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Reuters/Lucas Jackson
But, what can I do?
THE NPA PROBLEM

There is only so much Arun Jaitley’s budget can do to fix the rot in India’s banking system

T T Ram Mohan
By T T Ram Mohan

Professor, IIM Ahmedabad

Most analysts see raising public investment as the principal challenge in finance minister Arun Jaitley’s forthcoming budget. An equally big challenge is allocating enough funds for recapitalising public sector banks (PSBs). Analysts and investors will also wait to see whether Jaitley fulfils the government’s promise to set up a Bank Board Bureau (BBB) to appoint top management to PSBs and whether there is progress on a Bankruptcy Law.

The issues in the banking sector, however, go well beyond the remit of the budget.

India’s public sector banks (PSBs) have made headlines in recent weeks, thanks to rising non-performing assets (NPAs). No PSB has failed, so we do not have a banking crisis that typically involves the failure of several banks. A few PSBs, the Reserve Bank of India governor has indicated, may fail to meet the minimum regulatory capital required.

Others face an erosion in capital, which impairs their ability to lend. Without greater lending, the fall in private investment, which is primarily responsible for the deceleration in India’s economic growth, cannot be reversed. Recapitalising PSBs and restoring them to health should be a priority for the Narendra Modi government.

Addressing the challenge requires us to understand what has brought about the present situation, what to do with NPAs and how to prevent such a situation from recurring in the future.

What explains the rise in NPAs?

Commentators have a ready explanation for rising NPAs and losses at PSBs: incompetence and corruption. This may be true of some banks and some loans. However, the more fundamental reason is the nature of loans made by PSBs and the many shocks that the banking sector has been exposed to in recent years.

As of December 2014, five sectors accounting for 25% of the exposure of all banks had a share of 51% of all stressed advances. These were mining, iron and steel, infrastructure, textiles and aviation. Of these, steel and infrastructure accounted for 40% of the total stressed advances.

Here is the share of these five sectors in advances and stressed assets across banks:

Share in advances (%) Share in stressed assets (%)
Public sector banks 29 53.1
Private sector banks 13.9 34.1
Foreign banks 11.3 40
All scheduled commercial banks 24.8 51.1

The figures make one thing evident: private and foreign banks chose to take a lower exposure to these sectors than PSBs and have been less impacted as a result.

You could argue that PSBs should not have lent so much to these sectors. But then, it was private investment in infrastructure that drove the economic boom between 2004 and 08. Without the loans made by PSBs, we would not have had the much-touted Indian economic boom. The State Bank of India chairman, Arundhati Bhattacharya, has drawn attention to the unexpected shocks to which banks have been exposed:

“Gas was supposed to be available abundantly, it did not happen. We are supposed to be getting all approvals within short periods of time, which did not happen. Mining was closed down because the law-enforcement agencies could not ensure it was being done legally. Surely, the banks were not responsible for that. Mines were allocated and cancelled; licences accorded and taken away; rupee as a currency depreciated.”

Incompetence and corruption can explain some of the NPA problem but not all of it.

How do we deal with NPAs?

There are two crucial elements involved in dealing with NPAs: recognising and providing for them, and trying to recover as much as possible from them.

The RBI wants banks to clean up their balance sheets by 2017. It has pushed banks to fully provide for NPAs as quickly as possible. The positive side to this is that banks cannot disguise bad loans and continue to lend to undeserving promoters. The negative side, highlighted by Deepak Parekh, is that PSBs’ capital can get eroded so sharply that they will be rendered comatose.

The markets will not make capital available to PSBs in their present state. Instead, capital to compensate for losses must come from the government. This will have to be substantially higher than the Rs70,000 crore over the coming four years that the government has committed itself thus far.

There is, therefore, a compelling case for the government to depart from its promised fiscal deficit target of 3.5% of GDP for 2016-17 on grounds of recapitalising PSBs alone. Analysts will be closely watching the budget’s allocation for bank capital.

Another remedy proposed for the capital problem is consolidation amongst PSBs: under-capitalised and weak banks can be merged with healthier ones. This is not such a great idea for now. Mergers typically pose formidable managerial challenges that today’s troubled banks may not be equal to.

Banks must focus even more on recovery. This means restructuring loans where promoters can be trusted and can bring in fresh capital; throwing out promoters who cannot be trusted and bringing in new owners and management; and simply liquidating assets where no other approach is possible. It’s hard work, given India’s tardy legal processes, but PSBs need to put their best foot forward until the promised Bankruptcy Law comes through.

How to prevent bad loans from shooting up again?

There are some who believe that the very public sector character of PSBs militates against any sustained improvement in performance. The long-term solution, they say, is simply to privatise PSBs. They are wrong on two counts.

One, PSBs did show a steady improvement in performance for most of the post-reform period right up to 2011-12. Two, private ownership, we have learnt from the financial crisis of 2007 and the many banking crises across a range of economies, is no insurance against failure or against imposing costs on the tax payer. Banks above a certain size, whether private or public, have to be bailed out by the government because of the havoc that bank failure inflicts on the broader economy.

In any case, finance minister Jaitley has ruled out privatisation of PSBs in the near future. We need, therefore, to work towards improving governance and management within the framework of public ownership.

PSB boards must be professionalised and quality professionals inducted. We need a much better process of selecting CEOs for PSBs. The proposed BBB is expected to become operational in April this year. It will have representatives of the government as well as outside experts and will appoint CEOs and independent directors and also advise PSBs on matters of strategy. PSBs also need to improve their risk management processes. Human resources skills need to be improved across the board through training and mentoring.

Above all, it is vital that the government maintains a certain arm’s-length relationship with PSBs. Prime minister Modi has assured banks that this will happen. If the government can live up to its promise, we can expect better days for PSBs.

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Read all our stories on Budget 2016 here.