Bad Loans

Privatization by Malign Neglect: Nationalized Banks Gave Out Just 6% of Banking Loans in 2020-21

One story that I have closely tracked over the years is the privatization of the Indian banking sector, despite the government continuing to own a majority stake in public sector banks (PSBs). I recently wrote a piece in the Mint newspaper regarding the same.

The moral of the story is that the PSBs have continued to lose market share to the private banks, over the years. This is true of both deposits as well as loans.

In the last decade and a half, when it comes to loans, the share of PSBs in the overall lending carried out by scheduled commercial banks in India  peaked at 75.1% in March 2010. As of March 2021, it had fallen to 56.5%.

When it comes to deposits, during the same period, the share of PSBs in the total deposits raised by scheduled commercial banks peaked at 74.8% in March 2012. As of March 2021, it had fallen to 61.3%. Meanwhile, the private banks had gained share both in loans as well as deposits. (For complete details read the Mint story mentioned earlier).

One feedback on the Mint story was to check for how well PSBs other than the State Bank of India (SBI), the largest PSB and the largest bank in India, have been doing. In this piece, I attempt to do that. Data for this piece has been drawn from the Centre for Monitoring Indian Economy (CMIE) and several investor presentations of SBI. The data takes into account the merger of SBI with its five associate banks as of April 1, 2017.

Let’s take a look at the findings point wise.

1)  Let’s start with the share of different kinds of banks in the overall banking loan pie.

Source: Author calculations on data from the
Centre for Monitoring Indian Economy
and the investor presentations of SBI.

In the last 15 years, the share of SBI in the overall banking loan pie has been more or less constant (look at the blue curve, it seems as straight as a line). It was at 23.1% as of March 2006 and it stood at 22.7% as of March 2021. Clearly, SBI has managed to hold on to its market share in face of tough competition from private banks.

But the same cannot be said of the other PSBs, which are popularly referred to as nationalized banks, given that they were private banks earlier and were nationalized first in 1969 (14 banks) and later in 1980 (six banks).

The share of these banks in the lending pie has fallen from 47.9% in March 2006 to 33.8% in March 2021.

In fact, the fall started from March 2015 on, when the share of the nationalized banks in overall lending had stood at 50.1%. This is when the Reserve Bank of India (RBI) rightly started forcing these banks to recognise their bad loans as bad loans, something they had been avoiding doing since 2011, when the bad loans first started to accumulate. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more.

Not surprisingly, the share of private banks in the banking loan pie has been going up. It is up from 20% to 35.5% in the last 15 years, though a bulk of the gain has come from March 2015 onwards, when the share was at 20.8%. Clearly, the private banks have gained market share at the cost of nationalized banks. As stated earlier, SBI has managed to maintain its market share.

2) Now let’s take a look at the deposit share of different kinds of banks.

Source: Author calculations on data from
the Centre for Monitoring Indian Economy
and the investor presentations of SBI.

The first thing that comes out clearly is that the shape of the curves in this chart are like the earlier chart, telling us that conclusions are likely to be similar.

When it comes to overall banking deposits, the share of SBI has been more or less constant over the last 15 years. It has moved up a little from 23.3% to 23.8%, with very little volatility in between.

For nationalized banks, it has fallen from 48.5% to 37.4%, with a bulk of the fall coming post March 2015, when it had stood at 51%.

The fall in market share of nationalized banks has been captured by private banks, with their share moving up from 19.4% to 29.9% in the last 15 years. Again, a bulk of this gain has come post March 2015, when their market share was at 19.7%. Clearly, as nationalized banks have been trying to put their house back in order, private banks have moved in for the kill and captured market share.

The two charts clearly tell us that the banking scenario in India has been changing post March 2015, but they don’t show us the gravity of the situation.

To do that we need to look at the incremental loans given out by the banks each year and the incremental deposits raised by them during the same year. Up until now we were looking at the overall loans given out by banks and the overall deposits raised by them, at any given point of time.  

3) Let’s take a look at the share that different kinds of banks have had in incremental loans given out every year. Incremental loans are obtained in the following way. The outstanding bank loans of SBI stood at Rs 25 lakh crore as of March 2021. They had stood at around Rs 23.7 lakh crore as of March 2020.

The incremental loans given between March 2020 and March 2021, stood at Rs 1.3 lakh crore. This is how the calculation is carried out for different banks across different years. The number is then divided by the incremental loans given out by scheduled commercial banks, and the market share of different kind of banks is obtained.

In 2020-21, the total incremental loans given by the banks stood at Rs 5.2 lakh crore. Of this, SBI had given out around Rs 1.3 lakh crore and hence, it had a market share of around one-fourth, when it came to incremental loans given by banks.

Source: Author calculations on data from the
Centre for Monitoring Indian Economy
and the investor presentations of SBI.

