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Akash Prakash: Reflections on PSBs

Systemic reform of government-owned banks will ultimately have a huge positive impact on capital productivity in our economy

Akash Prakash

I had the opportunity to spend some time in India recently, meeting various stakeholders in the financial system. As always, the stress in public sector banks (PSBs) was the main topic of discussion. Opinion was mixed, with some asking how it matter what happened to the government-owned banks? They would simply go the way of other large public sector undertakings (PSUs) when faced with competition, wither away with time. Others argued that withering away was not an option, these banks were too large and systemically important, this is not an MTNL we are talking about, but 70 per cent of our banking system. Without the banks being able to lend how will we fund growth?

There were some clear takeaways however:

  • Most people felt we were on the verge of dramatic market share losses for PSBs. We have been seeing about a one per cent market share loss per annum, but most felt this would now accelerate to double or even triple that rate. The market share losses have been greater on the asset side, but many now expect that we will see a similar dynamic even on the liability franchise. In fact two or three private sector banks, when pushed as to why even today, in the digital age, they had aggressive branch opening targets, cited the need to gear up for this upcoming market share shift on liabilities. Given that private banks will need to provide a large share of incremental lending, one can argue that this market share shift on liabilities is needed to enable them to fund their lending expansion. Many of the banks we met had also mapped out the entire customer base of weaker PSBs, branch wise. They had clear targets of going after the higher quality customers, and serving their incremental funding requirements. They would cherry pick the most profitable relationships. If all this comes to pass, expect even greater strain on core PSU profitability.
     
  • Most investors have given up on the PSU space as being un-investable, pending a more credible plan for recapitalisation. Hence, the surge in valuation of both private banks and non-banking financial companies (NBFCs). I have already mentioned many times the valuation discrepancies in the space, with all PSBs combined having a lower market capitalisation than HDFC Bank. This has now extended to even the finance company space, with NBFCs having double the market cap. of PSBs. Clearly, investors are convinced that any financial institution that has adequate capital, competitive funding costs and the ability to originate and underwrite credit has a more or less free run to grow. Our economy should grow at 12-13 per cent nominally, with rising credit penetration, system credit growth should be upwards of 15 per cent, with 70 per cent of the system unable to grow more than 7-8 per cent, most well run financials can grow at 20-25 per cent. This simple logic has driven multiple expansions of all non-PSU financials.
     
  • Many players felt that we could support economic growth even with the PSBs in trouble and unable to lend. The bond markets were highlighted as having come of age. With macro stability, global appetite for Indian debt, even corporate paper was judged to be strong. New regulations being discussed by the Reserve Bank of India to limit borrower concentration and force large borrowers to access a minimum share of their incremental funding needs from non-bank sources, was also expected to force large corporate debt issuance. New liquidity ratio rules under Basel, would improve the attractiveness of corporate paper, with bonds meeting many of the regulatory criteria. Their weightage for regulatory purposes was poised to move from 10 per cent to 40 per cent, and broaden to include all types of corporate paper, not just financials. There was a feeling among many who had done the modeling that the combination of robust private bank and NBFC growth, combined with a healthy bond market and foreign flows was enough to fill the gap left by PSBs. This group did not see the stress in PSBs as hampering growth. There was, however, concern about the mix shift in lending. PSBs have a good small and medium enterprise (SME) franchise, they were in reality the true venture capitalists in our system. They were probably underpricing risk in this segment, to the benefit of SMEs. If they withdraw, how will millions of small businesses be able to access credit and at what cost? These SME's are not typically well covered by private banks. They will need to be funded by NBFCs, but at a higher cost. Eventually the small finance banks will fill the breach, but that is still a few years down the road.
     
  • All indications are that the PSBs are frozen, unable to lend, take risk or even move forward on settlements because of fears on vigilance and witch hunts. Barring the State Bank of India and Bank of Baroda no other PSB seems to be willing to take a decision. This is slowing down the resolution process and also hampering efforts to resuscitate viable but stressed assets. Proposed moves by the Bank Board Bureau to create a mechanism to provide vigilance cover for these banks and their managements to take decisions are eagerly awaited and much needed. There was a feeling that once this new mechanism is in place, we will see many more instances of asset sales and balance sheet restructuring.
     
  • There was positive feedback on the new bankruptcy code. International investors rated the bill eight on 10, saying it had everything they wanted. It will, however, take about two years to be fully functional. Numerous new institutions and specialist service providers will need to be created. Investors will be closely watching the implementation.
     
  • There was positivity around the Bank Board Bureau. It was trying to understand banks' genuine problems, seemed to have the political backing needed and was keen to move quickly. The board was also clearly trying to address longer-term systemic issues and not focus on short-term band aids. They were trying to bring in new talent, improve the incentive structure for current employees and ensure that decision-making was not impaired. There was also a clear sense that political interference had ceased completely under the new regime. It was also apparent that there was no political appetite to try and bring the government stake below 51 per cent in these banks. The banks would be forced to sweat and monetise assets, sell holdings, etc, but the 51 per cent was a binding constraint. The hope was that for the better banks, we can bring about enough change and clean up to allow them to do rights issues at a reasonable price and thus optimise the money set aside by the government.
     
  • On the asset quality review, most felt that it was a good thing as it brought out the problems in the open. The feeling is that the bulk of the problems have been recognised. It has also galvanised a sea change in promoter behaviour.
Thus, a mixed picture emerges. There are huge opportunities for the private players, real constraints for government banks, but a hope that we can fund our growth irrespective. This is a work in progress. Efforts seem to be underway to address some of the challenges, but the constraints are real. This is a real mess. For most PSBs, 15-20 per cent of their loan book is challenged. Systemic reform here will ultimately have a huge positive impact on capital productivity in our economy.

The writer is at Amansa Capital. These views are his own