By Atisha Kumar
In tackling health epidemics, it is important to administer the right dose of curative medicine. But to avert recurrence of the epidemic, it is imperative to develop preventive vaccines. It is no secret that India’s banking system is in poor health. Recapitalisation was necessary in a strong dose to revive banking. However, in the long term, India needs to implement structural reforms to ensure that an epidemic of bad loans and non-performing assets (NPAs) is not repeated. The government’s infusion of funds—first under the Mission Indradhanush in 2015-16 and then under a plan announced in October—acknowledge its recognition of the serious negative effects of banks’ high NPA ratios. The effects include low and declining bank credit, low profitability of banks, and declining capital adequacy ratios. To counter these, the ministry of finance announced a Rs 2.1 lakh crore plan to recapitalise banks on October 24. These funds will not only help public sector banks (PSBs) meet their minimum capital requirements, but they will also help banks clean up their balance sheets and cover bad loans.
Addressing the poor asset quality of banks was overdue. Many banks and lenders welcome the government’s recent package for recapitalisation with relief—urgently needed steps to boost private investment and drive growth. Now, it is important to put in place reforms that will prevent necessitating such measures in the future. The urgent should not crowd out the important. In addition to recapitalisation, a number of reforms are needed to strengthen institutional governance and align incentives in the banking system, particularly for PSBs. To some extent, the Mission Indradhanush encompasses wider banking reforms. Its seven points include creating a framework of accountability, separating the roles of CEO and chairman in PSBs, and creating a Banks Board Bureau (BBB) for appointments and governance reforms.
However, some of these reforms have not been implemented fully. It may be time to closely and regularly monitor implementation and progress on these reforms to ensure that asset quality improves in the long term. Beyond these, the Insolvency and Bankruptcy Code (IBC) may also provide another avenue for addressing NPAs. It requires banks and promoters to agree on a resolution plan within 270 days. Failing to do so can lead to asset liquidation. Its efficacy in resolving cases of default will be tested over the coming months. If promoters lose control over their businesses and banks take haircuts, a deterrent for future deviant behaviour may be created, thus providing a systemic solution to the bad loans problem.
The way forward
What other policies can help the banking sector become more robust? It may be useful to draw lessons from past schemes in India and abroad to tackle NPAs. In China, besides recapitalisation, banking sector reforms focused explicitly on strengthening financial regulation and supervision, improving corporate governance, and enhancing transparency. South Korea created the Financial Supervisory Service (FSS) to ensure adequate supervision in the aftermath of the Asian financial crisis of the late 1990s. Stronger supervision helped South Korea adequately deal with insolvent companies.
In India, RBI’s Strategic Debt Restructuring Scheme has not proven successful in part because of banks’ lack of coordination, their reluctance to accept write-downs on their debt, and lack of transparency and policy consistency. India’s banking system needs to be competitive, transparent and sufficiently capitalised to provide credit to fuel economic growth. To enhance resilience, several other measures including corporate governance reforms, improved financial supervision and more efficient debt recovery mechanisms will prove important. For example, the issue of recapitalisation bonds could be made contingent on the adoption of governance reforms by PSBs. We also need to raise the level of professionalism of public and private banks and increase competition. In the longer term, developing a deep corporate bond market will also help alleviate pressure on banks.
The banking system remains the most important source of formal credit for firms and households in India. However, its lending capacity has been limited by the high proportion of distressed assets in bank portfolios. Since 2015, the share of gross NPAs in PSB portfolios has risen rapidly. Between March 2015 and June 2017, this share has risen from 5.43% to 13.69%. This high share of NPAs presents a critical challenge for the banking system and the economy.
It has constrained credit and banks’ ability to meet international capital requirements. Relative to other emerging economies, India has low levels of private credit to GDP and credit to deposit ratio. Data from the International Monetary Fund (IMF) highlight that India’s private credit to GDP ratio was 50.2%, relative to 140% in China and 71% in Brazil in 2015. Similarly, bank credit as a ratio of bank deposits was 77% in India compared to 119% in Brazil and 312% in China in 2015. We need to make sure we don’t end up in a difficult situation again. Once banks are sufficiently liquid and the lending resumes, they need to feature improved asset quality and become self-sustaining. Prevention is just as important as the cure.
The writer is Economist, NITI Aayog. Views are personal