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Banking crisis is not over yet, but recapitalisation hiding the truth

The result is that these banks make good profits year and after year. (Illustration: rohnit phore)

By Gurbachan Singh

Reserve Bank of India (RBI) report released on December 24, 2019, showed that gross non-performing assets (NPAs) for the banking sector have come down to 9.1% in end-September, 2019 from 11.2% in FY18. However, we have seen such changes before. Unlike other countries, NPAs have resurfaced in India after 2000.

We all know that there have been serious difficulties in the banking sector. But is the situation grave enough to label it as a banking crisis? Yes. But before I explain this, it is important to understand why a label is important in the first place.

A crisis cannot be tackled till it is recognised as one. So far, there is hardly any acceptance that the trouble goes beyond huge NPAs. The difficulties are deeper, persistent and far reaching. The recognition that we have a banking crisis can be the beginning of a major policy change. At the moment, policymakers are not dealing with the chronic disease; they are providing a pain killer in the form of recapitalisation of banks. That too at an exorbitant and recurring cost. But policy change is a different story; the focus is on the recognition of a banking crisis.

We have had NPAs that stood at 14.6% in public sector banks (PSBs) as of March, 2018. To put this in context, considering the capital that banks hold, the PSBs as a whole had become bankrupt (and several PSBs were indeed individually bankrupt). The reason these banks survived lies in recapitalisation to the extent of Rs 2.5 lakh crore over the last five years. This does not include recapitalisation that happened earlier and it, of course, does not include recapitalisation that is likely to be required in the future, if there is no major change in policy!

The recapitalisation of PSBs hides or even prevents some significant signals that are otherwise associated with a banking crisis. Because the government recapitalises banks, there are hardly any bank runs. But the underlying crisis very much exists.

Also, given that recapitalisation of banks happens sooner or later, there is little contagion from one bank to another or from the PSBs to other parts of the financial intermediation business due to sentiment, panic, etc. However, it is important to note the following. First, Hal S Scott in his 2016 book Connectedness and Contagion made an important distinction between the two terms. Even though there is little contagion here, there have been serious adverse effects of the difficulties in the banking sector on the economy due to connectedness between the two (due to ‘fundamentals’ in the economy). Second, despite the significant improvements in the bankruptcy proceedings due to the Insolvency and Bankruptcy Code (IBC) that was brought in in May, 2016, the process to resolve the NPA cases is still slow. Furthermore, and more important, it has been reported that "for every one case resolved, four cases end up in liquidation, where the recovery falls down sharply to 15-25% of the book."

Given that PSBs are inefficient and at the end of the day loss-making in the aggregate (though not always for any fault of their own), the competition for private sector banks and foreign banks is rather weak. The result is that these banks make good profits year and after year. Now, high profits are usually associated with efficiency, innovation, risk-taking, creative destruction, and so on. Also, high bank profits are usually associated with the absence, and not the presence, of a banking crisis. However, in the context of banking in India, it is possible for private Indian banks and foreign banks to make good profits year after year even if they are not great banks, thanks to the continued protection for the PSBs. The sustained high profits and impressive growth of a section of banks and NBFCs is in part, if not entirely, a perverse and counter-intuitive outcome of, what is and has been for a while, a situation of a banking crisis in India!

Given that an Asset Quality Review (AQR) has been carried out for commercial banks and not for cooperative banks, the data for NPAs in the latter category of banks may not be reliable. But indicators suggest that NPAs there may be high too. The case of bad assets in Punjab and Maharashtra Cooperative (PMC) Bank is not an isolated one. There have been over 400 cases of cooperative banks over the period 2009-10 to 2018-19 with the Deposit Insurance and Credit Guarantee Corporation (DICGC).

AQR has also not been carried out for non-banking financial companies (NBFCs). So, again, it is hard to rely on the usual data on NPAs in such financial intermediaries. But there are reasons to believe that the problem is serious. The IL&FS case came to the surface in September 2018. But there can be many more NBFCs that have serious NPAs. It is also reflected in the credit spreads in debt instruments that have been issued by NBFCs (even if we leave aside the panic that gripped the debt markets for a while in India).It is well known that there are serious difficulties in the residential segment. There is a huge number of projects that are stuck, and there is a very big pile of unsold inventories in finished projects (estimated at Rs 8 lakh crore for top-8 cities as compared to sales of about Rs 2 lakh crore). It is, however, interesting that despite all this, so far average prices have not fallen much, if at all. This situation may continue. Alternatively, at some stage in future, prices may drop significantly. In that case, builders and investors may have serious difficulties in repaying or rolling over their debts. This will lead to another round of large NPAs; this is particularly true for housing finance companies (HFCs). The NPA problem does not stop here. NPAs are expected in Pradhan Mantri Mudra Yojana (PMMY). MK Jain, Deputy Governor of the RBI on November 27, 2019, highlighted this issue. It is true that there is no conclusive evidence at this stage that we have huge NPAs in cooperative banks and NBFCs, and in real estate loans (such evidence exists for commercial banks only). However, I would like to make two observations here. First, the lack of transparency itself suggests a serious weakness there. Second, in any case, there is a serious enough problem in commercial banks which still dominate the financial intermediation business.

There have been sizeable withdrawals by banks and mutual funds from short-term funding at NBFCs in a small span of time. This has, in turn, affected lending by such NBFCs. This alongside the slowdown in credit from PSBs to the industry is, in fact, an important reason for the growth recession in the economy in recent quarters. The degree of the credit slowdown in the Indian economy is mind boggling. From April-September, 2018 to April-September, 2019, the flow of funds from financial institutions to the commercial sector has collapsed from plus Rs 1,85,083 crore to minus Rs 1,28,760 crore.To come to the main point now, all the above facts and arguments imply that we can indeed label the current situation in banking as one of a banking crisis. This is, in fact, very much in line with the notion of a banking crisis in the well known book "This Time is Different"; published soon after the Global Financial Crisis (GFC) by Carmen M Reinhart and Kenneth S Rogoff.The banking crisis is very much here. It is time we recognised this. The recognition will pave the way for appropriate long-term policy changes.

The author is Indian Statistical Institute, Delhi Centre