The Modi government’s attempts to accelerate growth and realise the promise of achche din face two formidable obstacles today. One is the adverse global environment. The other is a banking sector weighed down by bad loans. There isn’t much we can do about the first. But the second can be tackled and should have been tackled by now. Unfortunately, precious time has been lost for want of clarity on the way forward. The Reserve Bank of India (RBI) is better placed than anybody else to feel the pulse of the banking sector. It will be up to the incoming RBI governor, therefore, to show the way.
The bulk of the bad loans is with public sector banks (PSBs). As bad loans mounted and banks had to make provisions for these, profits fell at PSBs or losses mounted. PSB performance suffered in comparison with private banks. The P.J. Nayak committee, constituted by the RBI, came to a quick conclusion in its report presented in May 2014: the problem at PSBs was fundamentally one of governance.
Active and passive investors
The committee argued that it was a mistake for the government, the majority owner, to be an active investor. Instead, it should become a passive investor. It should hand over its governance role, first to professional bankers and then to independent boards of directors. As the promoter, it should have no say in the appointment of chairmen and managing directors of PSBs. Try telling this to private sector promoters.
The Nayak committee’s diagnosis was flawed. If governance at PSBs was so poor, how did PSB performance show considerable improvement over most of the post-reform period? Yes, there were poor appointments and bad loan decisions. But these are not the most important reasons for the bad loan problem at PSBs over the past four years.
PSBs had lent to vital sectors, steel, aviation, mining, infrastructure, textiles, all of which came to be impacted by factors beyond the control of bankers. Steel has been exposed to heavy dumping by the Chinese; the telecom sector was impacted by the cancellation of 2G licensees; the power sector by the cancellation of coal blocks; and so on. Private banks had a relatively limited exposure to these sectors as they had chosen to focus on retail loans. That’s why they fared better. PSBs have ended up paying a price for funding the infrastructure boom that drove India’s phenomenal growth in 2004-08.
If you believe that governance at PSBs is primarily responsible for bad loans, you are bound to think that no good can come out of them until the right boards and managing directors are in place. You will think that bad loans are the result of pervasive ‘scams’. You will not see merit in giving adequate capital to banks so that they can step up lending — why waste scarce resources?
For a year or so, it appeared that the NDA government had become hostage to the Nayak committee’s diagnosis. The outcome has been ‘banking paralysis’, somewhat akin to the ‘policy paralysis’ that felled the UPA government. PSBs have been paralysed by lack of capital and a fear psychosis at all levels.
Ultimately, good sense seems to have prevailed. The government did not buy the thesis of the Nayak committee. It has moved to professionalise appointments at PSBs but intends to keep government equity holding at PSBs at a minimum of 51 per cent. This is welcome. But the government hasn’t gone far enough in tackling the key issues, namely, bad loans and bank recapitalisation. As a result, conditions in the banking sector have steadily worsened.
The response to a banking crisis is fairly standard. Recognise and provide for bad loans. Change management where necessary. Infuse capital into banks so that fresh lending and growth happens. Ours is not a banking crisis (which involves multiple failures of banks), we have a stressed situation. But the steps required are the same.
Too many mistakes
In implementing this standard protocol, we have made several mistakes. There is a sense that the RBI has been somewhat harsh in the norms it has imposed on bad loan recognition. Not all defaults are wilful or mala fide. There are situations where a project is stalled for reasons beyond the promoter’s control. In such situations, additional loans may be required to see the project through to completion. If loans in such cases are declared as non-performing assets, no further lending is possible, and the project is doomed.
Second, almost all bad loan resolution requires banks to write off some portion of the loan; otherwise the firm or the project is unviable. The RBI came out with schemes that allowed banks to stretch out loan repayments over 25 years and to convert loans into equity. These have proved inadequate. Loan write-offs are essential. The RBI’s latest restructuring scheme allows banks to divide loans into ‘sustainable’ and ‘unsustainable’ portions and to write off a portion of the latter. This initiative should have come much earlier.
Third, given the hysteria created over the bad loan problem, bankers are unwilling to take decisions on loan write-offs. They fear that they will invite action from the investigating agencies even after they have retired. This is understandable given the way the government has handled the Kingfisher Airlines case.
Top bankers are of the view that the offer made by Vijay Mallya does provide a basis for a settlement. However, nobody is willing to make a move given that the government seems intent on scoring political points. The government has now said it will constitute a high-level panel to vet loan settlements by banks. This too comes at least a year late.
Fourth, the government has been niggardly in infusing capital into PSBs. It has promised banks Rs.70,000 crore of equity capital over four years starting 2015-16. Most analysts think this amount hopelessly inadequate. It may be enough to meet the minimum regulatory requirement of capital, but it does not suffice to promote loan growth. The intention seems to be to let some PSBs just stay afloat until they are merged with stronger entities or sold to strategic investors. This is bound to hurt loan growth.
Fifth, the government is rushing to merge SBI and its five associate banks. Ostensibly, this is meant to create a bank that is in the top 50 banks by size in the world. The overriding priority today should be to address the bad loan problem. It does not help at all to saddle banks with the managerial headaches posed by merger. If a merger is intended, the benefits of the merger must be clearly articulated to investors and analysts. No such analysis has been presented. It is also strange that attempts at merger should focus on the strongest PSB when it ought to focus on the weakest banks.
Banking is a play on the economy. Strong economic growth can take care of the bad loan problem. This requires greater public investment and a revival of private investment.
Public investment is constrained by self-imposed targets for fiscal consolidation. Private investment is held back at least in part by high real interest rates that flow from the RBI’s policy of inflation-targeting. A revival of banking cannot happen by addressing issues specific to the sector alone, such as settlement of bad loans and bank recapitalisation. The answers to banks’ problems lie partly in the economy at large. The government and the incoming RBI governor need to sit together and revisit the present economic policy framework.
T.T. Ram Mohan is a professor at IIM, Ahmedabad.
PSBs have ended up paying a price for funding the infrastructure boom that drove India’s phenomenal growth in 2004-08