Insights into Editorial: Why more than note-ban, India needs a Big Bad Bank
The withdrawal of Rs500 and Rs1,000 notes on 8 November has changed the composition of money supply in the economy. A large part of what was currency in circulation is now coming to banks as deposits. The sudden inflow of deposits has given rise to speculation about how these will be utilized by the banks. There are reports that banks will increase lending. Some have suggested that banks’ non-performing asset (NPA) problems will get alleviated. However, according to few experts, NPA situation of banks may get worse, further adding to their capital woes.
The gross bad loans of 39 listed Indian banks in India, in absolute term, rose 92% in fiscal year 2016 to Rs.5.79 trillion even as after provisioning, the net bad loans more than doubled to Rs.3.38 trillion. In percentage terms, the average gross non-performing assets (NPAs) of this group of banks rose from 4.41% of loans in 2015 to 7.91% in 2016; net NPAs in the past one year rose from 2.45% to 4.63%.
Public sector banks, which have close to 70% market share of loans, are more affected than their private sector peers. Two of them have over 15% gross NPAs and an additional eight close to 10% and more. If we include restructured loans as well as those loans that have been written off, the total stressed assets could be as much as one-fourth of loans, at least for some of the government-owned banks.
Main reason behind the creation of bad loans:
- The main reason behind the rise is improper management of these loans by the banks. Many of the assets created utilizing these loans remain unutilized or partially utilized because of the ineffective management.
- Even the courts take many years for the resolution of these cases.
- In the last two years, especially, the bank bad loans have gone up dramatically mainly because of two reasons. One, the market failure and the other, bad debts were often not reflected properly by the banks.
- Crony capitalism is also to be blamed. Under political pressure banks are compelled to provide loans for certain sectors which are mostly stressed.
- In the case of sectors like electricity, the poor financial condition of most SEBs is the problem; in areas like steel, the collapse in global prices suggests that a lot more loans will get stressed in the months ahead.
- Stressed sectors like infrastructure, textiles and mining have added to the problem.
Why demonetisation may have little or no impact on bad loans?
- Deposits are liabilities on a bank’s balance sheet, which they use to make loans and advances, which are their assets. But, in the current context, banks do not know how long these new deposits will stay on their books. So they can deploy these only in short-term assets. Thus, banks will face constraints in using the new deposits to make new loans.
- Also, the burgeoning NPAs of the banking system have significantly eroded their capital base and hence their ability to lend. In June, gross NPAs (GNPAs) of listed banks were Rs6.7 trillion or 9.1% of their advances. The 27 public sector banks (PSBs) account for 80% of these NPAs. In 15 of them, GNPAs as a percentage of advances are more than or close to the capital to risk weighted assets ratio (CRAR). Except for the State Bank of India and a few other PSBs, the CRAR headroom required to make new loans does not exist.
- There is also a question of demand for new loans. Corporate credit demand has been slow. The currency ban has imposed a big negative shock on consumption demand, which in turn may lead to businesses cutting back on their working capital requirement, at least in the next few quarters. This in turn will affect the demand for working capital loans.
- If banks cannot make loans on these deposits, then they can park them with RBI as reserves. Banks would not prefer to park these deposits as reserves with the RBI beyond the cash reserve ratio (CRR) limit, because these reserves do not earn them any interest.
- Banks can also invest excess deposits in government securities (G-secs). G-secs being sovereign bonds do not pose any capital requirements on banks, give them returns and allow them to match their asset liability profile. But, the availability of G-secs in the market is determined by the borrowing programme of the government and is not easy to expand without raising fiscal concerns. This limits the supply of G-secs.
- Besides, with more incoming deposits, RBI will soon run out of G-secs that are needed to absorb the excess liquidity. This seems to be the case because RBI has now made it mandatory for banks to hold 100% CRR on incremental deposits. This announcement prevents banks from investing the incremental deposits in G-secs.
What are the main concerns now?
The move to ban the Rs500 and Rs1,000 notes does not appear to be a positive one for the banking sector. They may not be in a position to significantly increase lending and their capital base may get worse.
- If economic activity slows down in the aftermath of the currency ban and corporate performance deteriorates, there may even be a spike in their NPAs, at least in the short term.
- In addition to this, bank branches all over the country have been struggling to deal with the massive transaction load that this move has placed on them. The normal banking business has been disrupted and bank employees have been occupied in dealing with exchange, deposits and withdrawals of currency.
What can the government do?
- The government has to ensure the earlier hurdles, like not having enough debt recovery tribunals, hinder the banks from getting closure on their legal suits.
- The government must also work with the regulator to ensure that banking practices improve in all banks.
- Politically and administratively, the government should be aware that the state-owned banking sector is undergoing extreme fragility, and this is not the time to stress it further with various “nation-building” demands, particularly when it is reluctant to take bold steps that entail their fundamental restructuring.
- Reduced political interference is also necessary. The political system has too often taken taxpayers for a ride, with small benefits masking large hidden costs. They have the right to know what they are paying for. Stronger boards and improved governance mechanisms can ensure that PSBs make independent decisions on purely commercial grounds.
At a time when the banking sector has been struggling to recover its bad loans and to find adequate capital to deal with provisioning challenges, this sudden shock may worsen the situation even further. The Indian banks are in real danger of losing not only their market share but also their identity unless the government intervenes with surgical precision and alacrity. It is tie for the government and the RBI to come out with a smart option to resolve this issue that can no longer be put on the backburner.