Bad Loans, Good Money, And Why A Crisis Must Not Be Wasted

In banking and the economy, is government player, umpire, spectator, or cheerleader?

(Source: BloombergQuint)
(Source: BloombergQuint)

A truism embedded in the history of India’s political economy is that things must get worse before they get better, and that crisis compels reformative action. On Tuesday, India was presented with validation when the government finally announced its intent to capitalise public sector banks – remember the stench of bad loans was wafting across the economy since 2013.

Unquestionably it is a laudable first step. There are questions over the commas and semicolons of the package, about who is eventually paying for it, the fate of defaulters and the adequacy of the quantum – estimates have ranged between $30 billion to $65 billion by 2019.

What is clear is that recapitalisation alone will not be enough. Yes, there is excitement in the stock market but it is useful to remember that little has changed structurally, and the password for happy hours is still with the addicts in detox! The government has promised reforms but is yet to unveil them. For now intent is the plan.

To appreciate the need for more than just capitalisation one must review the state of decay perpetuated over a decade. The burden of bad loans is currently estimated to be around Rs 9.5 lakh crore or $145 billion, and the bulk of it is in public sector banks. The pile-up of unsustainable corporate debt, the burden of bad loans on banks and the unprecedented slowdown in credit growth despite rate cuts are indicators of the mess.

The rot caused by systemic debauchery is illustrated in the destruction of value.

Even after the bump up in the stock market, listed public sector banks – which hold assets worth 2.5 times that of all private sector banks – are valued at less than half that of private sector banks.

The market value of all the 21 listed public sector banks is less than that of just two banks – HDFC Bank Ltd. and Kotak Mahindra Bank Ltd. Indeed, the market value of the largest public sector bank, State Bank of India is nearly half of HDFC Bank and that of Bank of Baroda and Punjab National Bank is less than that of Bajaj Finance Ltd., a non-banking finance company.

The phraseology of ‘too big to fail’ has a unique connotation in the Indian context with the bulk of the public sector segment of banking being afflicted. The slide in investments – and impact on growth– is one manifestation.

A more serious issue is the vulnerability of savings.

Savers have over Rs 109 lakh crore in banks – of which 70 percent is in public sector banks – and over Rs 9 lakh crore is deemed to be at risk. Deposit insurance is limited. Sovereign ownership is a comfort, not an assurance.

The unattended ongoing crisis represents an inestimable risk to economic and political stability. Every crisis is a feel-good factor, the harbinger of reformative change, and hence must not be wasted.

Anatomy Of The Crisis

Albert Einstein once said if he had an hour to solve a problem he would spend 55 minutes thinking about the problem and 5 minutes on solutions. Critical to the resolution of the banking crisis is comprehension of the problem.

There are three distinct aspects to review.

  • There is the issue of economic philosophy – what role does the government play in managing the economy?
  • There is the political context – tactical and contextual myopia that leads to long-term damage.
  • There is the structural design – the operational mechanism of who borrows from whom to lend to whom for what.

The cliché about governance in India is that anything that can go wrong, will go wrong. The stench in India’s banking is a testimony to it. Take government ownership, political management and blend it with populism, policy paralysis, judicial interventionism and crony capitalism. Everything that could go wrong has gone wrong.

Customers wait to exchange banknotes at a Syndicate Bank branch in Dadri, Uttar Pradesh on November 15, 2016. (Photographer: Anindito Mukherjee/Bloomberg)
Customers wait to exchange banknotes at a Syndicate Bank branch in Dadri, Uttar Pradesh on November 15, 2016. (Photographer: Anindito Mukherjee/Bloomberg)

Must The Sarkar Run Banks?

It is true that nationalised banks have served as instruments of not just economic but also socio-political change. And there was a context to the nationalisation of banks in 1969.

But by 1980, as then RBI Governor IG Patel revealed in his book after demitting office, when five more banks had to be nationalised, even Indira Gandhi had lost the appetite for nationalisation.The question to interrogate in 2017 is, does ownership matter for the objectives of the government?

In their 2009 report on financial sector reforms, ‘A 100 Small Steps’, a committee of 12 experts led by Raghuram Rajan opined that there was “little evidence that the ownership of banks makes any difference to whether they undertake social obligations, once these are mandated or paid for” and add that “the majority of this Committee does not see a compelling reason for continuing government ownership.” Indeed, the report points out that “out of 138 countries only nine had a predominantly state-owned banking sector.”

