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RBI should not capitalize public sector banks: Raghuram Rajan

File photo. Raghuram Rajan urged state-run banks and company promoters to deal with the problem, while also calling on the government to infuse capital to the sector—steps he has previously advocated during his tenure. Photo: Abhijit Bhatlekar/MintPremium
File photo. Raghuram Rajan urged state-run banks and company promoters to deal with the problem, while also calling on the government to infuse capital to the sector—steps he has previously advocated during his tenure.
Photo: Abhijit Bhatlekar/Mint

Raghuram Rajan defends RBI actions, including ordering PSU banks to conduct comprehensive asset quality reviews of their balance sheets

Mumbai/Bengaluru: Reserve Bank of India (RBI) governor Raghuram Rajan on Wednesday urged the government to infuse capital into public sector banks, while repeating his opposition to using the central bank’s own reserves.

Rajan, who announced his decision not to seek a second term on Saturday, chose his second public appearance since then to explain the causes and remedies of the bad loan problem facing the Indian banking sector.

“Governments are sometimes reluctant to infuse bank capital because there are so many more pressing demands for funds. Yet, there are few higher-return activities than capitalizing the public sector banks so that they can support credit growth," Rajan said at an event organized by industry lobby Assocham in Bengaluru. He added that some of the fund infusion can be linked to stronger performance, so that better banks have more room to grow.

Acknowledging that the government’s resources are limited, Rajan floated the idea of bank recapitalization bonds, although he said this is a less effective form of capital.

“The banks would hold the bonds on their balance sheet. This would tie up part of their balance sheet, but would certainly be capital," he said.

Rajan once again rejected the idea of using RBI’s reserves for recapitalizing banks, first floated in the Economic Survey in February.

“The Economic Survey has suggested the RBI should capitalize public sector banks. This seems a non-transparent way of proceeding, getting the banking regulator once again into the business of owning banks, with attendant conflicts of interest," he said, adding that a better way is for RBI to give all its surplus earnings to the government in the form of dividends to be used for recapitalizing banks.

“In the last three years, we have paid all our surplus to the government. Separately, the government can infuse capital into the banks. The two decisions need not be linked."

Rajan also dismissed the argument that high interest rates are leading to low credit growth. Loan disbursals will pick up only when bank balance sheets are cleaned up, he said.

“I will argue that the slowdown in credit growth has been largely because of stress in public sector banking and not by high interest rates. As such, what is required is a clean-up of the balance sheets of public sector banks, which is what is underway and needs to be taken to its logical conclusion," said Rajan.

Through a series of charts, Rajan showed that the slowdown in credit growth in the past two years was mainly because public sector lenders were cutting back on disbursements to infrastructure firms and small enterprises.

“The silver lining message in the slower credit growth is that banks have not been lending indiscriminately in an attempt to reduce the size of stressed assets in an expanded overall balance sheet, and this bodes well for future slippages. In sum, to the question of what comes first, clean up or growth, I think the answer is unambiguously clean up!" Rajan said.

It is evident from the data that public sector lenders have been slowing their loan disbursals to infrastructure projects. Credit offtake to industry by public sector banks shrunk 2.7% in April 2016, a sharp decline from a growth of 12% in April 2014.

At the same time, private sector banks were more willing to lend to these sectors, given that the stress on their loan book was minimal, Rajan noted. Loan disbursals of private sector lenders grew 20.2% in April 2016, faster than the 16.9% growth in April 2014, Rajan showed in his chart.

Another worrisome trend is the slowdown in loan disbursals to the micro, small and medium enterprises (MSME) that are labour intensive. The MSME loan portfolio of public sector lenders that grew by an impressive 25% in April 2014 is now down to almost nil in April 2016, Rajan showed through another chart.

Given that the lending rates of private sector banks are usually equal or higher than that of public sector lenders, the argument that high interest rates prevented companies from borrowing is misplaced, he said.

“The logical conclusion, therefore, must be that it is not the level of interest rates that is the problem. Instead, stress is because of the loans already on PSB balance sheets, and their unwillingness to lend more to those sectors to which they have high exposure," Rajan said.

Rajan last year had asked lenders to recognize a large pile of distressed loans as bad. The directive resulted in many lenders racking up huge losses, while profits of others fell. Bad loans in the banking system rose to an unprecedented level of 5.8 trillion as of 31 March.

In his speech on Wednesday, Rajan stressed that state-run lenders must be brought back to lend to the infrastructure sector, explaining the criticality of clean bank balance sheets in this context.

“Rather than an across-the-board shrinkage of public sector lending, there seems to be shrinkage in certain areas of high credit exposure, specifically in loans to industry and to small enterprises. The more appropriate conclusion then is that public sector banks were shrinking exposure to infrastructure and industry risk right from early 2014 because of mounting distress on their past loans," he said.

He said that during 2007 and 2008, lenders had given loans based on flimsy frameworks that led to a misreading of future prospects of the projects.

As domestic demand slowed, the projections of various projects were rendered unrealistic, he said.

Malfeasance also contributed in some cases. Further, incentive structure and the short tenure of public sector bank chiefs encouraged pushing the problem into the future, Rajan said. “The short tenure of managers means they are unwilling to recognize losses immediately, and more willing to postpone them into the future for their successors to deal with. Such distorted incentives lead to overlending to or “ever-greening" unviable projects," he said.

The problem worsened due to a lack of monitoring of the loans and poor recovery mechanisms of banks, he said. “The inefficient loan recovery system then gives promoters tremendous power over lenders," Rajan said.

The governor found support from both bankers and analysts. “While his point is valid, pushing banks to clean up even before you have resolution systems in place could have been avoided," said a senior banker on conditions of anonymity.

“I agree with what the governor has to say. The slowdown in credit was seen much before and at that time, the capital of PSU banks was under pressure because of Basel, and investigations were also initiated in many cases," said Ashvin Parekh, managing partner at consulting firm Ashvin Parekh Advisory Services Llp.

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