Bank recapitalisation is no magic bullet

The 4-R approach to the banking challenge that has been espoused of late requires introspection. The strategy involves recognition, resolution, recapitalisation and reforms in the banking space and targets public sector banks which admittedly have relatively unfavourable prudential ratios. While there is a sense of urgency to get the 4-R done with expediency, there are some fundamental questions that we need to answer to ensure that the approach works and is not breached.

First, the recognition issue is quite delicate. While the Asset Quality Review process was taken up in 2015, it does appear that conceptually, the identification problem has not been sorted out. There are reports that the RBI has found considerable variance in the quantum of NPAs declared by some private banks, which indicates that there is scope for differential interpretation. Further, the concept of classifying NPAs as restructured assets was deeply flawed and led to the practice of evergreening. The argument put forward was that the projects failed not because they were inherently bad, but because of policy glitches involving impropriety. When the regulator took umbrage and the classification was changed, it lead to a torrent of NPAs being revealed. The process does not yet seem to have been completed. The message is that any kind of forbearance or accommodation made by the system to redefine NPAs is not a good sign.

Second, while there is euphoria on the Insolvency and Bankruptcy Code (IBC) being in place and errant companies being taken to task, the potential for wide-scale disruption and attempts to game the system is high. There could be sub-optimal solutions reached in order to eschew being called ‘insolvent’, as any such sale could be at a much lower price. Further, the revelation of names runs the risk of having these companies being blacklisted in future. In fact, if they are not, there could be ethical questions raised regarding banks’ lending to entities that have defaulted. Hence, while it is good for cleaning the system, the collateral damage caused to borrowers who have gone down due to a downturn in the business cycle but can otherwise recover once there is a turnaround in the economy, is considerable. This is a serious issue which does not have an easy solution given that none of the earlier strategies for NPAs has worked.

Third, the Government has announced a package for recapitalising banks which is probably a Hobson’s choice as there is no alternative. Hopefully this should not become a habit, as moving funds for capitalisation through the government-banks-government route can be only a last resort. If it is felt that PSBs are bogged down by being government-owned, then a bold decision should be taken to lower the government stake to less than 50 per cent, while the timing of equity sale can be decided later. Reluctance to make such a commitment has exacerbated the situation. Alternatively, if the decision is to retain public ownership and change the work ethic, then the Government should willingly recapitalise these banks, especially the weaker ones.

Fourth, there is a lot of talk about reforms in the banking sector. The ambitious Indradhanush scheme did not quite work the way it was expected to. While there is considerable talk about governance in PSBs, the important thing to note is that governance is a creation of the system in which institutions operate. When there is interference, lending judgments tend to be skewed and funds flow in the wrong places. Blaming banks is not the solution; correcting the systems is the way out.

Some areas have to be fixed. First, there should be no political interference in lending decisions. The Centre has assured us that nobody influences decisions. But we cannot be sure if the State and local governments have kept away from influencing decisions. Second, bank boards should be chosen through a UPSC-like system and not by doling out favours to those who served political interests or have occupied prestigious positions. Third, management as well as skilled staff have to be paid market-related salaries; while support staff could remain on the existing pay structure, core critical functions need higher compensation. In fact, the chairman or CEO should have a fixed term of five years and selection should be on a transparent basis without succumbing to the temptation to bring in only personnel from the private sector. The argument is that if the public sector culture does not change, then getting in a private sector person could demotivate the existing personnel. Besides, those who have been with the bank through the years are the best to head such organisations given their superior knowledge and experience.

Fifth, at the policy level it is essential to review the approach to banking. The very concept of loan waivers and other compulsions like interest rate subventions should be reconsidered. While there could be compensation by the States, the ethos of banking gets eroded when there is official sanction for a culture not to repay loans, which stretches to all sections. Curiously, as of March 2017, the share of priority sector loans in NPAs for PSBs was high, at around 30-40 per cent. While there are arguments for such lending, from the commercial point of view it is high-risk. When regulation makes such lending mandatory, the same ideology gets extended to sectors like infrastructure which further adds to the risk.

Sixth, the Government also has to be discreet when it keeps batting for lower interest rates. It is now axiomatic to badger the RBI to lower the repo rate and banks to transmit the same to boost lending. By doing so the message is that credit has to increase through lower rates with no ‘mention’ of credit quality, which is the major concern. Therefore, there is pressure on banks to enhance lending, which can lead to a perverse selection of portfolio.

It may be recollected that when the Indian economy grew by 8-9 per cent annually, lending was buoyant as it was expected that growth would only be in the upward trajectory. Little attempt was made to deepen the bond market for infra funding, and the banks took on this on the back of a liberal monetary policy. The turn in the business cycle will invariably pressure bank balance sheets again.

Hence, the crux is to get the lending right which requires skills, that can work only if there is no interference. We also need to be certain if we want the Government to own the banks and if so, whether they should be allowed to operate like any commercial venture. Otherwise, the charade will get repeated.

The writer is chief economist at CARE Ratings. The views are personal

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