The above chart tells us is that post March 2015, a bulk of incremental lending has been carried out by private banks. In 2014-15, the private banks carried out by 35.6% of incremental lending. This touched a peak of 79.5% in 2015-16 and their share was at 58.9% in 2020-21, the last financial year.

SBI’s share in incremental lending hasn’t moved around much and it stood at 24.4% in 2020-21.

The real story lies with the nationalized banks. Their share of incremental lending has collapsed from a little over half of the incremental lending in 2013-14 to just 0.2% in 2019-20. In 2020-21, it was slightly better at 6.3%.

These banks have barely carried out any lending in the last five years, with their share being limited to 6.1% of the incremental loans that have been given during the period. SBI’s share stands at 25.3% and that of private banks at 59.9%.

4) Now let’s look at how the share of incremental deposits of different kinds of banks over the years.

Source: Author calculations on data from the
Centre for Monitoring Indian Economy
and the investor presentations of SBI.

This is perhaps the most noisy of all the charts up until now. But even here it is clear that the share of nationalized banks in incremental deposits has come down over the years. It was at 50.9% in 2013-14. In 2017-18, the deposits of nationalized banks saw a contraction of 8.5%, meaning that the total deposits they had went down between March 2017 and March 2018. In 2020-21, their share of incremental deposits stood at 26.3%.

The chart also tells us that in the last six years, the private banks have raised more deposits during each financial year, than SBI and nationalized banks have done on their own.

5) In the following chart, the incremental loan-deposit ratio of banks has been calculated. This is done by taking the incremental loans given by banks during a particular year and dividing it by the incremental deposits raised during the year.

Source: Author calculations on data from the
Centre for Monitoring Indian Economy
and the investor presentations of SBI.

The curve for non SBI PSBs is broken because in 2017-18,
the banks saw a deposit contraction,
and hence, the incremental loan deposit ratio
of that year cannot be calculated.

The incremental loan deposit ratio of nationalized banks collapsed to 0.5% in 2019-20 and 7.4% in 2020-21. What this means is that while these banks continue to raise deposits, they have barely given out any loans over the last two years. In 2019-20, for every Rs 100 rupees they raised as a deposit they gave out 50 paisa as a loan (Yes, you read that right!). In 2020-21, for every Rs 100, they raised as a deposit they gave out Rs 7.4 as a loan.

One reason for this lies in the fact that many of these banks were rightly placed under a prompt corrective action (PCA) framework post 2017 to allow them to handle their bad loan issues.

This placed limits on their ability to lend and borrow. Viral Acharya, who was a deputy governor of the RBI at that point of time, did some plain-speaking in a speech where he explained the true objective of the PCA framework:

“Such action should entail no further growth in deposit base and lending for the worst-capitalized banks. This will ensure a gradual “runoff” of such banks, and encourage deposit migration away from the weakest PSBs to healthier PSBs and private sector banks.”

The idea behind the PCA framework was to drive new business away from the weak banks, give them time to heal and recover, and at the same time ensure they don’t make newer mistakes and in the process minimize the further accumulation of bad loans. This came at the cost of the banks having to go slow on lending.

As I keep saying there is no free lunch in economics. All this happened because these banks did not recognise their bad loans as bad loans between 2011 and 2014, and only did so when they were forced by the RBI mid 2015 onwards.

There is a lesson that we need to learn here. The bad loans of banks will start accumulating again as the post covid stress will lead to and is leading to loan defaults. It is important that banks do not indulge in the same hanky-panky that they did post 2011 and recognise their bad loans as bad loans, as soon as possible.

What banks did between 2011 and 2014, when it comes to bad loans, has already cost the Indian banking sector a close to a decade. The same mistake shouldn’t be made all over again.

Now with many of the nationalized banks out of the PCA framework, their deposit franchises remain intact, nonetheless, they don’t seem to be in the mood to lend or prospective borrowers don’t seem to be in the mood to borrow from these banks, and perhaps find borrowing from private banks, easier and faster.

Of course, one needs to keep in mind the fact that 2020-21 was a pandemic year, and the overall lending remained subdued.

Meanwhile, the private banks keep gaining market share at the cost of the nationalized banks. This means that by the time the government gets around to privatizing some of these banks, if at all it does, their business models are likely to have completely broken down. They will have deposit bases without adequate lending activity. 

The nation shall witness what Ruchir Sharma of Morgan Stanley calls privatization by malign neglect, play out all over again, like it had in the airline sector and the telecom sector, before this.

 

How Trustworthy are the Bad Loans Numbers of Banks?

The Reserve Bank of India (RBI) in the Financial Stability Report (FSR) released in January had said that by September, the bad loans of banks, under a baseline scenario, could shoot up to 13.5% of their total loans. In September 2020, the bad loans rate of banks had stood at 7.5%. Bad loans are largely loans, which haven’t been repaid for a period of 90 days or more.

If the economic scenario were to worsen into a severe stress scenario, the bad loans could shoot up to 14.8% of the loans. For public sector banks, the rate could go up to 16.2% under a baseline scenario and 17.8% in a severe stress one.

