PSB crisis: Strengthening India's banks

The government needs a clear vision for the future of India's banking sector, one in which state-owned banks play a smaller role

The Chinese and Indian economies have grown rapidly over the last decade. In China, this growth has been fuelled by a dramatic expansion of credit, up from 140 per cent of GDP in 2008 to 260 per cent today. Credit has also expanded in India over the last decade, but it started from such a low base that private sector debt is now only 86 per cent of GDP — less than half the average of advanced economies.
 
Given this difference, you might expect Chinese banks to be struggling with bad debt while Indian banks enjoy the stability that comes with slow credit expansion. In fact, things are the other way around. Many commentators suspect that the official non-performing loan ratio of 1.7 per cent understates the true extent of bad debt in China. A serious credit crisis may be looming in China.
 
But a credit crisis has already emerged in India, where the official non-performing loan ratio is 9.6 per cent and the ratio of “stressed assets”, which also includes restructured loans, is 14 per cent. Even at the height of the global financial crisis in 2008-10, non-performing loan ratios in Greece, Portugal and Italy did not reach this level.
 
The relatively small size of the Indian banking sector may spare the country from the kind of pain experienced in Ireland and Iceland during the global financial crisis. Nevertheless, the Indian banking sector is in urgent need of stabilisation and structural reform.
 
What’s gone wrong
 
India’s bad debt problem is concentrated in the public sector banks (PSB), though “concentrated” may be the wrong word, given that PSBs account for more than 70 per cent of total lending in India.
 

Step ahead: Once stabilised, India’s bank sector needs to be reformed to make sure that it contributes more effectively to economic development and at less cost to taxpayers. (Photo: Reuters)

The impaired loans are primarily to the corporate sector rather than households, with defaults arising from factors such as over-capacity, falling commodity prices and troubled infrastructure projects. The Reserve Bank of India is trying to bring problems into the open, having conducted an Asset Quality Review and enhancing the reporting of restructured assets. It has also asked banks to initiate forced bankruptcy proceedings against 12 large defaulters which, between them, account for 25 per cent of the banking system’s non-performing loans. A further 26 are scheduled for the same action in December if not resolved by then.
 
This high level of non-performing loans is eroding the ability of PSBs to retain earnings and is thereby damaging their capital positions. Under Basel III, banks must have capital ratios of at least 11.5 per cent by March 2019. Various analyst reports have recently estimated that to meet this standard, the PSBs will need to raise between $19 billion and $21 billion (a finding in line with our own estimates from 2016).
 
Immediate stabilisation
 
Given that the troubled banks are state-owned, a disorderly failure is extremely unlikely. Nevertheless, they must be recapitalised to the legally required level and this means somehow coming up with the $19 billion of capital required.
 
The government should resist the temptation to simply source this capital from its treasury. This would only increase its fiscal deficit while increasing the moral hazard in the PSBs. Rather, the required capital should be raised by selling non-core assets of the PSBs, such as the stakes they own in asset managers, general insurers and credit rating agencies. Combined with issuing new equity to the private sector (and thereby diluting the government’s equity) and making a temporary change to asset valuation rules, the required capital could be produced without any claim on the public purse — assuming there is no further deterioration in asset quality.
 
If the government wishes to provide some reassurance to the sector and its customers, it should consider guaranteeing bank assets, along the lines of the Asset Protection Scheme that the UK government used to stabilise RBS during the global financial crisis. The scheme was ultimately cash-flow positive for the government because RBS paid a premium for the guarantee and never claimed on it.
 
Structural reform
 
Once stabilised, India’s bank sector needs to be reformed to make sure that it contributes more effectively to economic development and at less cost to taxpayers. The best way to achieve this would be to drastically reduce the market share of state-owned banks. In many countries and over many decades, state-owned banks have shown a tendency towards poor risk management and misdirected lending.
 
Sometimes the problem is that lending decisions are guided by a political agenda rather than commercial logic. But even in the absence of this distortion, state-owned banks have less reason than private sector banks to be prudent lenders. The creditors of a PSB expect to be bailed out by the government if the bank fails. So they charge no risk premium when the bank’s lending becomes riskier, and the bank has no short-term financial incentive to limit its risk-taking. It is no surprise that the non-performing loan ratio of India’s private sector banks is less than half the non-performing loan ratio of its PSBs. There may be a role for state-owned banks to supply services that pure profit-seeking banks will not, such as, perhaps, micro business lending or major infrastructure project financing. And PSBs may also help to discipline the pricing of private sector banks. But these roles cannot justify PSBs accounting for 70 per cent of the market.
 
Privatisation would be the most direct way of reducing the dominance of state-owned banks, and they would have the secondary benefit of raising capital for the government to put to better uses.  However, they are likely to meet considerable political resistance, if only because PSBs employ hundreds of thousands of unionised workers.
 
A more gradualist approach, which the government may already be following by design or default, is to stifle the growth of PSBs while encouraging private sector development, as is happening with the liberal approach to granting new banking licences in India. Given the likely growth of India’s banking sector, this approach would not take long to reduce PSBs to less than half of the market.
 
But the approach taken is secondary to the goal. The government needs a clear vision for the future of India’s banking sector, and one in which state-owned banks play a smaller role. 

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Bergeron is a partner and Deshpande a principal in Oliver Wyman’s financial services practice, based in Mumbai