Central bank oversight has ensured that the Indian banking sector is in good shape. But in a strange policy twist, the government has approached the World Bank for a loan to recapitalise the nationalised banks that may well come with conditionalities for extensive financial deregulation.

As the world commemorates the first anniversary of the collapse of Lehman Brothers, it would be useful to remember that India was one of the few large economies where banks did not run into trouble.

We do know how banks in India escaped the scourge of high finance. A refusal by the central bank to allow banks to deal in exotic/toxic instruments, introduction of regulations that required greater provisioning against risky lending and the creation of stricter controls on loans to commercial real estate were some of the measures that helped to keep financial institutions safe in India. Union Finance Minister Pranab Mukherjee’s explicit mention in the 2009 budget speech of the role played by bank nationalisation was an acknowledgement of what we did right.

Now in a strange twist of policy, the government is in the process of finalising a multi-billion dollar loan from the World Bank to augment the finances of the public sector banks (PSBs). In January, the government announced in the second stimulus package that it would recapitalise the PSBs to help them expand lending in 2009-10. Soon afterwards the World Bank announced that as part of its expanded assistance to India during 2009-11 it could consider assisting in the recapitalisation of the PSBs but that the matter was “yet to be discussed with the government.” By early May, officials of the Finance Ministry were informing the media that a proposal had been sent to the World Bank for a loan of Rs. 16,000 crore-Rs 17,000 crore ($3 billion plus) to inject capital into the PSBs. And although Parliament was informed in July that the government was yet to finalise the loan, what was definite was that negotiations were on, with the World Bank and for capitalisation of the PSBs.

Why is the Finance Ministry looking at a $3 billion loan from the World Bank to recapitalise the PSBs at this point of time? All official and independent evaluations indicate that the nationalised banks and the banking sector as a whole are in good shape.

According to international norms (the Basel standards), the capital to risk-weighted assets ratio (CRAR) of banks — the summary measure of the amount of capital that is necessary to cover unexpected losses — should be a minimum of 9 per cent. The CRAR for all Indian banks stands substantially higher than this minimum and has steadily improved over the years. It was 12.3 per cent as of March 2007, rose to 13 per cent in March 2008 and further to 13.2 per cent in March 2009. This measure of capital adequacy is higher than what the banking sector in the United States, the United Kingdom and Japan now possess. Note also that even as the banks in the advanced economies were floundering in 2008 and needed a massive input of resources, their counterparts in India were improving their CRAR without any capital infusion. Only two banks in India — one an old private sector bank and the other a foreign bank — had a CRAR of between 9 and 10 per cent. Capital adequacy in the PSBs as a group is itself well above the norm: it was an average of 12.5 per cent as of March 2008.

The Committee for Financial Sector Assessment, the high-level Reserve Bank of India-Government of India evaluation of the financial sector that was completed earlier this year also noted that going by a number of “financial soundness indicators” — capital adequacy, asset quality and profitability — banks in India were in good shape at the end of 2008.

The PSBs may be adequately covered today but does that mean they have sufficient capital to cover a growth in lending in the future? Indeed, the argument on the need to recapitalise the nationalised banks is just that. As the CFSA noted, if the growth of lending by Indian banks is going to be substantial, then the requirements of recapitalisation will also be substantial.

Until now, the requirements of recapitalisation have been met by the government. If the government now feels that it cannot provide resources for the banks it owns, then it must look elsewhere — to the World Bank. (For at least now, recapitalisation by privatisation of the PSBs — another route for capital infusion — is not on the agenda. Or is it not?) This is likely to be the justification for the $3 billion application to the World Bank.

There are two problems with this “external funding is the only option” argument.

First, assuming — and this must be an assumption — that the PSBs do need an infusion of capital and that this is beyond their capacity to mobilise on their own, is a loan from the World Bank the only option? There are other options. Consider how China recapitalised its big three banks in the first half of this decade (the Industrial and Commercial Bank of China, the Bank of China, and the China Construction Bank ) and again as recently as in November 2008 a fourth large bank, the Agricultural Bank of China. The government through the Central Bank of China injected capital by using an unusual financing mechanism: foreign exchange reserves of upwards of $ 40 billion were routed through the state-held Central Huijjin Investment Corporation to hold equity in the commercial banks. This way the banks received additional capital and they remained in government hands.

India does not have to think of such a large transfer. The relatively trifling amount of $3 billion that it is said is needed for recapitalisation can surely be transferred (out of the current total foreign exchange reserves of $265 billion) to the PSBs, just as China did with a much larger amount. Such options should also surely be a less expensive option than taking a loan from the World Bank that will come with conditions. Perhaps because we take our intellectual counsel and policy advice from institutions based in Washington, we are unable to think of alternatives.

The second problem with the “World Bank loan is the only option argument” is that it may be hiding more than it reveals. It is quite likely that the real reason for the government wanting to go to Washington for a loan to fund recapitalisation is something else. Over the past four to five years we have had this tussle between the Finance Ministry and the Reserve Bank of India over the content and pace of financial liberalisation. It was a tussle in which fortunately for the economy the central bank by and large got the better of the argument. But the demands and desires of New Delhi have not ceased. We have had two high-powered groups on banking and finance (both set up by the government and not the central bank) — the Raghuram Rajan and Percy Mistry committees — both of which made recommendations, that can largely be described only as “market fundamentalist” and called for a significant liberalisation of the financial sector in a number of areas. The government has so far not found it easy to push through implementation of these recommendations. What better way to do so than to bring in at least some of them through World Bank conditionalities? And what better opportunity for the World Bank to meddle with India’s financial sector? While a lot is often said about conditionalities being forced on to governments, an unspoken practice in a number of countries is for domestic “reformers” to shoot from the hip of international organisations to overcome domestic resistance.

True, the loan now under negotiation will only provide funds for the PSBs and will not cover the financial sector as a whole. To that extent there will be limits on how much of deregulation can be effected in this manner. The conditions of the loan (partial disinvestment? bank consolidation? what else?) will be restricted to the functioning of the PSBs. It is, however, not unknown for the World Bank to bring in larger policy changes in a sector through narrow loans. An externally-aided bank recapitalisation package that comes with conditions will also be a good way of sidestepping the resistance of the RBI.

India escaped the worst of the 2007-09 financial crisis by following its own path, even if the overarching approach remained one of global integration and gradual financial liberalisation. It did seem that Washington and London could even learn from India on how not to blow a bubble that would bring banks to their knees. Is our government now preparing to do the opposite of what stood it in good stead?

(The author is Editor of the Economic and Political Weekly , Mumbai.)

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