No rationale for many state-run banks to exist as distinct entities: Srikanth Vadlamani
India has been talking about consolidating its public sector banks, but is yet to initiate any tangible developments on this front, and there is no rationale for so many of these banks to exist as distinct entities, says Srikanth Vadlamani, vice-president, financial institutions group, Moody’s Investors Service, said in an interview.
Another issue, which the government itself has recognized but on which progress has been limited so far, is giving back autonomy to the banks by essentially making them board-run entities, he said, and listed these two challenges as the biggest steps that remain to be taken, as part of the Narendra Modi government’s attempts to clean up the country’s banking system.
At the same time, Vadlamani also acknowledged that India has made significant progress to fix its banking system, with structural reforms such as bank recapitalization as well as the insolvency and bankruptcy code (IBC). “Post recapitalization, the banking system should no longer pose a constraint on addressing credit demand, as and when it revives... IBC’s creditor-in-possession model significantly strengthens the bargaining power of creditors over large borrowers. The much stronger position of creditors should, over the medium term, enhance overall credit availability to Indian corporates,” he added. Edited excerpts:
Most experts share the view that without a strong banking system, Prime Minister Narendra Modi’s vision of making India a $5-trillion economy by 2025 could remain a pipe dream. Do you feel the National Democratic Alliance (NDA) government is yet to realize that fixing the banking system should be its top priority?
With the recently announced bank recapitalization, there has been significant progress in fixing the balance sheets of public sector banks (PSBs). Post recapitalization, the banking system should no longer pose a constraint on addressing credit demand, as and when it revives.
The insolvency and bankruptcy code is also a major piece of structural reform that should directly benefit the banking system over the medium term.
IBC’s creditor-in-possession model significantly strengthens the bargaining power of creditors over large borrowers. The much stronger position of creditors should, over the medium term, enhance overall credit availability to Indian corporate entities.
Given that IBC has been in place only since last year, it is still early days in judging its effectiveness. However, if the spirit of the legislation is achieved, especially with respect to the timelines of the process, this should have the effect of enhancing the quantity and quality of credit available for large borrowers. And, it would also have the positive spillover effect of more participation from non-bank lending sources, including from the bond market. A diversification of large corporate borrowings away from being largely reliant on bank financing would be positive for systemic stability.
On the other hand, PSB governance remains an area where not much progress has been made. Repeated public statements on this issue leave no doubt that the government recognizes the magnitude of challenges in this area. However, the actual actions so far have fallen short of effecting structural changes.
Not addressing these corporate governance issues may not have a perceptible near-term impact. As long as PSBs are well capitalized, they would perform their role of providing credit to the economy. But this situation would be akin to kicking the can down the road.
As we have seen over the past two decades, these corporate governance issues have been manifesting with rather alarming regularity in the form of asset quality issues, which, in turn, have imposed significant costs on the government and the economy.
We often hear that it was due to political interference that banks were forced to lend and were saddled with non-performing assets (NPAs). How can this issue be addressed, and how can the government ensure that doesn’t happen again? The current reforms don’t address this point.
The relationship between the government and PSBs is a key factor which drives the overall performance of these banks; so, clarifying and institutionalizing this relationship has to be part of any structural reform of PSBs. To see this relationship through the narrow prism of political interference aimed at influencing lending decisions would be missing the woods for the trees.
This is not to deny that some of the NPLs (non-performing loans) in this cycle may have been on account of this factor and addressing any such interference is an unambiguous positive. However, in the context of the overall issue at hand, it is the other structural factors which are much more relevant.
Two fundamental issues seem to be hampering this relationship.
First, there is lack of a clear delineation of the role of the government in the actual running of these banks. This has often resulted in micro management by the government and a loss of autonomy at the level of the banks.
The changes introduced by the government, which accompanied the latest round of capital infusion, are an example of such micro management. The government has mandated certain issues such as a limit on banks’ share of corporate loans for a category of PSBs, conditions spelling out when banks should not participate in syndicated loans, and how to monitor large credit exposures.
