Do India’s Weak Banks Need A Stronger Dose Of Corrective Action?

Should the RBI’s prompt corrective action framework take a leaf out of the ‘Narrow Banking’ concept?

Tablets  are arranged for a photograph  in Tokyo. (Photographer: Akio Kon/Bloomberg)
Tablets are arranged for a photograph in Tokyo. (Photographer: Akio Kon/Bloomberg)

Oriental Bank of Commerce has disclosed that it has been placed under the Reserve Bank of India’s ‘Prompt Corrective Action’ (PCA) framework. Over the weekend, a letter from the bank’s top management said the action has been initiated in view of the high non performing assets (NPAs) at the bank.

Oriental Bank, whose gross NPAs are at nearly 15 percent of its loan book, is at least the seventh state-owned bank to be put under the RBI’s corrective framework regime. Others who have disclosed that they fall in this category include IDBI Bank Ltd., which has a gross NPA ratio of 24 percent; Indian Overseas Bank, with a gross NPA ratio of 23.6 percent; and Central Bank of India with a gross NPA ratio of 18 percent. United Bank of India, Dena Bank, Bank of Maharashtra and Uco Bank are also under strictures that come along with the corrective action framework.

As per the revised rules released in April, banks under PCA can fall into three risk buckets based on the level of bad loans, capital adequacy and profitability. Being put in the highest risk bucket will entail restrictions on dividends, branch expansion and discretionary action by the regulator. In most cases, the discretionary action pertains to conserving capital and restricting high-risk lending.

Do India’s Weak Banks Need A Stronger Dose Of Corrective Action?
Most of these are steps that prudent banks with weak financials would take even if they weren’t under a regulatory corrective framework.

As it stands now, the PCA does not limit an expansion in the bank’s lending nor does it prescribe any strictures on deployment of incremental deposits. To that extent it is business as normal for these lenders. Managements, too, have tended to under-play the significance of being placed under such a framework.

“It only involves monitoring of certain performance indicators and facilitates the bank to take corrective measures in a timely manner, in order to restore the financial health,” Mukesh Jain, the chief executive officer of Oriental Bank of Commerce wrote in a letter to employees dated October 7. In an interview to BloombergQuint on September 29, Mahesh Jain, CEO at IDBI Bank echoed a similar sentiment and said that the bank continues to lend to relatively low risk segments even though it falls under the PCA framework.

To be sure, bank managements are doing well to quell any concerns that depositors may have about the safety of their deposits.

However, passing off such corrective action as ‘business as usual’ raises the question of whether the framework is enough to achieve the desired results.

It is worth pointing out here that the track record of improvement under the prompt corrective action framework is not encouraging. Take, for example, Indian Overseas Bank which was put under a prompt corrective action framework way back in 2015. Since then the bank has seen its gross NPA ratio go up from 12 percent to 23 percent. It’s return on assets and return on equity have remained negative since the September 2015 quarter until now. Most other banks have come under this framework only recently.

Need For A Stronger Corrective?

At a time when a number of state-owned banks have an elevated level of bad loans and weak capital adequacy ratios, it may be worth debating whether a stronger corrective action framework is needed. One which restricts new lending and mandates that a greater proportion of deposits be parked in safe assets. The end goal of this could be to get these banks in a condition where they can be merged with larger lenders, without pulling the latter down. This would be in keeping with the government’s objective of having fewer but healthier state-owned lenders.

But how does one do this?

Could we, perhaps, peep into the past and look at an idea often discussed by late RBI Deputy Governor SS Tarapore. The concept called ‘Narrow Banking’ involves separating the deposit-taking and lending functions of a bank.

In 1997 the Tarpore Committee on Capital Account Convertibility had discussed this option in the context of those times and said: Noting with concern that some of the weak banks are growing at rates faster than the system, the Committee recommended that weak banks should be converted into narrow banks, i.e., banks whose incremental resources are deployed only in investments in government securities; in extreme cases of weakness, restraints should be applied on liability growth.

In ensuring that all incremental deposits flow into the government securities, the lender’s loan book growth reduces and a stronger safety buffer is created due to the increased investment in government securities.

Do India’s Weak Banks Need A Stronger Dose Of Corrective Action?

A 1998 research paper by Saibal Ghosh and Mridul Saggar published in the Economic and Political Weekly discussed the idea of ‘Narrow Banks’ further and laid out the pros and cons of such a suggestion. The paper noted that for banks with high NPAs, narrow banking could be a viable proposition. Since incremental deposits would be diverted to riskless securities, this would foreclose the build-up of any NPAs, the paper said. It added that narrow banking would reduce the need for regulatory monitoring of these lenders and strengthen financial stability of the system by separating deposit taking and loan making activities.

Arguments against the proposal listed in the paper included the fact that experimenting with the idea in the real economy could be costly. Also while parking incremental deposits in risk-free assets would help minimise any future liquidity mismatch if there was to be a run on the bank, such a move would erode profitability quickly and significantly.

Conversion to narrow banking may also lead to heightened market risk for these lenders, said the paper.

The idea got little traction but Tarapore continued to believe in its applicability. As recently as January 2016, Tarapore wrote in the Hindu Businessline that “If the political economy override is that the 51 per cent minimum government ownership is not negotiable, there is no option but to regulate the weak banks to become Narrow Banks.” He added that since the ‘Narrow Banking’ concept appears to be unacceptable to the authorities, the public sector bank system is bound to remain in an impasse.

While the concept of Narrow Banking is a dramatic one, it may be worth understanding the underlying thinking behind it to see whether it can be selectively and carefully applied to banks where there has been persistent weakness. It may also be worth considering whether some elements of that concept, such as the need to park a higher proportion of incremental deposits in risk-free government securities, could be included in the corrective action framework to make it stronger and more effective.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.