India gets serious about its banks
Finance Minister Arun Jaitley has outlined a plan to resolve Indian banks’ bad debt problem by shifting the focus from moral suasion and heightened transparency to proactively resolving the accounts of the 50 most indebted companies. This intervention is needed, as most banks would rather wait for handouts than sell bad assets at a steep discount. Skepticism is warranted, as past reforms have not solved the underlying problem. But the will to reignite the stalled credit and investment cycle is deepening, with the Reserve Bank of India’s new deputy governor Viral Acharya warning that India risks incurring a Japanese-style “lost decade.”
India relies on its banks for nearly 80% of its financing needs. The sector is dominated by 27 public-sector banks (PSBs) which account for more than 70% of total lending. Listed lenders recorded gross bad loans of INR7.2 trln (US$110 bln) at the end of December, concentrated in PSBs. With non-performing and restructured loans as high as 20% at some banks, the financial cancer has spread to the real economy. Credit growth was an anemic 3.3% in February, while private investment has been in the doldrums since 2012.
Discounting the few decent performers—especially State Bank of India, the country’s largest lender, and stellar private banks like HDFC—a little over half the banking system is struggling. Indian Overseas Bank, with non-performing loans in excess of 20% and total stressed assets of about 40%, is the worst offender—one of half a dozen or so PSBs with no sound commercial reason to survive. Until now, the state has drip-fed just enough capital to keep these decrepit banks alive.
From what I can glean from speeches by central bankers and talking to Indian bank analysts, a tougher approach is imminent. A proposal by deputy governor Acharya would place the banks’ largest debts under the control of a private asset management company, which would then invite private investors to bid for the stressed assets. These plans would be vetted by credit rating agencies, leaving the banks to pick the most desirable option. Any unresolved assets would be mopped up by the new bankruptcy code.
This is quite a departure from the RBI’s previous schemes, which put the onus on banks to heal themselves. First it permitted banks to extend the maturity of infrastructure loans, which account for roughly one-quarter of NPLs. Then it permitted them to swap debt for equity in defaulting firms and bring in new management. And finally it permitted them to divide outstanding loans into sustainable debt and equity. But stressed infrastructure loans have continued to sour, while few banks have the expertise to turn around troubled businesses.
Meanwhile, the government’s “Rainbow” plan—billed as the biggest banking reform since the bank nationalizations of the 1970s—has proved a damp squib. Fitch estimates that India’s lenders need US$90 bln of fresh capital to meet new Basel III capital norms by 2019, but New Delhi has only offered US$11.5 bln. A plan to transfer the management of PSBs to a privately-managed holding company has fizzled out. And a government-appointed committee, set up to improve governance in PSBs, has proved little more than a glorified appointments agency.
A more radical approach could entail new private capital raising, increased asset sales, widespread mergers, and—if Acharya’s proposal gains traction—“tough love” to prevent failing banks from lending or accepting deposits. This would funnel capital away from the weakest banks, which have a price-to-book ratios of around 0.5 or lower, to healthier PSBs (with P/B ratios of about 1) and private sector banks (with P/B ratios of 1.5-4). The worst performers would then be allowed to wither and die, while the share prices of the surviving PSBs would soar (see chart). India may even achieve its long-awaited sovereign credit rerating.
Whatever happens, a much larger public bank recapitalisation than that already planned is necessary. This could blow a hole in the government’s fiscal consolidation plan and would be a tough sell politically, especially given the public perception that many banks are run by government cronies. But India will never achieve its dream of 8-10% economic growth with a broken banking system. And after the shock of demonetisation, such radical reform is no longer unthinkable.