India’s big bank makeover
Under Raghuram Rajan, the Reserve Bank of India is trying to overhaul the way banks function
Mumbai: When Raghuram Rajan took over as Reserve Bank of India (RBI) governor a year ago, he knew exactly what he wanted to do and spelled it out.
Rajan spoke about freeing branch licensing, allowing banks to open outlets without seeking the regulator’s permission, putting in place a system of “on-tap" bank licensing and introducing differentiated models of banking to support India’s goal of delivering basic banking services to every household.
He also promised steps to improve management and resolution of a rising pile of stressed assets in the banking system as he assumed office on 4 September 2013, at a time when the economy was mired in a downturn and headed towards a second straight year of sub-5% growth.
“This is part of my short-term timetable for the Reserve Bank. It involves considerable change, and change is risky. But as India develops, not changing is even riskier," Rajan warned after taking charge as the 23rd governor of the central bank.
In the year since, many of those changes have been set in motion and India’s banking sector is still trying to adjust to the pace set by the former chief economist of the International Monetary Fund (IMF). There have been no complaints about inaction, only about the rapidity of change that’s coming.
“There are too many changes too soon. You have to give the system time to adjust," said a career banker who currently heads a mid-sized foreign bank, requesting anonymity. He acknowledged that the changes were needed and will help the system in the long run.
To be sure, it’s still a work in progress. The proposed reforms are far reaching and cut across every aspect of the banking system— from cleaning up bad loans and cracking the whip on wilful defaulters to improving corporate governance, opening up new avenues for capital raising to putting new bank structures in place.
But the process is underway, and there’s no doubting the seriousness of the central bank— and the new government of Prime Minister Narendra Modi—to complete it.
When Rajan moved to the corner office at RBI headquarters on Mumbai’s Mint Road, inflation had been surging and the rupee sliding. Bad loans of banks had been rising as slower economic growth and delayed regulatory approvals stalled projects and crimped cash flows, making it tough for borrowers to repay debt.
Gross non-performing assets (NPAs) had increased from 2.4% in March 2011 to 4.4% in December 2013. But if you added the accounts which were being restructured either bilaterally or through the so-called corporate debt restructuring (CDR) cell, overall stressed assets accounted for 10% of total loans.
By past standards, this may not have been high, but in order to prevent bad assets from rising further, Rajan moved quickly to put in place a new distressed asset management framework and sent out a tough message— that defaulting company promoters must be held accountable.
Getting tough
“Promoters do not have a divine right to stay in charge regardless of how badly they mismanage an enterprise, nor do they have the right to use the banking system to recapitalize their failed ventures," Rajan said then.
Large value restructuring now needed to be evaluated independently and borrowers who did not cooperate with the resolution process would see their access to funds become tighter and more expensive.
“You have to manage an account in a way that when it shows stress, you start working with it at that stage rather than wait for it to turn NPA. This is what was behind the RBI’s thinking," said Aditya Puri, managing director of HDFC Bank Ltd, India’s second-largest private sector bank by assets.
Stressed borrowers should not be allowed to play one bank against another, said Puri. “It is better that the whole system identify him as a stressed asset. And when he moves from the first level of stress to the second level of stress, it is better that everyone get together and find a solution," he said.
While bankers agree that the new framework is improving the way in which stressed assets are managed, inevitably some glitches have surfaced in the new framework, which are still to be ironed out.
For instance, several banks have sought a relaxation of a rule that says that the joint lenders forum (JLF), set up for accounts where repayment is overdue by more than 60 days must come up with a corrective action plan within 30 days and sign off on the plan within 60 days.
“...there are certain areas in the framework such as techno-economic viability study and joint lender forum meetings which take more time, so we are asking the RBI to give us that," said Shyam Srinivasan, managing director and chief executive officer of Federal Bank.
Still, Srinivasan concedes that the framework has helped improve customer behaviour; customers want to avoid being tagged “special mention accounts". The new framework created three categories of such accounts based on how long repayments on these accounts are overdue.
Banks will first need to undertake a forensic audit to ensure an account is viable and a borrower is not a wilful defaulter, before finalizing a restructuring package, according to K.V. Karthik, senior director, financial advisory services at Deloitte Touche Tohmatsu India Pvt. Ltd.
“Based on our experience, this process has taken much longer in the past and hence we will need to see how lenders address this concern," said Karthik, adding that another issue is borrowers who have multiple banking arrangements.
“It is difficult to say whether banks will try to minimize their exposures directly rather than opting for a JLF, which may end up in NPA recoveries, in case restructuring is not found viable. This would possibly defeat the very purpose of the JLF itself," he said.
