How To Fix The Indian Financial System’s Five Big Challenges

To say that the Indian financial system has been subject to heightened volatility over recent years would be quite the understatement. Given the cumulative shocks and dislocations, it must be said that the Reserve Bank of India has done an extraordinary job of navigating choppy waters. Now, with the generally positive reception that the budget has received, there is no time to waste in addressing the festering challenges of our financial system.

Five fundamental challenges need addressing: reviving credit growth; stemming the secular decline of trust in the formal financial sector; addressing extreme risk aversion; restoring and deepening access to finance to those marginalised in a post-pandemic world; plugging the gaps in long-term finance.

Challenge 1: Credit Growth

Multiple causes underpin flagging credit growth. First and foremost, the Indian banking system needs capital. The supply of credit will not be able to keep pace with the requirement of a recovering economy for as longs as banks remain undercapitalised.

The public sector banks, which still account for two-thirds of the banking system’s assets, are the most capital constrained, weighed down as they are by a disproportionate burden of non-performing assets. Government alone cannot come up with the required capital. Private capital will need to be mobilised. But investors will remain reluctant until they see significant changes to the governance of PSU banks. And even though the Budget announcement with respect to the privatisation of two PSU banks has been widely welcomed by the market, that is not a feasible option for all PSU banks, especially for the larger ones. By far the most important change that investors are looking for is operational autonomy. This can be achieved without forcing privatisation.

An alternative path to greater autonomy can be found in the long-standing recommendations of the PJ Nayak Committee to transfer the government’s equity stakes in PSU banks into a bank holding company. Such a cascading ownership structure could be used to create greater distance between the government and the banks that it owns. The committee’s suggestion in this regard is to empower the holding company’s board -- led by eminent persons with suitable experience -- to take responsibility for safeguarding and enhancing the of the government’s ownership stake in the underlying banks rather than interfering in operational management or the appointment of senior management. Responsibility for all of the latter would be transferred over time to autonomous boards of the respective banks, each with appropriate representation of qualified independent directors functioning alongside nominee directors of the holding company. Another advantage of the cascading structure is that it would allow the government to raise substantially more capital while being able to retain strategic control even with a much lower level of effective economic ownership in the underlying banks.

Recapitalising PSU banks will require a multi-pronged approach. For this purpose, it may be useful to divide PSU banks into a few categories. SBI is in a category of its own and has done a respectable job of building provisions against its stock of NPAs. It should be encouraged to raise Tier-1 equity from the private market with matching equity contributions from the government. PSU banks that have made good progress with provisioning against NPAs but that are unlikely to attract private strategic investors should be brought under a Nayak Committee-type Holdco. Government ownership in these banks should be reduced over time through gradual disinvestment with the objective of maximising from the sale of government shares.

Privatisation should be reserved for those banks in which the private sector is most amenable to taking strategic control on an as-is-where-is basis.

This might still leave a bank or two with disproportionately large asset quality and operational issues that would require very special attention and intervention. Separating their bad assets into another vehicle such as the ARC proposed in the Budget would be useful for all PSU banks trying to clean up their balance sheets.

Even private sector banks, especially the smaller ones, could do with additional capital. To attract such capital, while allowing corporate conglomerates to become majority owners of banks is a risky proposition, there is merit to relaxing limits currently imposed on ownership in banks by individual investors. It is harder, especially in today’s context, for smaller banks to find many patient long-term investors to contribute equity capital with their respective ownership shares capped at 5%. It is easier to find one or two deep-pocketed investors willing to take a more meaningful stake in the bank.

The RBI should be amenable to allowing fit and proper institutional and even corporate investors to own up to, say, 15-20% stakes in any private Indian bank. This would make it easier for these banks to raise vitally important growth capital, while retaining sufficient safeguards against potential abuse and conflict of interest.

Challenge 2: Decline Of Trust

The secular decline of trust in formal financial institutions is an altogether more delicate issue. From amongst the middle classes, salaried government employees and the elderly, for example, are still not comfortable depositing money with private banks. And notwithstanding the millions of bank accounts opened thanks to PMGSY, the rural and urban poor in particular are still hesitant to engage with the formal banking system. Declining trust has also afflicted investor behaviour. The recent spate of fraud and scandal amongst cooperative banks and NBFCs has made it harder for smaller banks and NBFCs to gain access to financing and triggered fears of liquidity stress in times of macroeconomic uncertainty.

