Three Reforms That Also Set India's Public Banks on a Bad Loans Path

The regulatory environment has not helped, nor have the owners.

Note: This is the second piece in a three-part series that examines the problems facing India’s public sector banks. Read the first here.                               

The mid-1990s saw seismic changes in India’s economy – as well as across its financial sector. For our purposes, though, we will focus on three major changes (‘reforms’, as we are so fond of calling them) in our banking space that left the most lasting impact on the industry, in particular on our public banks.  In each of these areas, the driving force was an impetus to ‘liberalise’ credit appraisal as well as credit delivery by banks.

Looking back, it is not difficult to understand why some of us had serious reservations even then about the way the transition was being handled.

The first move initiated by the Reserve Bank of India (RBI) sought to reduce delays in credit delivery for the corporate sector by undermining the consortium approach to large lendings. In a credit consortium, a number of banks get together to lend to a large client/project. The lead bank typically does the credit assessment, settles the terms and conditions of the loan (the tenure, the rate of interest, securities/collaterals etc) in discussion with the client and then shares its assessment with other banks. After these banks have vetted the appraisal and satisfied themselves about its acceptability, each bank approves its allocated share of the credit limits. The terms of the credit approval are the same across the consortium.

Often enough, this system brought on delays: for a large consortium, pooling the many approvals by different banks obviously took time. Rather than trying to address the systemic flaws and plug the holes, however, the RBI decided that the consortium approach was no longer essential and that a large corporation could raise several loans with different banks on a one-on-one basis, the loan terms being bilaterally agreed between the bank and the client.

Soon enough, the ‘Multiple Banking Arrangement’, as the new dispensation came to be called, became a possible breeding ground for unregulated credit expansion. What was even worse is that an unscrupulous client could collect a large number of credit approvals from a large number of banks and then shop around for the most favourable loan terms. Eager and under pressure to step up credit disbursements, banks were often willing to relax their credit approval terms very substantially. This was laissez faire in its classical form and had all the ills that inevitably follow in its wake.

The second reform was linked to the long-term margins that a project’s promoters were earlier required to arrange themselves without recourse to the banking system, called, in the context of working capital borrowings, ‘net working capital’. While certain normative minimums were earlier in place, the RBI in 1995 felt that the minimum-related stipulations were no longer necessary. Effectively, it meant that the promoter margins could be substantively lower from then onwards, and banks could insist on such margins only at the risk of losing custom. In an environment of easy money and high expectations on all sides, only a faint-hearted bank would stick with the stricter norms.

Somewhat later, in the late 1990s, the RBI permitted a relaxation in the norms for identifying a stressed asset that was to have far-reaching consequences. In a scenario where a large corporation had borrowed from several lenders and its accounts with one of those banks had slid to the NPA status, every lender was required to classify that same borrower’s account as an NPA, regardless of the status of loan servicing in its own books. This provision enforced some amount of borrowing discipline because the prospect of identification by a host of banks as a defaulting borrower significantly limited the corporation’s ability to borrow any further, indeed to carry on with its business in the usual manner. The RBI now decreed that this was no longer necessary, that each bank was free to classify a borrower’s account as an NPA or otherwise depending on the record of recovery of that loan in the books of the bank concerned.  

This ‘relaxation’ eventually proved to have seriously deleterious consequences: an errant borrower could now cock a snook at borrowing discipline by managing to keep just one of its loan accounts in order (while all the others were NPAs) and run his business with relative ease by using the one standard account that continued to be at his disposal. Banks also became increasingly inward-looking and far more opaque in dealing with one another, thus compounding the problems still further.

Former RBI governor Raghuram Rajan introduced the ‘asset quality review’ process whereby stressed assets were identified on an across-the-banking industry basis. Credit: PTI/ Files

This last policy aberration was sought to be undone in a somewhat roundabout manner by former RBI governor Raghuram Rajan, by introducing in 2014-15 the ‘asset quality review’ process whereby stressed assets were identified on an across-the-banking industry basis. Rajan knew he could not approach the problem from the perspective of India Inc – the system would never have allowed him to –and he chose the route that, as the governor of the central bank, was available to him. Famously, he called this the ‘twin balance sheet problem’. Skeletons started tumbling out of all manner of bank cupboards and, for reasons discussed in the earlier despatch, it was the public banks that showed up in much the poorer light. Their NPAs went through the roof and every completed quarter brought fresh misery. For these banks, it was as though the apocalypse was suddenly here.

For understanding the backdrop to the current crisis in our public sector banks, it is also necessary to consider how the sector has sought to absorb new technologies over the last 12 years or so. As scandalous as it may sound,  I will argue that, on balance, technology has managed to do more harm than good to many of these banks. The problems were often inherent in the technology platforms that we selected, but what really tilted the scales against success with new technology was the speed at which these banks went ahead with the project of full computerisation and nation-wide networking. The research was patchy and rushed, inter-linkages were poorly examined, and the training needs of employees – many of whom had spent nearly their whole working lives in a completely non-computerised environment – were given virtually a  go-bye. On another level, while many of our public banks had been traditionally customer-friendly, the new technology obviated the possibility of direct customer-banker interfaces in increasing measure.

Here again private banks scored handsomely over public banks. All the bigger private players, in any case, came into operation with the new technologies already integrated into their functioning. The burden of an ageing work-force, trained and skilled in ‘manual’ banking techniques but hopelessly at sea in their new work environment, was not one that the private banks carried. Besides, their logistical and infrastructural needs were far better met.

They appeared on the scene as fully functioning machines humming with operational efficiency, while their older public sector brothers had to reinvent themselves all over again. The one thing that was supposedly the public banks’ biggest strength – government support – actually turned out to be its worst liability. Governments everywhere speak in the language of deadlines and compliance. Imagination and creative thinking are their eternal blind spots. For India’s public sector banks, a governmental initiative spelt doom yet again – this time in the technology upgrade project.

For three decades, Anjan Basu worked for one of the largest commercial banks in India, inside the country as well as on overseas assignments.