By reducing the repo rate and by relaxing the prompt corrective action (PCA) framework for some public sector banks, the RBI may have delivered on the top items in the government’s wish list. The rate reduction is on the back of falling inflation but the logic for freeing three banks from PCA is a little more convoluted, because the banks continue to flounder. But the more important question is about their effectiveness.

High lending rates in India have more to do with risk than the cost of money. Corporate investment has been subdued for many reasons other than cost-excess capacities, a preference for the short term or even a general lack of animal spirits. While retail lending has grown on the back of lower risk perception, intense competition has already pushed lending rates down in this segment. The principal problem continues to be rate transmission.

As a former RBI Governor said, the RBI can only do so much with repo rates because it is credit risk that adds a large premium to the cost. The cost of deposits is actually moderated by the fact that over a third of a bank’s deposits consist of transactional money (CASA — a mix of zero cost and 4 per cent funds) which are not really financial savings.

This is not to deny liquidity pressures in the market or high borrowing costs, but those probably are due to cash-flow problems caused by the large bad loans. Whichever way we look at it, credit risk has a ubiquitous presence. But the RBI continues to experiment with the rate-fixing mechanism, shifting from internal benchmarks (prime rate, MCLR), to external benchmarks (repo/CD rates). But as long as credit risk remains high, lower repo rates can only marginally impact lending rates.

PCA: A bigger problem

The problem with the PCA framework is more substantive. If the original intent of the PCA was to stop the bleeding (accumulating new NPAs) by freezing lending, the half-yearly results for FY18 showed they did not work — gross NPAs (non-performing assets) actually jumped by over 15 per cent, despite lending falling by 8 per cent.

Further, the parameters tracked in the programme are interrelated, making it somewhat infructuous to consider them individually. For instance, losses negatively impact both return on assets (RoA) and the capital to risk weighted assets ratio (CRAR). Likewise, the net NPA ratio is a function of provisioning levels but moves in an opposite direction to the CRAR — increased provisions improve the net NPA, but also bring down the CRAR if losses result, which is precisely what happened with the three banks — Bank of India, Oriental Bank of Commerce and the Bank of Maharashtra — initially freed from PCA. These banks made excessively high provisions (258, 235 and 407 per cent, respectively, of their pre-provision profits) to bring down their net NPA ratios close to the magic mark of 7 per cent.

But the huge losses impacted their RoA and CRAR, which were perhaps overlooked on the strength of government agreeing to bring in fresh capital. But using capital to meet provisions goes against the intent of the rule, which is to set aside a part of current profits to meet future losses.

There is another dimension — because our system is public sector dominated, the problem of capital becomes a problem of the fiscal deficit, because these banks cannot raise capital on their own, nor does the government want to cede control.

Both the problems of interest rate transmission and credit risk have much to do with structural issues also. Our financial system is bank-led and our banking system is public-sector led. The former means that interest rates have to work their way through banking channels unlike, say, in the US where markets do the job through asset prices rather than the quantum of credit. But given our weak banking system and straitjacketed asset markets, rate transmission will be inefficient.

As for credit risk, it is almost entirely concentrated in the public sector, a problem that goes back to the time when they had to enter the risky space of long-term lending and infrastructure finance, due to the sudden demise of the specialised long term financing institutions such as the IDBI, ICICI and IFCI. To be sure, bad governance and a decadent debt culture also contributed, but the clear divide in asset quality between private and public banks is telling.

The current structure — a high-cost, low-efficiency model for delivering payments, credit and financing government borrowings — is clearly unsuited for the future and not sustainable because already both payments and lending are rapidly getting dis-intermediated by technology and innovation. The clutch of reforms such as bankruptcy and resolutions are targeted more at putting out the fire.

The writer is an independent consultant

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