Is COVID the bitter medicine needed by the Indian banking industry to overcome its ailments?
Around 1500 AD, Europe emerged from 1,000 years of economic and intellectual stagnation, otherwise known as the Dark Ages. Over the next few centuries, the European population and economy grew tremendously due to technological progress and credit (Hariri).
Credit is only possible in a world in which one believes that the future will be better than today. By borrowing against future income, we can invest today, delivering the means for economic growth.
India has a much lower credit-to-GDP ratio than many other countries. One might suppose that this is because its banks are overly conservative, but instead the performance on bank loan books is actually one of the worst globally. The performance of the public sector banks (PSBs) is especially bad, and COVID will only make these figures worse.
The moribund state of Indian banks’ balance sheets prevents them from being able to supply more credit to the economy, holding back growth.
These problems existed prior to COVID and have culminated in a number of crises in the last couple of years. Headlines such as the problems at IL&FS, DHFL, and Yes Bank were becoming more frequent than we’d like to see.
Solutions to the banks’ problems have been touted in the past; but vested interests and existing structures have acted as an insurmountable obstacle, preserving the status quo. The long term benefit to the economy is being sacrificed to short term interests.
A recent paper by Rajan and Acharya, a former RBI governor and deputy governor respectively, makes a fresh attempt to prescribe measures that can be taken to get the Indian banking system back on to a stronger footing, and to enable it to serve its purpose; to supply credit to worthy borrowers in the economy.
The first step is to acknowledge reality. NPAs need to be recognised. Indian banks habitually kick the proverbial can down the road, and weak firms persist in zombie mode, preventing the supply of credit to deserving borrowers. We saw a similar pattern in Europe after the Great Recession, holding back growth rates for many years. The US, on the other hand, was quick to clean the balance sheets of lenders, and the economy rebounded much faster.
Among other things, the ex-central bankers describe specific measures that can be taken to address the problems associated with PSB governance, quality of talent, risk management, and provisioning mechanisms and the incentives they create. There is an acknowledgement that some of their proposals have been suggested before, particularly following the Gyan Sangam in 2015. Yet over the last 5 years, very little has changed. It’s been easier to avoid confronting the festering problems. We can also note that since 2016, the rate of GDP growth has been monotonically declining.
Reforms can lead to a healthy revival of the banking system and the wider economy. With millions of jobs that need to be created to absorb the new labour supply every year, this is not just an economic, but a social imperative.
Fintechs also have a role to play in the economic revival. To the extent they’ve managed to survive this crisis with their balance sheet in good health, they will be critical to supplying credit to sectors unserved by banks such as SMEs, and small ticket loans to underbanked consumers.
Sometimes things need to get really bad for things to change. A crisis can act as a forcing function.
In 1991, a balance of payments crisis forced the Government to relinquish its grip on the economy, ushering in a new era of liberalisation. This kickstarted the economy, enabling it to depart from the long-standing “Hindu rate of growth”. Modern India, with a dramatically lower rate of poverty and an increase in choice for consumers, can look at this moment as a turning point.
The malaise in the banking system has been building up for many years. COVID has created a situation that may be as meaningful as 1991. With government finances under such strain, there could be an opportunity to drive through reform since the status quo is unsustainable.
Following the recent six month moratorium however, the RBI has announced a one time loan restructuring programme, allowing lenders to extend payment holidays to distressed borrowers for up to another two years.
The risk here is that banks repeat their behaviour of delaying the day of reckoning; why take the loss now when they don’t have to?
Churchill once advised that we should “never let a good crisis go to waste”. Will the Indian government seize this opportunity to give the banks the overhaul they need?