THE GIST of Editorial for UPSC Exams : 20 September 2018 (What ails the Indian banking sector?)

What ails the Indian banking sector?

Mains Paper: 3 | Economy
Prelims level: NPA
Mains level: The government’s focus on infrastructure during 2002-09, especially with the efforts made to promote public-private partnerships.

Introduction

There have seen rapidly increasing stress in the Indian banking sector, with non-performing assets (NPAs) steadily climbing from under 3% to over 13% of total assets.
Loan-loss provisioning for NPAs has seriously eroded the capital base of several banks, limiting their ability to make further loans.
The state of Indian banking is among the biggest challenges facing the country in accelerating investments and growth.

What are the cause?

The problems currently being faced by the banking sector arise from a fundamental change that occurred after 2002.
Before that Indian banks mainly had two types of loans.
(a) working capital loans to production entities, firms, and farmers (76% of banking portfolio); and
(b) retail term loans to households for housing, and durable goods (less than 24%).
Since then, banks have been aggressively making term loans to companies for fixed capital investments, like land, building, and machinery.
This now accounts for 38% of the portfolio, with working capital at 42% and retail at 20%. The bulk of NPAs by value are long-term loans to corporates.
This shift from short-term working capital loans to long-term loans has not gone entirely unnoticed.
The average tenor of assets (loan portfolio) has been rapidly going up relative to that of liabilities (deposits). While this is worrying, it is not the cause of the NPA problem.
There is a significant difference between de jure (contractual) and de facto (behavioural) tenors of bank deposits.
The average de jure tenor is usually computed by taking the weighted average of contractual tenors of demand and term deposits, which works out to about two years.

Remedies

It’s diagnosing the cause(s) and putting correctives in place is perhaps even more important.
The entire discourse appears to have boiled down to the governance practices in public sector banks (PSBs), particularly political interference and crony capitalism.
The solutions have more or less polarized around two ideologically coloured views
(a) privatization of PSBs; or
(b) strengthening independence and capacity of PSBs.
This is a perfectly legitimate debate and may lead to a part of the solution.
It should not forestall the search for other causes, which may be just as important.

The rise of NPA problem

The NPA problem has arisen from four features that characterised bank loans for fixed capital formation:
(a)Banks do not have the capacity to assess long-term credit-worthiness of borrowers. They rely almost exclusively on credit-rating agencies that provide ratings only when the concerned company intends to raise debt capital directly from the market.
(b) Banks have no capacity to monitor the use of long-term loans by borrowers. This is particularly egregious for project loans, especially when it is without recourse (lender has claim only on assets of the project, not of the parent company). Consequently, the parent company can use the funds for purposes other than for which they were borrowed without the banks being any the wiser.
(c) Such loans create an existential problem for borrowers since attaching such assets essentially means “winding up” the companies. It is only natural that company promoters would fight such an eventuality.
It is no wonder that bank managements have allowed potential NPAs to accumulate over the years through myriad forms of “ever-greening”. Reserve Bank of India’s forced recognition of NPAs has now brought the problem to light.
(d) There was gross mispricing of loans by banks. In practically all banks, the yield curve is almost parallel to, and sometimes even flatter than, that of government securities.
Even if banks were unable to assess the appropriate risk premium at different tenors due to (a) above, there is no reason why a premium was not attached to the illiquid nature of the underlying collateral, which is also related to (c) above.

The origins

This high exposure to companies in fixed assets, especially in project finance, did not happen by itself, but at the behest of successive governments.
It begins with a decision taken by the government in 1997 to stop issuance of tax-free bonds by development finance institutions.
In which were the main source of term finance for corporates.
This closed the only source of relatively low-cost funds for these institutions, and was instrumental in some of them converting to commercial banks and others shutting down.
Consequently, Indian commercial banks were forced to fill the vacuum and effectively converting to “universal banks” (performing roles of both commercial and investment banks).

The possible solutions

The most important solution to the NPA problem is to provide for rapid resolution of defaults. Something similar used to happen earlier with working capital loans and was taken care of by the promulgation of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, which resulted in gross NPAs falling from 19% in 2002 to 6% by 2006.
The Insolvency and Bankruptcy Code (IBC) was passed in 2016, which has made it easier for banks to effect recovery through liquidation of fixed assets.
The other critical solution is fundamental to the change that has taken place in Indian banking. Indian banking laws follow the “Anglo-Saxon” model in which there is a firewall between commercial and investment banks. The shift to universal banking was ‘reform by stealth’ and not accompanied by amendments to laws.
The Banking Act should be amended to permit issuance of bonds by banks for on-lending. Ideally, banks should be required to ensure that a minimum percentage of their term loans are financed by long-term market borrowings.

Way forward

Such a measure would have several positive effects.
If banks are required to issue bonds to finance a part of their term loans, it would lead to a much more rational (steeper) yield curve on bank loans since the interest rate on bonds would be significantly higher than that on deposits.
It is a more rational yield curve may drive some corporates to borrow directly in the bond market, reducing the pressure on banks. The Securities and Exchange Board of India has made it mandatory for listed companies to raise a part of their long-term debt from the market, but this can potentially distort credit allocation in the economy.
This would automatically correct the growing asset-liability mismatch problem, and improve the credibility of the banking sector.
Since banks would have to get themselves periodically rated, the yield curve of individual banks would reflect the strength of their loan portfolios. Banks with weaker balance sheets will have to offer higher interest rates on their bonds, which will get reflected in higher rates that they will have to charge to the same potential client.

UPSC Prelims Questions:

Q.1) With reference to the Real Estate Investment Trusts (REITs), consider the following statements:
1. They are mutual fund like institutions that enable investments into the real estate sector.
2. They are regulated by Securities and Exchange Board of India (SEBI).
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Ans: C