Above: Illustration by Anthony Lawrence

Burgeoning NPAs of banks can be tackled by creating a “bad” bank and using the expertise of distressed debt specialists from the private sector

~By Sanjiv Bhatia

India’s banking crisis is not a passing storm. It is a hurricane gathering force that could make landfall within the next six to nine months. The end game for India’s government banks (PSBs) could be drawing near. For the fiscal year 2017-18, 19 of the 21 government banks reported losses totalling Rs 87,000 crore. Bad loans, called NPAs, threaten the viability of these banks and pose significant risks to India’s financial stability. Despite the country’s high economic growth, the risk of bank failures and a systemic contagion is real and increasing in probability.

The Punjab National Bank scam made headlines because of its magnitude, but there are thousands of such scams which are only now surfacing. People with access to the levers of government power have made off with billions of dollars of public money. Their modus operandi for looting banks would make the bank-robbing duo of Bonnie and Clyde look like bumbling amateurs. A letter from a minister or a bureaucrat, a small slice of the pie as gratitude for the bank manager, and off they go with a loan that is never repaid. These scams have been going on since banks were nationalised in 1969, but few, if any, have ever been caught or punished.

The more relevant issue now is how to solve the problem and contain the damage. One thing is clear: fixing the problem will require a higher level of thinking than the one that created the problem. The solution, therefore, will come not from the politicians, bureaucrats and bank managers that created this mess but from the private sector and free markets.

Let’s first understand the problem so we can better grasp the solutions. Banks create money by issuing loans using a process called fractional-reserve banking. This is how it works. Say you deposit
Rs 100 in your bank. The bank is required to hold only a small portion of that deposit as reserves and can loan out the rest. If the reserve requirement is 10 percent, the bank can loan out 90 percent of the deposit or Rs 90 in this case. The borrower, in turn, deposits the money in her bank which can now loan 90 percent of that or Rs 81 to another borrower. The Rs 81 of new deposits further creates another loan of Rs 72.9 and the cycle goes on.

Fractional-reserve banking allows banks to create credit far beyond the underlying base deposits in the system. In the example above, a single deposit of Rs 100 can create loans worth Rs 1,000 which is calculated by adding Rs 90 + Rs 81 + Rs 72.9+ …. (mathematically this is the same as dividing the initial deposit of Rs 100 by the reserve requirement of 10 percent). Most countries only have a cash reserve requirement (CRR). In India, there is an additional Statutory Liquidity Requirement (SLR) by which banks are forced to keep a certain portion of the deposit in government bonds. In India, the current CRR is 4 percent, and the SLR is 19.5 percent, which is a total of 23.5 percent. So a Rs 100 deposit can create loans worth Rs 425 (100 divided by 235). This practice is hugely profitable for banks because they make interest on money created out of thin air. The process of credit creation works fine until loans start to default. If the bad debt becomes large, relative to the bank’s total lending, the bank is in trouble because it does not have the funds to pay interest to depositors or return their deposits. This is what is currently happening in India. Almost 14 percent of all bank loans have become nonpayable (NPLs) because borrowers cannot repay either the principal or the interest on these loans. The money loaned by a bank is an asset on its balance sheet, so when a loan becomes nonpayable, it reduces the bank’s assets, which correspondingly must also reduce its equity capital by the same amount. As a result, banks find themselves needing additional funds to meet their capital adequacy requirements.

Indian banks currently need about Rs 2.5 lakh crore to meet the minimum capital adequacy requirements of an international banking agreement called Basel III. This capital must come from the owners of the bank—in the case of PSBs from the taxpayers, and in the case of private banks from existing shareholders or new investors. In the absence of this capital infusion, the bank must close down. Every year, hundreds of banks worldwide fail as a result of bad loans and poor risk management. This is the creative-destruction process of free markets that enables efficient allocation of scarce resources—bad ideas lose out, and the resources invested in them get released and invested in good ideas.

The government of India has offered three solutions to resolve the crisis, all untenable: recapitalisation of PSBs using taxpayer money, merging smaller PSBs with a larger entity and requiring banks to recover and dispose the assets of companies that have defaulted.

Government recapitalisation using public funds is a bad idea. In the last six months, the government has injected Rs 88,000 crore to recapitalise PSBs, but the funds have been used instead to cover their losses for 2017-18. Recapitalisation is a massive waste of taxpayer money because it is an attempt to cover a hole that is getting deeper by the minute. There is an idiom every student of Economics learns: “Never throw good money after bad.” Recapitalising is an excellent example of this. It won’t work.

Recapitalisation was tried in the 1990s when the government injected Rs 20,000 crore into PSBs, followed by another Rs 58,600 crore in 2008. This did not improve the banks but instead created a moral hazard problem which encouraged them to engage in riskier lending practices knowing that if the loans failed, the government would bail them out. The culmination of fraudulent and poor lending practices in a fractional-reserve lending system is now a full-blown banking crisis.

