Some time ago, I wrote an article on the banking sector woes and the need to recapitalize the public sector banks. I argued that without recapitalizing, banks won’t be able to lend at all which would choke the entire economy. Few people asked for figures and few others contended that recapitalization was unnecessary to restart credit growth as banks were ‘flush with cash deposits’ due to demonetization. Yet some others contended that public sector banks were becoming irrelevant in Indian banking space and whatever space the public sector banks were vacating in lending, was being filled effectively by the private sector banks.

I present this one chart below (source: RBI’s Financial Stability Report, 2017) which tells everything. See how from the highs of 2013-14, credit creation by public sector banks slumped by March 17. Public sector banks had just stopped lending. Also notice how deposits growth was still healthy. So public sector banks had stopped lending despite being ‘flush with cash’. And see how despite a relatively robust growth in credit creation by private sector banks, overall credit created nonetheless fell to such low levels. Thus, private banks were not able to fill the space vacated by public sector banks.

Reasons for the poor credit creation by public sector banks despite healthy deposit growth are as follows: a) the amount of ‘cheap’ deposits determines the cost of credit. While cost of credit nevertheless impacts the overall amount of credit generated, a more significant factor acting as choke point in credit creation was lack of capital. Put simply, as per Basel/RBI norms, for every 100 rupees of credit creation, banks need to have say 10 rupees of shareholders’ money. But due to losses due to higher bad loans (non-performing assets or NPAs in banking parlance), public sector banks’ share capital had been vastly eroded. Let’s say due to sustained losses, a bank now has only rupees 6 left in share capital. So now, it would be able to give loans worth only rupees 60 no matter how cheap financing it has! Thus even though they had ‘cheap money’, they couldn’t lend. b) To how much high defaults impact credit creation, if we take all average figures for public sector banks during this period i.e a default rate of 16.5% as we will see later, an average recovery of 25 paisa to a rupee recoverable after 4 years as estimated by the world bank, means that if a bank’s average loan is for 5 years and its cost of money is 6% per annum, then it has to lend at 10% per annum just to break even on its defaults. Add to it another usual 2-3% of other costs and the break even lending rate pushes even higher. At such high rates, either the bank won’t be able to lend or would attract only high risk borrowers which would push more defaults in future. So the bank would eventually be pushed to stop lending and seek for bailout which is precisely what happened in India.

Similarly the reason for private banks not being able to pickup the tab once public sector banks stopped lending is as follows: private sector banks still occupy a small share in credit generation – an increasing one, yet small. Approximately, 75% of the credit belongs to public sector banks and only remaining 25% to private sector banks. When public sector banks stopped lending, the share of private banks in new credit generation automatically increased, still they weren’t able to fill in entirely and the overall credit growth slumped.

Since writing that article, the woes of banking sector in India, specially those of public sector banks, have exploded. Or should we say, have come out in open. In 2013, I had written about the ‘restructuring sham’ going on in Indian banks specially those in public sector. The banks were avoiding showing their defaulted loans as NPAs by simply ‘restructuring’ them. In a typical ‘restructuring’, when an account was on the verge of defaulting, the banks and the promoters would come together and renegotiate the loan whereby they would put off the repayment by 5-10 years and keep the interest in the intervening years at a nominal rate. A default would thus be put off. With a magic stroke of pens, all problems for everyone would be solved – the company would avoid the default, the promoters would remain in charge despite defaulting, the banks would avoid having to show the loan as NPA thereby having to make provisions for the bad loan as per RBI norms which would hurt their bottom-line and the bank management would keep showing a rosy picture to us avoiding unwanted attention. The party would go on for all the suited-booted men involved and the bill would grow larger – a bill to be paid by you and me – the taxpayers. Like a termite, this practice devoured public sector banks from inside. The longer it continued, the more it devoured and the larger the eventual bailout bill. Thanks to the efforts of ex-RBI governor, Dr. Raghuram Rajan, this orgy of vulgar greed and cronyism ended and the banks were forced to reclassify these ‘restructured’ assets as NPAs – the column where they always belonged. A look below (source: RBI’s Financial Stability Report, 2017) shows the horrific extent of this malpractice. Look at the March 2015 figures, red portion of the bar is way more than the blue one. This red portion is the proportion of these ‘restructured’ assets (which were in reality NPAs) whereas the blue one is the proportion of NPAs actually declared so by the banks. So while reporting their quarterly profits, the public sector banks would tell us their NPAs were only 4%, in reality they were around 14%! By ending this malpractice, Dr. Rajan stopped the eventual bailout bill from growing even further and prevented a total collapse of Indian economy.

