No more Rajagopals

R Gandhi, one of the deputy governors of the Reserve Bank of India (RBI), gave a very interesting speech titled Indian PSU Banking Industry: Road Ahead in Kolkata last week.
As a part of the speech he presented a table (a part of which is reproduced below) which shows how public sector banks (PSBs) are lagging behind their new generation private sector counterparts, on all parameters. 

 Public sector banks New generation private sector banks 
Return on Equity 16.5515.319.7115.3816.8117.06
Return on Assets
Net Profit Margin
Net Interest Margin 2.842.642.483.223.463.56
Staff Expenses / Total Income 10.7410.4810.998.978.397.96
Source: Reserve Bank of India

The new generation private sector banks generate better returns for their shareholders, operate at better margins and surprisingly even have a lower staff cost as a proportion of the total income they make, in comparison to public sector banks.
While one expects these banks to have done better than public sector banks, when it comes to returns to shareholders as well as operating margins, one did not expect them to have lower staff expenses as a proportion of their total income. That indeed is a major surprise.
There are multiple reasons for this difference in performance. First and foremost, private banks do not have to deal with political pressure to make loans to favoured individuals and companies.
Take the case of Lanco Infratech, a company, whose founding chairman Lagadapati Rajagopal was a member of the last Lok Sabha from the Congress party. This company, as on March 31, 2014, had total loans amounting to a whopping Rs 34,877 crore. Against this the company had an equity of only Rs 1,457 crore, meaning a debt equity ratio of 24:1.
To put in a simple way, the situation is similar to you and I approaching a bank for a home loan for a home priced at Rs 50 lakh. The bank agrees to give us a home loan of Rs 48 lakh and we need to put in only Rs 2 lakh from our end(which is essentially what equity is) to buy the home. This would mean a personal debt equity ratio of 24:1.
Of course, no bank would do this and would ask for a downpayment of at least 20% of the home price or Rs 10 lakh in this case. But public sector banks did not operate in a similar way when it came to giving out loans to crony capitalists. Crony capitalists got away without putting much of their own money at risk.
And the public sector banks are paying for the same now. The financial stability report released by the Reserve Bank of India (RBI) late last month put the stressed advances of public sector banks at 12.9% of their total loans. For private sector banks the same number was at 4.4%.
The financial stability report further points out that: “Among bank groups, exposure of public sector banks to infrastructure stood at 17.5 per cent of their gross advances as of September 2014. This was significantly higher than that of private sector banks (at 9.6 per cent) and foreign banks (at 12.1 per cent).” It is well known that many crony capitalists in India operate in the infrastructure sector. The higher exposure to this sector has led to higher stressed advances as well.
Interestingly, the government conveyed to the public sector banks at a recent retreat in Pune that it would not interfere in their commercial decisions.
“The banks/financial institutions should take all commercial decisions in the best interest of the organization without any fear or favour,” the government said.
If the government sticks to this decision the performance of public sector banks is bound to improve in the days to come. India does not need any more Lanco Infratechs and its Rajagopals. As RBI governor Raghuram Rajan put it in a recent speech, India is “a country where we have many sick companies but no “sick” promoters.” If public sector banks need to do well this needs to be corrected in order to ensure that big business does not take them for a ride in the years to come.
It needs to be pointed out here that employees of public sector banks are selected through highly competitive exams and they are not any lesser than their private sector counterparts. Hence, they have the ability required to figure out which loans to give and which to avoid, if they are allowed to operate on their own without any political interference.
Nevertheless, public sector banks need to put a proper performance appraisal system in place, something that their private sector counterparts already have. As RBI deputy governor Gandhi said in his speech: “The Performance Appraisal System (PAS) needs a complete revamp. Currently the PAS makes no meaningful distinction between individuals for identifying or deploying talent, skills and / or specialisation; nor does it guide determining compensation.”
In fact, stock options play a very important role in retaining and motivating managerial talent to perform better at new generation private sector banks. The government needs to seriously take a look at introducing stock option plans linked to performance, in public sector banks as well.
Further, the government currently owns 25 public sector banks (which includes the State Bank of India and its five associates). There is no reason as to why the government should own 25 banks. It is time that the government got around to selling at least 15 of the smallest banks. That would leave five big banks and SBI and its associates.
The money thus generated could be used to fund a part of the public infrastructure that India badly requires. This topic is a political hot potato and sooner the government starts work on it, the better it is going to be for it.
This will also save the government from another major headache. The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.”
This is not exactly a small amount and by selling 15 banks this won’t totally be government’s headache any more. Further, by concentrating on the largest banks, the government can ensure that these banks are better capitalized in the days to come and can strongly work towards government’s projects like financial inclusion.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article originally appeared in the Daily News and Analysis on Jan 20, 2015

