Tuesday, May 16, 2017

Capital is crucial to resolving India's bad loan problem

The government's Ordinance empowering the RBI to take steps to resolve the bad loan problem, it is hoped, will make a difference. It can- provided the government is willing to back it with the necessary capital. Indeed, by not infusing capital into public sector banks for so long the government has caused the bad loan problem to worsen. This is because banks have not been able to write off bad loans and because they haven't been able to expand credit, which, in turn, results in the bad loan to advances ratio looking bad.

Over a two year period, I expect the government will need to put in around Rs 100,000 crore. Mention something like this and you will see another round of public sector bashing. There will be calls to privatise PSBs because putting capital into them is "money down the drain".

Rubbish. You only have to look at the capital that governments in US and Europe have poured into private banks in order to see that this contention doesn't hold water. And here's an astonishing fact: the recapitalisation cost of India's PSBs, even if the government puts in Rs 100,000 crore on top of the Rs 70,000 crore it has committed under Indradhanush would be among the lowest in the world!

More in my column in BS, Don't dither on bank recapitalisation.

Don’t dither on bank recapitalisation
Following the financial crisis of 2007, America’s banks have bounced back faster than those in Europe. There’s little dispute as to how this happened. The authorities in the US moved faster to recapitalise banks than their counterparts in Europe. In the US, the government pumped $245 billion into banks. The banks eventually repaid $275 billion, including interest and dividend. 
 
There had been colossal failures in both management and governance at American banks. Yet, nobody argued that recapitalisation should be held back until these were overhauled. The rule in a financial crisis is simple enough: Recapitalise as quickly as you can. At many banks in the US, CEOs were replaced. There were some changes in the composition of bank boards. But the infusion of capital did not await a sea change in management or governance. 
 
If governments in US and Europe had withheld capital from banks until they had made sure that it would be used wisely, they might have waited for ever. Recovery in those economies would not have happened.  
 
The contrast in the approach pursued in India could not be starker. In 2015 , the requirement of equity capital at public sector banks (PSBs)  was estimated at around ~2,50,000 crore out of which at least ~1,25,000 crore was to have come from the government. Under Indradhanush, the government committed a much smaller amount — ~70,000 crore ($11 billion) — over a four year period, 2016-19.
 
In 2016, following the Asset Quality Review, bad loans, and hence the requirement of capital, soared. The government has, however, stuck to the sum committed under Indradhanush. It also took the position that capital would be given strictly on the basis of performance — weaker banks would have to fend themselves. It was a case of too little, too late. We should not be surprised that banks have sunk deeper into the mire and economic recovery has been tepid. 
 
Those opposed to giving capital to PSBs contend that mismanagement and poor governance are mainly responsible for the bad loan problems at PSBs. Infusing more capital into them would be only “money down the drain”.They should have said this to governments in the US and Europe who poured capital into privately owned banks during the financial crisis. 
 
The crisis of 2007 was only the latest in nearly 150 episodes of banking crises in 115 economies in the past four decades. Private banking systems plunge into crisis time and again. Each crisis makes enormous demands on tax payer money. That does not seem to be “money down the drain”. 
 
It is not true that the bad loan problem in India is mainly on account of mismanagement. The Economic Survey (2016-17) says emphatically, “Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: Timetables, exchange rates, and growth rate assumptions going wrong.” Translation: The bad loan problem is the result mostly of factors beyond the control of bank management.
 
If the finance ministry takes its own Chief Economic Advisor seriously, the course for the government should have been clear enough long back: Provide enough capital to PSBs, ensure  the right people are appointed as CEOs and strengthen the boards. None of this happened. The bad loan problem has remained unresolved. Together, these have led to a worsening of the financials of PSBs.

The government seems to have finally come out of its stupor. An Ordinance that empowers the RBI to address the bad loan problem has been issued. CEOs have been appointed at 10 PSBs. But these moves will not suffice unless they are backed with adequate capital. This year’s provision of ~10,000 crore means nothing. If bad loan resolution happens, the amount required this year alone could be up to ~50,000 crore.

Most people will recoil in horror at the sums involved. They will wail that PSBs make unacceptable demands on the exchequer because of inefficiencies inherent in public ownership of banks. This is an absolute myth.

The way banking systems are designed today, they are prone to failure — and these are overwhelmingly private banking systems. Governments everywhere incur recapitalisation costs from time to time. The best we can hope for is that the costs stay below an acceptable threshold. The Vickers Commission in the UK defined the threshold as an annual cost of 3 per cent of GDP. If this seems excessive, a cost of 5 per cent of GDP over, say, two decades would be the absolute minimum.

The cost of recapitalising PSBs over the entire period 1994-2016 amounts to less than 0.5 per cent of India’s average GDP in the period. This is about the lowest recapitalisation cost that any banking system in the world has inflicted on the economy. Enough of dithering. The government should put in whatever it takes to recapitalise PSBs.