Banking on thin ice

Explicit condemnation of large defaulters welcome

The Reserve Bank of India (RBI) has taken an unusually aggressive stance on the issue of non-performing assets (NPAs), which is proving to be an extremely serious problem, particularly for public sector banks. In a scenario in which these banks will have to mobilise significant amounts of capital over the next four years, the last thing they need is the drain from internal accruals that providing for NPAs calls for. Further, raising capital from the market is going to be extremely challenging. Potential investors will view these banks as leaky buckets, with the bad assets significantly diluting their returns. Against this backdrop, the RBI's reported intention to impose constraints on the lending activities of banks with high levels of NPAs and restructured assets, which many analysts treat as NPAs, indicates a resolve to at least prevent the problem from getting worse. Coming on the heels of this were RBI Governor Raghuram Rajan's views on the default problems that banks face and the nefarious role that large and politically connected borrowers play in this.

However, while the hardening of the stance and the explicit condemnation of large defaulters misusing privilege and connections are very welcome, they do not in and of themselves provide a solution. The reality is that the asset quality problems of public sector banks are the consequence of several fundamental organisational and governance problems, which measures like restricting lending are not going to fix. On the organisational side, antiquated practices and processes, an inability to attract the best talent because of limits on compensation and attrition of talent for the same reason are critical challenges to creating competitive businesses. On the governance front, the constant pressure from "higher powers" to lend to specific sectors and individuals and to show tolerance for the kind of behaviour that the RBI governor criticised, the dodgy nominations of independent directors and the general inability of boards to exercise any meaningful oversight on the management - all point to massive inadequacies in the framework.

As things stand, the only available channel for new capital infusion is for the government itself to provide it. If the asset quality problems are not fixed, this will become an endless fiscal drain. On the other hand, if capital is not enhanced, the ability of a large segment of the banking system to lend to businesses will be undermined, thus threatening the nascent recovery. For the government, this is indeed a "damned if you do, damned if you don't" situation. Only a comprehensive reform of the system, tackling both organisational and governance issues simultaneously, will work. Three steps can be immediately signalled. One, the top tiers of bank managements must be selected by open competition, in which insiders will also be considered. Their compensation can be at levels that are currently offered to regulators. Two, say, five of the best banks must immediately raise capital from the markets, even to the extent of the government giving up its majority. This will preserve the system's capacity to lend. Three, there must be special scrutiny of large accounts, to ensure that patronage does not buy them leniency. Boards and their committees need to be strengthened and empowered to do this. Many more actions are required, of course. The threat of a hobbled banking system is very real.