Crony capitalism: The truth about Indian banking is finally coming out

indian rupeesVivek Kaul  
One of the well kept secrets about the fragile state of the Indian economy is gradually coming out in the open. The Indian banks are not in great shape. The Financial Express reports that the chances of a lot of restructured loans never being repaid has gone up. It quotes R K Bansal, chairman of the corporate debt restructuring (CDR) cell, as saying that the rate of slippages could go up to 15% from the current levels of 10%. “The slower-than-expected economic recovery and delayed clearances for projects will result in a higher share of failed restructuring cases,” Bansal told the newspaper.
When a big borrower (usually a company) fails to repay a bank loan, the loan is not immediately declared to be a bad loan. The CDR cell is a facility available for banks to try and rescue the loan. Loans are usually restructured by extending the repayment period of the loan. This is done under the assumption that even though the borrower may not be in a position to repay the loan currently due to cash flow issues, chances are that in the future he may be in a better position to repay the loan. Or as John Maynard Keynes once famously said “
If you owe your banka hundred pounds, you have a problem. But if you owe a million, it has.” 
As of December 2013, the CDR cell had restructured loans of around Rs 2.9 lakh crore. Of this nearly 10% of the loans have turned into bad loans with promoters not paying up. Bansal expects this number to go up to 15%. Interestingly, a Reserve Bank of India (RBI) working group estimates that nearly 25-30% of the restructured loans may ultimately turn out to be bad loans.
And that is clearly a worrying sign. There is more data that backs this up.
 In the financial stability report released in December 2013, the RBI estimated that the average stressed asset ratio of the Indian banking system stood at 10.2% of the total assets of Indian banks as of September 2013. It stood at 9.2% of total assets at the end of March 2013.
The average stressed asset ratio is essentially the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. What this means in simple English is that for every Rs 100 given by Indian banks as a loan(a loan is an asset for a bank) nearly Rs 10.2 is in shaky territory. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank).
The RBI financial stability report points out that this has happened because of bad credit appraisal by the banks during the boom period. “It is possible that boom period[2005-2008] credit disbursal was associated with less stringent credit appraisal, amongst various other factors that affected credit quality,” the report points out. Hence, borrowers who shouldn’t have got loans in the first place, also got loans, simply because the economy was booming, and bankers giving out loans felt that their loans would be repaid. But that hasn’t turned out to be the case.
Interestingly, Uday Kotak, Managing Director of Kotak Mahindra Bank recently told CNBC TV 18 that the current stressed, restructured or non performing loans amounted to nearly 25% of the Indian banking assets. He put the total number at Rs 10 lakh crore of the total loans of Rs 40 lakh crore given by the Indian banking system. This is a huge number.
Kotak further said that the Indian banking system may have to write off loans worth Rs 3.5-4 lakh crore over the next few years. When one takes into account the fact that the total networth of the Indian banking system is around Rs 8 lakh crore, one realizes that the situation is really precarious.
Interestingly, a few business sectors amount for a major portion of these troubled loans. As the RBI report on financial stability points out “There are five sectors, namely, Infrastructure, Iron & Steel, Textiles, Aviation and Mining which have high level of stressed advances. At system level, these five sectors together contribute around 24 percent of total advances of SCBs (scheduled commercial banks), and account for around 51 per cent of their total stressed advances.”
So, five sectors amount to nearly half of the troubled loans. If one looks at these sectors carefully, it doesn’t take much time to realize these are all sectors in which crony capitalism is rampant (the only exception probably being textiles).
Take the case of L Rajagopal of the Congress party (who recently used the pepper spray in the Parliament). He is the chairman and the founder of the Lanco group, which is into infrastructure and power sectors. As Shekhar Gupta
 pointed out in a recent article in The Indian Express, Rajagopal’s “company got a Rs 9,000 crore reprieve in a CDR (corporate debt restructuring) process just the other day. His bankrupt companies were given further loans of Rs 3,500 crore against an equity of just Rs 239 crore. Twenty-seven banks were involved in that bailout.”
Here is a company which hasn’t repaid loans of Rs 9,000 crore. It benefits from the restructuring of those loans and is then given further loans worth Rs 3,500 crore. So, if the Indian banking sector is in a mess, it is not surprising at all.
As bad loans mount, banks will go slow on giving out newer loans. They are also likely to charge higher rates of interest from those borrowers who are repaying the loans. This is not an ideal scenario for an economy which needs to grow at a very fast rate in order to pull out more and more of its people from poverty. If India has to go back to 8-9% rate of economic growth, its banks need to be in a situation where they should be able to continue to lend against good collateral.
So is there a way out of this mess? A suggestion on this front has come from Saurabh Mukherjea from Ambit. He suggests that the bad assets be taken off from the balance sheets of banks and these assets be moved to create a “bad bank”. This would allow the good banks to operate properly, without worrying about the bad loans on its books. As he writes “This would, in effect, nationalise the bad assets of the Indian banks and the taxpayer would have to bear the burden of these sub-standard loans.”
The government had followed this strategy to rescue Unit Trust of India (UTI). All the bad assets were moved to SUUTI (Specified Undertaking of the Unit Trust of India). The good assets were moved to the UTI Mutual Fund, which has flourished over the years. The government also has gained in the process.
The trouble here is that even if the government does this, there is no guarantee that it might be successful in reining in the crony capitalists. Over the last 10 years crony capitalists like Rajagopal, who are close to the Congress party, have benefited out of the Indian banking system. Given this, it is but natural to assume that after May 2014, the crony capitalists close to the next government (which in all likeliness will be led by Narendra Modi) will takeover. And that is the real problem of the Indian banking sector, for which there can be no solution other than a political will to clean up the system.
The article originally appeared on on February 25, 2014

 (Vivek Kaul is a writer. He tweets @kaul_vivek)