Insights into Editorial: Banks need an autonomy stimulus
01 March 2016
Until recently, Indian banks were believed to be performing better compared to their global counterparts. However, recent reported losses of some Indian banks have raised concerns.
Global Banks Vs Indian Banks:
Globally bank shares are falling because of an expected fall in bank earnings as interest rates have become negative. In India, however, interest rates are firmly positive and also reported bank profits are soft because provisions are being made for weak assets.
- Some of the U.S. banks whose balance sheets were cleaned up are doing better than European banks where only cosmetic liquidity was provided.
What made Indian Banks perform better?
- Caps on external debt reduced fluctuations in Indian interest rates compared to more open emerging markets (Ems).
- Indian restrictions on short-term debt have also reduced chances of large cumulative cycles occurring as corporate bankruptcies create NPAs and stressed banks stop lending.
What’s affecting Indian Banks?
Is it NPAs?
As hyped, it is definitely not NPAs. Moreover, the asset quality problem affects only a part of the banking system, and only a particular type of loan.
- Non-performing assets (NPAs) that have stopped producing income are concentrated in public sector bank (PSB) loans to large corporates. Therefore the problem is limited in size and funds required to restore health are not excessive.
Is it corporate debt?
The sharp rise in emerging markets’ (EMs) corporate debt from 45% of gross domestic product (GDP) in 2005 to 74% in 2014 is a major source of global risk. It also rose in India, but is only 14% of GDP.
- Debt is concentrated in large infrastructure firms, but even so average debt-equity ratios remain at around unity since they are low for other firms.
The story of PSBs in India:
PSBs in India have demonstrated the ability to compete effectively and earn profits in the past. They did unexpectedly well after the 1990s reforms, and even overtook private banks on some parameters.
- They outperformed during and immediately after the global financial crisis. NPAs fell to 2.4% in 2009-10 from 12.8% in 1991. This indicates that, given the situation now, a similar recovery is possible, even as gaps in reforms are closed.
But, why are they not performing well now?
The problems of PSBs now are partly due to government interference but also to errors of judgment and to external shocks.
- The first two led them to participate much more than private banks in infrastructure financing. This had to be followed in order to encourage development. The onus fell more on them after development banks were shut.
- These institutions did not foresee the governance and administrative problems that delayed projects that were expected to be viable under high growth. Interest rate hikes, following the 2011 inflation peaks, also hit PSBs.
- NPAs were expected to come down as the economy revived. But external shocks and domestic political logjams continue to delay recovery. Capital adequacy regulation should ideally be countercyclical with buffers built up in good times.
- But recovery is taking too long. Moreover, loan growth from PSBs is the slowest, possibly because of a larger share of stressed assets.
Why Private Banks performed better during this period?
Private Banks concentrated more on lucrative and less risky retail lending. Hence, their market capitalisation overtook that of listed PSBs in 2011. Also, their diverse strategies reduced risk for the Indian banking sector as a whole.
Way ahead: What needs to be done now?
- Now, it is necessary to clean up bank balance sheets. The onus is on the government as the largest shareholder. The Budget has made a contribution towards refinancing PSBs.
- Refinancing must be accompanied by reforms that build proper incentives. These should increase PSBs’ independence, and force promoters to share risk and potential losses, while making it easier to change management and allow equity infusion to keep viable businesses going.
- Consider writing-off loans. If loans are written off, a business can become viable as fresh equity and new promoters are more likely to come in. Banks with clean balance sheets are more willing to lend.
- It is also time for change, for arbitrage-free systems with greater transparency. The government can subsidise industry if it is necessary, but this must be done upfront with the correct share of risk allocated to promoters and minimum discretion.
- Reduced political interference is also necessary. The political system has too often taken taxpayers for a ride, with small benefits masking large hidden costs. They have the right to know what they are paying for. The SC has already asked for information on large defaulters. Stronger boards and improved governance mechanisms can ensure that PSBs make independent decisions on purely commercial grounds.
Tackling a problem at the root bodes well for the future. And ignoring local detail leads to a blind echoing of global fears. Hence, the time is ripe for appropriate changes. Appropriate structural change makes some monetary stimulus feasible, both to reduce the pain and in response to the global slowdown.