Banks with impaired assets are just leaky buckets

The intent to infuse more capital into banks is risky move without clarity over balance sheet problems

Over the past few days, concerns over the state of bank balance sheets have intensified. First, Axis Bank declared that its asset quality problem was worse than previously indicated, causing its stock price to decline sharply. Soon after, Indian Overseas Bank showed a very large year-on-year decline in its quarterly profits, again leading to a massive fall in its stock price. While the general state of banks is well known and has presumably been discounted by investors, unanticipated signals even from a small number of banks that the situation might be worse than previously believed could have implications for the system as a whole. If markets begin to distrust financial declarations, banks will find it increasingly difficult to raise funds. As it is, credit growth is at an abysmally low rate, which is only partly explained by the moderation in inflation. The situation will only worsen if banks are unable to mobilise more funds. The recovery that some sectors are seeing could easily be choked off by a credit squeeze.

A number of things need to be done urgently. Many of the actions proposed in the Indradhanush programme are appropriate responses to the problem, but the time they may take and the magnitude of the action could dilute their impact. Two aspects of the problem need to be addressed with urgency. The first is, of course, a clear and transparent assessment and communication of the problem. Official numbers on non-performing assets are being questioned by an increasing number of observers; this is a clear manifestation of distrust. The problem is that everyone will make their own assessments, so no clear picture emerges. It would be in everybody's best interests for judgements to be made on the basis of common knowledge and understanding. The opacity problem has been compounded by the relaxation in disclosure norms made for infrastructure projects. Postponement would have made some sense if a solution were to be found in the meantime. But, that has not happened; inevitably, these exposures have to be classified as bad assets at some point. The government should make a worst case assessment and make it public as a first step to rectifying the situation.

Second, the intent to infuse more capital into banks, even if it is based on performance, is a hugely risky move without full transparency. Apparently well-performing banks may suddenly show themselves to be worse than reported. Any move to re-capitalise the banks should only be made once full transparency is achieved and, beyond that, a process of transferring these assets to appropriate institutions, with fairly distributed haircuts is initiated. As long as banks carry impaired assets, both known and unknown, on their books, they are leaky buckets and more capital is going to be wasted. The long-term capacity of banks to provide funds to their traditional borrower segments will be compromised and, in turn, this will become another noose around the neck of the growth momentum. There has to be a sense of urgency about this; Indradhanush on steroids. Many observers are beginning to list this problem on the top of their lists of what is wrong with the economy. The old management dictum "what does not get measured, does not get managed" is particularly appropriate here. (Disclosure: Kotak Mahindra and associates are significant shareholders in Business Standard Limited.)