Bad loans are just the tip of the iceberg

There has been an increased interest around the world in financial stability reports and attendant stress tests on the banking sector since the 2008 global financial crisis. In India, the institution of the Financial Stability Report (FSR) as a formal, half-yearly document from the Reserve Bank of India (RBI) began soon after the crisis. The latest report released on June 26 offers, in the words of the RBI Deputy Governor Viral Acharya, “a health check of the financial system through the lens of stress test and contagion analysis.”

The FSR is not a statutory report — neither the RBI Act nor the Banking Regulation Act mandate it. Such a report should therefore stand out as a proactive effort that must flag the dangers on the road ahead and prepare the ground to drive in inclement weather.

In the context of complex global conditions and evolving domestic risks, the FSR is like an early warning bell with “what if” analysis so that we are better prepared for various scenarios. Indeed, the FSR was introduced in March 2010 with this aim — to emerge as “one of the key instruments for directing pre-emptive policy responses to incipient risks in the financial system”, as the RBI put it then.

Eight years and 17 reports later, it is not clear if “pre-emptive” actions have worked to control some of the mess that is all too obvious in the system. One of the key failures remains the rising tide of non-performing assets, or NPAs, which stands out in the latest FSR as one of the deeper (though not the only) risks to financial stability.

It is ironic that the institution of the FSR appears to have coincided with a steady decline in stability indicators, leading to legitimate concerns on the gap between the rising number of red flags and our preparedness for scenarios highlighted by the FSR.

Enough has been written about how bad the NPAs could get in all three scenarios covered by the latest report — the baseline scenario which looks at the prevailing macro-economic indicators and two adverse macroeconomic risk scenarios (medium and severe). The bottomline is that this is a bad situation getting worse.

Twenty banks (18 of them in the public sector) having a share of almost 60 per cent of total bank assets will fail to maintain the required Capital to Risk-weighted Assets Ratio (CRAR) of nine per cent if a severe risk were to materialise. This is an alarming (but plausible) scenario.

Large borrowers at fault

Large borrowers (who have aggregate fund-based and non-fund based exposure of ₹5 crore and above) accounted for 54.8 per cent of advances and 85.6 per cent of NPAs. Furthermore, top 100 large borrowers contributed to 15.2 per cent of advances and 26 per cent of NPAs. This tells us that (a) the banking system instability has been contributed by the large borrowers, (b) concentration of large borrowers in advances means banking penetration among the small borrowers has not been so encouraging even with priority sector lending norms and (c) smaller borrowers are more disciplined and so less risky for banks.

Modern day banking in India is thus a living example of the adage that if you borrow ₹100, that’s your problem, and if you borrow ₹100 million, that’s the bank’s problem.

Coupled with issues of governance that have emerged at ICICI Bank, India’s largest private sector bank, at the level of no less than the Managing Director, the risk is more than financial. The biggest risk is ordinary citizens losing faith in the banking process itself, and the prospect of the socio-politico-economic turmoil that this can stir up.

Meeting these challenges requires more than the actions that the RBI cites, like the Prompt Corrective Action (PCA), under which RBI has placed 11 public sector banks.

These banks face restrictions on distributing dividends, remitting profits and even on accepting certain kinds of deposits, apart from restrictions on the expansion of branch network, and the lenders need to maintain higher provisions, along with caps on management compensation and directors’ fees.

A natural fallout is that these banks are constrained. They can no longer play their role fully in credit delivery. This has its own negative fallouts on the economy, underlining the vicious cycle at work.

Apart from PCA, the RBI has been relying heavily on the resolution mechanism offered by the Insolvency and Bankruptcy Code, 2016. How well that will work remains to be seen. The PCA and IBC are both fixing leaks; they do not guarantee that there will be no further leaks. Both processes have limitations in addressing structural issues associated with internal controls, internal audit and governance mechanisms.

That is the elephant in the room and needs to be fixed with strong messages, stronger action and a new and better level of professionalism in the banks along with exemplary punishment for violators.

The governance factor

There is no denying that the NPA is an issue of governance, linked to appointments, pressures from “above” coupled with wild bureaucratic mismanagement and poor oversight. Anecdotal stories abound on how loans are fixed.

Given the current scenario, the FSR displays unwarranted optimism when it concludes that “India’s financial system remains stable”. In fact, this is precisely the kind of comment that is not to be made in an FSR, which must not only simulate scenarios but also communicate them to the ecosystem with equal vigour. This means taking the message to the common citizen, a task often lost sight of in the thick of technical jargon that backrooms like to play with.

In introducing the report, Deputy Governor Acharya wrote: “…assessment of financial stability is key to taking right measures so as to evolve our financial sector to be more resilient following a difficult decade in the banking sector; it will help ensure, as Robert Browning said “My sun sets to rise again”.

A better prescription in these times would be the words of IMF Managing Director Christine Lagarde, who said in another context, “the time to repair the roof is when the sun is shining.”

Rattanani is a journalist and Pattnaik is a former Central banker. Both are faculty members at SPJIMR

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