Bringing banks back from the brink

When Lehman crashed in 2008, unleashing a global tsunami which became a full-fledged financial crisis, a curious thing happened in India. There was a massive flight of deposits from the private sector and foreign banks into public sector banks. The State Bank of India at one point was receiving fresh deposits of more than a thousand crore every day! The iconic software company Infosys publicly announced that they were moving their large cash balance from private banks (including ICICI Bank) to SBI. This was meant to assure their investors and shareholders that they were playing safe. By one reckoning more than Rs. 60,000 crore of deposits must have moved from private and foreign banks to PSBs just in a few months. In the western world there was a complete credit freeze, and dozens of bank failures so that Indian branches of these foreign banks were asked to repatriate banking capital out of India to pay for shortfalls in New York or London. Only the PSBs were flush with deposits.

The gross non-performing assets, i.e. bad loan ratio, has climbed steadily from around 7 per cent five years ago to 11.6 percent as of March 2018. This overall ratio of the commercial banking sector hides large variations within. For instance, IDBI Bank has an NPA ratio of more than 24 per cent while the best performing are less than 1 per cent. Eleven of the PSB’s are under Prompt Corrective Action (PCA) of the Reserve Bank of India, which restricts their lending, staff recruitment and branches.

Why did the public respond this way? Was it due to the inherent superior quality of public sector banks, or due to their perceived safety? Obviously it was because of the latter. The perception of safety of deposits in public sector banks is because of an implicit guarantee that the main “owner” or shareholder, i.e. the government of India, will never allow a PSB to go belly up. Depositor money is thus “safe” in a PSB and, as records reveal, no PSB has been allowed to fold up, nor has any depositor lost money. Unlike failures of private banks like GTB, the worst fate on a PSB has been a forced merger with a stronger PSB. Of course, there are plenty of failures among cooperative banks, but that is a different story.

But in the present day, the PSBs seem a sorry lot. The gross non-performing assets, i.e. bad loan ratio, has climbed steadily from around 7 per cent five years ago to 11.6 percent as of March 2018. This overall ratio of the commercial banking sector hides large variations within. For instance, IDBI Bank has an NPA ratio of more than 24 per cent while the best performing are less than 1 per cent. The ratio is particularly bad among the PSBs, who average above 12 per cent. Eleven of the PSB’s are under Prompt Corrective Action (PCA) of the Reserve Bank of India, which restricts their lending, staff recruitment and branches. The latest Financial Stability Report of the RBI foresees the overall NPA ratio to deteriorate further by March 2019 to 12.2 per cent, the highest since 2000. That period then was a recessionary period with large NPAs whose origins lay in the post Asian crisis of 1997. But thanks to deft macroeconomic management, combined with high growth, low interest rates and moderate inflation, the NPA ratio started declining in 2003 and reached a bottom of nearly 2 percent by 2008.  The high growth phase starting in 2003 benefited from the global high tide of growth and trade.

Unfortunately, this formula is not available to us in 2018. All four macro factors are adverse this year - interest rates, inflation, current account and fiscal deficit. The global growth which seemed to be strong and synchronous is faltering. The high yields on US government bonds combined with high deficit may be pointing to a recession next year. There is growing protectionism which is crimping India’s export prospects even more. So the strong GDP growth needs domestic impulse, mainly from consumption and investment. On the latter, the private sector is not fully providing its share of the momentum, so much of the burden lies on the public sector, which in turn is hampered by the fiscal deficit. So, high growth as a panacea to solve the NPA problem is not an immediate option.

When banks enter the insolvency resolution, they have already written off 50 per cent of the loan, but any additional haircut means more losses. The power sector is another potential minefield of NPAs. One report suggests that losses from writing off loans in the power sector could be an additional Rs. 2.5 lakh crore to the banking system.

Let’s recognise the banking “crisis” is a problem which requires urgent and constant attention. The latest financial reports indicate that collectively the sector reported a loss of nearly Rs. 80,000 crore in one financial year. Much of this is due to a write-off of bad loans. But a significant portion is also the result of fraud. The latest RBI report flags this issue. The new insolvency process is supposed to help banks get windfall gains, as bad loans are taken off their books. But except for the steel sector, and possibly cement, most of the other NPAs which are coming up for resolution are implying “haircuts” of more than 60 per cent.

When banks enter the insolvency resolution, they have already written off 50 per cent of the loan, but any additional haircut means more losses. The power sector is another potential minefield of NPAs. One report suggests that losses from writing off loans in the power sector could be an additional Rs. 2.5 lakh crore to the banking system. The government announced last October a plan to infuse Rs. 2.1 trillion of equity into PSBs. Of this, nearly Rs. 55,000 crore was supposed to come from raising equity from the stock market. That does not seem to be likely in the current context. IDBI has for now been rescued by Life Insurance Corporation (LIC), which has taken a big stake in the bank. That may eventually turn out to be a big win, due to insurance distribution synergy, and if the stock price pops up (much like Mahindra rescued the scandal-ridden Satyam and reaped a handsome bonanza much later). But the IDBI stake acquisition remains an uncertain bet.

PSBs still command a huge trust from the depositor public. SBI continues to be a talent factory. Many ex-SBI officers have led distinguished careers rising to the top in other public, private and foreign banks. The new CEO of the much maligned IDBI is an ex-SBI managing director. It is very important to nurse the PSBs back to health while we wait for the macroeconomic cycle to turn. The insolvency process is helping. Greater autonomy and flexibility to PSBs in governance, especially in lending, staffing and compensation would go a long way.

For instance, presently the banks are not even allowed to go the campuses for recruitment! The creation of a “bad bank” to be a temporary custodian of large NPAs may be inevitable, and imminent. The PSBs may also consider reducing government stake to 33 per cent, yet retaining their PSB character, as was proposed in Parliament many years ago. There could be a system of golden shares held by the government, which enables them to retain some veto and control. Solutions and ideas for banking revival abound. Now is the time to grab this “crisis” by the horns.

(The writer is an economist and Senior Fellow, Takshashila Institution)