Budget 2019: Here’s How To Fix The Financial Sector’s Troubles

Look at the financial sector’s recent troubles as symptoms and not root causes. Here’s how to address the latter.

Finance Minister Nirmala Sitharaman will present the Union Budget 2019 on July 5. (Photograph: PTI)
Finance Minister Nirmala Sitharaman will present the Union Budget 2019 on July 5. (Photograph: PTI)

Finance Minister Nirmala Sitharaman will present her maiden budget later this week. She has inherited an Indian economy that is surely not in the pink of health.

The government has come back with a very strong electoral mandate. A combination of a weak economy and a strong electoral mandate leads one to hope for a bold economic reforms agenda for the new government. The forthcoming budget provides the finance minister the first opportunity to articulate such an agenda.

The banking and finance sector has been in a tough spot once again. Just when the cancer of non-performing assets seemed to be getting into remission, problems have emerged in other parts of the system – non-banking financial companies and mutual funds. A true reforms agenda, however, should look at the recent events as symptoms and not root causes of troubles in the sector. It should aim to address these root causes.

Set Up A Resolution Corporation

Recent troubles with the NBFC sector have alerted everyone to the real possibility of an NBFC going bust. There are calls of a bailout of some sort, either from the government or from the regulator. Using any public money for bailing out private players will set a wrong precedent and hence be unwise. However, any NBFC bust up should not imperil the whole system. For this, we need a clearly defined resolution framework and an institution —a resolution corporation—that will ensure orderly management of bankruptcy of a failed financial firm.

Under the old Companies Act, winding up of NBFCs was possible in the event of a bankruptcy. However, the old act was repealed and the new law does not include the winding-up provision.

The Insolvency and Bankruptcy Code of 2016, does not apply to financial firms. So, when it comes to bankruptcy resolution, financial firms are in legally uncovered terrain. The government, in its previous term, attempted to pass the Financial Resolution and Deposit Insurance Bill, which came to naught. There is an urgent need to pass some variant of that bill which will have political support so that a resolution set up is put in place.

Pass The Individual Bankruptcy Law

The Insolvency and Bankruptcy Code, 2016 is possibly among the most significant financial sector reforms since liberalisation in 1991. It has provided a clearly defined process, institutions, and a law to deal with bankruptcy. However, it deals only with the bankruptcy of firms. It needs to be complemented with a similar legal and institutional framework for individual bankruptcy. There are two reasons for this.

  • First, given the prevalence of personal guarantees given to businesses by their promoters, the issues of personal bankruptcy will emerge from corporate bankruptcy and could complicate its resolution.
  • Second, the dramatic rise in consumer lending by banks, especially unsecured lending in recent years means that we are sure to have system-wide consumer credit problems in the coming years.

The history of NPAs in banking has taught us that having a bankruptcy law before the crisis hits would have made resolution better. It will be immensely useful to have the individual bankruptcy law in place before the consumer credit bust occurs.

Build Capacity At NCLT

The National Company Law Tribunal has emerged as the most important forum for resolving company law related legal disputes. It is also the designated forum to pursue bankruptcy under IBC. Cases demanding interventions from the NCLT, other than those related to IBC, have been growing rapidly. This has increased demands on the tribunal.

To keep it efficient, serious efforts on capacity building need to be made.

This would entail setting up more benches, appointing and training more judges, improving physical infrastructure, deploying more technology in its operations, etc. These efforts will need budgetary allocations.

Furthermore, there should also be an institutional set-up put in place, which will review the functioning of NCLT periodically and recommend continuous capacity-building initiatives. Without such efforts, with increasing caseload, NCLT may face the same challenges high courts face thus defeating the very purpose of setting it up.

Arrest Falling Deposit Growth Rate

Indian banking has seen a secular decline in deposit growth from over 20 percent before 2010 to around 10 percent now. Except for a temporary blip in FY17 and FY18 in the aftermath of demonetisation, the declining trend has resumed. Low credit growth in recent years has camouflaged the seriousness of the falling deposit growth. However, as the investment cycle picks up—as we all wish—it will start constraining banks’ lending capacity.

Already, the incremental credit-deposit ratio for some private banks is over 90 percent.

There are many reasons for this trend – falling household savings rate, better returns from small savings and improved penetration of mutual funds. Since banking remains the largest platform for savings mobilisation, we need to raise the deposit growth rate to sustain investments. There is no better way than a higher deposit growth rate for adding ‘durable’ liquidity into the financial system. Increasing the tax-free interest limit on deposit could be an easy step. There is a deeper underlying challenge of falling savings rate, especially in comparison to government borrowing. Total government borrowing (central plus state) now exceeds household financial savings; the government has essentially crowded out everyone else from tapping household financial savings. Addressing the savings rate, though, will require policy actions outside of the financial sector.

Push PSU Bank Consolidation And Improve Governance

In its last term, the government managed the merger of three PSU banks. It now has a template for consolidation of the PSU banks and should pursue it aggressively to bring down the number of these banks to below ten. However, it is equally important to improve governance at PSU banks. The PJ Nayak Committee has provided a comprehensive road map for governance improvement for both public and private sector banks. The government, as the majority owner in PSU banks, has the responsibility of improving their governance. With fewer banks, the task would be easier. Without improved governance, bigger PSU banks that emerge from consolidation could make bigger mistakes! And the last five years have taught us all how expensive those mistakes could be.

I do hope that some of these ideas find a place on the government’s agenda.

Harsh Vardhan is Executive-In-Residence at the Centre of Financial Services, SP Jain Institute of Management & Research.

The views expressed here are those of the author and do not necessarily represent the views of Bloomberg Quint or its editorial team.