A Ring Around Weak Banks

In systems where ownership of banks is predominantly in the private sector, the objective of the authorities is not to prevent all bank failures but to avoid systemic problems. Where the government is the predominant owner, a complacency develops that the owner is Too Big to Fail and given this false sense of immortality glaring losses tend to get mitigated. Moreover, for fear that private sector bank failures would spread to weak public sector banks, even private sector banks have not been allowed to fail in India after the famous Palai Central Bank failure in 1960.

With the introduction of more stringent prudential norms in 1992, the balance sheets of banks have been required to be more transparent and the government injected huge capital into public sector banks.

 

In a lecture in 1993, I had argued that in the same environment some banks have performed well while others have performed badly, and this is largely attributable to bank management. The strategy for recovery of weak banks set out by me had the following ingredients: First, the loyalty of core depositors is strong while borrowers are fickle; thus weak banks should concentrate on better customer service for their depositors. Secondly, weak banks should reduce their credit-deposit ratio (C-D ratio) to well below the national average. A high level of non-performing assets (NPAs) is symptomatic of poor credit management. Thirdly, weak banks should concentrate on raising their investment-deposit ratio as improving investment skills is easier than improving credit management. Fourthly, a selective closure of branches should be considered. Lastly, weak banks must recognise that their standard of living has to come down. A culture of self-abnegation has to be evolved by the top management which would then trickle down.

Between March 1993 and January 1997, 10 weak public sector banks which account for 20 per cent of the system increased their deposits from a little less than Rs 58,000 crore to a little over Rs 94,000 crore, an increase of about 63 per cent while the systems deposits increased by 77 per cent; of these weak banks, five banks had deposit growth rates equal to or higher than the system. The 10 weak banks should be subject to a stringent regime of liability control. In its radical form `incremental liabilities should be subject to 100 per cent reserve requirements and as such these banks should operate as what are called narrow banks. If the weak public sector banks had operated as narrow banks, over Rs 35,000 crore of additional deposits would have been protected. Increasing liabilities and credit at a brisk pace enables weak banks to show a deceptively lower NPA percentage as fresh loans are automatically treated as standard assets, while if fresh liabilities and lending in low, or in extreme cases nil, there

would be a clearer picture as to the NPAs.

The government has gone far beyond the call of duty to have provided so much to the public sector banks by way of recapitalisation. The government should now put an end to further recapitalisation and not respond to whining by weak banks that actual losses have been concealed. Weak banks need to recognise that the days of a monolith public sector banking system are over and employees of weak banks cannot expect to piggy-back on the well functioning public sector banks for purposes of emoluments and facilities. In todays competitive world it would be imprudent to pace the development of public sector banking on the basis of a lowest common multiple.

In the absence of clear financial statements, the lack of uniform reporting and the absence of serious penalties for inaccurate reports to supervisors, healthy banks are indistinguishable from unhealthy ones.

An attempt is made here to set out a strategy for dealing with weak banks in India. Banking cannot escape from the Darwinian principal of survival of the fittest. Concerted efforts must be made to put in place a vigorous policy of damage containment and an excoriating of the malaise which causes sickness in banks. I have, on earlier occasions, argued that we should put a ring around the weak banks. In essence, what this would mean is that there should be a cap on the growth of liabilities of these banks and there should also be severe curbs on their lending. The supervisory regime for these banks should be rule-based with corrective action being mandated with progressively more stringent liability control as the capital adequacy ratio (CAR) falls. If the CAR falls to 6 per cent the banks liability should grow at a rate not exceeding one-half of the rate anticipated for the system and the liability growth stipulation should be reduced to nil as the CAR falls to 3 per cent, and such banks should not be allowed to accept certificates of deposits.

Furthermore, for banks whose CAR is below 8 per cent, their credit growth should not be allowed to exceed one-half of the industry average and once the CAR falls below 6 per cent there should be a total cessation of credit expansion and such banks should become narrow banks. Supervisors should prescribe corrective action well before the problems manifest in lower CARs. Higher risk weights should be prescribed if the interest rate on advances of a bank is above the industry average reflecting the moral hazard problem of adverse selection resulting in more risky lending. Foreign exchange operations carry far greater risks and banks whose CAR falls below 6 per cent should be required to phase out their foreign exchange operations.

It would be a misadventure to follow the route of an asset reconstruction fund either for the industry as a whole or for an individual bank. Such gimmicks will not help recovery of loans.

The supervisors should make public, each quarter, an assessment of banks which have problems and there is great merit in reducing the extent of secrecy. Furthermore, each bank should be required to prominently display at each branch a summary note of one or two pages, approved by the supervisory authority, setting out in laymans terms, information on branch profitability, bank capital, impaired assets, provisioning and exposures. The statement should be such that the depositor can easily understand the overall performance of the bank and the risks to depositors. In this context, Indian supervisors would do well to study the disclosure systems in Chile and New Zealand.

We should avoid the temptation to dilute norms to shore up poor balance sheets. Again, when well run banks use their commercial judgment and deal cautiously with weak banks, neither the RBI as supervisor, nor the government as owner, should direct the banks to alter their commercial decision. Weak banks must be made to face their environment and this is the best discipline that can be imposed on them. The days of mollycoddling weak banks are over and only a hard-nosed banking policy can ensure that the contagion of weak banks does not spread to the entire banking system. Thus, a ring around the weak banks is an ineluctable necessity if the system is to be safeguarded.