The $200 Billion Indian Banking Crisis

In 2008 we witnessed the biggest financial depression ever to hit us and with it came a plethora of rhetoric and pledges promising that a similar situation would never knock at our doors. But for lack of a better word, the institutions did shit the bed, again. The very next year, alternatives for CDOs were introduced and parallel economies have just become stronger and instability stemmed from the deregulated markets has made volatility a prime character of the world economy.

The Indian economy has been based on the simple idea of self-sufficiency and it was this idea that did not pave its way into the South East Asian countries and China, amongst the other export dependent nations. Hence, India enjoyed a period of slow growth till 1990s and the rest of the big nations became export dependent but grew exponentially. This kept the Indian economy aloof of the fast changes and transitions the other economies witnessed and adapted, especially in the world of banking and finance.

 The protectionism in the pre-1991 phase allowed our banks to operate a heavily regulated market, where the markets were dictated by the few and the exchange rates were decided not by the market forces but by the Reserve Bank of India, under a strong influence of the government in the monetary policies. The few who were pulling the strings of the banks were the decision makers and there was an absence of rules around NPAs (Non-Performing Assets). The profits and losses of the public sector banks were not public knowledge and timely waves of nationalizing of Banks, especially in 1969 and 1980, further consolidated the power center in the hands of the government and the RBI. Injection of credit, though craved for by the market was consistently costly for the public to access. The crisis which was foreseen by a few economists in 1985 when the gross fiscal deficit crossed 10.4%, finally tipped the scales over in 1991 when the deficit crossed 12.7% resulting in a financial crisis which were followed by a multitude of changes in both the government and the RBI.

It was only in 1992 when the then finance minister, Manmohan Singh got the authority to implement reforms and deal with the aftermath of the 1991 crisis. The then Prime Minister, P.V Narasimha Rao had a clear agenda to let the economists handle the economy and the politicians handle politics. In 1992, the then RBI Governor, C Rangarajan along with Manmohan Singh started the implementation of a 5 year reform plan that made the banks perform as banks of the people. It was this period where India discovered its currency value and it is that wave, which allowed the government and the people to know the value of the Indian rupee and the value of their goods and services in the international market.

The devaluation of the Indian currency allowed the trade to grow exponentially, probably something that our banking institutions weren’t prepared well for. The capital adequacy reforms were phased in along with the prudential norms, slowly and steadily filling in the vacuum around the banking regulations and guidelines in the banking sector. A big fault line that was identified by Dr. Manmohan Singh was that the public banks treated themselves as branches of the government and not as individual commercial banks. This led to a high degree of exposure to the public banks and in 1997 Mr. Rangarajan issued guidelines to especially the public banks, highlighting the norms around capital adequacy in the light of the spurt in growth of credit provided by the nationalized banks.

The dot com crisis of 2000 didn’t affect the Indian economy to a high degree because of the lack of interconnectivity with the financial sector and to a major extent because of the low degree of exposure to the public banks to the tech sector. The private sector banks even though on a rise, held a very little percentage of the market assets to factor in any major influence on the banking sector.

It is important to know how the banking sector grew for us to understand how we reached the NPA crisis and the key ingredients that led the Indian economy to the brink of a major economic crisis.

Over the years leading to 2008, the growth of the banking sector allowed it to be a pivotal character of the Indian economy. This was further boosted by the FDI limits in the banking sector moving from 20% to 74% in the private sector banks and 20% in the public sector banks. The timely completion of projects and the ever increasing demands allowed the banks to be more optimistic to give out credit, to not just individuals but to business entities. The 9.8% GDP growth rate made it difficult for banks and the borrowers to foresee what was about to unravel. It made it difficult for the banks and the people to notice how the under layering of this credit flush wasn’t based on a steady ground. The banks wanted to pump cash into the economy and the market was willing to take it all, anticipating a similar growth trajectory. History and gravity, aren’t the best of friends when it comes to exponential growth.

The economic crisis of 2007-08 affected the Indian economy but an important reason why the effect was limited was due to the parallel economy that was run on cash or money that was off the books. This will be an important part of the story that we will be looking at later in this article.

