India has been grappling with the problem of stressed assets in the banking system for a while. This has held down private investment by restraining banks
from lending. Private investment has to revive, in order to create employment and pave the way for sustainable economic growth
. We cannot get banks to lend as before unless their capital position is strengthened; thus, there has been a strong case for extraordinary steps to resolve it.
The unprecedented bank recapitalisation programme unveiled by the government to fix this serious issue is a well thought-out move. It is well-timed, too: India’s economy has already witnessed green shoots of recovery, and a strong banking system will play a key role in translating that into a sustained one. Crucially, the package can enable public sector banks (PSBs) to make a smooth transition towards the full implementation of the global capital adequacy norms (Basel-III).
The notable feature of the new package is that a significant portion of the funds (Rs 1.35 lakh crore) committed to it will come from the issuance of recapitalisation bonds. Essentially, this means that surplus liquidity in the banking system is translated into government equity capital, thus making the recapitalisation programme less disturbing for government finances: The interest burden on such bonds would be just a fraction of the funds needed for an infusion of pure equity capital.
This instrument is not new in India, as we had already deployed it during 1990s. Moreover, the extra income that banks will get from investing in such bonds will bolster their profitability, thus setting the stage for an even stronger banking system
.While implementing this package, the government should ensure that only banks that strive hard to resolve stressed assets get fresh capital, mainly to avoid the risk of moral hazard
While bad loan resolution through the Insolvency and Bankruptcy Code (IBC) had raised hopes of improved debt recovery, there was a concern that banks would have to take large haircuts on stressed accounts resolved using the IBC route, which would in turn adversely affect their capital and thus lending ability.
However, with the new recapitalisation package, that concern has been allayed; fresh hopes of investment recovery and job creation have been created. And, it is possible that banks
will now bring more cases for resolution under the IBC.
What we have learnt from the current stressed asset problem is that sustained economic growth cannot be achieved when the banking system is in trouble, that resolving this issue is not easy, and that a weak banking system and resulting low credit growth, if left unaddressed, could set the stage for a prolonged period of stagnant growth.
Thus, it is equally important for the government to ensure that the stressed asset problem is not repeated. This calls for encouraging banks to create robust project appraisal mechanisms with an enhanced role for analytics
. The proficiency of staff to deal with such techniques can be improved through collaboration between state-owned banks
and private firms that specialise in the analytics business.
Reforming governance at PSBs and professionalising their boards are other crucial elements to help ensure that the banking system is not vulnerable to the stressed asset crisis again. Simultaneously, a detailed plan for a gradual reduction of the government stake in PSBs should be created. This is very important, because the new recapitalisation package will increase the government’s equity in those banks.
Since India is largely a bank-financed economy, a healthy banking system is necessary to ensure seamless credit flows to businesses. But over-reliance on banks has its own problems. For instance, Indian banks generally use short-term deposits to fund long-term loans, which could in turn create the problem of asset-liability mismatch. Also, small and medium enterprises often find it difficult to get bank loans due to the high-risk nature of their businesses. To resolve these issues, we should simultaneously start the process of making alternate sources of credit more favourable to borrowers.
India needs a vibrant corporate bond market, as that will deliver a plethora of benefits to the economy. For one thing, policy rate changes can be transmitted more quickly through the bond market than the banking system. For another, if the bond market emerges as a principal competitor for banks, the latter will have to fully pass on the benefits of interest rate changes to borrowers in order to retain clients, thereby leading to better monetary policy transmission.
The corporate bond market in India needs to develop further. While the issuance of corporate debt has been on the rise in India, private placement still accounts for a sizeable portion. Only large firms with high credit ratings seem to be raising funds from the corporate bond market now. Lowering the regulatory cost involved in the issuance of corporate bonds might encourage medium-sized enterprises to prefer this route.
In sum, a well-capitalised banking system and a vibrant corporate bond market are both essential to create a conducive environment for business investment. With the recapitalisation package, the government has done well to address the issues that have long plagued the banking system. Going forward, reforming governance at state-owned banks, divesting the government’s stake in those banks, and making India’s corporate bond market more vibrant should be given priority.
The writer is Deputy CEO, KPMG in India