Urjit Patel On ‘Creeping Banking Sector Fiscalisation’ And A Trilemma

Patel’s first book dwells on the relationship between the Indian government, the banks that it owns and the regulator. 

Urjit Patel, former governor of the Reserve Bank of India. (Photographer: Dhiraj Singh/Bloomberg)
Urjit Patel, former governor of the Reserve Bank of India. (Photographer: Dhiraj Singh/Bloomberg)

Urjit Patel’s first book since stepping down rather abruptly as Reserve Bank of India governor isn’t a “tell-all”. It isn’t intended to be one.

It says very little directly about the pulls and pressures that led to his premature resignation. It blanks out the demonetisation episode with which his tenure began. And the indiscretions across private banks that prompted him to refuse an extension to a few high-profile bankers.

What it does come close to being, though, is a (near) tell-all on government-owned banks. In particular, on the relationship between the Indian government, the banks that it owns and the regulator. Patel calls it, in his conclusion, the ‘trilemma’.

“It’s clear that it’s not possible to: (i) have dominance of government banks in the banking sector; (ii) retain independent regulation; and (iii) adhere to public debt-GDP targets. All three aren’t feasible on a durable basis,” Patel writes in his book titled ‘Overdraft’.

Creeping Banking Sector Fiscalisation

At the heart of the subject, Patel writes, is an inability to “arrest a creeping banking sector-fiscalisation.” By this he means that successive Indian governments have used their ownership of banks as a means for day-to-day macroeconomic management.

According to Patel, fiscal policy in India can be described at most times as ‘loose’ or ‘very loose’ and no fiscal firepower is kept in reserve for times when counter-cyclical measures may be needed.

As successive governments have found their capacity for further fiscal expansion becoming constrained, it has used the banks that it owns to fire up and pump-prime the economy; hence the term banking sector-fiscalisation.
Urjit Patel, Former RBI Governor (Book: Overdraft)

This has led to “political credit cycles” over the last decade or so.

Patel cites a few examples of such ‘quasi fiscal policies’ which stretch across governments. From the infrastructure-focused lending of the 2009-2013 period to MUDRA loans and the 59-minute loan approval programme launched in late 2018. “To counter the economic slowdown, in October 2019, banks, with due exhortation from the principal owner, undertook loan ‘fairs’ in rural areas to increase personal loans,” Patel says.

While the RBI should have ideally been able to check the consequences of any imprudent lending arising from such political credit decisions, Patel says that the organisation’s reputation has been that of a soft regulator at least until recenrly. “High professional integrity notwithstanding, the RBI’s reputation has been that of a soft regulator – deterrence has been undermined...”

The Clean-Up Phase

Patel took over as governor when the regulator had turned tougher, somewhere in the middle of the bad loan clean-up phase, although he was deputy governor when the asset quality review was initiated. He writes of the importance of the CRILC (Central Repository of Information on Large Credits), which, for the first time, gave an overarching view of the stress in the system.

The recognition phase of the clean-up went relatively smoothly and made way for the recapitalisation phase. Then came the resolution phase.

Patel says that suggestions were made to house stressed loans in a ‘bad bank’ — an idea which continues to resurface.

At the highest levels of policymaking the idea was not liked, mainly because borrowers and lenders would be off the hook, and it was in the nature of ‘mother of all moral hazard’ – an undesirable backdrop for the next lending cycle.
Urjit Patel, Former RBI Governor (Book: Overdraft)

In 2016, the Insolvency and Bankruptcy Code came into effect but early experience showed that banks and bankers were continuing to drag their feet on referring large borrowers for insolvency.

This, “necessitated, in 2017, further steps by the government and the Reserve Bank to confront the promoter–bank relationship by strengthening the legal and regulatory scaffolding,” Patel writes.

What followed was unprecedented for the RBI.

The Banking Regulation Act was amended to allow the RBI to explicitly ask banks to refer certain accounts for insolvency, under the guidance of an internal advisory committee. Two lists of accounts were sent to banks that year.

How were the accounts selected?

The process adopted for identifying the entities was consistent with the object of making the speediest recovery of economic value. The classification criteria recommended by the IAC was based on ‘an intelligible differentia comprising quantum, materiality, as well as age of the NPA’.
Urjit Patel, Former RBI Governor (Book: Overdraft)

A Tale Of Two Circulars: Feb. 12 vs June 7

Surprisingly, the direct intervention of a regulator in banking decisions didn’t go down as badly as some had feared. The RBI and Patel appeared to have the government’s backing. Not withstanding court delays, banks did start to refer individual accounts for insolvency.

Ironically, problems cropped up when the RBI tried to move away from a discretionary system to a rule-based one via the Feb. 12 circular.