The United States of America’s federal government provided a $700 billion bailout which in 2008, was 5% of the GDP of USA. The Indian economy saw a big plunge in the growth rate, largely due to this American economic crisis and the numbers were further pushed down by the global economic slowdown. It was in 2013 that the Debt Recovery Tribunal reported a recovery of only 13% of the total proposed recovery of ~$45 billion. It was in 2014 when the Asset Quality Review was initiated by the RBI under the governance of Mr. Raghuram Rajan to ascertain the position and exposure of the public sector and private sector banks, that the under layering was exposed one layer after the other.

Till 2013-14 there wasn’t a working framework in place to identify if a business entity had been declared as an NPA, when that business entity places a request for a line of credit with another bank. This made the banks blind towards an entity’s past performance of servicing the previous debt and the viability of the previous projects run by that very business entity. This pseudo Ponzi scheme was solved to a certain extent when the RBI shared the key data points for all banks to be on the same page and gauge the viability of an entity to be granted with a line of credit.

The vacuum around bankruptcy laws and structures allows the defaulters to leverage the banks into restructuring the loans and this allows the banks to reflect these potential defaulters as a non-NPA entity in the books. This allows the banks to keep their shareholders happy and allows them to keep lower provisions for possible bad debts. The tenure of the executives who grant these loans is not long enough for them to be held accountable when a restructured loan goes bad or even when a convention line of credit’s payments are not serviced. However, post the Asset Quality Review the bankers were vary of granting potentially risky loans to business entities and this can be observed by the loss in growth of credit flow through the public sector banks since 2014. What is interesting to note here is that this trend of decline in the growth of credit is only in the case of public sector banks at around 10% and the private sector banks are witnessing a growth rate of about 25%. What we can infer from here is the fact that the market is still credit hungry but the public sector banks have realized the exposure they have to the potential NPAs and they are trying to clean their books to reduce this exposure.

It was in 2017 that the NPA value in the banking sector crossed ~$204 billion and in 2019 this amount crossed ~$220 billion. The total NPA value is 9.8% of the total GDP of India and this becomes a problem for India because of the total NPA value, ~85% is owned by the Public Sector Banks.

Due to the high number of NPAs in the public sector banks, the banks faced a big decline in the percentage of depositors in 2014-15 and it is during this period that the government launched multiple schemes. Some aimed at making people open up bank accounts with bare minimum deposits and it is in November 2016, when the government launched the demonetization scheme which was opposed by the former RBI governor, Raghuram Rajan. In retrospect the government tried to avoid the recapitalization route by making the public deposit all their cash and in this process making the shadow economy a step closer to the GDP. Since the demonetization and other schemes couldn’t achieve avoidance of recapitalization, recapitalization in the public sector banks has been announced in 2017-18 and in 2019. The RBI has shared a list of willful defaulters and Individuals with a record and tendency of defaults which the government hasn’t acted up on in the past 3 years. Vijay Mallya, an Indian businessman and a former member of the Upper House of the Parliament of India is one of the defaulters and has been the current government’s poster boy for the NPA crisis. His debt just accounts for 0.005% of the total NPAs in the banking system. So, not only has the government been inefficient at handling the NPA crisis so far but also created propaganda based diversions for the public.

The weak due diligence and the lack of a proper structure of recovery of debts allows the NPAs to rise and settlements which recover a few cents on the dollar, hurt the banking sector. There are steps that the government and the RBI are working on to provide ease of business but at the same time provide the assurance to the banking sector of safe returns. However, the provisioning allocation by the banks is what the RBI has been stressing on to provide the safety net that the Public Sector Banks desperately need. Now that the NPA crisis is knocking at India’s doorstep and the fat lady is done with her song, the market’s reaction and how this financial crisis affects our slowing growth rate along with an all-time high unemployment is yet to be seen. It is difficult to gauge the liberal and optimistic growth rate projections of 7% that the government has recently released. It’ll be difficult for the market to accept these projections when the growth rate has been under 6% for a while. The recapitalization that the banks need is just a friendly word for a bailout that will be fueled by the taxpayer’s money. These patterns have been observed in the economic crises around the globe but do we let history guide us here or do we wait for the fat lady to sing?

Anuj Gandhi

Bain & Company

NOTE: THIS ARTICLE REPRESENTS MY PERSONAL VIEWS AND DO NOT REPRESENT THE VIEWS OF ANY OTHER ENTITY