India’s banking sector is frequently under the spotlight, and usually for unflattering reasons, from an insupportable pileup of loans gone bad (non-performing assets or NPAs in banking parlance) to outright fraud to cronyism or worse. The rot is endemic, has hit banks small and big, including some well-regarded names, and is by no means limited to the public sector. If government-owned banks like Punjab National Bank (PNB) and State Bank of India (SBI) have embarrassed themselves, names like YES Bank and ICICI Bank in the private sector have also made headlines for the wrong reasons. The list of banks of dubious honour is long, including, most recently, Lakshmi Vilas Bank (LV Bank), which the RBI (Reserve Bank of India) had to step in to bail out. The Covid-19 pandemic has aggravated the crisis by another order of magnitude, with the government-mandated moratorium on interest payments (it expired in September) and state-guaranteed loans threatening to further increase the already
humongous NPA pile (at Rs 9.4 lakh crore as of June 2019, nearly four times India’s health budget). This has created an unprecedented crisis of capital in the banking system.
Collateral damage: Depositors outside a PMC Bank branch in Mumbai after the RBI imposed restrictions on the bank
It’s not a crisis the government or the central bank have missed or ignored, but the proposed solution, many experts fear, could lead to a fate even worse than the current problem. An RBI internal working grouphas suggested an amendment to the Banking Regulation Act, 1949, to allow large corporate houses to become bank promoters.Broadly, those in favour argue that this is a way of recapitalising the banking system, and possibly the only way to fund India’s growth ambitions, while those ranged on the other side flag the risks of ‘connected lending’ (a phenomenon where banks promoted by existing corporate houses with other businesses end up favouring their own group businesses). It’s a knotty problem, and to correctly assess if privatising public sector banks is the panacea adherents of the idea think it is, we must first scrutinise the myriad co-morbidities of the larger banking system, including NBFCs (non-banking financial companies) and cooperative banks.
The NPA/ NBFC quagmire
In a report published on October 29, research consultancy Capital Economics issued a dire warning, that India’s banking sector, which had been in poor shape even before the pandemic began and suffered further balance sheet damage from the coronavirus crisis, warrants extreme concern. ‘[India’s banking] sector is entering a slow-burning crisis, where bad debts will eat into profits and restrict lending, holding back recovery [through] the decade’, wrote economists Shilan Shah and Simon MacAdam. They predicted that, relative to its potential, the Indian economy would see one of the weakest recoveries among major economies. As much as 65 per cent of India’s banking sector in terms of deposits is state-owned, says RBI data. Capital Economics reckons the sector was one of the most unprofitable in the world in 2018-19.
For over a decade since the global financial crisis in 2008, sparked off by the collapse of Lehman Brothers, the Indian banking sector has been on a roller-coaster ride. To escape the crisis, India entered one of the most extravagant phases in its financial history, involving a splurge of central spending, a loose monetary policy to lower interest rates and aggressive lending by banks. This phase saw Indian companies take on big loans and amass assets in money-guzzling sectors like infrastructure and telecom. While the spending did lead to a quick recovery, over a longer term, it left the banking sector saddled with NPAs, eroded the health of public sector banks (PSBs) and, as a consequence of the bad debt pile, led to sluggish lending. The problem of bad loans is certainly worse in the public sector. Of the total Rs 10.35 lakh crore worth of NPAs as of March 2018, 85 per cent or Rs 8.8 lakh crore are on PSB accounts, with SBI alone accounting for Rs 2.23 lakh crore (21.5 per cent) in 2017-18. Gross NPAs have risen from 2.3 per cent of total loans in fiscal 2008 to 9.3 per cent in fiscal 2019; well-run banks in the private sector tend to have gross NPAs below 5 per cent. Bad debts constrain a bank’s ability to continue lending: with its assets unable to generate enough income, the bank’s ability to issue further credit diminishes. “The challenge with public sector banks is that there are many internal organisational issues that are not being addressed or resolved,” says Ashvin Parekh, a financial advisor. “The whole system has been in gradual decay over the years.” The Covid-19 crisis has made things worse.