Anyways, the purpose of this article is not to write an account of Dr. Rajan’s tenure – though credit must be given where it is due – but to talk about banking sector woes. Since the last article, Indian banks have been hit hard by the Nirav Modi-Mehul Choksy scam followed by the Rotomac default and the ICICI scam. These are just the top ones to hit headlines in previous 2 months, a lot of other top accounts have defaulted too. In fact, almost every other day these days, the newspapers are filled with more such ‘scams’. In fact every corporate default is reported as a scam!

But defaults are a normal event in a capitalist economy. When businesses don’t do well, they default. There is nothing scam-ish about it. Yet in India, big corporate defaults, specially on public sector bank loans, have invariably come to be seen as scams – ones where promoters have the ability to pay yet default. There is a strong feeling that the public sector bank officials, under political pressure or after taking illegal gratifications, extend loans which shouldn’t be extended to crony capitalists. Invariably this money is siphoned off from the company by the promoters through some backdoor channels (to be invested in starting other business activities or betting in stock market or parked in safe heavens abroad). Then these promoters simply default and then the unholy debt restructuring party begins.

Let us look at the figure below (source: RBI’s Financial Stability Report, 2017). It tells us that contrary to what banks (specially public sector banks) would have us believe that their higher NPAs are due to lending to weaker sectors like agriculture, the highest defaults are happening in industrial sector – where these large borrowers are found.

Even within industries, the figure below (source: RBI’s Financial Stability Report, 2017) tells us that about 20% of the money – an unusually high number for any bank – lent by public sector banks to these large borrowers ends up in default.

So the ‘scam’ tag to each big default appears to be justified – a) if bad economy was the predominant reason then small industrial borrowers and agriculture would have shown highest default rates since these people are more vulnerable to business cycle volatility, b) the default rate for large borrowers is unusually high compared to rest of the borrowing groups, and c) defaults on loans by public sector banks (where corporate governance is weakest and where chances of misdeeds is highest) to the large borrowers are way higher than those on loans by private sector banks. The case of large borrowers and public sector banks appears clearly to be a case beyond the usual economic downturn and stalled projects excuses. There clearly seems to be an angle of wilful default in it. Why then, in India, we see the practice of wilful default with such impunity?

To understand this, we must step into the shoes of the promoters who float and run the company. The only thing which prevents a promoter from defaulting in a limited liability company is the risk of losing the company. A limited liability company feature ensures that even on default, a person will only lose his investments in the company – his assets outside the company can’t be touched by the creditors. Still the risk of losing the company acts as a sufficient deterrent to prevent wilful default but sadly, in India, until recently, a promoter didn’t even have to risk this! In India, a promoter could safely siphon off all the money from the company (with little fear of being caught by the taxmen), drive company to default and yet retain control over the company. This was because our bankruptcy laws, inspired by socialist ideals of ‘caring and nursing’ for a sick company, looked upon creditors as vultures and prevented them from ripping apart the ailing company for their own gain. Instead they were oriented towards reviving the sick unit. And who could care for a sick baby more than the mother who gave birth to it i.e. the promoter? This and the multitude of courts/laws/temporary injunctions in court proceedings, practically didn’t allow creditors to sell assets of a defaulted company. Bankruptcy proceedings were insanely long and resulted in very little recoveries for the creditors. World bank estimated that bankruptcy proceedings took on an average 4+ years in India yielding salvage value of 25 paisa to a rupee compared to 1 year and 80 paisa in USA, Singapore, Australia. Thus effectively, once a large amount was lent, the creditors were totally left at the mercy of the promoters.

The single most effective way of reducing wilful corporate defaults is to empower creditors and create the deterrent in the minds of the promoters that they will lose the control of the company if they default. The Insolvency and Bankruptcy Code, 2016 thankfully changes this landscape for better and resolves many of these issues and makes bankruptcy proceedings simpler and quicker. We still, however, need to see how things play out in practice though we must be hopeful.

