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Business News/ Opinion / The moral hazards of a sovereign guarantee
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The moral hazards of a sovereign guarantee

The explicit government guarantee, and the implicit understanding that these banks can always get capital from the government when in a pinch, ensures that capital is not used as judiciously and effectively as it should be

Pradeep Gaur/MintPremium
Pradeep Gaur/Mint

Earlier this week Indian Overseas Bank (IOB) informed the stock exchanges that the Reserve Bank of India (RBI) has initiated a “corrective action plan" against the bank. A day later, the bank’s managing director and chief executive officer told reporters that the bank had been given a year to reduce bank loans and improve profitability.

The action appears to have come in response to a surge in bad loans and the consequences that it has for the bank’s profitability and its capital adequacy. At the end of the June quarter, the bank reported gross non-performing assets (NPAs) at 9.4%, nearly double of the 5.84% reported a year ago. In absolute terms, bad loans in the 12 months till June 2015 jumped 60%. Profits, as a consequence of the increased provisioning needed against bad loans, fell 95% over a year ago.

The day after the news became public, rating agency Standard and Poor’s (S&P) issued a note. Given the seriousness of the matter (the RBI very rarely initiates such corrective action plans), one would have expected a downgrade in ratings or at least a change in the outlook on ratings. Surprisingly, S&P said that the corrective action plan has no immediate rating impact. The agency justified this by saying that the ratings “continue to reflect our expectation of a very high likelihood that the Indian government will continue to provide extraordinary support to the bank."

That view reinforces a lot of what is wrong with state-owned banks in India. The explicit government guarantee, and the implicit understanding that these banks can always get capital from the government when in a pinch, ensures that capital is not used as judiciously and effectively as it should be.

Earlier this year, the government tried to change this by saying that it will allocate only 6,990 crore to nine well-performing banks. But the smaller and weaker banks, who needed capital the most, cried themselves hoarse. The regulator decided to back the banks and was of the view that a change in capital allocation policy must be staggered. Eventually, the government yielded and allocated more capital to a larger set of banks. That brought us back to square one.

The blame for lack of accountability lies not only with the government but equally with the regulator, which, as this column has argued before, tends to be too easy on banks. For instance, why should the regulator not inform depositors and investors that a bank has been asked to take corrective actions? If anything, this would help stop the rumour mongering that begins whenever there is any sign of weakness at a bank. A clear notice from the regulator saying what went wrong and what corrective action the bank is being asked to take, will only give comfort to depositors. It will also force banks to be more careful as they would seek to avoid reputational risk.

Going by the RBI’s actions, the view appears to be that the regulator must protect the bank’s reputation to avoid any panic among depositors. While there may be some validity to that argument, the regulator must recognise that the strategy has a significant moral hazard attached.

There is one genuine problem that both the government and the regulator face. The question of who to pin the blame on when things go wrong. In the case of IOB, for instance, the current managing director took over in December 2014. Blaming him for the current mess at the bank is futile. Past chiefs of the bank are long gone, as are the general managers and chief general managers, who probably sanctioned the loans that are going bad. So who do you hold responsible and how? The government is trying to give new chiefs of state-owned banks fixed tenures of at least three years. But even that will have minimal impact as the vintage of loans turning bad may be older than that. Simply put, there is little disincentive to act irresponsibly.

To sum up, the backing of the government and the support of the regulator are only adding to the sub-par performance at state-owned banks. This is visible in the higher level bad loans on the books of state-owned banks when compared to private sector peers. It is also visible in the stock market returns (or the lack of any) in the case of these banks.

Over a 10-year period, the returns given by most state-owned banks have been dismal. For instance, the compounded annual return given by shares of IOB, the bank in question, over the last 10 years, is -8.4%. Apart from IOB, seven other state-owned bank stocks have given negative compounded annual returns. Shares of only State Bank of India and Bank of Baroda have given double digit returns. Bank of Baroda alone has managed to beat S&P BSE Sensex returns over the past decade. That says a lot. And what it says is not good.

Ira Dugal is assistant managing editor, Mint.

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Published: 08 Oct 2015, 07:32 PM IST
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