Originally Published 2014-06-13 07:12:12 Published on Jun 13, 2014
Big ticket reforms promised by Mr. Narendra Modi are likely to resume stalled projects and revive business climate. However, if India is to return to its erstwhile double digit growth, the importance of banking sector reforms cannot be overstated.
Need to fix banking sector woes to revive economy
"New Prime Minister Narendra Modi is said to have a master plan of sweeping reforms to revive the economy and return it to a high growth trajectory. However, the Indian economy still has fault lines that can derail future growth. Certain measures must be implemented to stabilise the economy in the short run and guarantee a resilient recovery. Foremost among these is fixing the banking sector.

Indian banks have long been criticised for having convoluted governance structures, low profitability and a tendency to accumulate bad debt or non-performing assets (NPAs) - loans that have stopped yielding interest. While the total stressed assets (including gross NPAs as well as restructured assets) of private sector banks increased from 3.49 per cent in March 2012 to 4.13 per cent in March 2013, in the case of public sector banks (PSBs), it jumped from from 8.68 per cent to 12.16 over the same period. According to a report by Fitch Ratings, total stressed assets in the entire banking sector will reach 14 per cent of total loans by March 2015.

Sluggish economic growth has made matters worse. Real GDP has slowed down from 8.9 per cent in 2010-11 to 4.9 per cent in 2013-14. Consequently, investment too slowed. Growth in gross fixed capital formation has fallen from 11 per cent to a mere 0.2 per cent over the same period. Credit growth itself has declined from 22.9 per cent in 2010-11 to 15.9 per cent in 2012-13, indicating a constrained corporate sector.

Delays in infrastructure projects have further exacerbated the asset quality of the banks, which have a significant exposure to such projects. As of March 2014, roughly 15 per cent of Gross Non Food Credit by Scheduled Commercial Banks (SCBs) was deployed towards infrastructure. Out of the loans advanced to the infrastructure sector, 20 per cent had already been restructured as of March 2013, with the proportion expected to increase to 30-40 per cent over the next two years.

In other words, the banking sector woes stem from a weak economy and stalled projects. However, more dangerously, they can result in a vicious cycle that, by creating a gridlock of investment and credit, can further harm economic growth.

Inefficient public sector banks

The Indian banking sector is dominated by PSBs, which account for 73 per cent of the market share. The banks are constrained by excessive regulation and are forced to increase their exposure to credit constrained sectors. For instance, priority sector lending norms is one of the many stipulations imposed on PSBs by the RBI that erode their competitiveness. On an average, these priority sector loans have been responsible for a relatively higher share of the NPAs among the PSBs over the last ten years.

Moreover, these banks have been found to have inadequate internal credit appraisal and risk management mechanisms. This is evidenced from the fact that banks with higher credit growth in 2004-08 ended up with higher NPA growth in 2008-13. Further, it is a well known fact that PSBs lack an appropriate mechanism in place to deal with stressed assets - a significantly higher proportion of NPAs are written off instead of being reduced. Weak recovery of bad loans, in turn, leads to poor balance sheets.

The symbiotic relationship between the PSBs and the government adds to the fragility in the Indian banking system. Inefficiency in recognizing stressed assets early as well as improper treatment of NPAs ultimately leads to moral hazard. The onus eventually falls on the government to rescue the failing banks.

Preventing a systemic crisis

The situation in India’s banking sector appears grim but it is not totally out of hand. Importantly, according to economic forecasts, India’s economic growth has bottomed out. This will improve the investment sentiment as well as the cash flow in the corporate sector, thereby reducing the quantum of stressed assets. However, pinpoint reforms to make a robust banking sector must be implemented. Three of these are discussed below.

Divestment: A recent report by the PJ Nayak committee recommends reducing the government’s stake in PSBs to less than 50 per cent. Although previous governments have categorically denied a push to divest the state’s stake, the new government has seemed keen to consider the proposal. This is prudent as the government’s limited resources must be directed towards productive development instead of indulging in recursive financing for a flawed banking model. If the playing field is levelled, PSBs will be forced to improve their financial health or be forced out of the market.

Differentiated Banking: Greater public discourse is now pushing the RBI to adopt a differentiated banking structure and promote smaller financial institutions. In fact, two new banking licenses have been granted to IDFC, an infrastructure lender, and Bandhan Financial Services, a microfinance company. This is likely to ease some pressure off the PSBs as well as improve financial inclusion.

Recapitalizing and Restructuring: The RBI recently published a paper, which recommends swift recognition of stressed assets by forming a Joint Lenders’ Forum (JLF); Corporate Debt Restructuring (CDR) for loans above Rs. 500 crore and; an increasing role of asset reconstruction companies and private equity players in the stressed assets market. The Finance Ministry has also proposed to create a holding company to enable banks to raise fresh capital from the market. Such recommendations, if quickly implemented, can dent the pileup of bad loans and provide the banks much needed breathing room.

Big ticket reforms promised by Mr. Modi are likely to resume stalled projects and revive business climate. However, if India is to return to its erstwhile double digit growth, the importance of banking sector reforms cannot be overstated.

(The writer is a Research Assistant at Observer Research Foundation, Delhi)

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