Why this may be time to thoroughly redesign Indian banking system

Lately, India's banking system has been beset by a bad debt crisis, which is crimping credit to productive sectors, dampening domestic investment and leading to subdued employment and GDP growth

Banks are the pillars that support the financial architecture of a modern economy. Their successes and failures are inextricably linked to those of the entire economy. There is a general belief that the Great Recession of 2008 was precipitated by the events which hobbled major banks of the US. Indian banks have also had their share of problems with consequences for the country as a whole.

Bank runs, bad debt, etc, are some of the chronic problems faced by banking systems across the world. Regulatory interventions and oversight of central banks, government support and shareholder activism have been broadly successful in maintaining stability, though punctuated with glaring failures.

In recent times, the Indian banking system has been beset by a massive bad debt crisis, which is crimping credit to the productive sectors of our economy. This weakening in bank credit has dampening effect on domestic investment, leading to subdued growth in employment and GDP. Therefore, it may be an appropriate time to rethink the basic design of the banking system and restructure it by addressing the flaws in its current structure.

In very broad terms, traditional banks have three core functions — acting as financial ‘investment’ vehicle for savers by accepting deposits, as credit supply vehicle for businesses by lending (including bill discounting and provision of working capital), and providing liquidity to facilitate transactions in economy by setting up a payment system. Traditional banks have combined these three functions as integrated behemoths. Further, balance sheets of Indian banks are often deeply intertwined due to substantial crossholding of their financial instruments. Therefore, any distress in an important bank causes panic due to the possibility of contagion also afflicting other banks. The latter might lead to a full-blown financial crisis, causing a terrible credit squeeze for the economy as a whole. This scary prospect forces public authorities to bail out weak banks, which is a burden on the taxpayer. It also provides perverse incentives (moral hazard) for bankers, as they know that their flanks are covered by public money.

After the introduction of implicit or explicit deposit insurance backed by the government, bank runs have mostly become a non-issue. Today, the genesis of most problems of banks lies in bad debt related to poor lending decisions, adverse macroeconomic conditions, flaws in legal system, political factors, etc.

This article will focus on the steps that can improve the quality of lending decisions, as it is a factor mainly dependent on the structure of the banking system. It is pertinent to note that a majority of lending decisions are made by bank officials who usually have no specialised knowledge or experience of the sector to which the borrowing firm belongs. The same credit committee may decide on loans to a textile unit, a leather factory, a township development project, among others. As expected, this often leads to sub-par credit appraisal of proposals. A system of lending under which loan proposals are processed by agencies and individuals having specialised knowledge and experience of the sector to which the borrowing unit belongs would possibly lead to better project selection and lower chances of bad debt in future. Moreover, deposit mobilisation by traditional integrated banks provides a very limited set of risk-return combinations to savers, with no choice about the sectors to which the credit is to be provided. In view of the above, it is proposed that the banking system be broken up into two separate parts.

Firstly, a payment bank system dedicated to facilitating transactions in the economy may be established. The deposits accepted by a payment bank would be for clearing transaction requests only and would be redeemable on demand. Such deposits should not be allowed to be used by the payment bank for lending or investment purposes. Such payment banks should not be permitted to pay any interest on outstanding deposits. The payment banks may be allowed to compete on the service charges to be paid by depositors on payment clearances. Paytm is a good example of such a rudimentary ‘payment bank’ taking shape.

Secondly, mobilisation of savings in the form of interest bearing deposits may be done by a cornucopia of sectoral banks representing a spectrum of risk-return combinations corresponding to various sectors like tourism, steel, education, etc. Some of the sectoral banks may specialise in government securities to cater to the savers who place a very large premium on ‘safe returns’. This will better serve idiosyncratic individual preferences of specific risk-return combinations as well as sectoral preferences.

Moreover, managers of sectoral banks can be expected to have specialised knowledge and experience of the sector to which they are lending. That would reduce the amount of bad debt in future by improving the quality of their lending decisions. Further, a low-capital-productivity sector (low marginal product of capital) would sustain a low sectoral lending rate, which would correspond to a low sectoral deposit rate, which in turn would lead to lower deposit mobilisation for that sector. Thus, capital allocation to sectors would correspond to their capital productivity, improving the allocative efficiency of capital through the banking system.

Furthermore, the central bank, or more appropriately the monetary authority, may engage in open-market operations with some of the larger sectoral banks by sale/purchase of securities, provision of reserve facility, discounting of pre-maturity assets, etc, to execute its monetary policy. Currently, the monetary authority aims to match the aggregate money supply growth with growth in the real economy at the aggregate level. This leads to sectoral mismatches causing either sectoral inflationary pressures or constriction of sectoral real growth. If the monetary authority undertakes open-market operations with sectoral banks, it would lead to better calibration of sectoral real growth with the money (credit) supply to the sector. It would improve inflation targeting by the monetary authority.

Further, traditional integrated banks, with inter se cross holdings, have footprints across a large number of sectors and their failure causes a widespread domino effect in many segments of the economy. Sectoral banks would be limited to their sectors only, so failure of sectoral banks would be more limited in its domino effect. This would reduce the need to bail them out.

As a counterpoint, it may be said that traditional integrated banks, lending to multiple sectors, provide the benefit of diversification to retail savers. However, any saver can easily diversify, in accordance with personal preference, by choosing a basket of saving units belonging to various sectoral banks. In fact, it is easily foreseeable that in due course the financial market would respond to such demand for diversification by providing a ‘deposit of sectoral deposits’, which would diversify by investing in a pre-defined basket of saving units of sectoral banks.

To sum up, the Indian banking system is perennially troubled by the problem of bad debt caused, inter alia, by poor lending decisions of bankers lacking sectoral knowledge and experience. Separating payment segment into a distinct domain, and then breaking up the deposit-lending segment of banks into sectoral banks with a spectrum of risk-return combinations may improve the quality of lending. A pertinent point to note is that the banking system is already taking tentative steps in the direction outlined above. However, faster and decisive transformation towards a better banking system can be brought about by internalising the arguments mentioned above. It is about time that some serious thought was given to explore the possibility of radically overhauling the banking system along the lines suggested above.

The author is Deputy Secretary, Cabinet Secretariat, Government of India. Views expressed are personal)