The next most crucial step in reducing the banking sector woes will be privatization of public sector banks. The charts above lay bare all the counter-claims regarding fancy notions about corporate governance in public sector banks vis-a-vis private sector. It is true that private sector banks have had their fair share in the recent banking scams. Yet let us not generalize the anecdotes more than we should. Let us not mistake isolated trees for the forest. The chart on stressed assets as a percentage of total loan portfolio tells us that while the bad loans accounted for only 4.7% of total loans in private sector banks in September 2017, the figure was 16.2% for public sector banks – over 3.5 times more! When we look at the large accounts, the difference is more telling. While the bad loans share to large accounts in public sector banks is 20%, it is just about 7% for the private banks. Indian public sector banks historically trade at a much lower price to book value than the private sector banks.

The numbers are clear. Corporate governance in public sector banks is systemically far worse than in private sector banks. And the reasons too are easy to see. Firstly, public banks run on taxpayer’s money – ones who are least empowered in their decision making setup. Lending decisions are made by management and influenced by powers that be and none of these have their own money at stake. The largest shareholder – government – has a lot of say in decision making but it doesn’t really take decisions based on commercial returns. In contrast, senior management in private sector banks usually own significant stake in the bank or at least the large shareholders are much more empowered in decision making. This naturally ensures money is more carefully lent in private sector banks. Secondly, the reason why private sector banks are preferable over public banks is that frankly, even if a fraud occurs in private banks, we the taxpayers, are concerned to a lesser degree about footing the bill. When a fraud happens in a public sector banks, we are directly hit – the loss is our loss – to be made good either from future earning or a future bailout. But when a fraud happens in a private sector bank, the first hit is taken by its shareholders. Agreed, if the scale is large enough, taxpayers will have to fund the bailout. Still there is a cushion of the existing shareholders available to the taxpayers – existing shareholders will absorb the loss before it comes to us.

This is not to say that public sector banks don’t serve any social objectives. But perhaps, the time has come for the taxpayers to evaluate at what cost. Is it really worth to keep bailing them out year after year with thousands and lakhs of crore rupees? Can a system of appropriate incentives and subsidies can be devised so that these objectives can be met at a lower cost by the private sector? Can differentiated banks like Bandhan Bank and others be used for specific purpose? Can we have more banks competing with each other employing different delivery models?

Has the time come? Perhaps, we shouldn’t pay for their big free lunch any more!

#ViewsArePersonal #BankGovernance #CorporateGovernance #Banks #BankFrauds #Privatisation #Bankruptcy




  1. Thanks, nicely explained. I agree with the conclusion that govt shouldn’t keep on paying cost of mismanagement of PSB every year. Public money is getting infused in recap of these regularly- sometimes 70k crore, sometimes 210k crore with bail in provision under different schemes. This is close to 10% of the Union Budget! Maybe annually paying private banks for carrying out social sector responsibility of PSB will be more economical.

    However the IBC code amendment is to exclude the promoters from bidding (unless they pay their dues back), which is in fact to prevent the moral hazard of wilfully defaulting and then getting back the ownership at cheap price during bankruptcy process. I do not agree with your understanding of that part. Thanks again.

  2. Sir, after reading the article, i get a feeling that you are pitching for privatising PSB’s, but in the article, you yourself have written that when the credit outgo slumped in the public sector, private sector was not able to completely fill the space ceded by the PSB’s. This fact itself suggests that, though limiting the governments stake in PSB is a must, it has to be gradual, which is the case right now. Furthermore, i would like to know how did you assume that agriculture sector, MSME’s etc take a greater hit when the economy is not performing, and thus the data which clearly shows that the industries have a disproportionate amount of bad loans, somehow points to a potential scam. I think, since industrial sector requires large capital investment, and are in general more leveraged compared to any sector, it should be obvious that they will also be the one’s who are more affected when the economy takes a turn for the worse.Furthermore, just because the PSB’s have a disproportionate share of bad loans should not lead us to conclude that it is because of the governments complicity with rich business. I read somewhere, that after government started the drive for fiscal consolidation, the PSB’s, who are conservative in nature, and did a lot of investment on safe government securities, were left with no choice but to engage in risky investments, which led to increase in NPA’s. Also, since you yourself have pointed out, as the share of total credit of PSB’S is 75%, they are bound to have more NPA’s on their books as compared to their private counterparts.
    At last, i would like to say, that you are my role model, and as you say, credit must be given where it is due, so here goes: it is admirable that you are still engaged in academics, and issues which are relevant and important.. it is really inspiring for aspirants like me. and please forgive me for my ignorance if i made some conceptual mistakes in the comment.. looking forward to your next article 🙂


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