Bitter prescriptions for banks may worsen fate of slackening economy

A research paper authored by two helmsmen at the Reserve Bank of India, its former Governor Raghuram Rajan and former Deputy Governor Viral Acharya, suggests radical measures for Indian banking. These measures may well worsen the fate of the Indian economy as it rapidly loses steam in the midst of its worst downturn since Independence.

Published on Monday, the paper, provocatively titled “Indian Banks: A Time to Reform?”, advocates sweeping reforms. It calls the privatisation of some public sector banks (PSB), the abolishment of the Department of Financial Services (DoFS) in the Union Finance Ministry, and repeats the familiar prescription calling for the creation of a “bad” bank for dud assets of banks.

The authors call for the “re-privatization” of a few PSBs by roping in private investors endowed with “technological expertise,” while keeping away corporate entities to avoid “natural conflicts of interest.”

It launches a scathing attack on the concept of directed lending and asserts that a large portion of the problems in the banking sector — most notably, the rising levels of non-performing assets (NPA) — arise from this linkage between political authority and banks. It concedes that sometimes the “direction” from the government has nudged the banks to lend for infrastructure projects or for widening financial inclusion. But they observe that oftentimes this has been used to “offer patronage to, or exercise control over, industrialists.”

The authors assert that it is “essential” to close down the DoFS. Such a move, they argue, would be an “affirmative signal” that the government is prepared to concede the independence of the boards of the banks. It would also assure banks that they would not be abused by political masters “for serving costly social or political objectives.”

The authors propose a more complex solution for a “bad bank,” one that would aggregate the NPAs off the balance sheets of banks, while leaving the newly created institution to find buyers for the downgraded assets. But this has already been attempted through the creation of Asset Reconstruction Companies (ARC). The idea is basically to pass off these poor assets to the ARCs at a discount leaving them to find other buyers down the line.

The authors suggest that private and national “bad banks” could be created that would participate in online auctions for better price discovery of these “bad” assets. In fact, the authors suggest that the “post-pandemic distress,” which is likely to result in a pileup of “saleable loans” provides a situation in which “private sector banks could take the lead.”

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Glib assertions

The study ignores that any nexus — in this case between those who hold the reins of political power and industry or commercial interests — it alludes to necessarily implicates both parties. That is, for every Vijay Mallya there is a willing and colluding bank as a counterpart. In fact, as the Kingfisher saga revealed, the easing of lending limits set for the airline industry, and the classification of the industry as an industry worthy of infrastructure status, resulted in the opening of cash pipelines to the company. After all, this happened with the approval and sanction of the RBI.

Moreover, many of the infrastructure projects undertaken by private companies were based on rosy projections of the future. For instance, road and power projects — many of which are not only in the doldrums now but have caused grief to their lenders — were based on such fancy projections. Traffic projections for many road projects were undertaken on this premise as were the power projects that were based on electricity demand projections that proved to be way off the mark. These projections proved to be disastrously optimistic because the economy had already started slowing down, at least since 2012-13.

The authors’ prescription of a pure market-based approach solution for the travails of Indian banking is likely to be just as disastrous, especially in the context of the Covid-led shock. It is particularly ironic — as these have come in the context of a collapse of markets — on both the supply side as well as the demand side.

As the Indian experience since COVID has shown, the government’s reliance on banks to provide the much-needed push to the economy has failed miserably. The NPA-laden banks, now even more risk averse, have baulked at the idea of lending. Meanwhile, borrowers with extremely grim forecasts of the future, are simply unwilling to borrow. One small scale industrialist asks: “The banks are willing to lend me but what will I do with the money if I have no buyers for my wares.”

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The problem with the Rajan-Acharya formula is that they are seeing the problem from solely the perspective of the banking industry — its viability, profitability and stability. However, the economic system is much larger, one that is the worry of any government, even the most negligent one. Since the variables are so many, governments would like to use every lever at its command. Most importantly, unlike the honcho at the central bank, it is directly responsible and answerable to popular demands, which is, after all, not such a bad thing in a democracy.

The fact of the matter is that COVID offers a massive opportunity to expand the role of the state to kick start the economy that was already sliding towards a crisis before the pandemic. With private investment sagging and demand faltering, the immediate need is for a coordinated economic stimulus. Only the state can perform that role, which requires it to get the banks to play their part in an economic recovery.

The perspective that Raghuram Rajan and Acharya offer aims to use the crisis as an opportunity, to set banks on a profit-driven path. A less bank-focused vision would quarrel with that view and ask: Where will the banks be when the economy is in tatters?

Interestingly, the equivalent of the Indian central bank in the US, the Federal Reserve, proposes just the opposite course of action. The Chairman of the Fed Jay Powell told Congress on Tuesday that small and medium sized businesses needed “direct fiscal support” rather than loans mediated through commercial banks. In effect, what he said was that providing more loans to distressed borrowers who may be unable to repay them “might” not be the answer.

When the centre of world capitalism ventures to pull all stops to steam the bleeding economy, is it not ironic that in India the market-driven logic is still powering, unmindful of the deepening catastrophe?