With the RBI announcing a moratorium on repayment of retail loans in March, as well as the financial pressure of the Centre’s Rs 3 lakh crore of collateral-free loans, the stress on PSBs has increased manifold. The consequences of these will unfold over the next few years, former finance secretary Subhash Chandra Garg says NPAs resulting from the coronavirus crisis could be as high as Rs 10 lakh crore. This complicates a long-standing problem. In late 2015/ early 2016, to come to grips with the NPA issue, the RBI, under then governor Raghuram Rajan, instructed banks to identify loans that could potentially turn sour, and set aside capital to hedge against the possibility. This threw up bad loans amounting to about Rs 10.4 lakh crore, but as a side-effect of this clean-up, banks became wary of lending. Sanjeev Kapoor, a Delhi-based chartered accountant, says he has been advising his clients to keep their money in established banks even if they are giving lower returns on fixed deposits because, he says, this indicates they are not desperate for deposits and, therefore, are in good financial health. “We will know the actual state of banks in March, but defaults have already begun. I don’t know what other regulations will come in on withdrawals.” The RBI has since made several interventions to address the NPA mess. These have not always had the desired effect. For instance, on February 12, 2018, under governor Urjit Patel, the RBI set a six-month deadline for banks to resolve NPA cases valued at Rs 2,000 crore or more, failing which they would have to immediately refer such cases to the NCLT (National Company Law Tribunal) for insolvency proceedings. This order, which required banks to report a default to the RBI for even a single day’s delay in repayment, was widely criticised, with several petitions filed in courts across the country, mainly from companies in the power, textiles and shipbuilding sectors. Petitioners alleged that the RBI order did not consider sector-specific issues and that it was arbitrary and discriminatory; in April 2019, the Supreme Court struck it down, sayingthe order exceeded the RBI’s authority.
Over the past four years, PSBs have written off about Rs 6.66 lakh crore of bad debt, with the Centre repeatedly bailing them out, in her budget speech this year, finance minister Nirmala Sitharaman said the Centre had infused about Rs 3.5 lakh crore into PSBs in the past few years. A former PSB chief tells India Today that there is an urgent need for structural changes. “Else,” he says, “PSBs will remain a black hole into which taxpayers’ money will have to be pumped in at regular intervals.” Nonetheless, the Centre has said it will continue to support the banking sector, a statement from the Prime Minister’s Office in July this year was explicit that the government would take any necessary steps to do so.
Janmejaya Sinha, chairman (India) of the Boston Consulting Group explains that a major issue is credit supply, saying, “The real challenge for the Indian economy is the need for more credit. [India’s] credit-to-GDP ratio is about 60 or 70 [per cent], while the ratio for China would be double that. We need a more robust and vibrant banking sector to improve credit flow.” According to Viral Acharya, former RBI deputy governor, India’s credit-to-GDP ratio is 56 per cent; in China, it is in the 150-200 per cent range. And as the economy recovers from its worst recession in decades, access to credit will be crucial.
The stress in the banking sector has taken its toll on NBFCs as well, which accounted for 30 per cent of all retail loans in fiscal 2019. The RBI’s annual inspection report for 2014- 15 red-flagged infrastructure funding firm IL&FS (Infrastructure Leasing & Financial Services), whose net-owned funds had been wiped out. On October 1, 2018, the Centre replaced the board of the beleaguered firm in an attempt to calm financial markets after it defaulted on its loans. Though the government tried to stabilise matters by appointing a six-member board led by Uday Kotak, chairman of Kotak Mahindra Bank, the ripple effect of IL&FS’s fall shook the entire sector, triggering defaults by other major NBFCs such as Dewan Housing Finance Limited (DHFL), which also went into insolvency; its promoters were arrested in a money-laundering case related to YES Bank.