Patel explains the genesis of that circular like this:

The IAC, a sub-committee of the central board of the RBI, was of the view that: (i) in the absence of rules, the IAC would have become a standing committee for assessing which defaulters should be referenced to the NCLT for resolution; (ii) a case-by-case process would increase the likelihood of legal challenges as, quite correctly, the extant process may be perceived as ad hoc, consequently discriminatory, and hence unfair by the initial sets of references, with exposures of at least Rs 30 billion, which were recommended to the banks; and (iii) putting in place a simple set of forward-looking regulations would enhance allocative efficiency as all stakeholders were now aware of the path with respect to defaults, legacy and the future.

The circular laid down a 180-day period from the first of default within which banks were asked to resolve an account. If they failed to do, the account was to be referred for insolvency. The circular saw push-back from sugar and power firms, among others.

But Patel writes that the mood around IBC had changed by July 2018.

From July 2018 onwards, the IBC was felt, at least by some lobbies, to be constraining, that is, too strict on borrowers in terms of regulatory timelines and the consequences thereof. Lawyers who had agreed to represent the RBI in the Supreme Court dropped out at the eleventh hour, literally the night before the hearing. The SC granted a stay and postponed hearings more than once, in effect, until the following year. In April 2019, the SC pronounced the regulation to be illegal. 
Urjit Patel, Former RBI Governor (Book: Overdraft)

Allure Of ‘Back To The Past’

The June 7 circular that replaced the Feb.12 circular diluted a few key aspects of the intent behind the original set of rules. First, it gave banks an additional 30-day period from the first day of default.

It also took away the time-bound imperative for insolvency proceedings, replacing it with higher provisions if insolvency proceedings were delayed. Patel sees this as a material dilution.

The June 2019 regulation is time-inconsistent if the goal is efficient resolution and recovery. Economic consequences for higher provision by government banks, touted as a disincentive by the regulator, will be felt only by taxpayers, as more money will have to be coughed up by the exchequer to shore up the quantum of uncompromised capital.
Urjit Patel, Former RBI Governor (Book: Overdraft)

“It’s difficult to fully understand, at least for those of us who are not lawyers, that a transparent rule is untenable, but discretion on a case-by-case approach is kosher,” Patel laments.

A dilution of the tougher stance taken by the regulator in the post 2014-period is visible in other actions in recent months, according to Patel.

For instance, the Prompt Corrective Action framework for weak banks. The framework was relaxed to “graduate five loss-making banks out of the PCA”, Patel says. The recapitalisation of these PCA banks helped them meet the criterion on net NPAs and “hardly anyone disagreed that this was to facilitate higher credit growth.”

The RBI also returned to the practice of forbearance for MSME loans. Relief was provided to commercial real estate loans as well.

The allure to go ‘back to the past’ should be eschewed if we want safer banks, Patel says.

While there may be grounds for remaining warily optimistic, in the sense that we will not completely reset the clock to pre-2014 despite setbacks in 2019 and early 2020, we have to be vigilant that U-turns don’t usher a serial bout of ever-greening and zombie borrowers; otherwise, victory over crony capitalism will, at best, be short-lived, and that the limited progress so far could turn out to be a false dawn.
Urjit Patel, Former RBI Governor (Book: Overdraft)

The Trilemma

While Patel’s book traverses more ground on the functioning of government banks, the reforms needed, attempted and eschewed, it eventually seeks to point out what he sees as a trilemma.

“It’s apparent that the temptation to deploy government banks for catalysing aggregate demand has intensified. The culmination is a vicious cycle: as the government’s headroom for running higher fiscal deficits is exhausted, government banks are encouraged to (over) lend to pump-prime the economy and boost preferred sectors,” writes Patel. This will eventually lead to higher NPAs and the need for equity infusion from the government, which, in turn, adds to the fiscal deficit and sovereign liabilities.

Breaking this cycle will mean either privatisation, which Patel sees as unlikely on a meaningful scale, or restoring regulatory and market discipline. But as Patel asks, “Where’s the fun in owning banks if control over operations, managing them and determining their regulation is not possible?”

Patel writes that as the fiscal elbow room narrows, governments will hold on to government banks to keep alive the ‘option value’ of using them for direct stimulus during economic slowdowns. “The only other free lunch (for a while) is opening the spigot to short-term external inflows of all sizes and shapes.”

In playwriting there is a conception known as ‘Chekhov’s gun’: if there is a rifle hanging above the mantelpiece in Act One, it is going to be fired at someone by the end of Act Five. In the regulatory, enforcement and legal landscape around loan recoveries in India over the last three decades, the unused rifle usually disappears by Act Three, hence not credible since all stakeholders know about the preordained vanishing act. Investment in policy and regulatory integrity requires staying the course; there is no other way.  
Urjit Patel, Former RBI Governor (Book: Overdraft)
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