‘We must not sow the seeds of another lending excess’

The recently released Global Financial Stability Report by the International Monetary Fund brings out the following salient facts:

The Indian industrial sector is now among the most heavily indebted in the world in terms of the ability of its cash flows to meet its bank loan repayments ; and,

The Indian banking sector comes out as worse-off compared to other emerging economies in terms of how little bank capital it has set aside to provision for losses on its assets.

What does it mean to have little bank capital as provision for losses? I like the following analogy. A bank not keeping adequate capital buffer to absorb losses on its loans that are more or less known to be arriving soon is akin to not preparing to rescue with emergency a person who has slipped off the terrace of a skyscraper, and instead in the midst of his almost surely fatal descent, hoping that the laws of gravity would somehow freeze and work differently this time. While such under-provisioning problem extends to some of the private banks too, the scale of the problem is three to four times magnified in the case of public sector banks (PSBs).

By and large, this scenario meets the adverse conditions of the narrative I provided about banking and banking panics. But in our context, several questions immediately come to mind: Why should I worry about whether I can bank upon my bank when my deposit is insured by the government? More so, if my deposits are with a stateowned bank? Why should I bother about my bank’s asset quality?

The double-edged sword of deposit insurance and state ownership of banks

Answering these questions is crucial to understanding how our banking sector problems are likely to play out. A moment of reflection reveals as long as I trust the deposit insurance and the guarantee of the state behind PSBs, I have no good reason to run and pull my deposit out of an insured deposit or a state-owned bank. The catch is this. When banks are in poor health, it does affect the potential borrowers. Once a bank’s asset quality is adequately impaired, the bank does not grow its lending book much with fresh loans. Bank management of a thinly capitalised bank is interested in primarily making two kinds of loans: First, ever-greening of existing bad debt — throwing more money after the bad, so as to help the borrower repay past loan, not acknowledge its true quality, and simply kick the can down the road; second, risky loans that give banks high returns so that it can make a last-ditch effort to rebuild capital quickly — doubling up bets in a casino when first round of gambling has all gone sour. Faced with such borrowing prospects, healthy borrowers who have access to alternative forms of finance may be able to switch out of bank borrowing. Financial intermediation, however, is likely to grow at an anaemic pace, and many deserving borrowers likely to remain starved of credit.

Ironically, the presence of a large safety net of deposit insurance and state ownership, which ensure that there are likely to be no bank runs, end up eroding any disciplining force that gets the bank health restored to a state where the economy can bank upon its banks to perform the economic function of fueling and lubricating growth.

And, indeed, recent global experience has shown that governments need to be watchful as to how large the safety net adds up to relative to its own capacity to provide for it.

Bank resolution options

I wish to propose that we deal with the ailing PSBs in creative ways instead of just propping them up with state aid. Let me elaborate. We keep hearing clarion calls for more and more government funding for recapitalisation of our PSBs. Clearly, more recapitalisation with government funds is essential. However, as a majority shareholder of PSBs, the government runs the risk of ending up paying for it all.

We must not allocate capital so poorly, recreate “heads i win, tails the taxpayer loses” incentives, and sow the seeds of another lending excess. There are better ways to do it. Let me offer five options:

Private capital raising: The healthier PSBs could have raised private capital by issuing deep discount rights in 2013, and some can still do so now. They must be required to do this to share the government’s burden of recapitalising banks. It might be a good way to restore some discipline and get the bank shareholders, boards and management to more seriously care about the quality of lending decisions.

Asset sales: Some banks will have assets or loan portfolios that are in good enough shape to be sold in the market. Modern banks no longer just make bank loans but also hold non-core assets such as insurance subsidiaries, market-making divisions and foreign branches. Such non-core assets can be readily sold. Other assets could be collected across banks and organised into different risk profiles, so as to build transparency and trust with healthier banks and other intermediaries with an interest in purchasing them. Such asset sales can generate some of the needed recapitalisation.

Mergers: As many have pointed out, it is not clear we need so many PSBs. The system will be better off if they are consolidated into fewer but healthier banks. After all, we do have cooperative banks and microfinance institutions to provide community-level banking. So some banks can be merged, as a quid pro quo for timely government capital injection into the combined entity. It would offer the opportunity to rejig management responsibility away from those who have under-performed or dragged their feet the most. Synergies in lending activity and branch locations could be identified to economise on intermediation costs, allowing sales of real estate where branches are redundant. VRS can be offered to manage headcount and usher in a younger, digitally-savvy talent pool into these banks.

Tough prompt corrective action: Undercapitalised banks could be shown some tough love and be subjected to corrective action, such as the revised Prompt Corrective Action (PCA) guidelines recently released by the RBI. Such action should entail no further growth in deposit base and lending for the worst-capitalised banks. This will ensure a gradual “run-off” of such banks, and encourage deposit migration away from the weakest PSBs to healthier PSBs and private sector banks.

Divestments: Undertaking these measures would improve overall banking sector health, creating an opportune time for the government to divest some of its ownership of the restructured banks, as it has over time in many other sectors of the economy. Perhaps re-privatising some of the nationalised banks is an idea whose time has come? All this would reduce the overall amount the government needs to inject as bank capital and help preserve its hardearned fiscal discipline, which along with a stable inflation outlook and the diverse nature of our growth engine, appears to have made India the darling of foreign investors at the present moment. Excerpted from RBI Deputy Governor Viral Acharya’s speech – “A bank should be something one Can “bank” Upon – at the FICCI FLO Mumbai Chapter on Friday