As part of its Rs 20 lakh crore stimulus announced in May, the Centre said Rs 45,000 crore would be infused into NBFCs through a partial credit guarantee scheme. Industry players say this has not yet had the desired effect because NBFCs do not have the size or the capacity to use it, they tend to rely on term loans to raise funds. They also stand the risk of their existing debt going bad. S.S. Mundra, an independent banking expert, says given the challenges the NBFC sector has seen in the past two or three years, regulators should consider scale-based regulation; a one-size-fits-all approach does not work with NBFCs of different sizes.
The debacles in the NBFC segment and the YES Bank, PMC Bank and LV Bank crises have rattled public faith in the banking system. Looking at the litany of high-profile cases, Nirav Modi and Vijay Mallya, both facing extradition charges in the UK for financial crimes in India; the case relating to former ICICI Bank CEO Chanda Kochhar and Videocon; that of DHFL’s Kapil and Dheeraj Wadhawan, who are both facing money laundering charges along with former YES Bank chairman Rana Kapoor; and HDIL’s (Housing Development and Infrastructure Limited’s) Rakesh and Sarang Wadhawan, who are facing charges of conniving with the PMC Bank management to swindle depositors’ money, it is clear as daylight how crony capitalism besets the banking sector. These stories also lend credence to worries about the RBI working group’s proposal to allow corporates with other business interests to become bank promoters. In July 2018, Parliament passed the Fugitive Economic Offenders Bill, in an attempt to prevent perpetrators of big financial fraud from fleeing the country. While the likes of Vijay Mallya, Nirav Modi and Mehul Choksi continue to dodge government efforts to bring them to justice in India, the bill is expected help the government confiscate the properties of these fugitives even before they are convicted. But even after this, in August this year, the RBI annual report said banks had lost Rs 1.85 lakh crore as a result of fraud in fiscal 2020, a 28 per cent increase over the previous fiscal year. As much as 80 per cent of these losses affected state-owned banks. According to Mohit Bahl, a partner in the KPMG Cyber JV-India, Singapore & Indonesia, there are three types of activities necessary to prevent such fraud. One set includes banks assessing their current exposure and identifying fraud risks under trade-based lending activities, this relates to the risks that led to the Nirav Modi-PNB scam. The second is a transformation of banks’ internal audit functions, while the third is the development of a fraud-risk assessment framework as an integral part of a bank’s control framework. In the first case, it is essential to assess all transactions across a bank’s network that may have used the modus operandi seen in the scam. Then, all overseas branches/ regions that may be impacted need to be identified, followed by a review of the documentation and processes followed in these transactions. Next, banks should assess their existing internal controls to monitor trade transactions, as also the role of bank staff and to investigate any collusion or negligence, including of compliance with job rotation guidelines.
Observers say the frauds point to a systemic failure, which could have been addressed to some extent if the Centre had chosen to implement some of the recommendations of the P.J. Nayak committee on governance issues in banking, submitted to then RBI governor Raghuram Rajan in May 2014. Although as many as 82 structural interventions had been recommended, only six or seven have been implemented so far. Auditing needs to be strengthened at all levels, internal, external and at the RBI. Bahl says to improve internal audits, it is important for banks to reassess their coverage and components (including execution), these include internal, IT, concurrent and management audits, etc, to bring them in line with dynamic risk assessment and changes in regulations. Also, a centralised transaction-monitoring unit that triggers early warnings for reconciliation bypasses, inadequate margins, breach of guidelines etc, needs to be deployed. The existing internal audit structure and allocation of roles and responsibilities need to be enhanced to improve overall functioning and set up real-time management reporting frameworks. After the PNB scam came to light, some said the RBI had been too busy fighting inflation to uphold other aspects of its mandate as a banking regulator and a protector of consumers. In the case of the PNB fraud, many are baffled that even the RBI’s auditors could not identify the scam. While the central bank has been refining its regulatory and supervisory architecture in the light of cases that have surfaced, it still has a long way to go, say experts.
