To fix mess in banking, admit the problem first

Banks reflect the health of an economy. When they prosper, all is well. But there are many things that could go wrong. Banks’ rising bad debts reflect on their balance sheets. In the old days, this led to a bank shutting down. But now they are supported by money from the government, which helps them survive but even though they survive, they put a strain on the fiscal deficit.

The recent fraud by Nirav Modi and his uncle Mehul Choksi resulted in a loss of over Rs 12,000 crores to Punjab National Bank. Further, dubious dealings in two leading private sector banks have led to huge losses, raising doubts over the roles played by their CEOs. These banks have been in a far more precarious situation because of the loans they have disbursed.

The PNB fraud is particularly disturbing for the BJP because of Nirav Modi’s proximity to Prime Minister Narendra Modi and his close association with the party. Nirav Modi was even a part of the official Indian delegation during the Prime Minister’s trip to Davos, Switzerland, to attend the World Economic Forum meeting earlier this year. This fraud put the tag of incompetence and corruption on nationalised banks, but the alleged corruption at two large and reputed private banks — ICICI Bank and Axis Bank — that followed the PNB fraud took the heat off the nationalised banks,

The problems at ICICI Bank and Axis Bank, with the diversion of depositors’ money to a favoured few, show that private sector banks are not immune from the problems of bad lending.Privatisation, without strengthening regulatory controls and improving governance, will neither prevent fraud nor curtail undue exposure to risk. We must remember that it was the reckless approach to risk-taking by large private sector banks that ultimately led to the collapse of Lehman Brothers in 2008 and exacerbated the global financial crises.

Though the actions of bank officials are crucial to keep public money safe and evaluate the loan requests (to ensure that loans can be paid back), it takes much more than this to keep the banks’ functioning smooth, and this includes the prospects of the world economy and various industries within it. Small failures do happen and they are expected too, and it is only when the failures cross a limit that the worry begins.

According to a September 2016 report by investment banker Credit Suisse, the health of corporate balance sheets in India remains poor and they barely earn enough to cover their interest payments. The report says 39 per cent of the debt is with companies not able to cover their interest payments. Among the poorly performing companies are metal and power companies, but while the situation of the metal companies has improved, the power sector still remains in the dumps. In an earlier report, Credit Suisse had maintained that the country’s 10 largest debtors owed the banks Rs 6.3 trillion (or lakh crores), which is about as large as the total fiscal deficit of the government, and this accounts for 13 per cent of all bank loans.

The difference is that while the likes of Nirav Modi used fraudulent means to rob the banks and the public, these companies were borrowing money for legitimate business purposes but were unable to honour their commitment to pay back the loans. The loans were largely taken when the economy was strong, such as during the period of high growth between 2004 and 2010. Large investments were made in power, steel and other infrastructure projects based on large bank borrowings. During the first decade after economic liberalisation (from 1991-92 to 2001-02), the bank credit-to-GDP ratio expanded from 19 per cent to about 25 per cent. In the next decade, that includes the boom period, this ratio more than doubled; from 25 per cent it reached 52 per cent.

This was the period that saw some of the highest GDP growth rates for the country. When the downturn happened, the government rushed in with a fiscal stimulus. This pushed up the fiscal deficit from four per cent of GDP in 2007-08 to 9.3 per cent in 2009-10, unleashing inflation but providing no relief to those wallowing in debt. Gross non-performing assets (NPAs) or bad debts increased to 10.2 per cent in September 2017. That was when the Reserve Bank cautioned against further deterioration, as it feared that gross NPAs could inch up to 10.8 per cent by March 2018. With bank loans forming over half the GDP, these NPAs would be about five per cent of GDP, a heavy price for the country to pay.

The sharp rise from 1.1 per cent of non-food credit in 1998 to 15.4 per cent by 2015 led to a buildup of bad loans and stranded assets. The new NDA government allowed the loans to grow, using bank funds to plug its investment deficit. It did not invest in vital infrastructure projects as part of the budget, leaving these to friends in the private sector.

So while low state investment reduced the deficit, huge amounts put in to recapitalise banks (around $19 billion to $21 billion) did the opposite, and increased the deficit.

What the government seems to be doing is trying to show that the fiscal deficit is not as bad as it may appear, and that it can be managed better by having a smaller rescue package for the banks. But all the fibbing about the state of the banking system only dodges the issue.

India has faced many banking crises. Hundreds of banks had shut down in the 1930s and 1940s.

The country is now in the middle of its third banking mess in three decades, and those in charge of economic policy are avoiding taking the hard, but necessary, decisions.

If the banking system breaks down, we will have to forget about rapid growth, and the fight against poverty may have to be severely compromised.