What this meant was that the RBI expected the overall bad loans of banks to shoot up massively in the post-covid world, even more or less doubling from 7.5% to 14.8%, under a severe stress scenario.

A past reading of the RBI forecasts suggests that in an environment where bad loans are going up, they typically end up at levels which are higher than the severe stress level predicted by the RBI.

Given all this, there should be enough reason for worry on the banking front. But as things are turning out the dire predictions of the RBI are still not visible in the numbers. The quarterly results of a bunch of banks for the period October to December 2020 have been declared and it must be said that the banks look to be doing decently well.

In a research note, CARE Ratings points out that the bad loans rate of 30 banks which form the bulk of the Indian banking system (including the 12 public sector banks, IDBI Bank and the big private banks), stood at 7.01% as of December 2020. The rate had stood at 8.72% as of December 2019 and 7.72% as of September 2020.

In fact, when it comes to public sector banks, the bad loans rate has improved from 11.22% as of December 2019 to 9.01% as of December 2020 (This calculation includes IDBI Bank as well, which is now majorly owned by the Life Insurance Corporation of India and not the union government, and hence is categorised as a private bank).

When it comes to private banks ( a sample of 17 banks), the bad loans rate has improved from 4.87% as of December 2019 to 3.49% as of December 2020.

On the whole, these thirty banks had bad loans amounting to Rs 7.38 lakh crore on loans of Rs 105.37 lakh crore, leading to a bad loans rate of a little over 7%. Do remember, the RBI’s baseline forecast for September 2021 is 13.5%. Hence, things should have been getting worse on this front, but they seem to be getting better.

What’s happening here? The Supreme Court in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders.

This has essentially led to banks not declaring bad loans as bad loans. Nevertheless, the banks are declaring what they are calling proforma slippages or loans which would have been declared as bad loans but for the Supreme Court’s interim order.

A look at the results of banks tells us that even these slippages aren’t big. The proforma slippages of the State Bank of India between April and December 2020, stood at Rs 16,461 crore, which is small change, given that the bank’s total advances stand at Rs 24.6 lakh crore. When it comes to the Punjab National Bank, the total proforma slippages were at Rs 12,919 crore between April to December 2020.

Similarly, when we look at other banks, the proforma slippages are present but they are not a big number. An estimate made by the Mint newspaper suggests that India’s ten biggest private banks have proforma slippages amounting to around Rs 42,000 crore.

The 30 banks in the CARE Ratings note had total bad loans of Rs 7.38 lakh crore or a rate of 7.01 %. If this has to reach anywhere near, 13.5-14.8% as forecast by the RBI, the overall bad loans need to nearly double or touch around Rs 14 lakh crore.

The initial data doesn’t bear this out. As the RBI said in the FSR, “[With] the standstill on asset classification… the data on fresh loan impairments reported by banks may not be reflective of the true underlying state of banks’ portfolios.”

Hence, the situation will only get clearer once the Supreme Court decision comes in and the banks need to mark bad loans as bad loans. While banks are declaring proforma slippages, it could very well be that the Supreme Court interim order along with restructuring schemes announced by the RBI and the fact the Insolvency and the Bankruptcy Code remains suspended, have led to a situation where they are under-declaring these numbers.

This is not the first time something like this will happen. Around a decade back in 2011, Indian banks had started accumulating bad loans on the lending binge carried out by them between 2004 and 2010, but they didn’t declare these bad loans as bad loans immediately.

Only after a RBI crackdown and an asset quality review in mid 2015, did the banks start declaring bad loans as bad loans. There is no reason to suggest that banks are behaving differently this time around.

It is important that the same mistake isn’t made all over again. Hence, the RBI should carry out an asset quality review of banks(and non-banking finance companies) and force them to come clean on their bad loans.

A problem can only be solved once it has been identified as one.

The article originally appeared in the Deccan Herald on February 14, 2021.

Indian Banks Will Have Rs 17-18 Lakh Crore Bad Loans By September

The Reserve Bank of India (RBI) publishes the Financial Stability Report (FSR) twice a year, in June and in December. This year the report wasn’t published in December but only yesterday (January 11, 2021).

Media reports suggest that the report was delayed because the government wanted to consult the RBI on the stance of the report. For a government so obsessed with controlling the narrative this doesn’t sound surprising at all.

Let’s take a look at the important points that the FSR makes on the bad loans of banks and what does that really mean. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more.

1) The bad loans of banks are expected to touch 13.5% of the total advances in a baseline scenario. Under a severe stress scenario they are expected to touch 14.8%. These are big numbers given that the total bad loans as of September 2020 stood at 7.5% of the total advances. Hence, the RBI is talking of a scenario where bad loans are expected to more or less double from where they are currently.

2) Under the severe stress scenario, the bad loans of public sector banks and private banks are expected to touch 17.6% and 8.8%, respectively. This means that public sector banks are in major trouble again.