THE CO-OP BANKING MESS
The crisis at PMC Bank, which jeopardised the deposits of hundreds of thousands of customers, has raised questions about slack corporate governance and allegations of nexuses between bank directors, politicians and businesses. In the PMC Bank case, real estate company HDIL was a major beneficiary of poor governance, the bank’s now-suspended managing director, Joy Thomas, reportedly admitted that PMC Bank’s actual exposure to HDIL was over Rs 6,500 crore, four times the cap fixed by the RBI and over 70 per cent of the bank’s assets of Rs 8,880 crore. (RBI guidelines limit a bank’s exposure to a single entity to 15 per cent of its assets.) This also raises
questions about why such a gross violation of RBI norms went undetected by the regulator for so long. As per RBI data, there were 1,551 urban cooperative banks in India in 2018, down from 1,926 in 2004, highlighting the high risk of failure of these banks. Often started with small capital bases, as little as Rs 25 lakh, these banks frequently become victims of political interests and fraud. Being unlisted, most do not attract public scrutiny unless something goes amiss.
For instance, Dhananjay Khanzode, a Pune-based depositor at Rupee Cooperative Bank and chairman of the depositors’ association, has been fighting for access to his savings and for those of hundreds of thousands of other depositors since withdrawal restrictions were imposed in 2013. Depositors have been allowed only a one-time withdrawal of Rs 1,000, or up to Rs 100,000 for medical purposes/ Rs 50,000 for education or marriage. Khanzode held a business account with the bank; since restrictions were imposed, his businesses, Sconnexion Software and Siddhivinayak Construction have collapsed. Depositors want to take the case to the high court; the hold-up is the pending merger of Rupee Cooperative with Maharashtra State Cooperative Bank. The latest in the line of bank failures is the story of 94-year-old LV Bank. In November, the RBI imposed a moratorium, capping withdrawals by account holders and creditors at Rs 25,000. The RBI also announced a draft scheme to merge it with DBS Bank India Ltd, a wholly-owned subsidiary of DBS Bank Ltd, Singapore.
A former public sector banker, speaking on condition of anonymity, says the collapse of LV Bank seemed inevitable eight years ago. Another banker from Mumbai talks about the buzz in the market about the “Rana Kapoor style of management”, saying it was apparent that trouble was brewing at YES Bank years before the bubble burst. For PMC Bank depositors, the situation is the same as it was a year ago, when the RBI took control of it. After the RBI placed restrictions on withdrawals, depositors have spent the year protesting, but the restrictions have remained and were recently extended to December 22, 2020. A former cabinet minister of the Modi government laments: “Who is standing behind these deposits?” At stake in said deposits are the entire life savings of some people.
SHOULD THE STATE OWN BANKS?
The plethora of problems in public sector banks has led some to ask whether India still needs state-controlled banks at all. Five decades after the nationalisation of banks in 1969, when the Centre took control of 14 private sector banks, there is a growing belief that the government cannot run banks as commercial entities. In an article in the Indian Express on September 5 last year, former RBI governor D. Subbarao asked whether PSU banks are still needed. ‘Banks were nationalised 50 years ago in a different era, in a different context,’ he wrote. ‘In the event, PSBs rendered commendable service by deepening bank penetration into the hinterland and implementing a variety of anti-poverty programmes.’ However, those tasks have been executed, so it’s time to move on, he argued.
‘Do we still need PSBs? Isn’t the financial sector-wide enough and deep enough to take care of financial intermediation without the government at the steering wheel? Aren’t there better uses for the government’s mind space and its time?’ In fact, PSBs have been losing market share to private banks. RBI data shows the market share of PSBs in loans dipped from 74.3 per cent in 2015 to 59.8 per cent in 2020, while that of private banks surged from 21.3 per cent to 36 per cent. The government has approved the merger of 10 public sector banks into four, which, it says, could transform the competitive landscape, and will bring down the number of state-owned lenders to 12. Subbarao, however, believes the mergers ‘will contribute nothing towards engineering a turnaround of the economy. Worse still, the administrative and logistic challenges of mergers will divert the mind space of bank management away from their most pressing task at the moment, of managing the NPAs and aggressively looking for lending opportunities.’ Those who argue for privatisation of PSBs also point to the value some private banks have created over the years. For instance, HDFC Bank became only the third Indian firm after Tata Consultancy Services and Reliance Industries to cross the $100 billion mark in market capitalisation, on November 12 this year. At over Rs 7.79 lakh crore, HDFC Bank’s market cap on December 16, 2020, overtakes that of all other PSU banks’ m-cap (around Rs 4.88 lakh crore) put together.
