Reserve Bank of India (RBI) Governor Urjit Patel said over the weekend that the central bank and the government were discussing the question of whether the problem of capital provisioning of public sector banks (PSBs) could be addressed in a time-bound manner. It is wise that the RBI, as the sector’s regulator, and the government, as the principal shareholder of these banks, are in communication on the problem, and that the RBI governor is concerned enough to discuss the question of time-bound capitalisation of the banks in public. The gross non-performing assets (NPAs) of the banking system stood at almost a tenth of the total bank loans at the end of the last financial year. NPAs are concentrated in state-controlled banks and some of which, therefore, have NPA ratios that are considerably higher than the sector-wide average. The stressed assets on banks’ books have already contributed to a slowdown in bank credit growth to industry, thus holding back private investment in economic growth. Of course, the prevalence of bad loans also presents a serious systemic risk to the financial system. Only four listed public sector banks have less than 10 per cent bad loans now and in quite a few cases, they range from around 15 per cent to 24 per cent.
It has been effectively argued that banks will not lend, and the systemic risk will not be eased, unless the government properly recapitalises the PSBs. Mr Patel pointed out that settling the existing bad loans might require banks to take haircuts, which would affect their capital provisioning. However, the overall figures for bad loans are deeply worrying in terms of the amount of scarce budgetary resources that they are capable of mopping up. Given NPAs were at over Rs 6 lakh crore at the end of the last financial year, a straightforward recapitalisation of PSBs would greatly strain the fisc. Furthermore, in the absence of deep governance reform, it is far from certain that the problem of NPAs will not recur. It is essential, therefore, that the structure of any bank bailout be such that future bad behaviour is not incentivised. Besides capital infusion by the government, Mr Patel mentioned capital raising from the market, a dilution of government equity, and mergers and sales of non-core assets as methods of ensuring capital adequacy for banks. But this is not enough. A dilution of government equity must be accompanied by a reduction in effective government control. It has been argued that privatisation is difficult when the book value of banks is so low. But it is low because the market correctly views their governance as defective. Governance reform, and a government willing to give up control, will unlock value.
In general, banks that have failed to control NPAs should be held accountable. There should be a move on their part towards narrow banking, if necessary, through reducing their footprint and a calibration of recapitalisation that takes accountability into account. The method of distributing capital across banks needs to be reconsidered in a way that the stronger banks receive more capital while the weaker banks are forced to contain lending until their performance can improve. Such an approach will produce a stronger public sector banking system and incentivise efficiency. The government must stand firm in the face of pressure from bank managements, borrowers and unions — as well as resist the temptation to keep control over this large swathe of the financial economy. Certainly, India cannot afford to throw good money after bad.