3) In the past, the RBI has done a very bad job of predicting the bad loans rate under the baseline scenario, when the bad loans of the banking system were going up.

Source: Financial Stability Reports of the RBI.
*The actual forecast of the baseline scenario was between 4-4.1%

If we look at the above chart, between March 2014 and March 2018, the actual bad loans rate turned out to be much higher than the one predicted by the RBI under the baseline scenario. This was an era when the bad loans of the banking system were going up year on year and the RBI constantly underestimated them.

4) How has the actual bad loans rate turned out in comparison to the bad loans under severe stress scenario predicted by the RBI?

Source: Financial Stability Reports of the RBI.
*The actual forecast of the baseline scenario was between 4-4.1%

In four out of the five cases between March 31, 2014 and March 31, 2018, the actual bad loans rate turned out higher than the one predicted by the RBI under a severe stress scenario. As Arvind Subramanian, the former chief economic advisor to the ministry of finance, writes in Of Counsel:

“In March 2015, the RBI was forecasting that even under a “severe stress” scenario— where to put it colourfully, all hell breaks loose, with growth collapsing and interest rates shooting up—NPAs [bad loans] would at most reach about Rs 4.5 lakh crore.”

By March 2018, the total NPAs of banks had stood at Rs 10.36 lakh crore.

One possible reason can be offered in the RBI’s defence. Let’s assume that the central bank in March 2015 had some inkling of the bad loans of banks ending up at around Rs 10 lakh crore. Would it have made sense for it, as the country’s banking regulator, to put out such a huge number? Putting out numbers like that could have spooked the banking system in the country. It could even have possibly led to bank runs, something that the RBI wouldn’t want.

In this scenario, it perhaps made sense for the regulator to gradually up the bad loans rate prediction as the situation worsened, than predict it in just one go. Of course, I have no insider information on this and am offering this logic just to give the country’s banking regulator the benefit of doubt.

5) So, if the past is anything to go by, the actual bad loans of banks when they are going up, turn out to be much more than that forecast by the RBI even under a severe stress scenario. Hence, it is safe to say that by September 2021, the bad loans of banks will be close to 15% of advances, a little more than actually estimated under a severe stress scenario.

This will be double from 7.5% as of September 2020. Let’s try and quantify this number for the simple reason that a 15% figure doesn’t tell us about the gravity of the problem. The total advances of Indian banks as of March 2020 had stood at around Rs 109.2 lakh crore.

If this grows by 10% over a period of 18 months up to September 2021, the total advances of Indian banks will stand at around Rs 120 lakh crore. If bad loans amount to 15% of this we are looking at bad loans of Rs 18 lakh crore. The total bad loans as of March 2020 stood at around Rs 9 lakh crore, so, the chances are that bad loans will double even in absolute terms. If the total advances grow by 5% to around Rs 114.7 lakh crore, then we are looking at bad loans of around Rs 17.2 lakh crore.

6) The question is if this is the level of pain that lies up ahead for the banking system, why hasn’t it started to show as yet in the balance sheet of banks. As of March 2021, the RBI expects the bad loans of banks to touch 12.5% under a baseline scenario and 14.2% under a severe stress scenario. But this stress is yet to show up in the banking system.

This is primarily because the bad loans of banks are currently frozen as of August 31, 2020. The Supreme Court, in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders.

As the FSR points out:

“In view of the regulatory forbearances such as the moratorium, the standstill on asset classification and restructuring allowed in the context of the COVID-19 pandemic, the data on fresh loan impairments reported by banks may not be reflective of the true underlying state of banks’ portfolios.”

The Supreme Court clearly needs to hurry up on this and not keep this hanging.

7) Delayed recognition of bad loans is a problem that the country has been dealing with over the last decade. The bad loans which banks accumulated due to the frenzied lending between 2004 and 2011, were not recognised as bad loans quickly enough and the recognition started only in mid 2015, when the RBI launched an asset quality review.

This led to a slowdown in lending in particular by public sector banks and negatively impacted the economy. Hence, it is important that the problem be handled quickly this time around to limit the negative impact on the economy.

8) Public sector banks are again at the heart of the problem. Under the severe stress scenario their bad loans are expected to touch 17.6% of their advances. The sooner these bad loans are recognised as bad loans, accompanied with an adequate recapitalisation of these banks and adequate loan recovery efforts, the better it will be for an Indian economy.

9) At an individual level, it makes sense to have accounts in three to four banks to diversify savings, so that even if there is trouble at one bank, a bulk of the savings remain accessible. Of course, at the risk of repetition, please stay away from banks with a bad loans rate of 10% or more.

To conclude, from the looks of it, the process of kicking the bad loans can down the road seems to have started. There is already a lot of talk about the definition of bad loans being changed and loans which have been in default for 120 days or more, being categorised as bad loans, against the current 90 days.

