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RBI expects Indian banks to maintain a CRAR of 9% (MINT_PRINT)
RBI expects Indian banks to maintain a CRAR of 9% (MINT_PRINT)

A fresh capital crisis looms over India’s banking sector

Another pile-up of bad loans could wipe out the capital of banks and call for bailouts with taxpayer money

The overhang of bad loans in the Indian banking sector has been a major factor behind the economic slowdown in the country. The problem pre-dates the covid crisis. During a downswing in the business cycle, several bank loans turn sour, leading to increased bankruptcies . Bad loans, however, tend to decline with rising incomes during upswings. Regulators expect banks to set aside the minimum mandated capital to provision for bad loans under the Basel norms. These norms have been strengthened further under the new Basel 3 framework in the wake of the global financial crisis of 2008-09. They have been made dynamic and aligned to the business cycle. The Reserve Bank of India (RBI) expects Indian banks to maintain a capital to risk-weighted asset ratio (CRAR) of 9%.

However, when an economic crisis lingers on, such provisioning is usually found inadequate and policy interventions by the state are warranted. There is enough research to show that if a banking crisis is allowed to linger, it has a negative effect on long-term growth. This is exactly what appears to have happened in India.

Non-performing assets (NPAs) as a percentage of gross bank advances began rising with the economic slowdown after the global financial crisis. They rose continuously from 2.2% in 2007-08 to peak at 11.2% in 2017-18.

These declined slightly, but still stood at a high 8.5% in 2019-20. Since growth was on a downward spiral, the modest decline in NPAs was likely the result of a combination of write-offs and resolution mechanisms arising from the Insolvency and Bankruptcy Code of 2016.

In its latest Financial Stability Report of June 2020, RBI has forecast that NPAs would climb to 12.5% in 2020-21 under a business-as-usual scenario, and to 14.7% if the covid-linked crisis were to escalate further and result in more bankruptcies.

India’s lingering banking crisis has adversely affected the demand and supply of credit. It is one of the major reasons why private investment has shown a declining trend over the last decade. It has also clogged the transmission channels of monetary policy, having made banks increasingly cautious of supplying loans.

Despite the benchmark real repo rate (the nominal repo rate minus the average of the wholesale and consumer prices indices) declining continuously from 6.4% in 2015-16 to 2.2 % in 2019-20, real bank credit growth stagnated at an average rate of under 10% annually between 2014-15 and 2019-20, compared to over 25% during the economic boom of 2003-04 to 2007-08. This is of particular concern, since Indian macroeconomic policy has relied on monetary rather than fiscal levers to address the downward spiral of growth over the last few years.

NPAs had risen during the last boom-bust cycle as well. They had climbed to almost 25% of gross advances in the mid-90s, before falling to 2.2% by 2007-08, thanks to bank recapitalization and an economic boom. Historically, NPAs in the Indian banking sector have been concentrated in public sector banks, which together form about 70% of the banking system. The write-off of NPAs and recapitalization, to adhere to mandated capital-adequacy norms, has therefore been largely through taxpayer bailouts, both during the 90s as well as now. Thus, 3.8 trillion has been infused into 18 public sector banks over the past decade to maintain the mandated CRAR.

Write-offs are the last resort for taking bad loans off bank balance sheets. There are two other mechanisms that have been tried as means to reduce the overhang of bad loans. One, the intervention of a regulator, and two, market mechanisms.

Resolution mechanisms in India were traditionally weak or non-existent prior to the 2016 passage of the Insolvency and Bankruptcy Code (IBC). Some of the decline in NPAs during the last few years can be attributed to this code coming into effect.

Market-based mechanisms to reduce the overhang of NPAs are more recent and derive from the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (Sarfaesi) Act of 2002. It enabled asset reconstruction companies (ARCs) to securitize bad loans and sell them in the market at a discount. While the bank is not repaid the full amount, it nevertheless realizes a portion of the dues upfront, and a portion through marketable securities redeemable over time.

There have been problems with India’s market for distressed debt. Banks received only a small amount upfront in cash, with the bulk through securities. The latter remained on their books and became a new source of NPAs. RBI, therefore, mandated a certain minimum to be paid to banks upfront in cash. This has had a dampening effect on the market for distressed debt, as an external injection of additional capital is required to effectively close a transaction.

It is still not clear what role the IBC and market-based mechanisms will play in resolving the banking crisis, and whether they would substantively reduce the need for taxpayer bailouts of the Indian banking system. At 9.4 trillion, NPAs were about 5% of India’s gross domestic product in 2018-19. With NPAs on the rise again, and national output projected to shrink, the problem will worsen. There is a renewed danger that the entire capital of public sector banks might get wiped out, entailing even larger recapitalization through the Union budget to maintain mandated capital reserves.

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