The second solution offered by the government—merging several underperforming PSBs into a bigger entity—is even wackier. Merging several overstaffed and poorly managed banks will not magically create a viable entity. Mergers work only if there are synergies to be exploited, and combining two inefficiently managed and troubled PSBs offers no such synergies. If anything, merging different work cultures will only exacerbate the problem.

The government’s third solution, requiring PSBs to recover and sell their distressed assets, also defies logic. Punjab National Bank, for example, has created a distressed asset recovery cell in each of its 6,900 branches and deployed close to 25,000 employees to recover bad loans. Now that’s putting the fox in charge of the henhouse. How can the same people who created the problem be expected to solve it?

So, how can this banking crisis be resolved quickly and with a minimal loss to taxpayers and the credibility of India’s financial institutions? Here is what should be done:

The first step should be the establishment of a “bad” bank, structured with the specific purpose of holding the bad loans of other banks. Bad loans consist of the out-and-out frauds and the distressed loans of good companies going through a bad time. There is little hope of recovering much from fraudulent loans, so the focus should be on distressed loans. Taking these bad loans off the balance sheets of the PSBs removes the requirement for taxpayer-funded recapitalisation. The responsibility for selling these distressed loans then shifts to the “bad” bank. Restructuring distressed companies is a specialised business handled by a rare group of professionals who understand how to value and revive them. People from the government or bureaucracy are not skilled at handling this task. It is, therefore, essential to staff the “bad” bank with experts from the private sector who are specially trained to handle distressed debt, and not ex-bureaucrats.

The next step is for the government to liquidate its ownership stake in PSBs by setting up a bank investment company, again managed by professionals from the private sector. The PSBs will become more attractive (and valuable) to potential buyers once their balance sheets have been cleansed by offloading nonpayable loans to the “bad” bank.

It is vital that India’s financial system be run with minimal government intervention. Capital is the lifeblood of any  modern economy, and a healthy and vibrant financial sector is essential to the efficient allocation of this capital to its best use. This can only happen in the absence of political pressure. Privatizing India’s banking system is a necessary step to solving the NPA problem.

The global financial sector is also undergoing structural changes, and alternative suppliers of financial services (fin-tech and other non-banking entities) are challenging existing business models. Cost reduction and innovation are the keys to survival in this environment, and it is clear that personnel-heavy and non-innovative PSBs are completely ill-equipped to compete in this rapidly-changing, high-technology, low-cost environment. It is imperative that India’s state-owned banks be allowed to exit in a controlled way so their market share can be freed up for other viable banks.

Once the nonpayable loans have been transferred to the “bad” bank, the government should invite global asset reconstruction companies (ARCs) to buy these distressed assets from the “bad” bank. Foreign investors are eager to invest in India’s distressed debt, especially since the passing of the Insolvency and Bankruptcy Code, 2016, which expedites the insolvency process to less than one year. But they are very sceptical about anything connected to the government and the public sector because of the usual issues related to poor implementation, burdensome and inconsistent regulation and lack of transparency. If the NPA problem is to be resolved quickly and successfully, this outside capital must be tapped using market-based solutions combined with a supportive regulatory, tax and market environment. The government must limit its involvement and back off the regulatory pedal, and help create an environment that encourages ARCs and outside investors to take on the sizeable risks associated with buying and rehabilitating India’s distressed companies.

ARCs will want to repackage the assets of the distressed companies they buy from the “bad” bank into smaller units (shares) and sell them to investors. This diversifies the risk from these bad loans across a wide range of investors. This process is called securitisation, and the SARFAESI Act (Securitisation and Asset Reconstruction of Financial Assets and Enforcement of Security Interest Act) of 2002 was designed for this purpose. But as with everything else in India, mindless government regulations and coercive tax laws have impeded the growth of the securitisation market. The government should dispense with burdensome and unnecessary regulations and provide favourable tax incentives to the ARCs, so the process of securitisation can begin.

Finally, a long overdue reform is the major overhaul and modernisation of India’s capital markets and a revamping of its regulator SEBI. There is an urgent need to create a viable secondary market for debt which includes the ability to repackage and securitise loans and sell them in the capital markets. Banks still dominate India’s lending structure providing almost 70 percent of all the credit in the economy. In the US, on the other hand, the vast majority of capital is raised in the capital markets using equities, corporate and municipal bonds, while bank lending is limited to retail lending. This reduces the stress on the banking system, and since capital market credit is subject to greater market discipline, it ensures a more efficient allocation of capital.

The window to solve India’s banking crisis is closing fast. The only way to successfully resolve the problem is to use market-based solutions. Politicians and bureaucrats must resist the urge to micromanage and control the process because they don’t have the required skill set to do so. Their interference will only aggravate the problem and jeopardise the country’s economy.   

—The writer is a leading financial economist and founder, contractwithindia.com