Undoubtedly, these norms were well-intentioned and keeping in mind the experiences of the banks in the most recent credit cycle. But these are precisely the type of issues that fall squarely in the domain of bank senior management to decide on, if they want to differentiate their banks in the marketplace.
It may well be the case that the government has been repeatedly forced to step in at such an operational level, because there is a lack of institutional capacity in the banks to make these decisions. But such interventions, in turn, have impeded building any capacity at individual banks, with PSBs happy to follow the herd. The striking homogeneity in the functioning of PSBs is a reflection of the lack of strategic autonomy at the bank level.
Second, while this has not been an issue in this cycle, PSBs have also been impacted by a conflation of government policy goals with their own operational goals. In India, as is the case with quite a few other emerging market systems, the broader banking sector regulations already incorporate policy objectives. The priority sector lending norms are an example of this.
However, in case of PSBs, they have often been made to take on more on their plate, and that, too, without any clear framework or guidelines. For instance, at least a part of the spurt in banks’ infrastructure lending during 2009-12 may be attributed to the government focus on ramping up infrastructure investment. Similarly, there is a significant emphasis now on increasing lending to the MSME (micro, small and medium enterprise) sector.
In terms of banking reforms, what are the big steps that still need to be addressed? What more does India need to do to clean up its banking sector?
The government has talked about consolidation of PSBs, although we have not seen any tangible developments on this front.
Consolidation in itself would represent a significant reform. The current structure of PSBs, with 22 of them in operation, is largely a result of how they originally came into existence rather than any justification based on current circumstances. They essentially are in the same business segments, and while some differentiation does exist based on geographic presence, it is not meaningful enough.
As such, there is no rationale for so many of them to exist as distinct entities. More importantly, given the pressing corporate governance challenges, it is much easier to effect focused changes at a smaller number of banks than an unwieldy 22.
Another issue which the government itself has recognized, but on which progress has been limited so far, is giving back autonomy to the banks by essentially making them board-run entities.
Weak board-level governance has led to a lack of continuity in senior management, poor succession planning and almost a vacuum in corporate strategy. The Bank Board Bureau is a structure which, in theory, could be a step in addressing this issue. However, it has not been effective so far.
What is your take on the government detailing how much capital each public sector bank will receive in the fiscal year ending March 2018? Will bad assets haunt banks even in the next fiscal year?
The capital infusion announced by the government is quite comprehensive, and should be able to address the capital needs of the PSBs. The key message from the capital allocation to individual banks is that the government would be supporting all the PSBs, irrespective of their size or the current state of their balance sheets. This situation reflects the government’s priority of maintaining systemic stability.
Given the explicit and unequivocal assurance of the government on recapitalizing all PSBs, concerns on their ability to meet the minimum capital norms after meeting their provisioning requirements should be laid to rest.
In terms of asset quality, the banks seem to be at the end of the bad loan recognition cycle. Already, some banks have been reporting a trend of a declining pace of new NPL formation, and this trend should sustain.
At this point in the cycle, the focus is on the resolution of NPLs. Resolution in most cases would have to involve a meaningful haircut on the banks’ exposures.
The first batch of 12 largest NPLs now in the bankruptcy process would be test cases in terms of the extent of the haircut actually required.
At this stage, it is anybody’s guess on what would be the level of write-downs. In the banks’ favour, they have built up a fair level of provisioning on their overall NPLs, as well as the specific cases in the bankruptcy process. Overall, the extent of write-downs required on their NPL books is the key unknown factor determining their asset quality in 2018.
Banks will also be impacted if the current trend of rising bond yields persists. Significant profits from treasury operations had somewhat cushioned profitability until the last quarter. This stream of income has dried up, and may actually start to prove a negative contributor, if yields rise further. Depending on the extent of further increases in yields, the capital requirements of the banks may be higher than what we are currently estimating.
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