And nothing works better in the Indian system like a bad idea whose time has come. This is bad idea whose time has come.

 

The Rs 20 Lakh Crore Bad Loans Problem of Indian Banks Hasn’t Gone Away

On December 29, 2020, the Reserve Bank of India (RBI) released the Report on Trend and Progress of Banking in India.

Like every year, the report is a treasure trove of information, especially for people like me who like to closely track the aggregate banking scene in India.

Sadly, most of this important information barely made it to the mainstream media, this, despite the fact that the health of the country’s banking sector impacts almost all of us. (This is one reason why I need your continued support).

Among other things, the report discusses the issue of the bad loans of banks in great detail. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more. They are also referred to as non-performing assets or NPAs.

Let’s take a look at this issue pointwise.

1) The total bad loans of banks (public sector banks, private banks, foreign banks and small finance banks) as of March 31, 2020 stood at around Rs 8,99,802 crore. This is the lowest since 2017-18. The following chart plots the bad loans of banks over the years.

Source: Reserve Bank of India.

Despite this fall, the Indian banking sector on a whole continues to remain in a mess. We shall look at the reasons in this piece.

2) The total amount of loans written off by banks has steadily been going up over the years. In 2019-20 it peaked at Rs 2,37,876 crore. The following chart lists out the loans written off by banks over the years.

Source: Reserve Bank of India.

Basically, loans which have been bad loans for four years (that is, for one year as a ‘substandard asset’ and for three years as a ‘doubtful asset’) can be dropped from the balance sheet of banks by way of a write-off. In that sense, a write-off is an accounting practise.

Of course, before doing this, a 100 per cent provision needs to be made for a bad loan which is being written-off. This means a bank needs to set aside enough money over four years in order to meet the losses on account of a bad loan.

Also, this does not mean that a bank has to wait for four years before it can write-off a loan. If it feels that a particular loan is unrecoverable, it can be written off before four years.

So, does that mean that once a loan is written off it’s gone forever and is no longer recoverable? In India things work a little differently. In fact, almost all the bad loans written off are technical write-offs.

The RBI defines technical write-offs as bad loans which have been written off at the head office level of the bank, but remain as bad loans on the books of branches and, hence, recovery efforts continue at the branch level. If a bad loan which was technically written off is partly or fully recovered, the amount is declared as the other income of the bank. Having said that, the rate of recovery of loans written-off over the years, has been abysmal at best.

Now getting back to the issue at hand. The bad loans of banks as of March 31, 2020, have come down to some extent due to write-offs. As the Report on Trend and Progress of Banking in India points out: “The reduction in NPAs during the year was largely driven by write-offs.” Interestingly, the RBI offers the same reason for bad loans coming down in the years before 2019-20 as well.

Let’s try examining the above logic in a little more detail. The bad loans or NPAs of banks as of April 1, 2019, stood at Rs 9,15,355 crore. During the course of 2019-20, banks wrote off loans worth Rs 2,37,876 crore. Nevertheless, as of March 31, 2020, the bad loans of banks had come down to Rs 8,99,803 crore.

If we subtract the loans written off during 2019-20 from the overall bad loans of banks as of April 1, 2019, the bad loans as of March 31, 2020, should have stood at Rs 6,77,479 crore (Rs 9,15,355 crore minus Rs 2,37,876 crore). But as we see they are actually at Rs 8,99,802 crore.

What has happened here? What accounts for the significant difference? Banks have accumulated fresh bad loans during the course of the year. The net fresh bad loans (fresh bad loans accumulated during the year minus reduction in bad loans) during 2019-20 stood at Rs 2,22,323 crore. Once this added to Rs 6,77,479 crore, we get Rs 8,99,802 crore, or the bad loans as of March 31, 2020.

The point to be noted here is that banks on the whole have accumulated fresh bad loans of more than Rs 2 lakh crore during 2019-20. This is a reason to worry. It tells us that the bad loans problem of Indian banks hasn’t really gone anywhere. It is alive and kicking, unlike what many bankers, economists, India equity strategists and journalists, have been trying to tell us. Many borrowers continue to default on their loans.

The net fresh bad loans accumulated in 2018-19 had stood at Rs 1,34,738 crore. This tells us that there was a huge jump in the accumulation of fresh bad loans in 2019-20. The current financial year will see a further accumulation of bad loans due to the covid-pandemic.

3) In a February 2017 interview to Dinesh Unnikrishnan of Firstpost, Dr KC Chakrabarty, a former deputy governor of the RBI and a veteran public sector banker, had put the bad loans number of Indian banks at Rs 20 lakh crore.

As he had said:

“I’ll put the figure around Rs 20 lakh crore…One should include all troubled loans including reported bad loans, restructured assets, written off loans and bad loans that are not yet recognised.”

The trouble was not many people took Chakrabarty seriously at that point of time. Nevertheless, the Rs 20 lakh crore number doesn’t seem far-fetched at all. As mentioned earlier, the bad loans number as of March 31, 2020, stood at Rs 8,99,802 crore.

