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Photo: AFP
Photo: AFP

India must fix its banks before time runs out

Viral Acharya and Raghuram Rajan have proposed wide-ranging reforms for a sector that’s flashing danger signals. A retreat of the state in favour of private participation may be the key

On Tuesday, Parliament amended our banking regulations to place cooperative banks under the Reserve Bank of India’s (RBI) supervision. A big-picture view of the role of banks in financial intermediation, however, would point to the urgency of far more sweeping reforms in this sector. The time for action is now. If it took the threat of a sovereign default for India to pull our economy back from the brink in the early 90s, it is the risk of a bank solvency crisis up ahead that calls for a sectoral shake-up in favour of market orientation today. The public cost of state-dominated banking has already turned unaffordable, and with a post-pandemic spike in bad loans on the cards, we cannot keep re-capitalizing lenders that mis-price risks and fail to make remunerative use of funds put at their disposal by depositors. Many of our banks need to change how they operate. Light on how this could be done has been thrown by two central bankers who have had a bird’s eye—or perhaps owl’s eye—view of all that ails Indian banks. In a research paper co-authored by former RBI deputy governor Viral Acharya and former governor Raghuram Rajan, titled Indian Banks: A Time to Reform?, propose a slew of reform measures that could forestall the sector’s ailments from acting as a “huge tax on growth". For the sake of India’s progress, these deserve top-level attention.

Among their proposals is the setting up of private and national “bad banks" to relieve regular lenders of dud loans. As Acharya and Rajan envision it, private operators could acquire such assets for recovery where state involvement is not necessary, while a national bad bank could take over bad loans in ailing sectors (say, power), until demand revives. A clean-up of bank balance sheets would free up capital for productive credit allocation. Similar efforts have fallen flat in the past, so doubts may shadow such an exercise. The duo’s other major ideas on loan quality, though, should be adopted without hesitation, be it improving the risk-management systems of lenders, the creation of out-of-court mechanisms to settle debts, or the drafting of private expertise to the cause. Stressed businesses and their creditors could indeed arrive at workable resolution plans through talks, and such efforts could be aided by an online platform set up for the sale of distressed assets. If these fail, court insolvency proceedings could kick in.

Once defaults are dealt with, the challenge would be to crisis-proof our banks so that they do not slide right back into danger. The key to this is efficiency in the gathering and allotment of money, which should be done in a way that maximizes value for debtors and creditors alike (depositors included). This depends on risk-informed credit judgements. To that end, work must start right away. Acharya and Rajan propose assuring state-owned banks greater autonomy over decisions. Further, they ask for a gradual withdrawal of the state from the sector, with government ownership reduced to a minority, even as some are fully privatized. State-directed lending may have played a role in India’s development, but central control has evidently left state-run banks vulnerable to pressures that result in money simply being lost. Profit-focused lending must prevail over patronage disbursements, something that private shareholders can police. Corporate houses with other businesses, though, would have to be kept out of this sector, given the conflicts of interest they would have. Widely-owned banks would be ideal. So a privatization programme could be calibrated to suit broad investor appetite. The end of state domination may be exactly what our economy needs.

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