(This document has been prepared with inputs received from Dr. Y.V. Reddy informally too. I am thankful to him for that.)
It was encouraging to note the recent remarks of Shri. Arun Jaitley, the Finance Minister, at a public function that the Government and the Reserve Bank of India would announce some big steps to resolve the bad debt problem in the Indian banking system. It is overdue. I hesitate to say that the government should not let a crisis go waste simply because the expression is a bit trite. But, that we have a crisis on our hands is undeniable. Recent RBI data (March Monthly Bulletin) tell us that credit to industries across all three categories – small, medium and large – is contracting. Even consumer loans which were growing vigorously this time last year is now growing only at around 12%. Clearly, economic growth foregone because of poor credit demand and supply is considerable. Official economic growth statistics mask the underlying problem. It should not lull us into a sense of complacency.
On balance, the public sector banking model has served India well over the years. It has largely fulfilled the economic development objectives that were behind bank nationalization some fifty years ago. The branch network of the public sector banks has ensured that banking services continue to reach the remote corners of the country. Second, the Asian crisis of 1997-98 and the global financial crisis of 2008 demonstrated the risks of a single institution dominated system and underscored the importance of a well-diversified financial system in maintaining systemic stability. Plain vanilla banking is sound banking. Nonetheless, the approaching golden jubilee of the first wave of bank nationalization is a good opportunity to reflect on their continued relevance under changed economic conditions and the financial landscape.
The Economic Survey for 2016-17 had mentioned it and recent private sector data also show that the accretion to the pool of problem assets is continuing. Structural changes in several industries might be contributing to problem assets in banks, even as legacy problem assets wait for satisfactory resolution. With technological changes occurring rapidly, old and comfortable assumptions about the underlying profitability and resilience of business models may not hold true. Therefore, in order to assess evolving business risks, banks have to reinvent themselves.
In a recent speech at the National Institute of Public Finance and Policy (NIPFP), Dr. Y.V. Reddy, former Governor of the Reserve Bank of India reminded us that India is a bank dominated economy and that, in the short to medium term, it is unlikely to change.
In his words,
Transmission of monetary policy depends on banks and, in particular, on their ownership and governance structures and functioning. With over 70 per cent of the banks and overwhelming proportion of the financial sector in the public sector, there are issues of incentives and accountability and political interference. In other words, the fact that overwhelming proportion of the non-performing assets are with the public sector banks shows that the reform will have to go much beyond simply recapitalizing the banks. The future of financial system and indeed modernization of financial sector of India depends on how we overcome the intractable problems of the public sector banks. Many risks with regard to public sector banks rest with the sovereign.
Indeed, the technical solutions he had proposed more than fifteen years ago in a speech in Kolkata for public sector banking remain relevant and useful today:
(a) All public sector banks could be converted into companies, to accord flexibility for changes in ownership, mergers, acquisitions, sound corporate governance and motivation for workforce to compete effectively.
(b) To professionalise the ownership functions and ensure that portfolio is shuttled around to optimise public interest, a holding company of public sector banks can be formed to which all shares held by Government and RBI are transferred. The mandate for holding company can be three-fold, viz., fiscal neutrality, protecting the interests of those banks that are serving special public purpose by infusing resources and enhancing bank-wise, genuine board management and worker motivation to cope with paradigm shifts occurring in banking industry. The critical element for success here is manning of holding company, but Government will be able to devote significant attention to a focussed task compared to several tasks of many institutions.
(c) To ensure genuine corporate governance and protect a private shareholder, even if the Government owns a majority, a Government company should be one where 100 per cent ownership vests with Government directly and not 51 per cent or above.
(d) The provisions of central vigilance, CBI, etc., would be applicable to a public servant, but not to any person employed in an organization that is substantially competing with private sector organizations, procedures similar to private sector should apply.
(e) Cooperatives as a genuine people’s movement should be differentiated from a cooperative as a mere form of organization. Cooperatives should also be distinguished between those who accept public deposits and those who do business with only members in a restricted area. In other words, a distinction should be made between a bank and a credit union. A bank should be covered under the Banking Regulation Act, irrespective of whether it is registered under Companies Act or Cooperatives Act. The rest will have to be credit unions of some form or the other.
(f) Regional Rural Banks (RRBs) should be revamped so that ownership of Centre and State is also made optional. They could be brought under Companies Act and flexible ownership promoted through National Bank for Agriculture and Rural Development (NABARD). RRBs have the unique capabilities to enhance credit delivery in rural areas if the overhang problem is sorted out.
On recapitalisation of public sector banks, private sector estimates put the figure at 1.2 lakh crores of rupees (1.2 trillion) over the next four years. I had crunched the numbers. It is encouraging to note that the banking sector recapitalisation demands on the government over the next several years compare rather favourably to the previous exercises that the government undertook in the Eighties and in the Nineties, as a percentage of the total budget expenditure and as a percentage of GDP. The recapitalisation bonds that the government issued and to which banks subscribed is one route to complete the exercise (See ‘An old solution to bank capital woes’, Aarati Krishnan, BusinessLine, February 24, 2016). Clearly, the economy can absorb it. However, recapitalising the banks without tackling the underlying issues that give rise to non-performing assets every decade would be a waste of precious government resources that have equally, if not more, deserving alternative uses.
That is why the Fourteenth Finance Commission had suggested that there was scope and need to further lower the fiscal costs of re-capitalisation by restricting it to select and better performing public sector banks, instead of an across-the-board policy of covering all of them, in view of the competing demands on available budgetary resources (see paragraphs 16.45 and 16.46). The non-performing public sector banks could be advised to manage their asset portfolio and growth in tune with the available capital. This would promote competitiveness amongst these banks and act as a hard budget constraint on them. This approach requires that the government takes a view on, as well as make an assessment of, the number of public sector banks that can cater to the desirable share of the public sector banking system in India, in order to serve the social objectives.
The non-performing loan crisis that is still stalking the Indian banking system is a national emergency. As Dr. Y.V. Reddy said in the Sixth Raja Chellaiah Memorial Lecture at NIPFP in March this year, it is also a critical opportunity to arrive at a “national consensus to seek a banking system for India that is flexible, dynamic, fair and truly national – where the owners, workers, depositors, borrowers and regulators commit themselves to a real paradigm shift in public policy. It is pragmatism and not ideological extremes that has made India strong in external sector and perhaps a similar approach will work in financial sector also.”