced this illusion of strength was the sector's strong show: It had achieved a 1 per cent return on assets, managed a capital adequacy ratio of 12.6 per cent against the prescribed 9 per cent; recorded 44 per cent profits and an improved recovery meant that the ratio of non-performance assets to net advances was down to 4.5 per cent.

Although much of the good show may have come from treasury income-investments in government securities in a declining income regime-credit was due in no small measure to the regulator, the Reserve Bank of India, which insisted on the banks implementing its rigorous guidelines. This forced banks to implement risk management systems to address credit and market risks and also look at operational risks as a preparation for the Basel II Accord.

However, all this has now come apart with the fiasco of the Global Trust Bank, which has succeeded in shattering the confidence of investors and depositors and led to nagging questions being raised about efficacy of the methods followed by the regulator-the Reserve Bank of India-to keep tabs on banks.

While it can be debated whether the RBI could have stepped in earlier to stem the rot at the Hyderabad-headquartered GTB, the collapse of a new private sector bank has once again raised questions about the fragility of the Indian banking system.

It is also true that despite there being 27 public sector banks, 30 private sector banks and 37 foreign banks in the country, a large segment of the semi-urban and rural customers and the small and medium enterprises (SMEs) have inadequate access to banking. This is because most banks, both public or private, are concentrated in urban areas and very few cater to those residing in the semi-urban and rural areas.

There are still bigger problems dogging the banking sector. These include the high level of credit risk and low intermediation charges. While it is true that aggressive provisioning-with the RBI making it mandatory to make 100 per cent provisioning for all non-performing loans more than four years old-has brought down net NPA levels to 4.5 per cent of the net loans, this percentage is still seen by many as being too high.

The highly-skewed allocation of funds poses another challenge. While the corporate sector has received 60 per cent of all incremental lending by banks, the SMEs continue to remain starved. Overall, the banking sector has shown a chronic inability to recover the cost of capital. This failure has been compounded by huge loans to sectors that have been net destroyers of value over the years.

Again, despite the establishment of asset reconstruction companies (ARCs) to take over bad debt and the passage of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, the actual recovery continues to be tardy. As Viren Mehta, Industry Leader, Global Financial Services, Ernst & Young, explains: "Till there is enough global interest generated in the paper issued by ARCs and till such time as the global majors are allowed to work out loans sold to ARCs, banks will continue to be weighed down by NPAs and stressed assets.

For the public sector banks that are still governed by the diktats of their political masters, representing multiple constituencies, the task is even more complex. After all, the chairmen of the public sector banks are appointed by the central government, and are under the constant watch of the Central Vigilance Commission and the Central Bureau of Investigation, and Parliament. It is hardly surprising, therefore, that most senior and middle level managers go to extreme lengths to avoid risks. Grossly inadequate compensation to directors and limited access to information also restricts the ability of board members to be effective.

What adds to the confusion is the presence of so many commercial, rural and cooperative banks as also non-banking financial institutions, with a profusion of confusing, even conflicting, rules. The lack of centralised operations, low transaction volumes and inadequate economies of scale make it tough for them to make the investments needed for growth.

But to say that the coming years are going to be difficult is to state the obvious. For the economy to grow at 6-7 per cent annually, the banking sector will need to make massive investments. In the long term, the key issue will be the ways and means to raise such funds. And in this game, the smaller banks will be the losers.

Banks will also now have to learn to live with a spread of 200 basis points because interest rates, as R.R. Rao, Executive Director, ICRA, points out, are never a one-way street. And when rates head northwards, efficiency will hold the key to keeping banks going. And a hike in rates will mean that the banks cannot depend on government securities. They will have to find more fee-based services to supplement their income as also raise the standards of service.

Banks will have to eliminate non-performance by conducting "governance'' audits. And go in for mandatory rating by independent agencies to prevent mishaps like GTB. It would also help a lot if the ARCs are provided greater teeth. Last but not the least, the regulators need to encourage consolidation so that banks can not only survive in competitive environments but thrive in them.