Abhijit Bhatlekar/Mint
Abhijit Bhatlekar/Mint

Improving public sector banks’ efficiency priority for government: report

Implementation of the Goods and Services Tax (GST), the most widely anticipated pending reform, is unlikely to be smooth

Cyclical and political headwinds have continued to shape policy outcomes in the second year of the National Democratic Alliance (NDA) government’s term, and the focus has been on incremental measures rather than bold reforms, according to a report by Standard Chartered Bank.

While the pace of policy changes has been more gradual than initially expected, they are moving in the right direction, said the report titled India—Policy changes: Inching in the right direction.

Implementation of the Goods and Services Tax (GST), the most widely anticipated pending reform, is unlikely to be smooth. While the ruling party is likely to gain more seats in Rajya Sabha in 2016, it will fall short of the two-third majority required to push through the GST legislation. The government will need to build political consensus with regional parties ahead of elections in India’s largest state.

Most investors under-appreciate the medium- to long-term positive impact of some of the policies being pursued by the current government. The recent approval of the bankruptcy bill is a noteworthy positive.

Measures to increase financial inclusion, enhance the efficiency of subsidy disbursal, increase railway investment, and foster ‘competitive federalism’ (increased competition between states), while incremental in nature, and are likely to lead to eventual growth gains.

Efforts to kick-start India’s investment cycle, cited by the government as one of its most important policy priorities, are set to continue.

A clear pick-up in the investment cycle is likely only with a lag, however. External and domestic headwinds, including slow export growth, high corporate leverage, excess capacity and the clean-up of banks’ balance sheets, are likely to continue to curb private investment, which is crucial to a sustained growth revival. Reduced support from public investment due to fiscal constraints is also expected.

Banking sector

Public sector banks (PSBs) dominate India’s banking system, accounting for 70% of system assets.

These banks have been weakening for the past two decades, consistently losing market share in both deposits and loans to private sector peers. They are less efficient in delivering services, and suffer from cost inefficiencies and consistently higher delinquencies than private banks. This has resulted in declining profitability and capital efficiency.

In recent years, declining pre-provision profitability and high loan delinquencies have led to a heavy capital drain on PSBs. Moreover, market concerns about endemic problems in the sector have led to a sharp decline in earnings and book multiples.

This has left the banks solely dependent on the government for capital at a time when fiscal constraints limit the government’s capacity to provide it. The issues facing PSBs are largely governance related, and reforms in this direction should therefore be the government’s priority.

What has been done?

Numerous government committees have been set up over the years to address governance-related problems in the banking sector. In terms of implementation, however, most governments have done little beyond providing enough capital to ensure the banks meet minimum regulatory requirements. The Modi government has gone a bit further.

In August 2015, acting on some of the recommendations of the P.J. Nayak Committee, it announced a plan to recapitalise PSBs and improve their governance.

The ‘Indradhanush’, or Rainbow, plan includes (1) a four-year PSB recapitalisation plan, with capital provided to banks based on criteria including size, efficiency and need for capital; and (2) the establishment of the Banks Board Bureau (BBB) in April 2016 to reform the governance structure of PSBs.

Challenges ahead

Improving the efficiency and competitiveness of PSBs is a critical priority for the government, as these banks are India’s primary providers of growth capital. Loan growth numbers for the past two years highlight the challenges they face. PSBs’ loan book increased at a 7% compounded annual growth rate, versus 20% for private sector banks. Insufficient capital is only part of the problem; governance is the bigger issue, and the government’s plan does not do enough.

The government plans to inject 70,000 crore into PSBs over the FY16-19 period; 25,000 crore of this has already been provided. The banks urgently need a larger capital injection that exceeds the 45,000 crore balance.

Capital injections and a clean-up of bad loans will help in the near term; however, governance changes are imperative for PSBs’ long-term viability. Establishment of the BBB is aimed at improving governance.

Edited excerpts from Standard Chartered Bank report India—Policy changes: Inching in the right direction.

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