Banking industry

Breaking the banks

Print edition : June 23, 2017

In Hyderabad in April, following the merger of five banks with SBI. Photo: K.V.S. GIRI

The government’s recourse to an ordinance to solve the “bad loan” menace in the Indian banking system raises serious questions of moral hazards and its motive in driving public sector banks towards privatisation.

IN what has been widely termed as a last-ditch effort at resolving the burgeoning burden of bad loans in the Indian banking sector, the Union government on May 5 issued an ordinance that seeks to stem the rot that has been festering in the sector for almost a decade. The ordinance, which amends on a temporary basis provisions of the Banking Regulation Act until its ratification by Parliament, allows the Reserve Bank of India (RBI) to exercise direct control in settling non-performing assets (NPAs), which are now close to Rs.10 lakh crore.

That public sector banks, which carry the heaviest burden of NPAs, would have to undergo a deep “haircut” was always a possibility; but the ordinance now raises fears that the banks would have to go for a tonsure even as reckless and truant borrowers get off scot-free.

The key provisions of the ordinance pertain to the manner in which outstanding loans, especially those of large borrowers, can be renegotiated in a far more aggressive manner than earlier with the central bank acting as some kind of a referee, only this referee would function like a supremo. There are serious problems with this approach because, shorn of the legalese, what the ordinance facilitates is the creation of an arena in which truant borrowers—many of whom have not only borrowed beyond their means but have even wilfully avoided repaying the loans—can sit across the table and bargain with the banks about how much they would pay and on what terms.

Moral hazards of a haircut

Banking industry specialists have pointed out that lending is a commercial activity, which is based on an evaluation of the business decisions of borrowers and their assessment of commercial viability. When a loan’s continued viability comes under stress, which increases the risks for the lender, there may come a time when the bank has to take a call on encashing its collateral or restructure the terms of the loan or even enter into a negotiated settlement. All these are options with commercial implications, which the banks are in a position to exercise. The central bank has guidelines, rules and procedures, which banks are supposed to comply with while exercising these options. To seize control of the entire process simply because of a political perception that things need to be expedited suggests a serious conflict of interest for the central bank.

H.R. Khan, former Deputy Governor of the RBI, wondered if banks, which ought to take a decision on the extent of the “haircut” or the valuation of outstanding loans, were unable to do so, how the central bank would be able to do it.

It is said that bank officials are wary of entering into a speedy negotiated settlement for fear of being scrutinised by the Central Vigilance Commission or other investigating agencies.

But defining the problem in a such a narrow framework ignores the larger issues at stake. There are good reasons why such deals ought to excite the attention of regulatory and investigating agencies. After all, these are publicly owned banks and in that sense their money belongs to citizens at large. Moreover, since the government (particularly the Finance Ministry) is the custodian of this ownership, it has a duty to ensure that negotiations do not degenerate into corrupt practices.

In short, while a speedy settlement may be an important objective, fairness and transparency are more vital. The ordinance strikes at the very heart of this balance. Moreover, the fact that the central bank has its member on every bank board implies that it, too, is a part of the decision-making process. To pretend that it is now the supercop entrusted with the task of cleaning the banks’ books is an ingenious effort at abnegating its responsibility in causing the build-up of the NPA problem.

Rapid expansion of NPAs

The rapid expansion of the banks’ portfolio of bad loans is of recent vintage. Their explosive growth is vindicated by the following statistics: gross NPAs as a percentage of all advances in the banking sector increased from 3.46 per cent in September 2012 to 9.55 per cent of all advances in September 2016. The rapid build-up of NPAs is obviously a result of several factors.

While the general slowdown in the economy is an obvious factor, reckless borrowing by large companies, which, in financial parlance, is referred to as highly leveraged operations that imply lower contributions of equity and more borrowings, has been a major contributor, particularly in sectors such as infrastructure and steel.

