Banks need an autonomy stimulus

At a time when banks are in trouble globally, recent reported losses heighten the tendency to put Indian banks in the same basket. But global bank shares are falling because of an expected fall in bank earnings as interest rates become negative. In India, however, interest rates are firmly positive. In India, reported bank profits are soft because provisions are being made for weak assets. Tackling a problem at the root bodes well for the future. U.S. banks whose balance sheets were cleaned up are doing better than European banks where only cosmetic liquidity was provided.

Moreover, the asset quality problem affects only a part of the banking system, and only a particular type of loan. Non-performing assets (NPAs) that have stopped producing income are concentrated in public sector bank (PSB) loans to large corporates. Therefore the problem is limited in size and funds required to restore health are not excessive.

The sharp rise in emerging markets’ (EMs) corporate debt from 45 per cent of gross domestic product (GDP) in 2005 to 74 per cent in 2014 is a major source of global risk. It also rose in India, but is only 14 per cent of GDP. Debt is concentrated in large infrastructure firms, but even so average debt-equity ratios remain at around unity since they are low for other firms. Ignoring local detail leads to a blind echoing of global fears — a relative perspective diminishes India’s debt-related risk.

Caps on external debt reduced fluctuations in Indian interest rates compared to more open EMs. A mechanical sell-off of EM assets occurs in periods of rising global risk, as liquid portfolios are sold irrespective of a country’s own prospects. But the Indian experience in 2008, 2011 and 2013 is that they tend to return if prospects are robust. In the current cycle there are signs that domestic investors are using foreign exit to come in at a good price — a sign of maturing markets with a wider base. Indian restrictions on short-term debt have reduced chances of large cumulative cycles occurring as corporate bankruptcies create NPAs and stressed banks stop lending.

In addition, PSBs have demonstrated the ability to compete effectively and earn profits in the past. They did unexpectedly well after the 1990s reforms, and even overtook private banks on some parameters. They outperformed during and immediately after the global financial crisis. NPAs fell to 2.4 per cent in 2009-10 from 12.8 per cent in 1991. A similar recovery is possible now, even as gaps in reforms are closed.

Public and private banks

The problems of PSBs now are partly due to government interference but also to errors of judgment and to external shocks. The first two led them to participate much more than private banks in infrastructure financing. They came from a history of hand-holding large corporates in order to encourage development. The onus fell more on them after development banks were shut. They did not foresee the governance and administrative problems that delayed projects that were expected to be viable under high growth. Interest rate hikes, following the 2011 inflation peaks, also hit PSBs. A loan-based system is highly sensitive to a rise in interest rates.

Meanwhile, private banks concentrated on more lucrative and less risky retail lending. They did well in this period, and their market capitalisation overtook that of listed PSBs in 2011. But their diverse strategies did reduce risk for the Indian banking sector as a whole.

NPAs were expected to come down as the economy revived. But external shocks and domestic political logjams continue to delay recovery. Capital adequacy regulation should ideally be countercyclical with buffers built up in good times. But recovery is taking too long. Moreover, loan growth from PSBs is the slowest, possibly because of a larger share of stressed assets. Therefore it is necessary to clean up bank balance sheets. The onus is on the government as the largest shareholder. The Budget has made a contribution towards refinancing PSBs. There is little risk for depositors or of systemic spillovers.

The Indian taxpayer has, however, for long subsidised government and large private investment. Earlier this was through loss-making public sector undertakings and development banks whose loans were rarely repaid. The 1990s reform closed some of these channels, and sought to bring in a larger role for market forces. But private infrastructure investment was inadequate. So PSBs were persuaded to step in again. Even if losses are due to external causes, promoters have poor incentives when they can escape liability. A readily refinanced bank does not choose projects carefully. Moreover, relationship lending easily degenerates into corruption or gives in to pressure from powerful connections.

Onus on the government

Therefore, refinancing must be accompanied by reforms that build proper incentives. These should increase PSBs’ independence, and force promoters to share risk and potential losses, while making it easier to change management and allow equity infusion to keep viable businesses going. If loans are written off, a business can become viable as fresh equity and new promoters are more likely to come in. Banks with clean balance sheets are more willing to lend.

The problem is banks tend to stop lending to companies whose assets are declared to be NPAs. If an asset is recognised as an NPA, provisions must be made for possible losses. Therefore, before imposing an asset quality review in end 2015, the Reserve Bank gave banks new tools to make restructuring easier. It remains to be seen if these are adequate to provoke the mindset change required to aggressively revitalise projects and lend more.

Even so, it is time for change, for arbitrage-free systems with greater transparency. The government can subsidise industry if it is necessary, but this must be done upfront with the correct share of risk allocated to promoters and minimum discretion. The political system has too often taken taxpayers for a ride, with small benefits masking large hidden costs. They have the right to know what they are paying for. The SC has already asked for information on large defaulters. Stronger boards and improved governance mechanisms can ensure that PSBs make independent decisions on purely commercial grounds.

Appropriate structural change makes some monetary stimulus feasible, both to reduce the pain and in response to the global slowdown. Many negatives need positive counters.