Between 2014-15 and 2019-20, the total bad loans written off by banks was Rs 8,77,856 crore. We are taking this particular time period simply because in mid 2015 the RBI launched an asset quality review and forced banks to recognise bad loans as bad loans. Up until then the banks had been using various tricks to kick the bad loans can down the road.

If we add, the bad loans as of March 2020 to bad loans written off between 2014-15 and 2019-20, we get Rs 17,77,658 crore. What does this number represent? It represents the total bad loans, the Indian banks have managed to accumulate between 2014-15 and 2019-20. And it is very close to the Rs 20 lakh crore number suggested by Chakrabarty.

Of course, this calculation does not take into account the loans which are bad loans but have not yet been recognised as bad loans. Former RBI Governor Urjit Patel in his book Overdraft—Saving the Indian Saver writes:

“In February 2020, ‘living dead’ borrowers in the commercial real-estate sector – under a familiar guise (‘a ghost from the past’, if you will) viz., ad hoc ‘restructuring’ – have been given a lifeline. It is estimated that over one-third of loans to builders are under moratorium.”

Professor Ananth Narayan of the S. P. Jain Institute of Management and Research, writing in the Mint in June 2020, said: “Banking NPA recognition remains incomplete… For a while now, RBI has allowed banks to postpone NPA recognition for some of the over Rs 8 lakh crore of MSME, MUDRA and commercial real estate loans.” The situation could only have worsened post the spread of the covid-pandemic.

If we take this into account, the bad loans of Indian banks over the last five years have amounted to much more than Rs 20 lakh crore. In that sense, Dr Chakrabarty has had the last laugh. As Chakrabarty had said in the Firstpost interview: “Unless this portion is recognised first, there will be no solution to the bad loan problem.”

Or to put it simply, how do you solve a problem without recognising that it exists.

13 Reasons RBI Shouldn’t Allow Large Corporates/Industrial Houses to Own Banks

Apna hi ghar phoonk rahe hain kaisa inquilab hai.

— Hasrat Jaipuri, Mohammed Rafi, Mukhesh, Ravindra Jain and Naresh Kumar, in Do Jasoos.

Should large corporates/industrial groups be allowed to own banks? An internal working group (IWG) of the Reserve Bank of India (RBI), thinks so. I had dwelled on this issue sometime last week, but that was a very basic piece. In this piece I try and get into some detail.

The basic point on why large corporates/industrial groups should be allowed into banking is that India has a low credit to gross domestic product (GDP) ratio, which means that given the size of the Indian economy, the Indian banks haven’t given out enough loans. Hence, if we allow corporates to own and run banks, there will be more competition and in the process higher lending. QED.

Let’s take a look at the following chart, it plots the overall bank lending to GDP ratio, over the years.


Source: Centre for Monitoring Indian Economy.

The above chart makes for a very interesting read. The bank lending grew from 2000-01 onwards. It peaked at 53.36% of the Indian GDP in 2013-2014. In 2019-20 it stood at 50.99% of the GDP, more or less similar to where it was in 2009-10, a decade back, at 50.97% of the GDP. Hence, the argument that lending by Indian banks has been stagnant over the years is true.

But will more banks lead to more lending? Since 2013, two new universal banks, seven new payment banks and ten new small finance banks have been opened up. But as the above chart shows, the total bank loans to GDP ratio has actually come down.

Clearly, the logic that more banks lead to more lending is on shaky ground. There are too many other factors at work, from whether banks are in a position and the mood to lend, to whether people and businesses are in the mood to borrow. Also, the bad loans situation of banks matters quite a lot.

In fact, even if we were to buy this argument, it means that the Indian economy needs more banks and not necessarily banks owned by large corporates/industrial houses, who have other business interests going around.

Also, the banks haven’t done a good job of lending this money out. As of March 2018, the bad loans of Indian banks, or loans which had been defaulted on for a period of 90 days or more, had stood at 11.6%. So, close to Rs 12 of every Rs 100 of loans lent out by Indian banks had been defaulted on. In case of government owned public sector banks, the bad loans rate had stood at 15.6%. Further, when it came to loans to industry, the bad loans rate of banks had stood at 22.8%.

Clearly, banks had made a mess of their lending. The situation has slightly improved since March 2018. The bad loans rate of Indian banks as of March 2020 came down to 8.5%. The bad loans rate of public sector banks had fallen to 11.3%.

The major reason for this lies in the fact that once a bad loan has been on the books of a bank for a period of four years, 100% of this loan has been provisioned for. This means that  the bank has set aside an amount of money equal to the defaulted loan amount, which is adequate to face the losses arising out of the default. Such loans can then be dropped out of the balance sheet of the banks. This is the main reason behind why bad loans have come down and not a major increase in recoveries.

This is a point that needs to be kept in mind before the argument that large corporates/industrial houses should be given a bank license, is made.

