Bank recap needs further reforms

The ratio of non-performing loans to total credit for all of India’s banking, has been steadily deteriorating for at least six years. There are many reasons, and not all of them are blameworthy. For instance, when banks were asked to provide large scale credit for infrastructure projects, it was partly due to pressure from national policy. India wants to quickly spend more than one trillion dollars on infrastructure, and the bulk of this comes from debt funding. These projects are of long gestation and have a longer payback period. Hence the most appropriate debt funding for these is through long term bonds, or through development finance organisations like the World Bank, Asian Development Bank or our own erstwhile ICICI and IDBI. Such organisations are designed to give twenty to fifty year loans at low interest rates. But after the demise of domestic development finance organizations (like ICICI and IDBI), and in the absence of a well-developed market for long term bonds, it fell to commercial banks to lift the burden of infrastructure finance.

In addition to asset liability mismatches, and overexposure to the infra sector, the PSBs also suffer from political interference. The top management including the Chairman is appointed by the government, and some loan proposals probably get an informal endorsement from political sources.

Notice that only public-sector banks can be pressured or nudged to participate in loans to infra projects, and not so much their private sector counterparts. So PSBs by lending to long term risky infrastructure projects, exposed themselves to asset liability mismatch. This is not to say that they did not do adequate due diligence, but to underscore the fact that banks are fundamentally unsuited to fund long term infrastructure projects. PSBs under government ownership had to provide the funding. So, when the risky projects faced delays due to land acquisition, or environmental clearance, the projects got delayed and the loans started deteriorating. The rot had set in.

In addition to asset liability mismatches, and overexposure to the infra sector, the PSBs also suffer from political interference. The top management including the Chairman is appointed by the government, and some loan proposals probably get an informal endorsement from political sources. Of course, much of this has been curbed in the current regime, and we also have a formal structure to make appointments based on merit and transparency. But genuine management autonomy insulated from the wishes of the political owners remains a distant dream, as in many public-sector organisations.  This is not a bane of public sector ownership per se. In many countries, public sector companies thrive commercially.

In addition to the asset liability mismatch and overexposure to infrastructure, there was also a business cycle downturn. These are the genuine reasons. On top of these are the reasons of malfeasance and also what’s called “extend and pretend” in banking parlance. There are anecdotal instances of crony capitalism, and in one case there are criminal proceedings already underway against senior bankers. Two years ago the Reserve Bank of India, initiated Asset Quality Review to correctly identify the stressed loans. No more extend and pretend. The government too initiated Indradhanush 1 and 2, a comprehensive package of infusing capital and restructuring the public-sector banking system. After AQR the stark ratios came into the limelight, and NPA resolution started in earnest. After provisioning for bad loans, the net worth of some banks was completely eroded, and for other banks it was dangerously low. As the Chief Economic Adviser said, the NPA problem should not be seen as a banking problem alone, but a national problem. India’s banking system is getting prepared to meet the Basel-3 standards which requires higher capital provisioning for risk. And with a ten percent NPA ratio, the existing capital requirement is also steep. If you keep capital aside (locked up) for bad loans, there is no room to make new loans. Not surprisingly credit offtake is at a sixty year low. Fresh credit to industry from PSBs has virtually dried up. Nay it is shrinking. Money supply growth is also at a fifty-five year low. All this is ironic, because banks are flush with cash which was deposited in the aftermath of demonetisation.

(Apart from) overexposure to infrastructure, there was also a business cycle downturn. These are the genuine reasons. On top of these are the reasons of malfeasance and also what’s called “extend and pretend” in banking parlance. There are anecdotal instances of crony capitalism, and in one case there are criminal proceedings already underway against senior bankers.

Hence after two rounds of somewhat feeble capital infusion, the latest recapitalisation announcement is a big bang, and is likely to be effective. No wonder banking stocks went up by as much as 35 percent in a day or two. The market too is sensing that this infusion will enable bank credit to start flowing healthily again. The government has done a neat trick. It has sold recap bonds to the PSBs in exchange for excess cash deposits. And that same cash will be injected as fresh equity. Of course, as of this writing, the details are not fully known. For instance, how can the government which is only part owner inject equity? The others, including foreign shareholders too must put in funds. At what price will they be given this chance? Did they not enjoy windfall benefits of their stock value, at the expense of the taxpayer? How will the recap bonds be repaid by the banks? Will banks be allowed to down-sell those bonds? Will those bonds become tradeable? Or will they be converted to perpetual bonds (i.e. never to be repaid), as was done in 1992-93? All these questions need to be answered before we can fully estimate the impact.

However, it is clear that the total injection of 2.11 lakh crore is a much-needed booster shot for India’s public-sector banks’ recovery.  However, for PSBs to become healthy and sustainably profitable, we need crucial reforms. Most of these pertain to governance and functioning. This means genuine autonomy in management, recruitment, lending and recovery decisions. It means accountability to the shareholders through the board. It means greater exposure to market forces and competition (no preferential treatment and captive business from government).  It also means reducing the stake of the government. This may not be essential if the functioning autonomy is maintained. A former NDA minister had said in Parliament that the PSB stake will be brought down to 33 percent, while retaining their public-sector character.  Full privately owned banking systems could not prevent the worst-of-the-century Lehman crisis. So the debate on private versus public ownership is not settled. But the need for reforms in many areas, excluding outright privatisation is imperative. The recap will be really effective only when other reforms are speedily ushered. Else there will be another NPA crisis looming in the coming years.