Drastic remedies can only be sparked by such shocks for Indian banking sector: View

bank-thinkstockThe problems in the Indian banking sector are not new. When the government decided to nationalise banks in 1969, it created an environment of entitlement among borrowers and employees. It limited the autonomy of bankers and also ended their accountability, while it started to meddle with the decisions of the banks to serve broader political interests. The weaknesses created by this structure enabled several opportunistic borrowers to take advantage of the system, leading to the piling up of NPAs. It is a wonder that we do not have a full blown crisis on our hands yet.

The banking system is built on the simple principle of credit, where one can use other people’s money for a cost, provided one returns it with interest. The bank performs the role of being the primary borrower of other people’s money, keeping these as deposits. The system is robust only if the credit at both levels is of good quality. We are at a point where credit quality has been seriously eroded in the system, and are still considering gradual steps to stabilise a crumbling edifice.

Consider the early years of nationalisation. The primary objectives were to spread out geographically, and direct credit at interest rates fixed by the government to sectors that the government chose. Banks also funded the government substantially, a good portion of deposits being pre-empted for investment in government securities.

The large-scale branch expansion that followed created the workforce that is unionised and effectively stalls measures that require the merging, closure or reorganisation of banks. Since the earlier objectives were motivated by welfare economics, dialogues with employee unions fail.

The directed lending system meant that as long as banks lent to those that the government wanted to favour, they would be bailed out. This attitude is well entrenched, even if the beneficiaries have changed from credit-starved farmers to cash-rich crony capitalists. Before the 1990s, the interest rates were regulated. Today, banks are free to lend to whomsoever they choose, at rates that their boards decide, but accountability for bad debt is low. Even as NPAs pile up, arguments to keep PSU banks alive and capitalised are louder than the more effective decision to simply wind them up.

The Narasimham Committee in the 1990s recommended that there should be three tiers for banks. Three to four large banks that compete internationally; a few banks that operate nationally, and several smaller regional banks that operate with special knowledge of the areas they work in. It asked for interest rates to be free, government ownership to be phased out, competition to be introduced, government borrowings to be from the marketplace, and bank boards to be revamped. Employee unions opposed the recommendations and they were only partially implemented.

But 1990s was also the time when the economy opened up. Developmental financial institutions ceased to exist, and the primary sources of public finance were banks and stock markets. We have seen a groundswell of crony capitalists that have taken advantage of our weak financial sector. Public sector banks, cooperative banks and regional rural banks have been prime targets. Since it is easy to set up businesses and raise money from the markets through dubious disclosures, several low quality businesses simply accessed capital from the system.

A weak lending system does not have the wherewithal to hold back credit or monitor and insist on repayment. Business plans that are built with high ambition and a primary dependence on favourable government policy, fall apart when winds change.

The culture of accessing public funds in the banking system and wasting it on poor quality projects has been a problem for a long time. As long as supporting politicians and their constituencies also benefit from the pay-off, the process continues.

But credit is a creature that grows. As money is funnelled into a venture, it spirals into larger amounts of loan, recycled for various uses and returning to the system as increased flow and demand. The banking systems strength and fragility stem from its ability to create money.

As one scam after another is uncovered, where public funds that were lent to banks have been sunk into NPAs, built up and actively hidden by clever accounting and provisioning norms, it becomes obvious that a deep and intensive clean-up is needed. Every time there is a scandal, too much attention is focused on the details of the drama and the blame game that follows. There is too little energy spent on remedial action, leading to a slow bleed of the affected organisation and the quickly spreading rot. As they say, we cannot waste a crisis.

There are a few basic things to fix. First, banks should not be owned and run by the government if such a structure leads to poor accountability for credit. Except SBI, which is too big to fail, other PSU banks should be wound down. Weak banks should not be merged with strong banks to create further weakness. Second, there should be strict provisioning and disclosure norms for NPAs so that the clean-up of books is complete.Third, Asser Reconstruction Companies should be built to take over the debt, strengthen bankruptcy code, recover whatever is possible and enable banks to start afresh. Fourth, banks should be enabled to come together as a consortium not only to lend, but also to stand up to poor quality borrowers, share information and effectively present an alternate front of lenders against exploitative borrowers.

The funds held by the banking system belong to the public who make deposits with the faith that it will be safe. The on-lending of this money is definitely risky, and, therefore, has to happen within a clearly defined framework of sound lending principles, accountability and disclosure, fine-tuned by the market forces of pricing, choice and competition.

What we have now is a muddled system, where public funds can be directed towards unviable and poor quality projects; managers and employees can circumvent the process for personal gains; unscrupulous operators can game the system; bad debts can be hidden from public view, and everyone can fight about why a failing bank has to be kept alive. We cannot afford the drama and damage of a bank that will go bust, but maybe drastic remedial action needs that kind of shock.