Although the share of large corporates in gross advances of all scheduled commercial banks was 56.5 per cent in September 2016, their share in the gross NPAs of these banks was almost 90 per cent. This was aggravated by ambitious revenue projections—for example in infrastructure projects such as roads—which forecast revenues that did not eventually materialise. Debt-servicing was thus hit, jeopardising loans advanced by banks. Moreover, the number of “wilful” defaulters—borrowers who do not repay loans even when they have the means to repay them—has climbed precipitously in the past 15 years. In 2002, there were 1,676 “wilful” defaulters whose total outstandings amounted to Rs.6,241 crore. By 2016, 6,857 “wilful” defaulters owed a total of Rs.94,649 crore, which was about 10 per cent of all NPAs in the banking system. As a result of the massive build-up of bad loans, banks’ lending to industry has slowed down significantly.

An interesting facet of the media’s coverage of the banks’ mounting levels of NPAs is this: while farm loan waivers are ridiculed and pilloried as a populist political gimmick, very little is done to name and shame the much smaller number of large-scale borrowers who have contributed the most to the massive build-up of bad loans. In 2011-12, the gross NPAs arising from industrial borrowers were 2.2 per cent of all advances; they rose to 13.7 per cent in 2015-16. During the same period, NPAs arising in the farm sector increased modestly from 4 per cent to 6.1 per cent.

Government complicit

Banks do not operate in a vacuum. While it may be convenient for both the government and the RBI to spread the fiction that banks have only themselves to blame for the mess they are in, things are not as simple. There is no doubt that the rapid expansion of credit, which began about a decade ago, was responsible for the bubble that came to be associated with the phase of rapid growth of the Indian economy. But the pump pumping inflated a bubble that apparently, for a short while, drove growth in some sections of Indian industry, most notably the infrastructure segment. The celebrated case involving the flamboyant Vijay Mallya and his Kingfisher Airlines, which crashed spectacularly a few years ago, highlights why blaming the banks does not address the source of the problem.

In September 2010, Indian banks decided to “restructure” outstanding loans of airline companies, including one of Kingfisher Airlines. This was done under the direct authorisation of the RBI and the Finance Ministry. Earlier, the central bank had classified the airline industry as part of the infrastructure sector, which eased the terms on which airline companies could access credit from banks.

Kingfisher Airlines

Kingfisher Airlines was one of the prime beneficiaries of the largesse. Indeed, a part of its outstanding loans was converted into equity, which was in itself a poorly judged and financially imprudent decision for any bank to take. The “restructured” debt package offered by a 13-bank consortium led by State Bank of India was viewed by many financial analysts at that time as utterly without logic or prudence. Veritas, a Canadian investment research company, termed the package as “a giant, collective swindle of public money”. Veritas observed that lenders were now not only creditors but owners in a fast-crashing Kingfisher Airlines, an observation that ought to have been obvious to even the financially illiterate.

Much has been written about the manner in which Kingfisher Airlines has taken the banks for a ride, but the popular narration in the media of a glitzy tycoon running away with the banks’ money misses how this was made possible by not only the prime banking regulator, the RBI, but also the Finance Ministry. It is important to recall that the Finance Ministry is not only the custodian of the banking system but also the principal agency that enables the government, as the owner of public sector banks, to exercise effective control over it. Seen from this perspective, the government’s decision to loosen the terms on which Kingfisher Airlines continued to borrow or postpone repayment of its substantial loans was serious dereliction of its fiduciary responsibilities.

Allowing such restructuring to proceed, without appropriate checks and balances, constituted a breach of the central bank’s regulatory and supervisory responsibilities.

The ordinance, by distancing both the RBI and the government from the spiralling problem of bad loans, sustains the fiction that the problem is of the banks’ making, with neither the effective owner nor the regulator in any way responsible for inflating the bubble that has now assumed dangerously unsustainable proportions. What explains the government’s hurry in “cleaning up” the balance sheets of the banks?

Given that the deep haircuts are going to result in obvious losses to banks, what is the motive for forcing them to quickly negotiate a settlement with the borrowers, many of whom are clearly unwilling to repay? The only plausible explanation for pursuing this morally hazardous route is that the government is driving the banks towards privatisation, for which a clean-up of the balance sheet is necessary. Another possible motive, but one which sits well with the objective of privatisation, is to push for mergers of banks, for which there is a need for a “surgical strike” against bad loans.

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