Investigations and a blame game have begun about Kingfisher Airlines. Similar problems are likely to unfold in numerous other loans which have gone bad, particularly when the losses there are much larger than what was seen in Kingfisher Airlines. The governance and regulation of banks is what failed. We have not learned the lessons - for eg, on March 17, Reserve Bank of India (RBI) has come out with a corporate debt restructuring (CDR) scheme for micro, small and medium enterprises (MSME) which has worse design features than the original CDR. We need reforms.
Where did we go wrong with Vijay Mallya? Banks seem to have made mistakes in credit appraisal, and on the valuation of collateral and the brand name. RBI is the regulator of banks, and is supposed to write regulations which ensure safety and soundness of banks. Partly, these regulations were technically unsound, and did not push banks towards the right path. Partly, RBI's inspectors failed to see the problems inside banks when inspections took place.
The essence of recoveries from a failing company is rapid action. The essence of banking regulation is to force banks to confront bad news, and recognise losses early. However, RBI's banking regulation has consistently been motherly towards banks, and delayed action. This intellectual failure is the essence of India's banking crisis. If banks had pulled the plug on Kingfisher Airlines early on, the recoveries would have been larger. The regulatory philosophy of 'extend and pretend', and the lack of technical finance knowledge on bank fragility, is the heart of the problem.
RBI's systems like CDR, strategic debt restructuring (SDR), wilful defaulters, etc, have all been weak on the foundations of the rule of law. This lack of concern for the rule of law will now have consequences. An array of investigation agencies are now going into failed transactions. The Central Bureau of Investigation started working on Kingfisher Airlines in July 2015, and has registered 10 FIRs involving banks.
When faced with investigative agencies, bankers will legitimately respond by describing the governance, regulation and supervision which shaped their decisions. As an example, Sangita Mehta, Saloni Shukla and Anirban Chowdhury, writing in the Economic Times on 14 March, report that bankers viewed the decision by RBI in 2010 to include the aviation industry in CDR "as a signal to lenders that they should extend more loans to shore up Mallya's ailing carrier."
Kingfisher Airlines is a tiny problem when compared with the overall banking crisis. The overall scale of bad loans in Indian banking is perhaps 100 times bigger than this. Banks, RBI and Department of Financial Services (DFS) have to gear up for investigation agencies looking into these losses.
RBI has, as yet, not changed course. As an example, on March 17, RBI has come out with a CDR framework for MSMEs. This is a less transparent version of CDR with reduced checks and balances. Banks will now be able to freely hide bad news about their MSME exposures. It would have helped to think two moves ahead. What will happen to the equity value of banks, when shareholders are told that banks now have a greater ability to hide bad news for their MSME portfolio? And, with the first wave of inquiries coming in from CBI/CVC/CAG, will the behaviour of front line staff in RBI and banks change?
How will this unfold, and what should policymakers do different? If things proceed in the present direction, Indian banking is in for a long bleak period. Investigations will kick off fear and block rational thinking about existing bad loans. RBI and banks have woken up and understand the inadequate equity capital in banks. There will be extreme risk aversion, and slow growth of bank credit, for years.
As yet, there is no coordinated strategy between the finance ministry and RBI that adequately deals with the banking crisis. The private sector sees the problem, and sees the lack of a strategy. This exerts an adverse impact upon share prices of banks, and on the outlook for India in the eyes of the private sector.
What is to be done? A team is needed at the finance ministry which will work on this problem. The composition of this team has to command respect. The first job for the team is to make estimates about the magnitude of the problem, and to communicate them to the world. A combination of knowledge and honesty will engender trust.
The implementation of the bankruptcy code needs to take place at full speed, alongside dismantling failed RBI frameworks like SDR or wilful defaulters. The implementation of the Resolution Corporation (RC) needs to take place at speed, so as to achieve the institutional capacity to deal with at least small private bank failures. The Financial Stability and Development Council (FSDC) needs to be built out as an institution at speed, so that it will have a team which will war-game crisis scenarios that can abruptly arise, and respond to systemic crises if they arise.
In the US and the UK, the Lehman crisis was accompanied by fundamental legislative reforms about financial regulation. A similar work program is required here. The problems that we see today were anticipated by one decade of expert committee reports, so the blueprint for building a capable RBI is at hand.
The liability of the government on account of public sector banks is unlimited. Medium-term fiscal planning is required, based on estimates about the size of the hole in banks. Is this a good use of public money? Each Rs 1 lakh crore can make 10,000 kilometres of expressways. The Bharatiya Janata Party can use its majority in the Lok Sabha to enact a money Bill which amends the Bank Nationalisation Acts.
The private sector will suffer from a sustained drag on access to bank financing while these problems are being sorted out. The world over, the bond market has been a 'spare tyre' when there are problems in banking. We need to construct the Bond-Currency-Derivatives Nexus at full speed in order to reduce the damage.
The writer is a professor at National Institute of Public Finance and Policy, New Delhi