THE GLOBAL ANALYST, JUNE 2016: Indian Banking Sector

Indian Banking Sector: Rejuvenation Mode*

M G Warrier

This decade will be marked in India’s banking history as one which has seen unprecedented changes in the financial sector both from structural and policy perspectives.

The major player in the country’s financial sector, namely commercial banks, by and large, received parental care from government and the regulator (Reserve Bank of India), ever since the Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949 came into effect. The debate about the damage control in progress to save commercial banks from stressed assets (read wilful defaulters or mischievous borrowers), is trespassing all boundaries, to the extent of impairing the effectiveness of the interventions and policy initiatives from government and the regulator, that have protected the interests of savers and depositors who have been providing precious resources for banking business.

Just on the eve of Finance Minister Arun Jaitley’s scheduled interaction with Government-owned banks, ‘displeased with the performance of public sector banks  (PSBs) in recovering dues during 2015-16, the government has asked lenders to "seriously" speed up efforts to get back money from defaulting borrowers’(this is a quote from a media report!). Definitely, finance ministry has every right to ask CEOs of banks to come prepared with answers for the questions that are disturbing GOI as owners of PSBs. But sharing the concerns with the media, even before banks get an opportunity to ‘defend’ their case, is uncharitable. The media report continues to elaborate the admonitions by the finance ministry:

“Recovery efforts have not matched the exponential growth in gross non-performing assets  (gross NPAs). Most recovery is coming from written-off accounts, which are increasing every year.

The total recovery by all PSBs  was flat at Rs 1.28 lakh crore in 2015-16 against Rs 1.27 lakh crore in 2014-15, according to the finance  ministry's communication to the chiefs of state-owned banks.

Within these recovered amounts, the share of written-off accounts has increased from 41 per cent in 2014-15 to 46 per cent in 2015-16.”

And much more. Read on:

“Gross NPAs  of PSBs grew from Rs 2.67 lakh crore (5.43 per cent of gross advances) in March 2015 to Rs 4.76 crore (9.32 per cent) in March 2016. The stressed assets (gross NPAs plus standard restructured assets) of PSBs grew to Rs 7.33 lakh crore in March 2016 from Rs 6.62 lakh crore a year ago.

Fresh slippages increased by as much as 118 per cent to Rs 3.90 lakh crore by the end of March 2016 from Rs 1.78 lakh crore in March 2015.”

The message sent to banks by Finance Ministry, just before the meeting of PSBs convened by FM scheduled on Monday, June 6, was ritualistic. Beyond admonitions like this by publishing scary statistics, it is time all stakeholders of the Indian Banking System (private sector banks included) sat together and seriously deliberated about measures needed to restore the health of the institution of banking which has a major role to play in promoting economic growth.

Post-independence, India has been lucky in ensuring sustainability of major pillars of governance conceived in the Indian Constitution. These are legislatures, judiciary, executive and the institution of CAG. Among regulators, Reserve Bank of India(RBI) the financial sector regulator has played a significant role in nurturing the banking system by effective participation in institution-building and preventing bank failures. At this stage of development, health of public sector banks with more than two-thirds share in banking business need to be restored in national interest. Here, RBI and PSBs need legal and moral support from GOI. Such support is additional to the role being played by GOI as ‘owner’ and will include:

i)                   Level playing field for PSBs in the matter of recruitment, training, career progression and remuneration package for staff as compared to major ‘successful’ private sector banks.

ii)                Board being professionalised.

iii)              Transparent incentives and disincentives for executives and middle management professionals. Their survival and career progression should be dependent on performance (now they are not)

One wishes, this time, FM and his executives spend more time listening to CEOs of PSBs.

RBI’s role

Reserve Bank of India’s vision about the cleansing up of bank balance sheets was brought out in uncertain terms in his speech at CII’s first Banking Summit by Dr. Raghuram Rajan, Governor, Reserve Bank of India at Mumbai on February 11, 2016. Linking fall in bank share prices to the recent efforts to cleanse bank balance sheets, he said:

 “Some of the greater decline of bank share prices can therefore be explained by the fact that they are seen as a leveraged play on the economy. On bad days, they move down more, on good days they move up more. With markets generally in decline, the decline in bank share prices has been more accentuated.

However, part of the reason is that some bank results, mainly public sector banks, have not been, to put it mildly, pretty. Clearly, an important factor has been the Asset Quality Review (AQR) conducted by the Reserve Bank and its aftermath. So it may be useful to understand the rationale for the AQR, the process, and what I believe will be the outcome.”

