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Slow, steady, and sensible: Modi’s new approach to reviving India’s banks

Reuters/Anindito Mukherjee
Promising measures.
  • T T Ram Mohan
By T T Ram Mohan

Professor, IIM Ahmedabad

Published Last updated This article is more than 2 years old.

The Modi government moved last week to address problems that have bogged down public sector banks (PSBs) over the past three years.

The initiatives are rather belated: at least some should have happened soon after the government assumed office over a year ago. Nevertheless, the government’s initiatives, outlined below, hold out the promise of reviving India’s banking sector in which PSBs have more than 70% of assets.

Reviving India’s banks is key to stimulating credit growth and investment in the Indian economy.

The weight of non-performing assets

India’s banks, mostly PSBs, are groaning under the weight of non-performing assets, arising from loans made to infrastructure, construction and other sectors that have run into trouble since 2012. According to the Reserve Bank of India’s (RBI) latest Financial Stability Report (pdf), gross non-performing assets were 4.7% of total advances in September 2014. Restructured loans—loans where the parties have reworked the terms to prevent a default—amount to another 6.4%.

Typically, around 25% of restructured loans turn non-performing. This would add 1.6% to non-performing loans, making for a total of 6.3%. That is high but still lower than the figure of 10% at the beginning of the previous decade. As finance minister Arun Jaitley put it recently, the situation is challenging but there is no cause for panic or alarm.

The capital conundrum

Banks are required to make provisions for non-performing assets. This erodes their capital. Under international norms, banks need to hold a minimum level of capital, known as capital adequacy, in order to be able to lend. So, when banks’ capital is eroded, it limits their ability to lend. This is one reason credit growth and investment have slowed down over the past few years.

PSBs badly need capital to sustain credit growth in the coming years. The total requirement of capital is estimated at Rs5 lakh crore in the coming five years. This amounts to Rs1 lakh crore every year. Of this, the requirement of equity is about Rs50,000 crore, with the government having to chip in Rs25,000 crore.

Soon after assuming office, the government decided it would give capital to banks based on their performance. Accordingly, it gave banks only Rs6,990 crore in the budget for 2014-15 and Rs7,940 crore in 2015-16. This approach was totally misguided. You don’t punish banks by withholding capital—if you do, the economy takes a beating. You put in fresh capital so that banks can resume lending and revamp management and governance so that problems do not recur. That’s exactly the plan the government unveiled last week.

The government plans to infuse Rs70,000 crore into PSBs over the next four years, starting with Rs 25,000 crore in 2015-16. All banks that need capital will get it, not just the better performing ones. The market approves: PSB stocks rose in value following the announcement.

Revamping management

While infusing fresh capital, the government is moving to revamp management and governance as well. Some of the initiatives are in line with recommendations made in the report of the P J Nayak committee, which was tasked by the RBI to make recommendations on governance in Indian banks. The report (pdf) was submitted in May 2014.

First, the post of chairman is to be separated from that of the managing director in all PSBs except at State Bank of India. Accordingly, the government has named chairmen for five PSBs. In another departure from practice, it has named two professionals from the private sector to head two of the PSBs.

Separating the posts of chairman and managing director is intended to ensure that the CEO does not become all powerful. The flip side is that if the chairman and the managing director do not get along or if the chairman is a political appointee, the bank cannot function smoothly. It is possible to have checks on the chairman-and-managing director by having a strong board of directors, so whether a separation of roles is essential is moot.

Bringing in private sector professionals sounds good in principle but it’s hard to see why the best professionals in the private sector would want the job. Moreover, getting results in the public sector requires an ability to deliver within a host of constraints, so private sector professionals may be at a disadvantage. Both these initiatives need to be monitored carefully.

In other respects, however, the government is not going by the Nayak committee recommendations. The government intends to constitute a Bank Board Bureau (BBB) that will make all top appointments at PSBs, including appointments of independent directors. The Nayak committee had proposed the BBB as an intermediate step towards the creation of a bank holding company to which the government’s equity holding in PSBs would be transferred. It had wanted the BBB to be staffed entirely by eminent bankers so that the government was distanced from the running of PSBs.

The government has instead proposed a seven member BBB, with one chairman, three government representatives—including a deputy governor of the RBI—and three professionals. What we have is a modified version of the Appointments Board, headed by the RBI Governor, which used to make top appointments to PSBs.

Clearly, the government will continue to call the shots when it comes to bank appointments. Nor is the government keen to relinquish majority ownership in PSBs, contrary to what the Nayak committee had recommended. This is understandable.  For the government to relinquish majority ownership in PSBs entails too much of a risk to financial stability. And, as long as the government has majority ownership and is accountable to parliament, it is bound to have the final say in the matter of appointments.

The government is also weighing another recommendation of the Nayak committee—introducing variable pay and stock options as incentives for PSB managers. The government must tread warily. Measurement of performance in the PSB context is not easy. Besides, heavy use of financial incentives can erode both competitiveness and the culture at PSBs.

Those who expected the Modi government to make radical changes in PSBs will be disappointed. It is clear that the government wishes to retain the present framework but would like it to produce better results. This is a sensible approach to take. PSBs did improve their performance over two decades of reform. They can do so again—if only the government is willing to let bankers get on with their jobs.

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