End the domination of public sector banks, not simply recapitalise them. That’s true reform

Let zombie firms linger on & banks stay crippled a little longer if it leads to deeper reform, so India can get away from broken financial system of the 1980s.

Illustration by Ramandeep Kaur | ThePrint

The clamour for recapitalisation of public sector banks to revive GDP growth has grown in recent weeks. However, past episodes of recapitalisation show it can, at best, provide a short-term band-aid to the economy, with high long-term costs.

As the moratorium imposed by the government ends, it is expected that many bank loans will go bad. The argument for recapitalisation is linked with the need to take firms to the Insolvency and Bankruptcy Code (IBC) and resolving them. It is argued that, in the aftermath of the pandemic, many companies in India are bankrupt. In a recent article in the Business Standard, Ajay Shah argues that many stressed firms are “zombies”, and resolution of their financial distress through the IBC is essential for restoring growth.

When a firm gets into difficulty, the shareholders and lenders experience a loss. Covid-19 has imposed these losses; there is nothing which can change that fact. In the short run, that loss is not recognised by poorly regulated banks. Putting firms through resolution converts this invisible loss into a visible loss on the balance sheet of the bank. Pushing the resolution will thus make the problems of Indian banks more visible.

In a paper late last year, Arvind Subramanian and Josh Felman argued that the government should recapitalise public sector banks to enable them to meet their capital requirements. This policy package will clean up bank balance sheets, and will allow them to get back to lending.

Pulling these two pieces together, the way forward for India consists of pushing forward into resolution of stressed firms through IBC, coupled with large-scale fiscal resource injection into public sector banks. There are important limitations in this proposed path.

Problems of public sector banks

We need to look deeper inside the problems of public sector banks. Even if senior policy makers think that PSU banks should resolve their bad debts, do public sector bank employees have the correct incentives to actually do so, and to make sound decisions in the IBC process? And, even if all the cleaning up of balance sheets is completed, do public sector bank employees have the correct incentives to lend, and to lend wisely?

The story is likely to play out quite differently. First, public sector bankers are reluctant to make decisions, to declare loans NPAs and take companies to bankruptcy — this would air their dirty laundry in public and bring the wrath of agencies and regulators upon individual employees. The best thing that IBC can achieve is that the threat of the bankruptcy process induces a negotiation, where the promoter agrees to bring in some equity capital and the lenders agree to accept some haircut. But for the bank employee, there is the threat of agencies and regulators launching an investigation if this is done. While accepting a haircut can lead to an investigation, not signing off on a resolution has no personal consequences. The very nature of agencies, regulators and public sector banks is thus not conducive to resolution.

Second, bankers in the public sector banks are not geared to lend. Research by Abhijit Banerjee, Shawn Cole and Esther Duflo shows that public sector banks have been less aggressive than private banks in lending, in attracting deposits and in setting up branches. Bankers in the public sector are often reluctant to make credit decisions owing to the fear of agencies and regulators.

Let us suppose that there is some progress on resolving firms and some in increasing bank lending. By putting in about 10 per cent of GDP into bank recapitalisation, we can hope to get back to some growth. The bigger consequence would also be that the banking system will continue to be largely government-owned, and that the present behaviour of agencies and regulators will remain intact.

We, in India, tend to debate a big decision of putting Rs 10 lakh crore into bank recapitalisation or not. The problem lies in the fact that generally, every year, we are putting in Rs 2 lakh crore towards this, so we are effectively doing one such big recapitalisation every five years. Is this a good use of public money?

Is there a better way?

The question we need to ask is whether the benefits from this policy are worth the cost, and if there is a better way.

We need to think about regulatory capacity. From the Nirav Modi scam in PNB and the misappropriation of funds in Yes Bank, we have seen deficiencies in banking regulation by the RBI. Past and present RBI employees have tried to deflect this blame, saying the RBI is not able to regulate public sector banks. This is only partially true.

There is a lack of fair competition in banking. Historically, many restrictions were imposed on private and foreign banks on entry and on opening branches, in order to protect public sector banks. Many rules are phrased in ways that favour banks, at the expense of non-banks. All these competitive barriers are not in the interests of the nation. While existing weak banks will be limping for a long time, greater competition will create other ways to meet the needs of customers.

IBC is a resolution mechanism for non-financial firms, but there is no resolution mechanism for financial firms. In particular, public sector banks do not fail. It is well understood that while new private banks should be allowed to enter, their failure should not be a drag on tax-payers. Allowing the entry of more banks needs to be coupled with a mechanism for resolution of troubled banks. A resolution authority would monitor and diagnose failure early and move quickly to resolve the firm. This requires enacting the FRDI Bill, with clauses within it that give sufficient supervisory and decision making authority.

And then, there is the problem of inefficient use of capital. Shah, Subramaniam and Felman worry about how Indian GDP growth is held back by the problems of resolution and banking. But the present structure of banks and banking regulation is geared to waste capital, to give bad loans, and create bad incentives for non-financial firms. In the traditional Indian ways, credit goes to the wrong borrowers. Our objective should not be to get back to the good old ways.

We should thus ask. How bad is it for India, if zombie firms linger on a little longer? How bad is it for India if banks stay crippled for a little longer? We should welcome these two outcomes if that is the price of the deeper reform, to get away from the broken model of the financial system that has bedevilled Indian growth from the 1980s onwards. That deeper reform is about changing the laws and organisation structures of regulators and agencies, and moving away from a banking sector dominated by public sector banks.

Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.

Views are personal.