There are many other reasons why large corporates/industrial houses should not be given bank licenses. Let’s take a look at them one by one.

1) The IWG constituted by the RBI spoke to many experts. These included four former deputy governors of the RBI, Shyamala Gopinath, Usha Thorat, Anand Sinha and N. S. Vishwanathan. It also spoke to Bahram Vakil (Partner, AZB & Partners), Abizer Diwanji (Partner and National Leader – Financial Services EY India),  Sanjay Nayar (CEO, KKR India), Uday Kotak (MD & CEO, Kotak Mahindra Bank.), Chandra Shekhar Ghosh (MD & CEO, Bandhan Bank) and PN Vasudevan (MD & CEO, Equitas Small Finance Bank).

Of these experts only one suggested that large corporates/industrial houses should be allowed to set up banks. The main reason behind this was “the corporate houses may either provide undue credit to their own businesses or may favour lending to their close business associates”. This is one of the big risks of allowing a large corporate/industrial house to run a bank.

2) As the Report of the Committee on Financial Sector Reforms (2009) had clearly said:

“The selling of banks to industrial houses has been problematic across the world from the perspective of financial stability because of the propensity of the houses to milk banks for ‘self-loans’ [emphasis added]. Without a substantial improvement in the ability of the Indian system to curb related party transactions, and to close down failing banks, this could be a recipe for financial disaster.”

While, the above report is a decade old, nothing has changed at the ground level to question the logic being offered. Combining banking and big businesses remains a bad idea.

3) Let’s do a small thought experiment here. One of the reasons why the government owned public sector banks have ended up with a lot of bad loans is because of crony capitalism. When a politician or a bureaucrat or someone higher up in the bank hierarchy, pushes a banker to give a loan to a favoured corporate, the banker isn’t really in a position to say no, without having to face extremely negative consequences for the same.

Along similar lines, if a banker working for a bank owned by a large corporate or an industrial house, gets a call from someone higher up in the hierarchy to give out a loan to a friend of a maalik  or to a company owned by the maalik, will he really be in a position to say no? His incentive won’t be very different from that of a public sector banker.

4) As Raghuram Rajan and Viral Acharya point out in a note critiquing the entire idea of large corporates/industrial houses owning banks: “Easy access to financing via an in-house bank will further exacerbate the concentration of economic power in certain business houses.” This is something that India has had to face before.

As the RBI Report of Currency and Finance 2006-08 points out:

“The issue of combining banking and commerce in the banking sector needs to be viewed in the historical perspective as also in the light of crosscountry experiences. India’s experience with banks before nationalisation of banks in 1969 as well as the experiences of several other countries suggest that several risk arise in combining banking and commerce. In fact, one of the main reasons for nationalisation of  banks in 1969 and 1980 was that banks controlled by industrial houses led to diversion of public deposits as loans to their own companies and not to the public, leading to concentration of wealth in the hands of the promoters. Many other countries also had similar experiences with the banks operated by industrial houses.”

This risk is even more significant now given that many industrial houses are down in the dumps thanks to over borrowing and not being able to repay bank loans. Hence, the concentration of economic power will be higher given that few industrial houses have their financial side in order, and they are the ones who will be lining up to start banks.

5) Another argument offered here has been that the RBI will regulate bank loans and hence, self-loans won’t happen. Again, this is an assumption that can easily be questioned. As the RBI Report of Currency and Finance 2006-08 points out: “The regulators temper the risk taking incentives of banks by monitoring and through formal examinations, this supervisory task is rendered more difficult when banking and commerce are combined.”

This is the RBI itself saying that keeping track of what banks are up to is never easy and it will be even more difficult in case of a bank owned by a big business.

6) The ability of Indian entrepreneurs to move money through a web of companies is legendary. In this scenario, the chances are that the RBI will find out about self-loans only after they have been made. And in that scenario there is nothing much it will be able to do, given that corporates have political connections and that will mean that the RBI will have to look the other way.

7) There are other accounting shenanigans which can happen as well. As the RBI Report of Currency and Finance cited earlier points out:

“Bank can also channel cheaper funds from the central bank to the commercial firm. On the other hand, bad assets from the commercial affiliate could be shifted to the bank either by buying assets of the firms at inflated price or lending money at below-market rates in order to effect capital infusion.”

Basically, the financial troubles of a large corporate/industrial house owning a bank can be moved to the books of the bank that it owns.

8) If we look at the past performance of the RBI, there wasn’t much it could do to stop banks from bad lending and from accumulating bad loans.  This is very clear from the way the RBI acted between 2008 and 2015. Public sector banks went about giving out many industrial loans, which they shouldn’t have, between 2008 and 2011. The RBI couldn’t stop them from giving out these loans. It could only force them to recognise these bad loans as bad loans, post mid-2015 onwards, and stop them from kicking the bad loans can down the road. So, the entire argument that the RBI will prevent a bank owned by a large corporate/industrial house from giving out self-loans, is on shaky ground.

