No light at the end of the tunnel?

Former Reserve Bank of India Governor Urjit Patel’s talk on India’s banking sector at Stanford University last June has not received the attention it deserves. Patel sees no light at the end of a long tunnel. His diagnosis is debatable and his pessimism seems overdone. 

Three points emerge from Patel’s talk. One, the present non-performing asset (NPA) crisis largely stems from regulatory failures and public ownership of banks. (Patel believes the two are linked). Two, Raghuram Rajan and Patel made a valiant attempt to rectify the failures of the past by tightening regulation during their tenures. Three, there are indications once again of a lurch towards lax regulation and, therefore, Indian banking will continue to be bedevilled by concerns about stability.

The significant regulatory failure, according to Patel, was allowing a credit boom to happen by relaxing norms for company, group and non-banking financial company (NBFC) exposure. There is some merit in this contention, although it’s not obvious that growth of 20 per cent in non-food credit in 2007-12 was excessive. India’s credit boom may seem a case of bad business judgement today. However, neither businessmen nor bankers nor the regulator could have anticipated the global financial crisis of 2007 that derailed major projects set in motion earlier.

Public sector banks (PSBs) account for most of the NPAs. Since government spending is constrained by the fisc, it uses PSBs to pump-prime the economy or boost preferred sectors. Over time, this results in higher NPAs and capital infusion into PSBs by the government. Bank lending to infrastructure and related sectors was thus a form of deferred government spending. One wonders whether that is as terrible as it sounds. Massive PSB lending to infrastructure has eased a long-standing constraint on economic growth. Hasn’t China done likewise for long — and quite successfully thus far? 

After 2014 (when Rajan was governor and Patel deputy governor), the RBI significantly tightened regulation. The RBI’s Asset Quality Review resulted in vastly improved recognition of the NPA problem — witness the three-fold increase in NPAs at PSBs. Better recognition of NPAs was certainly needed. Talk to bankers, however, and they will tell you that recognition was carried too far. It seriously eroded banks’ capital and undermined their ability to lend. This hurt economic growth and thereby banks’ ability to manage the NPA problem. The RBI overlooked the fact that growth, not NPA resolution, is the best way out of an NPA crisis. 

Patel says that the RBI’s February 2018 circular removed banks’ discretion in dealing with defaults. There was a clear message to bankers: No more extend and pretend. The RBI placed 11 PSBs under the Prompt Corrective Action (PCA)  framework that placed restrictions on their lending. Alas, says Patel, much of the good work has since been undone. The February 12 circular was struck down by the Supreme Court and this raised doubts over the ability of the RBI to give directions to banks on NPA resolution. The government relaxed the PCA framework and brought five PSBs out of it. 

The former governor may have spoken too soon. Within days of him giving his talk, the RBI issued a revised circular on NPA resolution to replace the February 2018 circular. The new circular provides a time-frame for resolution that is more realistic. It does away with the draconian principle of declaring even a single day’s failure to make repayment as default. It affords some discretion to bankers and provides incentives for resolution. The RBI has asserted its power to give directions to banks on NPA resolution. 

As for the PCA, it can only be a temporary measure. If extended for long and to a large number of banks, it ends up hurting banks as well as borrowers. The relaxation of the PCA framework was especially necessary given that the NBFC sector had moved into distress. 

Patel concludes on a grim note. We are confronted with a trilemma in banking. It’s not possible to have all of three things: Dominance of PSBs, independent regulation and adherence to debt-to-GDP targets. Something has to give. 

We need clarity on the independence of the bank regulator. Is there any legal impediment to the RBI implementing “fit and proper” criteria for government-appointed directors on the boards of PSBs? Or imposing fines on PSBs that do not fill vacancies in top management or the board for long spells? Or specifying a minimum compensation for independent directors on bank boards? Independence is not given on a platter, it often has to be wrested. 

If indeed regulation can’t be effective, reducing the dominance of PSBs is one answer to the problem. This is already happening. The share of PSBs in banking assets is down to 66 per cent and it should be down to 50 per cent in a few years. Do we need to accelerate the process through selective privatisation? Patel does not say so explicitly. He only asks that the government assess whether its return on equity at PSBs is adequate. 

It’s not all gloom and doom in Indian banking. The RBI’s Large Exposure Framework is a big leap forward in managing risk. As Patel concedes, there is improvement in the assessment of loans. The process of appointment of chairmen and managing directors at PSBs is more rigorous than before. Fifty years after bank nationalisation, it would be unfortunate if we were to substantially abandon the public sector model precisely when the signs are promising. 

The writer is a professor at IIM Ahmedabad