Tinkering With Reforms Will Not Soothe the Ailing Indian Banking Sector

With the Indian banking sector struggling with the burden of bad loans, will the government undertake radical reforms to ease the stress?

State Bank of India

Not reading the signs right. Credit: Eric Parker

The Indian banking sector has been in the news lately for all the wrong reasons. Non-performing assets (NPAs) threaten to wipe out the entire net worth of many public sector banks (PSBs), profits have plummeted, credit off-take is way below desired levels and markets have hammered banking sector stocks to record new levels with many scrip trading at half the book values. Raghuram Rajan, the Reserve Bank of India (RBI) governor, has declared that the problem is far worse than it appears and a ‘deep surgery’ is required to cleanse the system.

Over the past few days, finance minister Arun Jaitley has tried to soothe the market sentiment. He first assured investors and analysts that the PSBs’ non-performing assets were not as large as Rajan implied and that the government’s plans for re-capitalisation would adequately address the problem. Then on February 14, he announced that a further set of reforms for PSBs will soon be unveiled. With his assurance and the worst third quarter results, markets calmed a bit and the free fall that started on February12 seems to have been arrested, at least for the time being.

What lies ahead

Jaitley has not announced any details of the reforms except to clarify that government ownership in PSBs will not be diluted below 51%. His goal, therefore, is presumably confined to completing the infusion of 70, 000 crore rupees as additional government equity in an attempt to improve PSB capital adequacy levels and implement the remaining agenda of the Indradhanush package of PSB governance reforms. The proposed additional capital infusion will fall far short of the additional capital actually required, which has been estimated by the RBI at around 2.5 lakh crore rupees for reaching Basel III norms. This does not take into account the current spate of NPAs announced by PSBs. A firm estimate of additional capital required by PSBs is surely required at this stage.

With only a partial infusion proposed at present, PSBs will remain hugely under-capitalised and thereby seriously impaired in their credit operations. With its limited fiscal space, the government can at best take the PSBs out of the ICU but not restore them back to health.

Given the obvious lack of appetite for their stocks, PSBs can hardly hope to raise the remainder of the required capital from the market. Even the mighty State Bank of India had to face serious embarrassment when it tried to raise capital through a market issue about 18 months ago. It has since held off any attempt to approach the market to raise further capital. The situation is far worse now. North Block must know that the market will not oblige. That leaves the age-old practice of arm-twisting the LIC and other cash-rich public sector enterprises to pick up PSB equity. But is it prudent to load the LIC, which is the guardian of ordinary citizens’ savings, with such dodgy equity in the forlorn hope of turning PSBs around? This may well end up having a sizeable negative impact on its net worth.

Short of privatising them, turning around PSBs requires that the governance practices and incentive structures that drives their operational behaviour be radically transformed. The government could have bitten the bullet and implemented the Naik Committee’s recommendations that included reducing government holding below 50%; establishing a Bank Bureau to hold all government equity, and determine the pace and nature of its divestment to maximise revenues; create an institutional intermediate agency between the government and PSBs to operationalise the arms-length governance and completely professionalise the boards.

Will this be acceptable to the all powerful Department of Financial Services? It should start by removing all government of India and RBI representative from PSB boards. And will creating a Bank Bureau shield PSB management from post-facto enquiries by the Vigilance Commissioner or the Comptroller and Auditor General? Their fear freezes even reasonable risk-taking by PSB managements, thereby rendering them open to either rank conservatism or acting principally on the behest of their superiors. This hardly makes for efficient commercial banking. Some of these steps may have been on Jaitley’s mind when he referred to banking sector reforms. But these measures, I am afraid, may not achieve the desired results.

Anglo-Saxon vs Chinese model of commercial banking

At a recent seminar on banking sector reforms organised jointly by the Bombay Stock Exchange and the Centre for Policy Research, it was highlighted that private sector-dominated banking sectors are congenitally prone to systemic failures. Since 1980, there have been as many as 110 systemic banking sector crisis in 80 countries where private banks dominate the system, despite best possible supervisory oversight and regulation. The cost of these systemic crisis has been between 3-5% of the GDP in the year in which the crises have occurred. This could be called the Anglo-American or the trans-Atlantic model of banking, which saw the infamous Lehman Bank collapse.

On the other hand, a government-owned and PSB-dominated banking sector requires periodic re-capitalisation, the cost of which has been estimated at best around 0.5% of the GDP. In this model, which can be for convenience called the Chinese model, public sector banks are used as extensions of the Ministry of Finance to channel investment funds to selected industries and regions or to targeted population segments with the explicit understanding that PSBs will be bailed out from time to time as needed.

There is too much confusion all round with the RBI continuing to signal its preference for an Anglo-Saxon model of commercial banking and the government implicitly operating on the basis of the Chinese model, which effectively eliminates all issues of moral-hazard, perverse incentive structures and prescribes uniform working norms for all PSBs that are by definition guaranteed by the sovereign against failure. Riding the two boats leaves the Indian banking sector in the worst of both the worlds.

If Prime Minister Modi is convinced of being able to make the necessary governance improvement, he can go in for the Chinese model of public sector dominated commercial banking in India. That will, however, require a clear articulation of the operational plan and a blueprint for ensuring that PSBs are insulated from the vagaries of multiple regulation, oversight, pressures that prevent due diligence and an incentive structure that strictly links performance to outcomes. This would also necessitate building up a sufficient quantum of fiscal reserves to be used for bailing out the banks. The Chinese have managed that. Alternately, he could simply privatise PSBs and require the system to follow emerging global regulatory norms that strive to reduce the frequency and cost of systemic banking failures. But the choice better be made now.

Rajiv Kumar is Senior Fellow CPR and Founder Director Pahle India Foundation