What ails the Indian banking sector?

What ails the Indian banking sector?The problem escalated due to the government’s focus on infrastructure during 2002-09, especially with the efforts made to promote public-private partnerships

The past two years or so have seen rapidly increasing stress in the Indian banking sector, with non-performing assets (NPAs) steadily climbing from under 3% to over 13% of total assets. Loan-loss provisioning for NPAs has seriously eroded the capital base of several banks, limiting their ability to make further loans. There is general consensus that the state of Indian banking is among the biggest challenges facing the country in accelerating investments and growth.

While there is certainly urgency in finding a solution to the problem, diagnosing the cause(s) and putting correctives in place is perhaps even more important. Unfortunately, the entire discourse appears to have boiled down to the governance practices in public sector banks (PSBs), particularly political interference and crony capitalism. Hence, the solutions have more or less polarized around two ideologically coloured views—(a) privatization of PSBs; or (b) strengthening independence and capacity of PSBs. While this is a perfectly legitimate debate and may lead to a part of the solution, it should not forestall the search for other causes, which may be just as important.

The cause

I argue that much of the problems currently being faced by the banking sector arise from a fundamental change that occurred after 2002. Prior to that, Indian banks mainly had two types of loans: (a) working capital loans to production entities, firms, and farmers (76% of banking portfolio); and (b) retail term loans to households for housing, and durable goods (less than 24%). Since then, banks have been aggressively making term loans to companies for fixed capital investments, like land, building, and machinery. This now accounts for 38% of the portfolio, with working capital at 42% and retail at 20%. The bulk of NPAs by value are long-term loans to corporates.

This shift from short-term working capital loans to long-term loans has not gone entirely unnoticed. Concern has been expressed in many quarters about the serious asset-liability mismatch in the banking sector, whereby the average tenor of assets (loan portfolio) has been rapidly going up relative to that of liabilities (deposits). While this is worrying, it is not the cause of the NPA problem.

There is a significant difference between de jure (contractual) and de facto (behavioural) tenors of bank deposits. The average de jure tenor is usually computed by taking the weighted average of contractual tenors of demand and term deposits, which works out to about two years. However, most deposits—demand and term—usually remain with banks for much longer periods, which can be as high as 14-15 years. Thus, the de facto average tenor is probably above 10 years, which may well be higher than the average maturity of the loan portfolio. This difference between de jure and de facto means that the asset-liability mismatch becomes a problem only when there is a loss of depositor confidence and withdrawal of deposits. This is not the situation as yet. The NPA problem has arisen from four features that characterised bank loans for fixed capital formation: (a)Banks do not have the capacity to assess long-term credit-worthiness of borrowers. They rely almost exclusively on credit-rating agencies that provide ratings only when the concerned company intends to raise debt capital directly from the market.

(b) Banks have no capacity to monitor the use of long-term loans by borrowers. This is particularly egregious for project loans, especially when it is without recourse (lender has claim only on assets of the project, not of the parent company). Consequently, the parent company can use the funds for purposes other than for which they were borrowed without the banks being any the wiser. Hence, whatever little appraisal was done initially becomes vitiated.

(c) Such loans create an existential problem for borrowers since attaching such assets essentially means “winding up” the companies. It is only natural that company promoters would fight such an eventuality. Since winding up petitions, especially with multiple lenders, was a complex legal process, which often took 7-10 years, with promoters using every possible trick to stall proceedings, banks faced the alarming prospect of making large loan loss provisions which would stay on the books for many years with very little recovery at the end. It is no wonder that bank managements have allowed potential NPAs to accumulate over the years through myriad forms of “ever-greening”. Reserve Bank of India’s forced recognition of NPAs has now brought the problem to light.

(d)Finally, there was gross mispricing of loans by banks. In practically all banks, the yield curve is almost parallel to, and sometimes even flatter than, that of government securities. Even if banks were unable to assess the appropriate risk premium at different tenors due to (a) above, there is no reason why a premium was not attached to the illiquid nature of the underlying collateral, which is also related to (c) above.

The origins

This high exposure to companies in fixed assets, especially in project finance, did not happen by itself, but at the behest of successive governments. It begins with a decision taken by the government in 1997 to stop issuance of tax-free bonds by development finance institutions, which were the main source of term finance for corporates. This closed the only source of relatively low-cost funds for these institutions, and was instrumental in some of them converting to commercial banks and others shutting down. Consequently, Indian commercial banks were forced to fill the vacuum and effectively converting to “universal banks” (performing roles of both commercial and investment banks).

The problem escalated due to the government’s focus on infrastructure during 2002-2009, especially with the efforts made to promote ‘public-private partnerships’. This led to a rapid increase in project financing to private infrastructure firms. The global financial crisis in 2008-09 required banks to take substantial further exposures in long-term loans as external commercial borrowings by Indian corporates dried up. Thus, to pin all the blame on poor governance in PSBs, especially by government interlocutors, appears gratuitous.

The solutions

The first and most important solution to the NPA problem is to provide for rapid resolution of defaults. Something similar used to happen earlier with working capital loans and was taken care of by the promulgation of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, which resulted in gross NPAs falling from 19% in 2002 to 6% by 2006. However, the SARFAESI Act is of consequence only in cases where collaterals are moveable assets, and especially where there is a single claim-holder.

The need for a Bankruptcy Act was anticipated and recommended in the Tenth Five Year Plan in 2002. After much delay, the Insolvency and Bankruptcy Code (IBC) was passed in 2016, which has made it easier for banks to effect recovery through liquidation of fixed assets. As IBC institutions and processes are strengthened, it should take care of the existing NPAs and, up to a point, the need for banks to do ever-greening. However, it does not in itself address the other issues associated with long-term loans, especially mispricing.

The other critical solution is fundamental to the change that has taken place in Indian banking. Indian banking laws follow the “Anglo-Saxon” model in which there is a firewall between commercial and investment banks. The shift to universal banking was ‘reform by stealth’ and not accompanied by amendments to laws. Countries which have universal banking, such as Europe and Japan, permit banks to issue bonds for financing term loans. Our Banking (Regulation) Act, 1949 does not do so. Banks can issue bonds only for raising their own capital.

The Banking Act should be amended to permit issuance of bonds by banks for on-lending. Ideally, banks should be required to ensure that a minimum percentage of their term loans are financed by long-term market borrowings. Such a measure would have several positive effects. First, if banks are required to issue bonds to finance a part of their term loans, it would lead to a much more rational (steeper) yield curve on bank loans since the interest rate on bonds would be significantly higher than that on deposits.

Second, a more rational yield curve may drive some corporates to borrow directly in the bond market, reducing the pressure on banks. The Securities and Exchange Board of India has made it mandatory for listed companies to raise a part of their long-term debt from the market, but this can potentially distort credit allocation in the economy. A more rational bank yield curve would obviate some of this distortion as there would be a self-selection element in companies’ decision to issue long-term bonds.

Third, this would automatically correct the growing asset-liability mismatch problem, and improve the credibility of the banking sector.

Finally, since banks would have to get themselves periodically rated, the yield curve of individual banks would reflect the strength of their loan portfolios. Banks with weaker balance sheets will have to offer higher interest rates on their bonds, which will get reflected in higher rates that they will have to charge to the same potential client. This should introduce a self-correcting mechanism in banks’ lending behaviour well before they run into serious problems.

The choice facing the government is clear: either revert to the status quo ante where banks eschew lending for fixed capital formation; or amend banking laws to reflect the new reality. Sitting on one’s hands and berating the banks is not an option.