Is privatisation, then, the answer to the woes of the banking sector? Experts say privatisation may have benefits but, left unregulated, it can be disastrous. While the crisis of capital in banking is hard to ignore and the RBI working group’s recent suggestion to allow corporate entry can be defended citing those requirements, critics of the idea, such as ex-RBI governor Raghuram Rajan and ex-deputy governor Viral Acharya, see this move as granting back-door entry to large corporates, which would be a paradigm shift from strict arms-length restrictions the RBI has so far maintained in this regard. The RBI maintains that the proposed amendments in the Banking Regulation Act will prevent connected lending and strengthen supervisory mechanisms for large conglomerates, including consolidated supervision. The RBI working group has also recommended that well-run large NBFCs, with an asset size of Rs 50,000 crore and above, including those owned by corporate houses, may be considered for conversion into banks, subject to completion of 10 years of operations and meeting additional criteria such as due diligence requirements. It also recommended that the cap on promoters’ stakes, in the long run (15 years), be raised from the current 15 per cent to 26 per cent of the bank’s paid-up equity capital. RBI officials say the top 100 NBFCs (of the universe of 10,000 with assets of Rs 32 lakh crore between them) control 80 per cent of the assets. If some become banks, the RBI will be able to directly lend them money and they will also be able to raise deposits from the public. “It will also free up space for NBFCs, and better and more necessary regulations for the sector could be put in place,” points out Raman Aggarwal, area chair of the Council for International Economic Understanding, a New Delhi-based think tank.
The RBI’s recommendations have kicked up a big debate in banking circles. Rajan and Acharya, who came down heavily on the proposal, wrote: ‘While the proposal is tempered with many caveats, it raises an important question: Why now? Have we learnt something that will allow us to override all prior cautions on allowing
industrial houses into banking? We would argue no.’ It is even more important today to stick to the tried and tested limits on corporate involvement in banking, they argued. The RBI has invited comments on the recommendations of its working group, and this window is open till January 15 next year. Sachin Chaturvedi, a member of the working committee that drafted the recommendations, has said the overall aim was to provide capital to an economy that is aiming to grow to a size of $5 trillion by 2024, to provide a greater avenue for industrial houses in capitalising economic activity and to give NBFCs a bigger role in providing capital. “The question is, how do we make sure that corporates do not channel funds from their banks to their other companies?” asks Madan Sabnavis, chief economist with Care Ratings. “Corporates operate a plethora of subsidiary companies. No one will know which companies they will be lending to, or what the holding structures of those companies are.” Even in the case of NBFCs operated by corporates, more often than not, they finance products from other group companies, so there are chances that violations will happen.
If the RBI working group’s recommendations are accepted, it will be the first definite step towards the re-entry of corporates into the banking sector, after the final round of bank nationalisation in 1980. This may not happen overnight, apart from parliamentary sanction of the proposed amendments, the RBI will also need to review the
regulatory oversight in place. The move could also prove to be a political hot potato, given the history of crony capitalism and outright fraud leading to massive NPAs. Ila Patnaik, a professor at NIPFP (the National Institute of Public Finance and Policy), who formerly served as India’s principal economic advisor, argues that before beginning discussions on privatisation or corporate entry, the Centre must bring back the Financial Resolution and Deposit Insurance Bill (FRDI). Existing banking laws empower the RBI to effect changes in bank management, or impose moratoriums and recommend mandatory mergers. In the cases of YES Bank, LV Bank, IDBI Bank and PMC Bank, these methods were invoked. In 2018, the NDA regime withdrew the FRDI bill, after the limits on deposit insurance became politically contentious. “With some corrections, this bill needs to be [re-introduced],” Patnaik argues. She says it would have empowered the RBI to set up an additional level of checks and balances for banking supervision, such as an additional supervisor in the shape of a resolution authority like the US Federal Deposit Insurance Corporation, to take over failing banks and either run them temporarily, sell them, infuse equity into them, or, as a last resort, to liquidate them. However, the bill was withdrawn because of controversy over a provision to ‘bail in’ troubled banks, using uninsured depositor money to infuse equity into them if a buyer couldn’t be found.
