Cost of the Free Lunch Gaurav Agarwal
Cost of the Free Lunch Gaurav Agarwal

In the previous article – Paying for the Free Lunch – we had argued that there was a party going on in public sector banks with the big industrialists at the cost of the taxpayer. In this article, we will first reinforce that view with additional data to remove any doubts the reader may have and then estimate the bill of the party which she – as a taxpayer – has to pay. Contrary to the defense offered by the bankers, industrialists and some economists, the poor performance of Indian public sector banks is not because of any social obligations they have to fulfill or an unexpected economic downturn but because of the party we talked about.

The first defense offered is that public sector banks have to lend to the farmers, small and medium businesses, students, economically weaker sections and in other government run schemes – all typically put together called as the ‘priority sector‘. These loans are inherently riskier because they are made to relatively poor people who face greater economic uncertainties and have poorer ability to repay loans. Also due diligence regarding the credit worthiness of these people is difficult as it is difficult to find information about them. On the other hand, the non-priority sector, comprises of the ‘big guys’ – people who are relatively affluent, big industries etc. A rich man is always less prone to economic vagaries since he has the power and means to diversify. Also, it should be worth the banker’s time to collect information about big companies and such information should also be easier to come. As such it makes sense for the priority sector default rates to be higher than non-priority sector.

This is what should happen in a normal, no-free lunch scenario. But take a look at the figure below. It can be conclusively seen that defaults in the non-priority sector tower way above those in priority sector. And also that the default rate in the non-priority sector for public sector banks is way way way higher than that in private sector banks.

The additional chart below presents the default rates in various sectors for all banks. Since public sector banks account for three-fourth of the total loans advanced, the below numbers predominantly show the performance of public sector banks. Again the abnormally high default rate in the industrial sector where big loans are present stands out.

See more data… Vivek Kaul shows in the table below, how for the same bank, industrial defaults are so much higher compared to small retail loan defaults.

If the above is not enough, RBI’s Financial Stability Report, 2017 presents the following chart. As can be seen in it, large borrowers account for only 55% of the total loans banks made whereas their share in total bad loans rises disproportionately to 85%!

What is the one big message which is coming from the above figures? That the water is muddier where the big fishes are. Continuing with the same trend, even among these big fishes, the bigger the fish gets, the muddier the water becomes. The same report has the following to say about the 100 largest borrowers, “The top 100 large borrowers (in terms of outstanding funded amounts) accounted for 15.5 per cent of credit and 25.0 per cent of GNPAs of SCBs.” The same thing is presented in a pictorial form in the chart below.

The message is loud and clear. The bad loans in Indian banking sector are not an outcome of just social responsibility and bad economy, but of the unholy ‘free’ luncheon. And as can be seen in the charts below, the party was running wilder in the public sector banks. The chart below shows the default rates (NPA ratio) of large borrowers. See how public sector banks have the ratio touching 20% whereas private sector banks have managed to contain it around 8%.

The default rates in public sector banks are almost 3.5 times that in the private sector banks (chart below). And this was after we saw how their defaults were way higher for the big industrialists than for the weaker sections.

Howsoever you look, whatever slicing and dicing of data you do, you can’t escape the fact that a wild party was going on. And the scale of this party had brought the entire banking system to the brink of default. India globally ranks 5th in terms of bad loans ratio – only behind the Eurozone crisis hit Greece, Ireland, Portugal and Italy. And this ranking only takes in the gross NPA ratio (9.85%) whereas if we take our public sector banks and include the restructured loans, the real default rate is 16.2% (for public sector banks) and 12.2% overall!

And do you remember what happened in the countries above us? As a result of banks going bust, the governments had to foot the bill and had to cut your pensions, wages, shut down schools and hospitals, stop welfare programs. Their entire economies went into deep recessions shrinking in some cases by as much as 25-30%! Unemployment soared just like inflation and people lost their life’s savings in days! These are the real costs which have to be paid in a banking crisis – even if the defaulting banks are private banks. If defaults are happening in public banks, in addition to the above, people have to pay additional price by virtue of being shareholders in the banks via government.

In India, recovery rates on bad loans is on an average 25% as per World Bank estimates. Total advances made by public sector banks is 55 lakh crores. Out of these 16.2% are in default. The default rate for private sector banks is 4.7%. If we want to isolate only the cost of the wild party going on in public sector banks, we can very crudely attribute only the differential 11.5% (16.2 – 4.7) to be the additional bad loans due to this party. This translates into a 6.40 lakh crores bad loans. 75% loss rate on these means a bill of about 4.8 lakh crores for the government and general public to pay! Taking an average government ownership of 75% in these banks, it translates into a direct 3.6 lakh crore hit on taxpayers’ funds!

Two notes of caution are advisable here while interpreting the above results.

  1. This 3.6 lakh crore is just the size of the bill of this unholy lunch party. In addition, public sector banks are less profitable than the private sector banks (which are in part due to the social obligations they have to fulfill and also in part due to the inherent inefficiencies and incompetency of public sector). The operating profit  (which is profit before making provisions for the bad loans) for public sector banks is 1.6% of their total assets whereas it is 3.2% for private sector banks. This differential of 1.6% on a total asset base of around 97 lakh crores translates into 1.5 lakh crores per annum! Had these banks been in private sector, they would be earning roughly this much more for their shareholders. 75% of it (government’s share) is 1.1 lakh crores which is the annual subsidy taxpayers are paying to these banks to make up for their social obligations and also their inefficiencies. Please note this is the per annum subsidy – taxpayers pay it year after year. And this is on top of the direct 3.6 lakh crore lunch party bill.
  2. The figure of 3.6 lakh crore is just the direct cost of the lunch party. There would be far greater hidden costs as well. For example, due to higher NPAs, banks’ capital would erode. So they would begin to stop lending to otherwise healthy and honest new entrepreneurs. Also whatever new lending happens would need to happen at higher interest rates to make up for the loss on defaults. Overall impact on the economy would be reduced credit growth and thus reduction in economic growth. More people would now go unemployed who would then be unable to feed and educate their children thereby worsening the social development indicators of the country.

All these are very real costs. The real costs of socialism. Some may argue that this lunch party is an outcome of crony capitalism but then crony capitalism is an outcome of a mixture of half baked capitalism and a heavy dose of socialism only. Left to itself, private banking sector was more successful in avoiding this party because after all, it was their money. We, as a nation, need to think if there can be an alternate, more cost effective way of achieving our social goals.

To what extent must we pay the bill.




Disclaimer: The views expressed here are solely those of the author in his private capacity and do not in any way represent the views of the Government of India, or any other entity of the Indian Government.




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