Urgent next steps in banking sector reforms

We must accelerate recoveries from non-performing assets, recapitalize public sector banks, and introduce reforms that will increase the efficiency of these banks

Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Now that the Bills on goods and services tax (GST) have been passed by the Lok Sabha, the top priority must be fixing the problems of public sector banks. This requires action on three fronts. We must (i) accelerate recoveries from non-performing assets (NPAs), (ii) recapitalize public sector banks to strengthen their ability to expand credit, and (iii) introduce reforms that will increase the efficiency of these banks

This article explores how we might address these challenges.


The traditional strategy for dealing with NPAs has been to reschedule the loans. However, this helps only where projects suffer from a short-term “liquidity problem”. It cannot help when there is a “solvency problem”, i.e. the income stream simply cannot service the debt even over a longer period. Most of the large NPAs reflect solvency problems. revenue streams were overestimated and costs have increased beyond original projections.

Such projects can only be rescued if banks take a haircut and reduce the debt. Understandably, this is something bankers hate to do. There are two ways of handling the problem. The Reserve Bank of India (RBI) has notified schemes for both, but neither of them has worked.

The Strategic Debt Restructuring Scheme allows banks to convert the debt into equity, take control of the project, remove the existing management, and induct new management. Ideally the project should be auctioned off to the highest bidder and the existing management, if not suspected of malpractices, should also be allowed to bid. The difference between the amount paid for the equity and the value of the debt converted, is a market-determined debt write-off. The scheme has not worked for a variety of reasons. These include problems of coordination among the different banks involved, regulatory uncertainties (especially for infrastructure projects) which deter new investors, and the unwillingness of bankers to accept a sufficient write-down of the outstanding debt. There is also the practical problem of running the projects taken over until a new management comes in. Banks are ill-equipped to do this.

The second option is to work with the existing management and negotiate a suitable debt reduction. This is what the RBI’s most recent Scheme for Sustainable Structuring of Stressed Assets (S4A) was designed to do. It has the advantage of not having to look for a new management, but since the incumbent management remains in place, and the debt write-off is not competitively determined, there is a danger that the concessions given may attract the charge of cronyism and corruption. Bankers worry about this since Section 13.1. d (iii) of the Prevention of Corruption Act (Poca), 1988 makes a public servant liable to the charge of corruption if he/she, “while holding office as a public servant, obtains for any person any valuable thing or pecuniary advantage without any public interest” (italics added). Bank employees are public servants for the purpose of the Act, and the term public interest is not well defined.

Some think that the problem can be overcome by setting up an independent “oversight body” to approve the debt reduction terms. But since the oversight body will also consist of public servants, the problem remains. Poca clearly needs to be amended, and a proposal pending in Parliament should be expedited. However, this may not suffice, because proposals for a settlement have to be developed by bank managements, and then submitted to the oversight mechanism. Bankers have no incentive to propose large reductions in debt, especially since it is an implicit acknowledgement of poor lending practices on their part.

The best solution is to create a new government institution—the so-called “bad bank”—to which the public sector banks transfer their large problem assets at a realistic price, leaving it to the new entity to handle recovery. Realistic pricing of the assets transferred is absolutely critical, since otherwise the hole in the balance sheets of banks will simply be transferred to the new institution. It should remain in the books of the banks, and can then be recapitalized appropriately. Bankers will be much more willing to transfer their NPAs at a low price to a new public sector agency, than offer the same benefit to a private party. The new entity can then offer realistic levels of debt reduction without making a loss on its books. It will also be much less vulnerable to the charge of corruption if the public interest and urgency involved in cleaning up NPAs is clearly spelt out in the mandate of the entity. Its proposals could also be vetted by a high-level oversight board.

The new entity would have to be funded by the government, perhaps by government guaranteed bonds which are exchanged for NPAs offloaded from banks. It could work in partnership with private asset management companies specializing in particular areas to bring in new investors. It could experiment with both approaches—a change in management in some cases, and retaining existing managements in others.

These ideas have been discussed in several quarters for some time. It is time to take the plunge and announce the establishment of the new institution, and set a target for taking up 10-20 of the largest NPAs in the near future. Early success will help clear the air.

Recapitalization of public sector banks

The capital requirements of public sector banks to sustain credit growth at 15% per year were estimated by the finance ministry two years ago. The strategy needs to be completely reworked since the scale of NPAs is much larger than was then expected. Bank profits after provisioning for the NPAs will therefore be much smaller than expected. The scope for raising funds from the market has also reduced given the poor performance of the banks. The burden on the budget is therefore bound to be higher.Three difficult questions arise.

(i) Will the additional capital now needed be provided by additional budgetary funds? If sufficient budgetary funds cannot be provided, is the old idea of falling back on the RBI’s reserves going to be activated?

(ii) Are we willing to lower the government equity below 51% in order to allow public sector banks to raise capital on favourable terms? If so, it may be possible to attract one or more strategic investors into some of the public sector banks. They need not be given any direct role in management, but could be given a seat on the board, as China has done. The reduction in government equity below 51% may be resisted because it jeopardizes reservations in employment. These fears can be addressed by building suitable provisions into the shareholders agreement, and announcing that the government, which will remain the dominant though not the majority shareholder, will ensure that reservations continue.

(iii) Should budgetary funds for recapitalization continue to be distributed across public sector banks in the traditional way, with the weaker banks getting proportionally more in order to achieve a reasonable growth in lending, or should we allocate them in a manner which favours the better-performing banks?

The latter approach will increase the overall efficiency of the public sector banking system as a whole, and incentivise the weak banks to improve their performance.

Reforms in the banking sector

Looking ahead, we cannot avoid serious banking sector reforms if we want the public sector banking system to become more efficient. In this context, reducing the government equity below 51%, and attracting some strategic investors, would be a very major step. It will not only reduce the pressure on the budget to provide funds for recapitalization, it will also set the stage for a more commercial orientation for public sector banks. This is critical if public sector banks are to compete more effectively with private sector banks.

If reducing government equity below 51% is not feasible at present, we should at least experiment with the halfway house suggested by the P.J. Nayak committee, of vesting the government’s shareholdings in public sector banks in a separate holding company, and limiting the finance ministry to deal only with the holding company on policy issues. The individual public sector banks should be free of finance ministry control and become board-managed entities. The holding company should appoint a non-executive chairman and other representatives on the board. Top appointments in the banks, including those of the chief executive officer, should be made by the board of each bank, and not by the appointments committee of the cabinet.

The Bank Boards Bureau was initially seen as a step towards the establishment of a holding company, but it has not been empowered to play this role. Even in the matter of appointments, it only makes proposals to the appointments committee of the cabinet, which is not very different from the pre-existing position.

The steps listed above may appear controversial, but if we can’t move in this direction, we should be realistic and not expect any significant progress in the resolution of the NPA problem, or improvement in the quality of lending by public sector banks, in the future. This is bound to take a toll on our economic prospects for the next several years until private sector banks grow in size and come to dominate the market. But that could take 20 years.

Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.

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