Expect banking revival in 2021

The potential turnaround in banking means the government does not need to act in haste, only to repent at leisure

2020 was a terrible year for the Cassandras pronouncing on the Indian economy. They said the economy would shrink by double digits. They are being proved wrong. They said the banking sector would end up with non-performing assets (NPAS) at a new high. Most likely, wrong again.

The resilience of the banking sector in 2020 was a huge surprise. Gross non-performing assets (GNPAS) stood at 7.5 per cent at the end of September 2020. The RBI’S latest “Trend and Progress in Banking” says that, but for the standstill on recognition of NPAS, GNPAS in the system would have been higher than by 0.1 per cent to 0.66 per cent for a sample of banks.

Even if we took the upper end of the range for the sample and applied it to all banks, GNPAS would have been 8.16 per cent sans the standstill. That is still marginally below the level of 8.2 per cent in March 2020. Given this improvement, the pessimistic estimate in the RBI’S latest “Financial Stability Report” (January 2021) is hard to comprehend. The RBI expects

GNPAS to shoot up to 13.5 per cent by September 2021.

Market analysts don’t share the

RBI’S pessimism at all. The RBI may have overestimated GNPAS in 2021 because it uses the December 2019 data — and not the subsequent improvement — as the base for its two-year projections. Or is the estimate intended to goad the government into coughing up enough capital for public sector banks (PSBS)?

All indications point to a strong revival of the banking sector in 2021-22. Economists Kenneth Rogoff and Carmen Reinhart estimate that it takes a banking sector eight years, on average, to emerge from a crisis. If we take 2011-12, the year that GNPAS started rising, as the commencement of our crisis and allow for disruptions, a revival in 2021-22 is pretty much on the cards.

Then, there is strong growth projected for the coming year. Analysts estimate India’s real GDP to grow by 10 per cent in 2021-22. That could translate into credit growth of over 15 per cent for banks. Expect a boost to the bank bottom line.

Thirdly, banks have sharply increased provisioning in recent years. The provision coverage ratio at banks has increased from 42 per cent in 2016 to 72.4 per cent in September 2020. Thanks to increased provisioning, net NPAS were down to 2.8 per cent in March 2020. The bad loan legacy is almost done with.

Indian banking is now roughly in the position it was in 2002-03. At 10.3 per cent of loans, gross NPAS at PSBS are at about the same level as in 2002-03, 9.4 per cent. The banking sector recovered strongly after 2002-03 on the back of rapid growth. There is every prospect now of the story repeating itself.

As in the years after 2002-03, a turnaround at public sector banks (PSBS) looks highly likely. Consolidation among PSBS should begin to yield results. The quality of top appointments has improved under the Banks Board Bureau. Private banks, which have been growing their books at 15 per cent or more in recent years, will have to slow down as their systems get stretched. Don’t be surprised if PSBS begin to claw back some of the lost market share of the past decade.

The looming improvement at PSBS means that the policy prescriptions dished out in recent years for a sinking segment — a bad bank, a Bank Investment Company (BIC), wholesale privatisation — are no longer appropriate. Bad loans have been adequately provided for. So there is no great need for a bad bank that will take bad loans off the books of banks. Banks needed to be empowered to address bad loans through restructuring and a one-time settlement. After the pandemic, this is happening.

The BIC is intended as a vehicle distanced from the government and to it the government’s shares in PSBS will be transferred. The BIC will be initially 100 per cent government-owned but it will itself hold less than 50 per cent of the shares in PSBS.

If the government wishes to free PSBS from political interference, it can do so under the present dispensation. We don’t need a BIC for the government’s share-holding to drop below 50 per cent. It can happen even otherwise with amendments to the law.

We need greater clarity on PSB recapitalisation. A common refrain is that the government’s capital infusion into PSBS yields very little because of poor valuations of these banks — it is “money down the drain”. We need to understand why PSBS’ valuations are so low.

Thanks to fiscal constraints, the government infuses only enough capital for PSBS to meet the regulatory minimum. The capital adequacy ratio of PSBS in March 2020 — of 13.1 per cent — was one percentage point above the regulatory requirement. Two things happen when PSBS operate at the regulatory minimum of capital.

One, managers at PSBS are reluctant to take risks in lending. Credit growth and the net interest margin suffer as a result and this impacts profitability adversely. Two, valuations depend on how far above the regulatory minimum a bank’s capital is — the higher the capital, the more stable it is perceived to be. Private banks in India tend to operate at around five percentage points above the minimum and command commensurately high valuations. The government’s inability to infuse capital is in itself an impediment to high valuations of PSBS.

The pat answer that some have to the recapitalisation challenge is to let the government’s shareholding fall below 50 per cent in PSBS. That way, PSBS can access capital from the market without making demands on the fisc. If only matters were so simple! Shedding majority ownership in PSBS at one go could seriously jolt depositor and investor confidence and adversely impact growth in financial savings.

There is a strong case instead for the government to be discriminating in its approach to PSBS. The stronger PSBS today can access capital from the market under majority government ownership. The government might conserve capital for infusion into these PSBS so that they operate at well above the minimum. In PSBS that cannot access capital from the market, it might consider a strategic sale.

Even the latter is not easily accomplished. The sale of weak PSBS at the present valuations could prove highly contentious. The prudent course would be to first infuse the minimum capital required into weak banks until their valuation reaches a respectable level.

It follows that the government must adopt a threephased approach. In phase one, provide adequate capital to the stronger PSBS and just enough capital to the weaker ones. Allow performance and valuations to improve. In phase two, attempt a strategic sale of two or three weak PSBS and watch the outcomes for a few years. If the outcomes are satisfactory, in phase three, allow the government stakes in a few PSBS to fall below 51 per cent but hold on to majority ownership in the stronger PSBS.

The situation does not admit of quick fixes. In the interests of financial stability, caution is required. The potential turnaround in the banking sector means the government does not need to act in haste, only to repent at leisure.