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The financial results of HDFC Bank for the period April to June 2021 have got a few experts worried. The gross non-performing assets (NPAs), or the bank’s bad loans, jumped to 1.47% of its total advances. They were at 0.81% as of 31 December 2020.

With India’s best-managed big bank feeling some heat, the question is how the second covid wave will impact other banks on the bad-loans front. While dud loans remain a worry, there is a structural problem at the heart of Indian banking. This might limit their expansion in the years to come.

As of May, bank lending to industry stood at 26.8% of non-food credit. The retail lending of banks was at 25.9% of non-food credit. Food credit is the money lent to Food Corporation of India and other agencies to help them largely buy rice and wheat directly from Indian farmers. When this is subtracted from overall bank lending, we get non-food credit.

As of March 2013, lending to industry made up 45.8% of non-food credit, while retail lending was at 18.4%. This difference has shrunk since 2013 and this is where the fundamental problem with Indian banking lies. Banks have been happy to lend to individuals, but seem unwilling to lend to industry.

Before we get into this, it is important to understand how banks really operate. Banks take money from savers and lend to borrowers. While this sounds logical, it’s incorrect. As the Bank of England points out in a document titled ‘Money Creation in the Modern Economy’, “When a bank makes a loan… to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created."

Hence, the conventional wisdom on banks is wrong. In fact, as Josh Ryan-Collins, Tony Greenham, Richard Werner and Andrew Jackson write in Where Does Money Come From?, “Banks do not need to wait for a customer to deposit money before they can make a new loan to someone else… It is exactly the opposite: the making of a loan creates a new deposit in the borrower’s account… thus creating the illusion that the borrowers have made deposits."

So, what is really happening is that when banks give loans, the borrower taking the loan spends that newly created money, which through a series of other transactions ultimately ends up in a bank as a deposit. Hence, savings are an accounting consequence.

Given this, commercial banks are a much more important part of an economy than most people realize. As Collins and others point out: “The primary determinant of how much [banks] lend is not interest rates, but confidence that the loan will be repaid." Other than this, prospective borrowers need to be confident about their own ability to repay their loans. They also need to feel confident about the state of the economy.

How does all this come together with respect to Indian banking? The Reserve Bank of India has driven down interest rates over the last couple of years in the hope that corporates will borrow and expand. But that has not happened because commercial banks aren’t in the mood to create fresh money by lending to corporates. Further, many businesses are also not confident about borrowing money, given the state of the economy and/or their past borrowing binge.

In this scenario, banks have continued creating fresh money through retail lending. As Collins and others write: “The incentives that they face often lead them to favour lending against collateral, or existing assets, rather than lending for investment in production."

Most retail lending, like giving out home or vehicle loans or loans against shares, fixed deposits, etc, is against collateral or existing assets.

This has led to a situation where banks are reluctant to lend to small businesses in the country. Bank lending to micro and small industries was at 3.8 trillion as of March 2015, and it barely grew to 3.84 trillion, as of March 2021. Lending to overall industry during the same period has grown at 1.6% per year to 29.2 trillion. Meanwhile, the retail lending of banks has grown at 15.8% per annum to 28.1 trillion.

Corporates can borrow from other sources, but banks remain their major source of long-term funds. This has created a major problem for the Indian banking sector.

As Mark Carney, former governor of the Bank of England, said in the context of the borrowing binge that happened before 2008: “This borrowing was largely for consumption and real estate investment rather than businesses and projects that would generate the earnings necessary to service those obligations."

Something similar is playing out in India currently. There is no reason to suspect that retail loans won’t be repaid. But the real question is, will banks continue to be able to give out fresh retail loans at the same speed as they have over the past few years? At the end of the day, it is economic activity that creates the ability to take on newer loans and repay them. And economic activity happens when industry borrows to expand, thereby creating jobs and incomes.

Vivek Kaul is the author of ‘Bad Money’.

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