Dealing with Stressed Loans

RBI’s approach to handling stressed assets of banks is well articulated in the following observations by Dr Rajan in the same speech:

“But to do deep surgery such as restructuring or writing down loans, the bank has to recognize it has a problem – classify the asset as a Non Performing Asset (NPA). Think therefore of the NPA classification as an anesthetic that allows the bank to perform extensive necessary surgery to set the project back on its feet. If the bank wants to pretend that everything is all right with the loan, it can only apply band aids – for any more drastic action would require NPA classification.

Loan classification is merely good accounting – it reflects what the true value of the loan might be. It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely losses. If the losses do not materialize, the bank can write back provisioning to profits. If the losses do materialize, the bank does not have to suddenly declare a big loss, it can set the losses against the prudential provisions it has made. Thus the bank balance sheet then represents a true and fair picture of the bank’s health, as a bank balance sheet is meant to. Of course, we can postpone the day of reckoning with regulatory forbearance. But unless conditions in the industry improve suddenly and dramatically, the bank balance sheets present a distorted picture of health, and the eventual hole becomes bigger.

In 2008-9, after the global financial crisis, the Reserve Bank agreed to forbear on certain kinds of stressed loan restructuring, hoping that this was a temporary need pending stronger growth. Unfortunately, for a variety of reasons, the stress has not been temporary, and growth in these sectors has proved elusive. Therefore, early in the process, the Reserve Bank set about giving banks the tools to deal with stressed loans, including information about the degree of the borrower’s collective indebtedness from the system and more effective ways to reduce the project’s financial stress such as the Joint Lender’s Forum, the Strategic Debt Restructuring mechanism, and the 5/25 mechanism. In a way, the RBI has been trying to create a functioning resolution process in a situation where the existing bankruptcy system functions poorly.”

A pragmatic option

One wishes, the finance ministry takes RBI’s advice seriously and goes beyond periodical stereotyped reviews to initiate corrective measures for preventing further accumulation of ‘stressed assets’ on banks’ books and for recovery of at least major portion of those already accumulated. Enough ‘food for thought’ is available in the speech delivered by RBI Governor Dr Raghuram Rajan on February 11, 2016. To the pessimists who predicted danger in going ahead with Asset Quality Review of banks, Rajan had this to say:

“A lot of work has gone into this review, including many meetings with the Government at every level including the highest. The Government has been fully involved and supportive. We have mapped out a variety of scenarios on possible outcomes. The Finance Minister has indicated he will support the public sector banks with capital infusions as needed. Our estimate is that the Government support that has been indicated will suffice. Our various scenarios also show private sector banks will not want for regulatory capital as a result of this exercise. Finally, the RBI is also working on identifying currently non-recognizable capital that is already on bank balance sheets, such as undervalued assets. The RBI could allow some of these to count as capital as per Basel norms, provided a bank meets minimum common equity standards.

There are some wild claims being made by some financial analysts about the size of the stressed asset problem. This verges on scare-mongering. Our projections are that any breach of minimum core capital requirements by a small minority of public sector banks, in the absence of any recapitalization, will be small. They will need government equity or preference share infusion since they are typically banks that will find it difficult to raise equity in the markets. A few others will need a top up of their capital to ensure they have a reasonable buffer over and above minimum capital. What the Government has already explicitly committed is, in our view, enough to take care of all reasonable scenarios, and the Government has committed to stand behind its banks to whatever extent needed. The RBI will provide whatever liquidity is needed by any bank that needs it, though we do not foresee liquidity stress.

In sum, while the profitability of some banks may be impaired in the short run, the system, once cleaned, will be able to support economic growth in a sustainable and profitable way. The economic assets of our public sector banks, such as the trust they are held in by the population, their knowledgeable employees, their location and reach, and the low-cost funding they have access to, can then be fully realized.”

Improving Bank Management and Governance

Simultaneously GOI need to support banks in improving management and governance. Dr Rajan has clear perception on what to do. He said:

“We must also ensure that we are not faced with this situation again. The Government, through the Indradhanush initiative, has sent a clear signal that it wants to make sure that public sector banks, once healthy, stay healthy. Strengthening Board and management appointments, decentralizing more decisions to the professional board, finding ways to incentivize management, all these will help improve loan evaluation, monitoring and repayment. Banks must review their procedures to ensure they can make good credit decisions. The new bankruptcy code, when enacted, will finally give creditors a way of collecting repayment through the judicial process in reasonable time. So my hope and belief is that the next time will be different for public sector banks – they will emerge from this clean up stronger and more capable.”

Conclusion

Let us believe the RBI Governor’s words: “The market turmoil will pass. The clean-up will get done, and Indian banks will be restored to health. While we should not underplay the dimensions of the task, we should be confident that it is manageable and that the Government and the RBI will do what it takes to make sure that banks are able to support the tremendous growth that lies ahead”.

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*Submitted version of articlepublished in The Global ANALYST, 2016