If we want to ensure healthy growth in the economy, we need to ensure that the public sector banking system can restart lending
Banking sector stress in India has emerged as one of the critical risks which could jeopardize growth. There is good reason to worry. Our banks are saddled with too many non-performing loans and credit expansion has slowed dramatically. Growth in industrial credit (year on year) has slowed to less than 5% in the first quarter of 2016. This is clearly not consistent with even 7.5% gross domestic product (GDP) growth, let alone accelerating to 8%.
The nature of the problem
The problem was revealed by the Reserve Bank of India’s (RBI’s) asset quality review, which showed that assets that should have been classified as non-performing were not being recognized as such. Experience from around the world suggests that when such problems are discovered, they must be dealt with promptly rather than covered up.
This was done and the banks have started recognizing non-performing loans and making provisions for them. This has led to large losses in 2015-16. Public sector banks (excluding the State Bank of India) reported a loss of ₹ 29,115 crore, a huge reversal from the profit of ₹ 19,569 crore in 2014-15.
If the problem had arisen in only one or two public sector banks, it would have been easy to handle. The erring banks would have to recognize the non-performing assets (NPAs) and make full provisions and if, as a result, their capital base shrank, they would have to shrink lending to stay within the capital adequacy norms. Other banks which have been more efficient, including both public sector banks and private banks, would expand to take up the space.
The banking system as a whole would become healthier, and the economy would get the credit expansion it needs to sustain growth. Unfortunately, the public sector banking system as a whole is in difficulty. The private sector banks are in much better shape, but they account for only a quarter of total lending, and no reasonable expansion on their part can compensate for the slowdown by the public sector banks.
If we want to ensure healthy growth in the economy, we need to ensure that the public sector banking system can restart lending. This requires action on three fronts: recapitalization of the public sector banks to support expanded lending, cleaning up the NPAs accumulated from the past and improving the quality of lending in future. Each of these is an acknowledged part of the government’s banking reform agenda, but everything depends on the quality and speed of implementation.
Recapitalization of public sector banks
In 2015, the finance ministry had estimated that a revival of growth required bank credit to expand by 12% in 2015-16 and 15% per year for the subsequent three years, and for this, the public sector banks would need an additional ₹ 2.4 trillion of capital by end-March 2019 to meet the Basel III requirements.
Of this total, ₹ 60,000 crore was expected to come from retained profits, ₹ 1.1 trillion from the market by new issues of capital, and ₹ 70,000 crore from the budget. The budgetary contribution was to be ₹ 25,000 crore in each of 2015-16 and 2016-17, declining to ₹ 10,000 crore in each of 2017-18 and 2018-19.
This calculation needs to be completely reworked, given the large losses reported for 2015-16, which more than offset the capital infusion from the budget. And we cannot assume that we have heard the last of the NPA problem.
In addition to declared gross NPAs amounting to 9.8% of advances, the public sector banks are also carrying on their books assets that were allowed to be restructured earlier, in accordance with RBI’s restructuring scheme, amounting to 4.4% of total advances. There are also “stressed assets" which, according to Credit Suisse, amount to a further 6.1% of total advances.
Both restructured assets and stressed assets are currently shown as performing, but a large part could well turn into NPAs in the next two years. In that case, the contribution of profits to building up capital is likely to be very small.
The prospects for raising capital from the markets also need to be revised downwards because PSU bank shares have taken a beating in the markets. For example, Punjab National Bank shares are trading 32% lower than a year ago, Canara Bank 34% lower, and Bank of India 46% lower. Since the volume of equity that can be sold is fixed because of the constraint that government equity must not go below 51%, the amount of capital that can be raised at the prevailing low prices will be much lower than assumed earlier. Furthermore, there will be administrative resistance to selling equity at what will be seen as depressed prices.
It follows that the recapitalization from the budget will have to be much larger than assumed earlier. To remove uncertainty in the markets, the finance ministry would be well advised to issue a fresh press note on the scale of infusion proposed. There are ways of doing this which would not affect the fiscal deficit. One of them is to do it via a special declaration of dividends from the built-up reserves in RBI, as proposed in the Economic Survey.
This could be offset by lower dividends declared in future, allowing the government to make the fiscal adjustment needed over time. Alternatively, the government could hand over government bonds in the required quantity in exchange for equity. International fiscal accounting does not treat contributions to capital of banks as affecting the fiscal deficit in the year it takes place. There would, of course, be an impact over time via the interest payments on these bonds.
