Apart from what a contracting loan-book will mean for a PCA bank's NPA ratio, narrow-banking will mean such banks earn less.from their funds.
The Prompt Corrective Action (PCA) ideal is smart as it puts in perspective the fragility of a bank as the resuscitation process is put in place. The number of such banks has reached double digits, which is alarming because this number constitutes a sizeable portion of the banking edifice of the country. As these banks belong to the government, there is not much consternation among deposit-holders; or else, there could have been a deluge of panic. It would be interesting to conjecture the shape of things to come.
The PCA doctrine looks at three aspects: capital, NPA and profitability. Banks under PCA would have restrictions in terms of lending, opening branches, expanding business lines, paying dividend, invoking remuneration hikes and so on. This would be analogous to the system of narrow-banking where banks would stop lending and put incremental funds in government bonds. There could be some diversification permitted in the form of retail lending that is considered to be a better avenue in terms of risk of build-up of an adverse portfolio. While the PCA circular of RBI does not talk about stopping retail deposits (though there can be curbs on wholesale deposits) as this would unleash a modicum of panic, there is some talk on this count, too.
Some of the consequences are compelling. First, once banks stop lending or reduce the same to specific sectors where there is no large ticket lending, the loan book would start contracting as companies start repaying loans. If this happens, statistically, the NPA ratio would increase while banks wait for the IBC processes to play out. Therefore, unless the NPAs diminish at the same pace as the repayments of loans, there would be an upward bias in the numbers.
Second, banks will have to be prepared to earn less on their funds. Narrow-banking involves investing in G-Secs that, typically, give lower returns compared with commercial lending. The difference could be as much as 2-3%, which will affect the net interest income and margins, and thus, put pressure on the profit ratios—one of the parameters being tracked in the PCA doctrine. Intuitively, it can be seen that there would be a longer time-frame to traverse as these banks have to get out of the web of high NPAs and losses.
Third, banks have to also be prepared to face challenges on the investment portfolio. Investing in G-Secs is good in terms of not building an adverse portfolio. Also, risk weights for G-Secs are virtually non-existent—that helps in capital adequacy. But, banks will have a problem when they have to mark to market their investment portfolio periodically. Consider the current situation where interest rates are in the higher range and RBI is probably going to only increase interest rates as the days of cheap money are over. In such a context, the portfolio would be revalued in the downward direction which means that provisions on the portfolio have to be made by these banks. Hence, what they escape on the NPAs front can come back on the MTM front—albeit in a smaller magnitude, unless interest rates come down and the value of their portfolio improves. RBI may have to allow for spread of these losses in case the amount involved is high.
Fourth, banks have to typically control their operating costs, which is manageable to a large extent. The reaction of unions would be critical here because as all salaries and increments are decided for the PSBs in a whioe, having a differential scale would be novel and may have to be accepted to ensure that the boat is not rocked further. But, this has to be thought through because the PCA banks will also have to truncate other businesses, which can mean considerable reorganisation.
Fifth, these banks will not be allowed to pay dividend in case they make profit—which will affect the government the most as this comes into the Budget as non-tax income and is significant as the public sector units including banks have their role to play. But, to the extent that some of these banks are loss-making, there would anyway not have been any dividend payments made.
While these points would be pertinent to the specific banks under PCA, there are some broader implications for the system. To begin with, the extent to which these banks would have to curtail their activity will also impinge on the money market. This would depend a lot on the size of the banks which play in the call market or even the bond market. The exact impact may be difficult to estimate at present as the precise rules to be imposed on specific banks is still unknown.
The other issue relates to lending or credit offtake in the system. If these banks are going to be restrained from lending, then how would companies source credit? Two issues are running in parallel—some of the larger banks are going to pull out of the system, and this means that the supply will be lower. On the other side, the others which can lend would not like to expand their presence in the high-risk sectors and run against the barrier on large exposures put by RBI. This puts pressure on the non-PCA PSBs and private banks. Some of the latter are already saddled with increasing NPAs and would also prefer to go into retail. In this scenario, where would companies get their funding?
The external commercial borrowings route is also getting difficult with higher interest rates and a volatile exchange rate. The corporate bond market would be the main avenue for funds but, admittedly, this is meant more for the better-rated companies. While the issuance of BBB rated bonds are seeing some traction, the bulk of the issuances are in the higher grades, which means that there would be some gap in funding as banks are probably the only institution that lend to lower-rated companies based on collateral. The bond market surely will evolve, and on the back of the IBC support, in due course of time, can move to the concept of secured debt issuances—this will be the practical way out. But, the disequilibrium in the short run will be palpable, and it is likely that there could be deferment in borrowing due to non-availability of funding in an environment when the interest rates are increasing.
A lot of these answers will emerge in the coming months as the economy seeks to regain momentum.