Home >Opinion >Online-views >Thinking beyond the non-performing assets

The Financial Stability Report published recently by the Reserve Bank of India (RBI) has indicated that the non-performing assets (NPA) problem in Indian banking is not over and, in fact, may be getting worse. This clearly is the worst crisis facing Indian banking since liberalization in 1991.

Resolving this crisis and getting government-owned banks back to health so that they can start lending (especially in an election year) has become the key topic of discussion. Current discussions on this issue focus almost entirely on the extent of the crisis and the cost to the government in resolving it—the amount of capital government as owner of these banks must infuse to restore them to health. There is some discussion also on the most efficient mechanism (for example, a bad bank, a special situation fund, and asset reconstruction company) that would minimize capital commitment on the part of the government.

Providing a large amount of capital to the banks is a significant fiscal drag. With its commitment to fiscal consolidation and keeping deficit under control, capitalizing banks becomes a serious fiscal challenge for the government. Not only that, the government has to find ways and means to raise large amount of capital and it also permanently carries a negative spread on these investments perennially into its annual budget; government borrows money at about 7-8% and invests in stocks where dividend yield in the best of times has never been more than 3%. In fact, it has been much lower in the recent years as most public sector banks (PSBs) are paying no or very low dividend. Capital gains, if any, are notional and are never realized as the government has never sold a single share in the market and is unlikely to be able to do so as long as it is committed to majority ownership in these banks. Owning public sector banks, thus, is fiscally a bad choice for the government. It appears worse in the context of a deep and developed equity market in India, which can easily provide as much capital to banks as needed if permitted. So, all the discussion on the fiscal costs of resolving NPAs is relevant.

But this crisis also provides the right opportunity to ask some fundamental questions about the banking sector that go beyond the current NPA crisis. First, we must ask questions about the role of the government in the banking sector. Should the government have any role in the banking sector at all? If yes, what should that role be and why? How best is this role performed—through ownership, regulations, incentives such as subsidies and tax concessions, or using any other instrument? Even if some government ownership is needed, what percentage of the sector should be government owned and managed? What is the cost benefit trade-off for the government’s ownership? What are the second order consequences—such as uneven playing field in banking, widespread mispricing of risk and misallocation of capital? How do we minimize the negative consequences of government ownership?

Second, even if the government chooses to own and manage some of the 21 banks, we should also ask questions about the long-term viability of the government-owned banks. The core question is where can these banks be competitive if they had no NPAs? What would it take to make them survive and thrive? The competitive challenge state-owned banks face is staggering and they are constrained in their ability to respond to this challenge. Chastened by their experience of lending to infrastructure and industrial projects, all banks are now talking about focusing on consumer lending. John Maynard Keynes would call this a “fallacy of composition" in that if all banks want to only focus on consumer business then that business will become very unattractive. Already, all segments of consumer lending are hyper competitive with not just banks but non-banking financial companies (NBFCs) also competing. Consumer banking business is where new private sector banks and NBFCs are incumbent and strategically reoriented PSBs will be challengers.

At the root of the challenge faced by PSBs is the schizophrenic approach of both the government as owner and the management of these banks; they are expected to behave like competitive commercial firms when facing customers and like government departments in all other aspects of their functioning—human resource policies, procurement, running schemes, vigilance.

Creating a common pool of senior management creates homogenization in thinking and strategy. These banks are managed almost as if they are actually one bank with 21 different brands. For government-owned banks to be competitive, especially in consumer banking, each will have to develop its own strategy, prioritize customer segments, geographies and products and then compete. They will have to adapt practices that are common in the consumer lending business but will not pass through scrutiny of vigilance. Under the homogenizing force of government ownership and also the constraints it imposes, doing so will be impossible.

It is said that a crisis is too precious to waste. And so it should be with this banking crisis. Such crises psychologically prepare all stakeholders for radical changes and so it would be a tragedy if we somehow get over the crisis without making radical changes. Else, we run the risk of such a crisis repeating every few years with ever increasing fiscal costs. This is the time we must ask basic questions about merits of overwhelming about 70% government ownership and its consequences to the functioning and survival of government-owned banks. Revolutions have always begun with basic questions.

Harsh Vardhan is an executive-in-residence at the Centre for Financial Services of the SP Jain Institute of Management Research. These are his personal views.

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