Since the direct entry of corporates into the banking sector is likely to meet political opposition, an easier intermediate step the government might consider is to allow large NBFCs to enter the sector first. Some experts say that allowing large NBFCs into the banking space will by itself afford the RBI better regulatory oversight of that segment. In 2016, the RBI had come up with an ‘on-tap’ model for universal banking licences, under which individuals with 10 years of experience in banking and finance at a senior level and NBFCs with a successful track of 10 years could apply for a licence, provided the entity had a minimum paid-up equity capital of Rs 500 crore. Large industrial houses were kept out of scope. However, this model did not elicit much interest, a likely damper being the 15 per cent cap on promoters’ holdings. Allowing private promoters to hold 26 per cent in banks could act as a trigger for at least a few NBFCs to get into the banking space.
Following the recommendations of the P.J. Nayak committee, a Banks Board Bureau was set up in the RBI in 2016. The big ideas were to end political meddling in the appointments process and the functioning of bank boards, and to help build capacity to attract, retain and nurture talent. But the recommendations fell flat. India Today reached out to Nayak to try and understand why, but he chose to not speak on the issue. Other members of the same committee said it was impossible to even loosen government control, in any matter of note related to PSBs, any corrective action or merger or even to get a grip on NPAs. “This is the correct reform, but introduced at the wrong time,” says the same member. “There is a need to ring-fence capital from corporates’ requirement for capital. This can easily be done through technology as well as stricter regulations,” says Charan Singh, chairman of Punjab and Sind Bank.
Banks are the oxygen of the economy, they provide credit to businesses and individuals. For the economy to grow, outstanding bank credit has to nearly double from the current Rs 95 lakh crore over the next five years. For India to become a $5 trillion economy, credit growth needs to be at 15 per cent a year for the next five years, it is currently about 8-10 per cent. A former public sector banker explains that credit outflow is integrated with how banks are run. Until now, even with multiple blueprints to reform PSBs, the pace of change has been slow. There needs to be a greater appetite for risk, bankers are currently too wary of lending. As the primary stakeholder in these PSBs, the Centre needs to play a leadership role. “Best practices flow from the top,” says a banker with a long career at the head of a PSB. The CEOs of PSBs are rotated every two years, and they report to both the bank board as well as the government, which makes the job an administrative tightrope. Walking that tightrope also makes them riskaverse in a way not always good for business. The BCG’s Janmejaya Sinha suggests the government bring its ownership in PSBs below 50 per cent. “Government-owned banks should work the same way Uday Kotak owns his bank. This will take care of HR-related issues and create a spirit of competition,” he says.
On the RBI’s suggestion of allowing corporates to set up banks, Sinha argues that if industrial houses can own NBFCs, why not banks? He also argues that industrial houses will not have the courage to fail depositors. There are others who say that recent measures will soon bear results. According to a Business Today-KPMG Best
Banks and Fintech study, which did an in-depth analysis of the financials of banks for FY19, the worst may be over for India’s banks. Results suggest that the merger of the 10 PSBs into four large banks will bring economies and other benefits of scale. The de-risking effort by ICICI Bank and Axis Bank is also showing results, with asset quality deterioration halting after almost
The Indian banking sector has expanded considerably in the recent past, with new entities creating niches for themselves. Small finance banks and fintech are taking deposits and lending, small finance banks ended FY19 with advances of Rs 70,000 crore. As the Indian economy grows, the culture of credit must also evolve, today, entrepreneurs seek easy and fast credit. Indian banks, especially PSBs, need to quickly get their acts together and either embrace new-age banking or risk irrelevance.