Tackling wilful defaulters
RBI along with the government have also sent a strong message to the system that wilful defaulters must be dealt with strongly.
Rajan is also working with India’s capital markets regulator to toughen norms for wilful defaulters by blocking access that such borrowers have to all public funds, including via the capital markets. Currently, wilful defaulters are prevented from accessing bank funding but can access money from the capital markets.
The central bank is also looking at the creation of a new category of borrowers termed non-cooperative borrowers.
“Non-cooperative defaulters may not be in violation of the laws but we have this genre of promoters who hold up collections at every court using every instrument. That’s perfectly legal but from the perspective of the financial system it’s a problem because it can take years to collect. So we are saying that you are not a criminal but you are a financial risk. From that perspective, can we increase the cost of any new loans made to that person? Hopefully that makes the person think twice. So there is a financial stability angle there," said Rajan in an interaction with reporters on 7 August.
The classification could help banks as the process of classifying a defaulter as a “wilful defaulter" requires them to prepare documentation supported by requisite evidence, according to Karthik of Deloitte Touche Tohmatsu India.
“This may prove difficult in case the borrower adopts delaying tactics and does not cooperate and or provide access to banks/forensic auditors to examine their books of account. In such cases, the non-cooperative classification can help banks," said Karthik.
Meanwhile, the government, in consultation with RBI, is working on strengthening recovery mechanism like the Securities and Reconstruction of Financial Assets and Enforcement of Security Interest (Sarfaesi) Act, 2002, and Debt Recovery Tribunals, which are the last resort for lenders to recover money from defaulters.
The track record of these recovery mechanisms has not been encouraging so far. For instance, only ₹ 18,500 crore in loans have been recovered under the SARFAESI Act in FY13, according to RBI data. That compares with the ₹ 68,100 crore worth of loans where the law was invoked. At the country’s 33 Debt Recovery Tribunals, cases worth ₹ 1.44 trillion were pending as of 31 March 2013, according to the latest statistics published by the finance ministry.
Governance standards
The surge in bad loans over the last two years exposed another weak link in the banking system—governance at India’s state-owned banks, which still account for 70% of assets in the banking industry.
According to the RBI’s annual report, not only were the gross and net NPA ratios of state-owned banks more than the industry average, they also accounted for about 92% of the restructured loans. This, is turn, sparked concerns about governance and credit appraisal processes followed by these banks.
Instances such as the arrest of the chairman of Syndicate Bank—a small-sized state-run bank—in an alleged bribes-for-loans scandal have further highlighted the shortcomings in state-owned banks and drawn attention to the need for reforms.
“...international experience suggests that governance structures in state-owned banks merit special attention, such as by ensuring a healthy complement of independent and professional directors, strong fit-and-proper appointment processes, and by mandating that they be at arm’s length from political interests which may impact commercial decisions," Thomas Richardson, senior resident representative (India and Nepal) at the IMF, said in an August interview.
Some of these reforms had been highlighted by a committee set up by Rajan in January to review the governance of boards of banks.
The committee, headed by veteran banker P.J. Nayak, submitted its report in May and suggested a series of changes including splitting of the post of chairman and managing director of state-controlled banks and giving longer tenures to the chiefs of such banks.
Most importantly, the committee recommended that the government set up a bank investment company and transfer its holding in the state-owned banks to this company as a way to distance itself from the functioning of the banks.
The committee’s recommendations are yet to be implemented and analysts have noted that many of them need significant legislative changes and strong political backing.
“...implementation of the key recommendations will require changes in legislation, and there is much uncertainty over whether there is the political support necessary for its passage. Other recommendations that do not require legislation have a much higher likelihood of implementation, and will help strengthen corporate governance standards—particularly at the state-owned banks," said ratings agency Fitch in a note published on 26 May after the recommendations were released.
To be sure, some progress is being made with the new government suggesting that it is looking into proposals to give longer and fixed tenure to chiefs of state-owned banks and is also considering splitting the post of chairman and managing director to improve governance structures.
“Professionalizing the management of the banks, we have taken some decisions in this regard. We expect banks to have better risk management. The department of financial services has been actively working in this regard" a Press Trust of India report cited finance minister Arun Jaitley as saying on 25 August.
Capital requirements
While reforms in state-owned banks has been a long-pending issue, a more immediate issue is the large amount of capital needed by these banks to offset rising bad loans, meet the Basel-III international capital norms and to support growth in the Indian economy.