The method of distributing capital across banks also needs to be reconsidered. It was earlier announced that each bank would be assured of enough capital to achieve a 7% growth in lending. This approach favours weak banks over stronger performers. A better approach would be for each bank to be assured only of enough capital to avoid an actual contraction in lending. The rest of the capital should be distributed across banks according to some criterion of performance, so the better-performing banks get more capital while the weaker banks are forced to contain lending until their performance can improve. Such an approach would produce a stronger public sector banking system and incentivise efficiency.
Resolving the NPA problem
The legacy problem of NPAs must be resolved as quickly as possible so that the banks can focus on resuming lending. This is easier said than done. Some assets are best classified as loss assets and should be written off in the books, even as efforts are made to recover whatever value can be recovered through liquidation. Unfortunately, the legal process of recovering value is extremely cumbersome. The new bankruptcy code is a potential game changer, but will take time to operationalize. We are at least two years away from being able to test the code in practice. In the meantime, our bankers will have to do the best they can.
In many cases, problem projects can be turned around through a combination of haircuts by the banks, fresh capital from investors and new management. RBI has devised two schemes for this purpose. One is the strategic debt restructuring (SDR) scheme, which allows banks to convert their debt into equity according to a predetermined formula, take control of the company and then induct new management to turn it around.
Action has been initiated in several cases under this scheme but no successful takeover has been completed thus far. One of the problems is that banks typically convert only enough debt into equity to gain control but are unwilling to accept haircuts on the remaining debt, which may be too large for the project to be attractive to a new investor.
The second RBI scheme is the Scheme for Sustainable Structuring of Stressed Assets (S4A), under which banks can offer existing managements an opportunity to rehabilitate the project by dividing the debt into two parts: a “sustainable’’ component, which can be serviced by the project based on some assumptions about revenue, and the “excess’’ component which can be converted into equity or redeemable preference shares.
Sustainable debt must be more than 50% of the total debt. S4A leaves the project in the hands of existing managements and also gives the banks more flexibility in the time taken to resolve the problem. A key issue is how large a part of the debt is deemed to be sustainable. Managements and banks are bound to differ on this issue.
There is much talk of selling assets to privately managed asset reconstruction companies (ARCs), which can then organize the turnaround. Another idea is that the proposed National Infrastructure and Investment Fund (NIIF), operating with private partners, provide both equity and new credit to stressed infrastructure projects going through the SDR mechanism.
In both cases, the critical issue will be whether banks are willing to take a large enough haircut on existing debt to make the restructured project attractive. Understandably, bank managements will hesitate to offer large haircuts in favour of private parties, fearing that their bona fides may be questioned.
This problem could be solved by creating a government-owned “bad bank" which purchases problem loans from the banks, and concentrates on turning the projects around, possibly with the help of private ARCs. Bank managements will be much more willing to sell assets at a discounted price to another public sector company, which will then undertake the task of negotiating the best deal with potential new owners. The terms of reference of the new entity can be sufficiently clarified to encourage it to negotiate the best possible deal with new private managements. It could work in partnership with ARCs to fulfil this mandate.
Improving the quality of lending
We also need to improve the quality of lending by public sector banks in future so that the same problem does not arise again. That raises a number of issues well beyond the scope of this article. A key issue is how to increase the autonomy of the banks to operate as commercial entities. One way of achieving commercial autonomy is to privatize public sector banks but there is no support for privatization of banks in any political party.
A more practical approach would be to reduce the government’s shareholding to say 33%, with the remainder dispersed among the public. This has been recommended by more than one expert committee, and Yashwant Sinha as the finance minister in the Atal Bihari Vajpayee government had publicly favoured this approach, but he could not muster support in the Bharatiya Janata Party.
The P.J. Nayak committee had suggested that if the dilution of shareholding is not acceptable, it should be possible to distance the government from the managements of the banks by creating a public sector holding company and vesting the government’s shares in the holding company. Some statements have been made that this may be acceptable and the newly created Banks Board Bureau is a first step in this direction.
There are two key elements in any effort to distance government. One is that the public sector banks should deal with only one regulator, RBI, and the extensive quasi-regulatory control exercised by the department of financial services should be ended. The role of the government as owner would be performed by the holding company and the government would deal only with the holding company on all issues.
A second requirement is that public sector banks should become board-managed institutions, with the board responsible for all appointments, including that of the chief executive officer (CEO). If the shares of the government are actually transferred to a holding company, then decisions regarding appointments could be taken by the board of the new company on the recommendation of the board of the bank.
It is worth noting that the proposal to separate the post of chairman and CEO is important only if the institution becomes fully board-managed. Unless this is done, the CEO will constantly look to the government as the effective appointing body.
The objective of creating a genuinely commercial environment in which public sector banks can function and managements are made accountable can only be achieved if the government is willing to step back from exercising direct control. Unless strong action is taken along these lines, we can assume that things will continue as they have.
Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.