9) Also, it is worth remembering that the RBI cannot let a bank fail. This creates a huge moral hazard when it comes to a bank owned by a large corporate/industrial house. What does this really mean? Before we understand this, let’s first try and understand what a moral hazard means.

As Alan S Blinder, a former vice-chairman of the Federal Reserve of the United States, writes in After the Music Stopped: “The central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains ( and incur costs) to avoid it. Here are some common non financial examples: …people who are well insured against fire may not install expensive sprinkler systems; people driving cars with more safety devices may drive less carefully.”

In the case of a large corporate/industrial house owned bank, the bank knows that the RBI cannot let a bank fail. This gives such a bank an incentive to take on greater risks, which isn’t good for the stability of the financial system.

As the Currency Report points out:

“The greatest source of risk from combining banking and commerce arises from the threat to the safety net provided under the deposit insurance and ‘too-big-to-fail’ institutions whose depositors are provided total insurance and the mis-channeling of resources through the subsidised central bank lending to banks. Because of the safety net provided, the firms affiliated with banks could take more risk with depositors’ money, which could be all the more for large institutions on which there is an implicit guarantee [emphasis added] from the authorities.”

Other than incentivising the other firms owned by the same large corporates/industrial houses to take on more risk in its activities, it also means that now the RBI other than keeping track of banks, will also need to keep track of the economic activities of these other firms. Does the RBI have the capacity and the capability to do so? 

10) Another argument offered in favour of large corporates/industrial houses owning banks is that they already own large NBFCs. So, what is the problem with them owning banks? The problem lies in the fact that banks have access to a safety net which the NBFCs don’t. RBI will not let a bank fail and will act quickly to solve the problem. And that is the basic difference between a large corporate/industrial house owning a bank and owning an NBFC. Also, the arguments that apply to large corporates/industrial houses owning a bank are equally valid in case of them owning NBFCs, irrespective of the fact that large corporates already own NBFCs. Two wrongs don’t make a right.

11) We also need to take into account the fact many countries including the United States, which has much better corporate governance than India, don’t allow the mixing of commerce and business. As the Report of the Committee on Financial Sector Reforms (2009) had pointed out: “This prohibition on the ‘banking and commerce’ combine still exists in the United States today, and is certainly necessary in India till private governance and regulatory capacity improve.”

The interesting thing is that in the United States, the separation between banking and commerce has been followed since 1787.

As the Currency Report points out:

“Banks have frequently tried to engage in commercial activities, and commercial firms have often attempted to gain control of banks. However, federal and state legislators have repeatedly passed laws to separate banking and commerce, whenever it appeared that either (i) the involvement of banks in commercial activities threatened their safety and soundness; or (ii) commercial firms were acquiring a large numbers of banks.”

Also, anyone who has studied the South East Asian financial crisis of the late 1990s would know that one of the reasons behind the crisis was allowing large corporates to own banks.

12) This is a slightly technical point but still needs to be made. Banks by their very definition are highly leveraged, which basically means the banking business involves borrowing a lot of money against a very small amount of capital/equity invested in the business. The leverage can be even more than 10:1, meaning that the banks can end up borrowing more than Rs 100 to go about their business, against an invested capital of Rs 10.

On the flip side, the large corporates/industrial houses have concentrated business interests or business interests which are not very well-diversified. Hence, trouble in the main business of a large corporate can easily spill over to their bank, given the lack of diversification and high leverage. This is another reason on why they should not be allowed to run banks.

13) As Raghuram Rajan and Viral Acharya wrote in their recent note: “One possibility is that the government wants to expand the set of bidders when it finally sets to privatizing some of our public sector banks.”

This makes sense especially if one takes into account the fact that in recent past the government has been promoting the narrative of atmanirbharta.

In this environment they definitely wouldn’t want to sell the public sector banks to foreign banks, who are actually in a position to pay top dollar. Hence, the need for banks owned by large corporates/industrial houses looking to expand quickly and willing to pay good money for a bank already in existence.

Given this, the government wants banks owned by large corporates/industrial houses in the banking space, so that it is able to sell out several dud public sector banks at a good price. But then this as explained comes with its own set of risks.

 

To conclude, the conspiracy theory is that all this is being done to favour certain corporates close to the current political dispensation. And once they are given the license, this window will be closed again. Is that the case? On that your guess is as good as mine. Nevertheless, if this is pushed through, someone somewhere will have to bear the cost of this decision.

As I often say, there is no free lunch in economics, just that sometimes the person paying for the lunch doesn’t know about it.

Aa gaya aa gaya halwa waala aa gaya, aa gaya aa gaya halwa waala aa gaya
— Anjaan, Vijay Benedict, Sarika Kapoor, Uttara Kelkar, Bappi Lahiri and B Subhash (better known as Babbar Subhash), in Dance Dance.