RBI Involvement In Bad Loan Resolution ‘Conceptually Not Defensible’, Says YV Reddy

If the RBI’s intervention in bad loans is an ‘unconventional measure’, they should tackle the task and exit soon, said former RBI governor YV Reddy.

YV Reddy, former governor of the Reserve Bank of India (Photographer: Namas Bhojani/Bloomberg News)
YV Reddy, former governor of the Reserve Bank of India (Photographer: Namas Bhojani/Bloomberg News)

The Reserve Bank of India is being asked to perform the function of a bank owner in the current bad loan resolution framework, said former governor YV Reddy in an interview with BloombergQuint. The arrangement is “conceptually not defensible”, he said.

Reddy, who turns 76 in August, has been widely credited as among the most successful Reserve Bank governors, having acted early to ensure the Indian banking sector was shielded from the worst of the global financial crisis. When asked what led to the current crisis in Indian banking, Reddy said there were a number of reasons. These range from banks being asked to do business, such as infrastructure lending, which they may not be best suited for, to the weak governance standards across public sector banks, which still make up 70 percent of the banking sector. Fiscal and monetary stimulus and regulatory forbearance also contributed to the build-up of bad loans, he said.

Indian banks have seen stressed assets surge to nearly 16 percent of all loans, according to an estimate by rating agency Moody’s Investors Service. The reported numbers rose after the RBI conducted an asset quality review due to concerns that banks were under-reporting bad loans. While the review helped in the recognition of stressed assets, resolution remained slow. This has led to an unusual situation where the Reserve Bank is now directly involved in the resolution of bad loans.

Earlier this month, the RBI identified 12 accounts and asked banks to refer them for resolution under the Insolvency and Bankruptcy Code. The decision was taken by an Independent Advisory Committee of the RBI, whose composition has not been revealed.

I think conceptually it is not defensible. Because the job of the regulator is to tell the bank. Say that you do not have adequate capital. You bring adequate capital because I have to protect the depositors. I have to protect the system. It is the business of the bank, the board and the bank owner to take action.
YV Reddy, Former Governor, Reserve Bank of India

Reddy added that since a large part of the problem is concentrated on the books of public sector banks, the situation should be handled by the government. “It has to be handled from that side. Instead, it is directing the regulator....” Reddy said.

He, however, said that if the RBI’s involvement is being seen as an unconventional measure, then the regulator should finish the task and exit quickly.

...Maybe because it’s a crisis situation it may be seen as an unconventional measure and it may be defensible. But from a system point of view, it is not desirable. If the problem has to be solved, do it quickly and then get out of this somewhat inconsistent situation of an owner not being able to perform the ownership function and therefore asking the regulator to do the job of the owner.
YV Reddy, Former Governor, Reserve Bank of India

In order to allow the RBI to intervene directly in the resolution of bad loans, the government amended the Banking Regulation Act via an ordinance. While doing so, Finance Minister Arun Jaitley said the present status quo cannot continue. The government, however, has still not committed to providing additional capital to banks which would allow them to take the steep haircuts required to clear out bad loans.

Under the government’s capital infusion plan, only Rs 10,000 crore each has been allotted to banks this year and next year. The need for capital, as estimated by rating agencies, is much higher.

Also Read: Government ‘Marching In Step’ With RBI On Bad Loans, Says Sanjeev Sanyal

Reddy said there are a number of options that can be used to recapitalise banks, including recapitalisation bonds which have been used in the past. He also suggested the government look at providing ‘callable capital’ to banks. Callable capital, as the name suggests, can be called upon when needed. However, to the extent that it can be counted towards regulatory requirements, it provides relief to banks.

Reddy explained that his approach towards bank capital is different from the prevailing view.

What is capital? Capital is required to make sure the depositors have enough money or the system has enough money. It becomes important when there is limited liability. These banks are constituted under the statute of the government. And a sovereign cannot say I have limited liability. A sovereign by its very nature has unlimited liability. Therefore, the injection of capital is essentially to meet the regulatory requirement and convince everyone that I am also behaving like any other owner. That is why I say there is no threat to the solvency of the system. Therefore, the injection of capital is only to meet the technical requirement of the regulator.
YV Reddy, Former Governor, Reserve Bank of India

Reddy expressed concern over the weak credit growth prevailing in the economy and said that credit has to be unchoked to ensure that the economy continues to grow. Bank credit growth fell to multi-decade lows of near 5 percent last year and continues to remain weak at 6 percent, shows periodic data released by the central bank.

Reddy also noted that if bank credit growth remains below the nominal growth in the economy, then credit is being accessed from sources other than banks. In this scenario, the regulator needs to take a systemic view to ensure that risks are not merely being shifted from banks to other stakeholders in the financial system, such as mutual funds.

It must be recognised that if the economy is growing at 11-12 percent in nominal terms, then credit growth has to be higher than that. But if credit growth is this low, then somebody else is giving money. Who is giving money? Is it mutual funds? Now if the corporates are not healthy, somebody is going to take the hit. So when the chips are down, will the mutual funds be in trouble? So that’s where you have to take a financial system view. If you are analysing a complex problem like this, you can’t only look at banks.
YV Reddy, Former Governor, Reserve Bank of India

Reddy, whose autobiography ‘Advice & Dissent’ releases this week, expressed disappointment that the RBI could not manage to improve the functioning of public sector banks to the extent that he would have liked.

“...My regret is that the most important part of the banking system has not improved the way I would have liked it to be..” said Reddy.

However, when asked whether the Reserve Bank had been a more successful monetary authority than a banking regulator, Reddy, known for his wit, said that the RBI should take credit for doing a good job despite the fact that 70 percent of the banking system is owned by the government.

I will tell you why it should take credit. Because it has been able to handle banking despite public sector banks being dominant.
YV Reddy, Former Governor, Reserve Bank of India