In fact, as early as in 1998, the Narasimham Committee had advised that government shareholding in banks to be brought down to 33 percent.

Two decades later, the lowest holding of government in any public sector bank is 58 percent.

This government does not subscribe to the idea of privatisation, primarily due to the risk of transfer of public wealth of many to a few. Fair enough. But does it have to invest faith in the political management of public savings? Why not transfer the holdings of public sector banks into a trust or a sovereign fund à la Temasek, get the Sarkar out, and professionalise banking?

The Economic Risks Of Politics

It is true that there is no economics without politics. It is equally true that political and economic cycles are not always in sync. At the same time, the construct of democracy requires parties to win elections. Electorates expect a fair return for votes – in governance and growth that translates into prosperity. Parties are often caught between ‘all is well’ and ‘all will be well’.

To ensure this, parties in power choose to intervene – to influence the generation of income, increase in consumption and demand for investment. For instance, the government, on Tuesday, announced a stimulus package promising revival of growth – an array of infrastructure projects entailing an expenditure of over Rs 7 lakh crore.

Presumably, some or most of these will be executed in concert with private players and banks will be lending to these projects. How do the players factor the economic risks of politics?

Take a look at the list of stranded projects or sectors under stress on the NPA map – infrastructure, power, telecom, transport, and steel. Manufacturing enterprises must deal with politics of pricing, bureaucracy, and markets. Two of three factors of production – labour and land are constrained by myriad regulations. Then there is judicial intervention, populist legislation, and policy unpredictability.

The saga of bad loans is scarcely unidimensional. World over, investment is about return on capital. In India, delays and denial have embedded a phenomenon called return of capital. There is the entrepreneurial pathology and then there is a structural malaise. There is a business risk and then there are political risks.

Businesses can be expected to understand and assess business risks but not political risks.

Evidently, this calls for a systemic clean-up, mitigation of policy and political unpredictability and an end of the permission raj.

Liability Of Mismatched Risks

At an operational level, the architecture of banking is stuck with a serious mismatch of assets and liabilities, resources, tenures, and risk.

On the liability side every rupee in the portfolio of the banking system is essentially risk-averse capital. On the asset side, every rupee that banks lend goes to risk-vulnerable enterprises.

Much of the lending is of long tenure and savings is of short tenure. The need for long-term financing to bridge resource and tenure risks is known and was well recognised. In the 1950s and 1960s, in the Harrod Domar era of economic thinking, the government had established institutions for long-term lending – IFCI Ltd. in 1948, ICICI in 1955, IDBI and UTI in 1964 – institutions with capacity and capabilities to match resource and risks. Over a period of time IFCI flailed, IDBI and ICICI morphed into banks.

A pedestrian walks past an IDBI Bank ATM branch in Jaipur, Rajasthan. (Photograph: Sanjit Das/Bloomberg)
A pedestrian walks past an IDBI Bank ATM branch in Jaipur, Rajasthan. (Photograph: Sanjit Das/Bloomberg)

By late 1990s the need for specialised institutions was rediscovered leading to the creation of IDFC Ltd. in 1997, IIFCL in 2006 and NIIF in 2015. IDFC is now a bank and the other two haven’t quite taken off. Aggravating the situation is the poor depth of long-term debt market. The gap in capacity and capabilities has consequences and must be redressed if banking is to survive and thrive.

Player, Umpire, Spectator, Or Cheerleader?

Finally, the choice of policies for development is contextual – the call depends on the economic and political imperatives. There are many paths to choose from – there is the much-mentioned Keynesian way, the Harrod-Domar model favoured by PC Mahalanobis and company in the 1950s, the Schumpeterian template of circular flow interrupted by innovation and/or the Samuelson system of autonomous and derived investment.

The fact is, the government’s action in one domain has consequences in another domain. A wrong twist on the Rubik’s cube can – and does – misalign colours on the plane. Critical is whether the government wants to be a player, umpire, spectator or cheerleader – and what in which segment of the economy. It is this positioning that enables efficient management of business and political cycles, determines success and failure.

Shankkar Aiyar, political-economy analyst, is the author of Aadhaar: A Biometric History of India’s 12-Digit Revolution; and Accidental India.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.