Getting Indian banks back on the track

After a long slump, private sector investments in India may be on the cusp of a revival, according to some analysts. China’s fading star as an investment destination and improvements in India’s public infrastructure will bring in a new tide of global investments, they argue. This could raise the animal spirits of Indian industry, and catalyse a new wave of domestic investments.

The past decade has seen many such false dawns, with analysts routinely predicting an imminent recovery in investments. Favourable global conditions could be outweighed by domestic challenges even now. The poor governance of India’s State-owned financial institutions could emerge as a major bottleneck. After all, India’s last investment cycle was busted when loans to a large number of marquee projects turned sour.

Three key factors led to the spike in bad loans during the last boom — shady banking, poor regulation, and a global commodity price shock.

A 2022 research paper by economists Abhishek Kumar, Divya Srinivasan, and Rakesh Mohan suggests that the sharp fall in commodity prices after the 2008 financial crash hit the profitability of commodity-sensitive firms, which were unable to pay back their loans. Non-performing assets (NPAs) in the banking sector and profit ratios in commodity-sensitive firms moved in tandem, their research shows.

But why did some commodity-dependent firms go bankrupt while others survived? The answers lie in the governance standards in such firms as well as in the banks that were lending to them. Price volatility is par for the course in the commodities sector, and a well-managed company should not go bankrupt because of that, a veteran financial analyst said. During the investment boom of the 2000s, bankers lent recklessly to companies that had very obvious flaws in their business models, he added.

Bankers from State-owned banks led the pack. The largest of them, State Bank of India (SBI), would report a steep increase in bad loans every time its chairperson changed. Each new incumbent would uncover some of the skeletons buried by his/her predecessor. Bankers would be reluctant to classify loans as NPAs since that would hurt their bottom line. The Reserve Bank of India (RBI) indulged them.

During the financial crisis of 2008, the RBI allowed banks considerable leeway to avoid classifying loans as NPAs as long as they met its guidelines on “restructuring” of such loans. Intended as short-term measures to tide over an unprecedented crisis, they remained in force for many years. Rather than take away the punch bowl from the “credit binge party”, RBI may have ended up spiking the punch bowl, former RBI governor Urjit Patel commented in his 2020 book Overdraft: Saving the Indian Saver. Some bankers went rogue and kept lending to companies even when they knew such loans would not be returned. Others were just incompetent. “The banks themselves applied little risk analysis in sifting good from bad assets; they kept lending without much due diligence… and they may also have been in denial that there was a severe problem of poor quality assets,” wrote Patel.

It was not until 2015 that RBI attempted an honest accounting of bad loans in the banking system. That asset quality review (AQR) led to a three-fold rise in reported NPAs of State-owned banks. Some of them were eventually put under a “corrective action” plan to repair their balance sheets. They also received fresh capital from the government. Without that taxpayer-funded bailout, a few State-owned banks might have collapsed.

In 2016, the new insolvency and bankruptcy code (IBC) was introduced, which allowed bankers to sell or liquidate the assets of loan defaulters. While the IBC regime has been diluted in recent years, it still represents a step in the right direction. Company promoters know they can lose control over their firms if they don’t pay up loans.

A blueprint for reforming the banking sector was prepared in May 2014, just when the Narendra Modi-led government took office. The PJ Nayak committee suggested that all banks be brought under the ambit of the Companies Act, and all government shareholdings transferred to an omnibus Bank Investment Company (BIC). It also recommended HR changes to improve the functioning of banks. The committee’s focus was on revamping governance of State-owned banks, which accounted for the lion’s share of loans (and bad loans) in the country.

As a transition measure, an independent banking board should decide bank board appointments, the Nayak committee suggested. Independent professionals rather than ministerial nominees were needed to provide effective oversight of banks, it said. The government set up a Banks Board Bureau in 2016 but ensured that it remained an ineffective body. Finance ministry bureaucrats still call the shots in appointments to bank boards. The other recommendations of the Nayak committee were put on the back burner.

Although the banking sector saw a clean-up operation, the governance structure of State-owned banks has remained unchanged. India’s poorly governed banking sector remains ill-equipped to support and sustain a recovery in investments. Bankers can be trusted to make judicious decisions when they report to a competent and empowered board. We should expect to see a broad-based revival in investments only when bankers start lending without fear or favour.

Pramit Bhattacharya is a Chennai-based journalist. The views expressed are personal