BANKING REFORMS
The Problems
1. Indian banks – particularly public sector banks – are loaded down with non-performing loans. This means that they find it difficult to grow their new lending to industry, and growth suffers.
2. Cleaning up bad loans cannot be left entirely to the National Company Law Tribunal (NCLT), as that will quickly become clogged. But bankers worry that if they take bold decisions out of court then they will be subject to investigation.
3. Public sector banks are not professional enough. The government still controls appointments to their boards and their managements are short of talent and expertise.
4. Banks are forced to do too much and take on too much risk. Public sector banks have to bear the burden of government policy priorities such as loan waivers and directed lending. All banks suffer from the lack of well-developed financial markets that could take on some of the risk.
Banking Reforms
Raghuram Rajan
The banking system is overburdened with non-performing loans. Much of the problem lies in public sector banks, but private sector banks like ICICI and Axis Bank have not been immune. Some of the malaise comes from a general need to improve governance, transparency and incentives in the system. However, the difficulties in even some private banks suggest that ‘simple’ solutions like privatizing all public sector banks may be no panacea.
At any rate, banking reform should tackle four broad areas:
1. Clean up banks by reviving projects that can be revived after restructuring debt.
2. Improve governance and management at public sector banks.
3. De-risk banking by encouraging risk transfers to non-banks and the market.
4. Reduce the number and weight of government mandates for public sector banks, and for banks more generally.
Reviving projects that can be revived
The National Company Law Tribunal will help restructure debt for the largest firms and projects under the Bankruptcy Code.
However, the NCLT will be overwhelmed if every stressed firm or project files before it. Instead, we need a functional out-of-court restructuring process, so that the vast majority of cases are restructured out of bankruptcy – with the NCLT acting as a court of last resort if no agreement is possible. Both the out-of-court restructuring process and the bankruptcy process need to be strengthened and made speedy. The former requires protecting the ability of bankers to make commercial decisions without subjecting them to inquiry. The latter requires steady modifications where necessary to the Bankruptcy Code so that it is effective, transparent, and not gamed by unscrupulous promoters.Of course, for many projects, financial restructuring is of little use if the project cannot proceed for other reasons such as lack of land or permissions or input supply. Any new government will have to give priority to rectifying these issues. I will not go into details here since some of these bottlenecks are covered in other notes.
Improving governance and management at public sector banks
· Public sector bank boards are still not adequately professionalized, and the government rather than a more independent body still decides board appointments – with the inevitable politicization. The government could follow the P.J. Nayak Committee report more carefully. Eventually strong boards should be entrusted with all bank-related decisions, including CEO appointment, but held responsible for performance. Strategic investors could help improve governance.
· Risk management still needs substantial improvement in public sector banks, regulatory compliance is inadequate and cyber risk needs greater attention. Interest rate risk management is notable for its absence, which means banks are very dependent on the central bank to smooth the path of long-term interest rates. These are all symptoms of managerial weakness. There is already a talent deficit in internal public sector bank candidates in coming years because of a hiatus in recruitment in the past.
Outside talent has been brought in very limited ways into top management in public sector banks. This deficiency needs to be addressed urgently by searching more widely for talent. Compensation structures in public sector banks also need rethinking, especially for high-level outside hires.Project lending has to be improved
· Significantly more in-house expertise can be brought to project evaluation and structuring, including understanding demand projections for the project’s output, likely competition, and the expertise and reliability of the promoter. Bankers will have to develop industry knowledge in key areas or bring on board industry experts, since consultants can be biased.
· Real risks have to be mitigated where possible, and shared where not. Real risk mitigation requires ensuring that key permissions for land acquisition and construction are in place up front, while key inputs and customers are tied up through purchase agreements. Government will have to deliver what it is responsible for in a timely way. Where these risks cannot be mitigated, they should be shared contractually between the promoter and financiers, or a transparent arbitration system should be agreed to.
· An appropriately flexible capital structure should be in place. The capital structure has to be related to residual risks of the project. The more the risks, the more the equity component should be (genuine promoter equity, not borrowed equity, of course), and the greater should be the flexibility in the debt structure.
· Where possible, corporate debt markets, either through direct issues or securitized project loan portfolios, should be used to absorb some of the initial project risk. More such arm’s length debt should typically refinance bank debt when construction is over.
· Financiers should put in place a robust system of project monitoring and appraisal, including where possible, careful real-time monitoring of costs. Promoters should be incentivized to deliver, with significant rewards for on-time execution and debt repayment.
