An interesting idea that has been mooted of late is the concept of differentiated lending by public sector banks (PSBs) based on their size. This is not very different from the concept of differentiated banks, which has been in the implementation stage in the last few years with the setting up of payments banks from the deposits side and small banks on the lending side. While the final step in the model of differentiated banking is to have a set of large universal banks that do all kind of lending with a focus on large tickets, the others come in the middle rung and cater to different kinds of clients, while the absolutely small ones like the new banks get restricted to their niche territory. A template that can be used for illustration is the manner in which old private banks operate. They continue to be niche banks in their geography, with dedicated customers where personal relationships have been built. While most have not witnessed any kind of exponential growth, they have good business models and have generally not been a worry in terms of bad assets or capital. The ostensible reason for moving some of the smaller PSBs to the niche areas of MSMEs (micro, small and medium enterprises) and retail lending is that they are not quite adding value to the other streams of lending and are more like followers in a consortium. In addition, with their small size, the non-performing assets (NPAs) get exaggerated and lead to the creation of a weak balance sheet. Is this the right answer?
The issue is complex because the system that has been created has undergone a metamorphosis in the last couple of years, with several structures being created within the banking umbrella. The Reserve Bank of India (RBI) notification on large exposures seeks to move banks out of very large size lending (`10,000 crore by March 2019 would be the large limit for bank exposure) to corporates by nudging them more to the debt market. Hence a threshold of lending has been created within the existing operations that wants banks to do away with long-term lending. Banks had moved towards such lending perforce out of compulsion once the concept of development finance institution (DFI) had gotten erased with the advent of universal banking. This led all banks to get involved with infrastructure lending as the share of long-term loans in the entire portfolio increased to almost 60% from levels of 40% over a little more than a decade. The failure of such projects had a ratchet effect on these banks. Simultaneously, the system now has the concept of small banks, which aim at priority sector lending only and include agriculture and SMEs at their core. This means that these banks are basically targeting a niche sector.
It is interesting that the priority sector continues to be the most vulnerable to economic cycles as well as weather conditions. Now, nudging the smaller PSBs, which also happen to be the weaker ones, to focus only on smaller loans runs the risk of concentration and this may not be a very good idea for them. The history of NPA creation shows that there has been a tendency for overexposure to specific sectors that has exacerbated the overall picture. At one time, it was steel and textiles, and then the coverage increased to infrastructure, aviation, mining, etc. Therefore, there is definitely wisdom in diversification of asset portfolio. Hence, asking these PSBs to concentrate on specific sectors could turn out to be counterproductive. Two major reforms that have been undertaken in the last year were demonetisation and the goods and services tax (GST). Both of them have affected the SME sector specifically, which is significant here. If lending was concentrated to this sector, then the probability of a very adverse portfolio being built would have been much higher. Hence, too much concentration in this segment may not be advisable. Retail would be a different game as there are fewer inter-linkages between loans given to various individuals and chances of a meltdown are almost negligible (though the CBO crisis in the US was due to this factor). Curiously, some of the private sector banks that have done very well on quality of assets have gravitated more towards this area.
A way out would be to follow a different strategy for these banks, which moves them to less risky areas. First, RBI can specify the sectors where they should not be over-investing, which can be a good way to begin the strengthening process. Every year, the list of high-risk sectors could be indicated for these banks. Hence, if infrastructure and steel are the problem areas, then exposures to these sectors must be capped, if not restricted, to only working capital purposes. Second, the volume of term loans in total can be monitored and fixed so that there is a right blend of working capital and term loans in overall lending portfolio. A lesson from the recent experience is that when defaults take place on big tickets, it shocks the system more than smaller ones. Third, the size of individual loans that can be given to any party can be capped at lower levels than the existing norms, which ensure that analogous to the large exposure norms, these smaller and weak banks have to restrict their exposures to a certain amount.
Fourth, small and weak banks can be defined by performance parameters such as net worth, level of capital, profitability ratios like return on assets and net worth, NPA levels, etc. Once a company is able to cross these thresholds, then it could move to the mainstream and lend according to normal commercial judgement. This way, there would be special monitoring of the performance of banks in such a manner that they are being evaluated on a regular basis. In fact, such rules can hold for other banks too, which are otherwise large, but slip on performance parameters. Such hand-holding could be an alternative route pursued as it identifies banks for such action based on performance indicators rather than size, and hence takes care of futuristic scenarios too. By linking such conditions to performance, there will be continuous pressure on all the banks to perform. As an adjunct, once they cross the threshold level of performance, additional capital can be infused if required. This will also even out the risk attached to large long-term loans, or else, in an effort to restrict the activity of the smaller banks, there could be the creation of higher concentration of risk with the other large banks, and this can become a problem if there is a major economic slowdown, which can never be ruled out in this volatile world.