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The Indian banking system was almost broken when the economic reforms began more than two decades ago. The rapid expansion of credit since bank nationalization as well as bizarre schemes such as loan melas left banks with enormous bad loans and abysmally low levels of capital adequacy.

Indian banking has come a far way since then, despite the occasional wobbly moments. Yet, there can be no doubt that there are growing problems. The dramatic decision by the Reserve Bank of India last week to restrict the lending activities of United Bank of India is one indication that some banks could be in serious trouble as a result of their lax lending.

Much of the stress is concentrated in the public sector. Their bad loans have quadrupled since 2008, with restructured loans also rising sharply. A Mark-to-Market column in this newspaper recently cited a presentation by the Indian central bank that showed how the provision coverage of banks was worse than that in crisis-hit European countries such as Portugal and Greece.

How deep is the problem? A full-blown banking crisis seems highly unlikely. But there is reason for concern if economic conditions continue to deteriorate. The results of the latest stress tests conducted by the banking regulator should be released in its forthcoming report on financial stability; they will make for interesting reading.

Finance minister P. Chidambaram has told Parliament that top 30 problem accounts are responsible for more than a third of the total bad loans in the books of the public sector banks. The All India Bank Employees Association, a trade union, has earlier this month released a consolidated list of the largest defaulters. The list is headed by companies such as Kingfisher Airlines, Winsome Diamond and Jewellery, Electrotherm India, Zoom Developers and Sterling Biotech. Interestingly, none of the large overleveraged Indian conglomerates and infrastructure companies can be found on the list. It is perhaps safe to assume that these companies have used their clout to get their problem loans restructured.

The Indian central bank is clearly concerned about the rising tide of bad loans and restructured assets in Indian banks, especially those owned by the government. It is expected to put out a new discussion paper on the problem later this week. Governor Raghuram Rajan has also said that wilful defaulters or a new category called uncooperative defaulters—who do not collaborate with lenders to achieve equitable and efficient resolution of stressed assets—may be forced to pay higher interest rates for future loans.

India is just coming out of a huge credit boom during which bank loans rose much faster than an increase in nominal gross domestic product. It is not unusual for a financial system to be burdened with bad loans at the end of such a credit party.

The real issue is what to do now. There are several issues worth considering. First, any efficient economy must encourage the failure of firms so that capital gets reallocated to newer uses rather than getting frozen in hopeless projects. But it is also true that some firms run into temporary trouble in a cyclical downturn. Bankers need to use their experience to figure out which loan should be restructured and where they should move towards a tougher result such as change in management or liquidation.

Second, the process of loan resolution should be done based on economic parameters alone, rather than under political pressure. It is no surprise that the banks owned by the government are in more trouble than private sector and foreign peers. The central bank, which has a reputation of probity, should keep an eye on the resolution process so that financial stability is not endangered. The Financial Sector Legislative Reforms Commission has already recommended the establishment of a corporation for resolutions so as to minimize the risk of failing financial firms.

Third, even while Rajan has done well to indicate that wilful and uncooperative defaulters could be forced to pay higher interest rates for loans in the future, we cannot help speculate whether matters would have been different if India had an active corporate bond market. Corporate borrowers with large leverage or weak cash flows would have by now been punished severely by the bond markets, as against the sweet deals offered by Indian banks to troubled companies such as Kingfisher Airlines. India will continue to be a bank-led financial system for a long time (or perhaps forever) but the presence of an active corporate bond market would have acted as some sort of transparent indicator on corporate borrowing costs (just as a strong government bond market could discipline the profligates in Delhi).

The banking sector is generally well managed, and far stronger than it was when the reforms began. But its current troubles should be seen as an occasion to move towards a stricter process of loan resolution, less government control over the banks, and the development of an active corporate bond market.

What is responsible for the banking mess? Tell us at views@livemint.com

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