Projects that are going off track should be restructured quickly, before they become unviable.· And finally, the incentive structure for bankers should be worked out so that they evaluate, design and monitor projects carefully, and get significant rewards if these work out. Equally, bankers who preside over a series of bad projects should be identified and penalized.
Privatize or not?
Is privatization of public sector banks the answer? Much of the discussion on privatization seems to make assumptions based on ideological positions. Certainly, if public sector banks are freed from some of the constraints they operate under (such as paying above the private sector for low-skilled jobs and paying below the private sector for senior management positions, having to respond to government diktats on strategy or mandates, or operating under the threat of CVC/CBI scrutiny) they might perform far better. However, such freedom typically requires distance from the government. So long as they are majority-owned by the government, they may not get that distance.
At the same time, there is no guarantee that privatization will be a panacea. Some private banks have been poorly governed. Instead, we need to recognize that ownership is just one contributor to governance and look at pragmatic ways to improve governance across the board. There certainly is a case to experiment by privatizing one or two mid-sized public sector banks and reducing the government stake below 50 per cent for a couple of others, while working on governance reforms for the rest. Rather than continuing a never-ending theoretical debate, we will then actually have some evidence to go on. Some political compromises will be needed to allow the process to go through, but so long as the newly privatized banks are not totally hamstrung in their operational flexibility as a result of these compromises, this will be an experiment worth undertaking.
Merge or not?
An alternative proposal to improve governance is to merge poorly managed banks with good banks.
It is uncertain whether this will improve collective performance – after all, mergers are difficult in the best of situations because of differences in culture. When combined with differences in management capabilities, much will depend on whether the good bank’s management is strong enough to impose its will without alienating the employees of the poorly managed bank. We now have two experiments under way: State Bank has taken over its regional affiliates, and Bank of Baroda, Vijaya Bank and Dena Bank have been merged. The performance of the latter merger will be more informative. Thus far, market responses suggest scepticism that it will play out well. Time will tell.De-risk banking by encouraging risk transfers to non-banks and the market
Too many risks devolve on to banks, including risks such as that of interest rate volatility that banks elsewhere typically lay off in markets. Too much project risk stays with banks because other financial instruments such as equity and subordinate debt cannot be issued cheaply. Risk also returns through the back door. For example, banks do not make loans to housing developers because of their intrinsic risks. But they do make loans to non-bank financial companies, which make loans to developers. To prevent risk from returning to bank balance sheets, NBFCs must be able to raise money directly from markets. Financial market development, addressed in Eswar Prasad’s note in this volume, will help banks focus more on risks they can manage better and thus bear more effectively, while sharing or laying off what they cannot. Banks will have to complement financial markets rather than see them as competition. The use of financial technology will be especially helpful to them in this endeavour.
Reduce the number and weight of government mandates for public sector banks
Uncompensated government mandates have been imposed on public sector banks for a long time. This is lazy government – if an action is worth doing, it should be paid for out of budgetary resources.
Mandates also are against the interests of minority shareholders in public sector banks. Finally, it does not draw the private sector in to compete for such activities. The government should incentivize all banks to take up activities it thinks desirable, not impose it on a few – especially as the privileges associated with a banking licence diminish.Along these lines, requirements that banks mandatorily invest in government bonds (the SLR requirement) should continue to be reduced, substituting them instead with the liquidity coverage ratios and net stable funding ratios set by Basel.
Among the more dangerous mandates are lending targets and compulsory loan waivers. Government-imposed credit targets are often achieved by abandoning appropriate due diligence, creating the environment for future NPAs. Loan waivers, as the RBI has repeatedly argued, vitiate the credit culture and stress the budgets of the waiving state or Central government. They are poorly targeted, and eventually reduce the flow of credit. Agriculture needs serious attention, but not through loan waivers. An all-party agreement to this effect would be in the nation’s interest.
Finally, the government should keep its banks well capitalized, conditional on improvements in governance and management efficiency. This is simply good accounting practice, for it prevents the government from building up contingent liabilities on bank balance sheets that a future government will have to pay for.
The Solutions
1. The P.J. Nayak Committee recommended a path to greater independence for public sector banks, and its ideas should be implemented. Eventually, public sector bank boards should be independent and accountable, and allowed to choose the banks’ CEOs.
2. Banks need to build up more in-house talent for such specialized tasks as managing project finance. Public sector banks may have to start paying more to attract world-class talent.
3. Some mid-sized public sector banks should be privatized as a test case.
4. Banks should not be forced to implement the government’s policy priorities. In particular, an all-party agreement that loan waivers should be avoided is in the national interest.
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