State-run banks need ₹ 2.4 trillion in equity capital to conform with Basel-III norms by 2018, finance minister Jaitley said in his budget speech in July.
“In order to meet this huge capital requirement, we need to raise additional resources to fulfil this obligation. A part of this fund would be mobilized through public offerings made to retail customers," Jaitley said.
But raising the entire amount of capital requirements from retail investors seems like a tall order and institutional investors may need to be roped in. Banks such as Canara Bank and Union Bank of India have stated their intention to raise funds through so-called qualified institutional placements to professional investors, but these issues are yet to be launched.
As one way to facilitate capital raising, the RBI recently eased norms for raising money via bonds issued under Basel-III norms. The changes included reducing the maturity of such bonds and allowing banks to issue such securities to retail investors.
The RBI also allowed a temporary writedown of the principal value of the bonds in case the bond issuer finds itself in trouble. In case the bank reaches the point of non-viability, then the writedown should be permanent, RBI said.
All this is expected to make it easier for banks to raise capital, but it still may not be enough.
“While the recent relaxations are expected to widen the investor base and increase investor appetite...raising such large capital would still be quite a challenge for PSBs (public sector banks). Their inability to raise such large capital could impact their growth as well as market share," rating company Icra Ltd said in its quarterly update on the banking sector released on 3 September.
New banking structures
While near-term issues are being tackled one at a time, a longer-term agenda to create a more heterogeneous banking industry that can meet the diverse needs of the Indian economy is also being chalked out.
The proposals envisage the setting up of small banks and payment banks as one way to increase penetration of financial services. While payment banks are envisaged as entities limited to accepting deposits and remittances of funds, small banks are seen as local-area lenders that will provide a full suite of basic banking services, including loans and deposits.
“What they are moving towards is a more differentiated banking sector and if we go in that direction, we will eventually catch up with what we should have had from the start," said Shinjini Kumar, leader of the banking and capital markets practice at PricewaterhouseCoopers, adding that the RBI has started to become more sensitive towards different types of businesses rather than just the size of the business.
According to a recent study by industry body Associated Chambers of Commerce and Industry of India, about 100 entities, including microfinance institutions, telecom companies, non-banking financial companies and public sector companies are waiting to apply for such licences once the final guidelines are announced and RBI invites applications.
“The opening-up of the sector suggests that the banking sector’s market share of the total financial sector will increase, particularly with potential conversion of large players like the postal department and some finance companies. As banks are more closely regulated than finance companies, we believe that will benefit the overall stability of the financial sector," said Geeta Chugh, senior director and analytical manager, emerging Asia financial institutions, at rating agency Standard and Poor’s.
Revamping cooperatives
What could potentially emerge as a game changer for the banking sector is the attempt to make the cooperative banking sector more mainstream—an issue which the RBI lists as one of its agendas for 2014-15.
“The Reserve Bank plans to engage with the government of India for enabling legal changes to help large and willing multi-state urban cooperative banks to convert themselves into commercial banks," the central bank said in its annual report.
Currently, conversion of urban cooperative banks into commercial banks is not permitted but such a move could help widen the reach of the commercial banking sector rapidly, given the existing network of cooperative banks. As of 31 March 2013, India had 1,606 urban cooperative banks with outstanding advances of ₹ 1.81 trillion and deposits of ₹ 2.77 trillion.
However, any change in the legislation governing cooperative banks may prove to be difficult as cooperative banking remains a state subject, said Kumar of PwC.
While cooperative banks have a wide network, not many of them are efficiently run, which may prove to be a hindrance in any plan to use such banks to increase the penetration of financial services, said Nasser Munjee, chairman of Development Credit Bank, the only urban cooperative bank to have converted itself into a commercial lender—back in 1995.
“Cooperatives are not particularly well run. There are only a handful of cooperative banks that are well run," said Munjee, while adding that regulations should not prevent the conversion of such well-run cooperative banks into scheduled commercial banks.
“There is always this debate about consolidating the banking system. My view on the issue has always been that in a sub-continental country, this idea of having a few banks doesn’t make sense. I think what we have needs to be expanded. You need to have many more banks," said Munjee, commenting on the proposal to create new banking entities like small banks and payment banks.
But will this expansion in the sector hurt the profitability and business of existing private and public sector banks, which have already seen a slowdown in the growth of their business due to a slowdown in the economy?
No, says Puri of HDFC Bank. “There is more than enough demand and each structure will cater to a particular need," Puri said.
Vishwanath Nair contributed to this story.
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