RBI needs to do more to build faith in the integrity and stability of the financial system. To this end, RBI must systematically strengthen and broaden its supervisory capacity. The answer to dealing with challenges in the NBFC sector is not to make their business model unviable, but rather to supervise and regulate the sector more effectively. In addition to building capacity to better oversee systemically important NBFCs, appropriate changes to existing banking legislation must be pursued to ensure that the RBI is able to exercise the same authority over PSU Banks as it does over private banks. There is also a need for tighter coordination between RBI and other financial regulators to reduce the possibility of unseen systemic risks building up in unintended ways such as was the case with credit risk in the asset management business for example. And finally, the RBI should explore the introduction of automatic stabilisers to its regulatory tool kit – breaks that are taken off or applied automatically with the ebb and flow of systemic credit and leverage.

Challenge 3: Extreme Risk Aversion

The third big challenge is overcoming extreme risk aversion, especially as it concerns corporate lending. The bust following the infrastructure boom brought home harsh realities about the weakness of creditor rights in India. Aside from raising additional capital, restoring the flow of credit to corporate India lies will depend on a) strengthening creditor rights and b) ensuring that bankers do not get unfairly prosecuted for ‘honest mistakes’. The Insolvency and Bankruptcy Code was a milestone.

Yet bankers remain reticent to invoke the process which is very cumbersome and still vulnerable to legal challenges from disgruntled stakeholders. The law as it stands is designed for high- cases. There is a need to design a more streamlined process for smaller companies and to introduce legislation for personal bankruptcy. Getting bankers to become more comfortable again with making discretionary judgments that are inevitable in credit approval decisions is trickier. Decriminalising offences under the Companies Act is a step in the right direction. But formal legal protection needs to be provided to financial services professionals making lending decisions in good faith.

Challenge 4: Restoring And Deepening Access To Finance

The fourth structural challenge that still remains to be properly addressed is financial inclusion. Despite the dramatic increase in bank accounts amongst the poor thanks to PMJDY and the proliferation of micro-finance institutions and Small Finance Banks, formal sector credit remains overwhelmingly directed towards government, large corporates, and the salaried urban middle classes. Micro-enterprises, the largest creator of jobs in the country – still hardly have access to formal sector credit. The pandemic has only worsened the situation.

A two-pronged strategy is needed to tackle financial inclusion. Nimble and specialist non-bank business models catering to the ‘last-mile’ must be nurtured, albeit in ways that keep the overall financial system safe.

If NBFCs were incentivised, by regulation, to securitise incremental assets above a certain threshold size of balance sheet, they could continue to pursue profit growth without necessarily expanding the size of their balance sheet.

Second, the harnessing of the digital revolution to democratise access to credit can be sped up. Data APIs covering publicly-available GST data are being used to held lenders shape better credit risk models and products for micro-enterprises to share data on their respective GST filings with lenders. This is likely to bring massive growth in risk-mitigated lending to the ‘last mile’. Likewise, if the government would, for a few years, subsidise smartphone usage amongst the poorest third of the population, as the reach of broadband services deepens, those currently left out would very quickly become integrated into the formal financial system.

Challenge 5: Gaps In Long-Term Finance

Last, but not least, is the challenge of long-term finance. India’s experiment with private and PPP infrastructure development may have run into trouble, but the need for investment in infrastructure remains as pressing as ever. In this context, the Budget announcement of the launch of a new DFI is very welcome, provided, however, we learn the right lessons from the past. What are these lessons? For one, the new DFI must not be listed. Its goal must be profit-satisfying, not profit-maximising. It must be incorporated and regulated under a special regulatory/legislative dispensation – it cannot be run under the extant restrictive RBI framework for an infrastructure finance company.

In addition to anchoring the equity capital for this DFI, GoI must help reduce the cost of the long-tenure debt financing for its balance sheet through partial credit enhancement if necessary. The DFI should be focused primarily on construction finance.

Rather than continually growing its balance sheet, it should strive to recycle its loan book by selling post-construction credit to banks and/or infrastructure debt funds.

The DFI should become a catalyst for a post-construction bond-market. It must strive to lead the financial system in setting standards for sustainability. And most importantly, it must be managed autonomously with an independent board, accountable to the government. It will need the best of talent and so should not be subject to government pay restrictions, even if it is itself government-owned.

Beyond creating a DFI, the Budget proposal to scale up asset recycling by linking the sell-down of brown-field government infrastructure with a national pipeline of “shovel ready” projects is also very welcome. Given that construction risk is high – and was one of the principal causes of the infrastructure mess of the UPA years – it is only appropriate that the government take on the burden of getting projects off the ground, inviting the private sector to invest only once they are operational and cash flows become more predictable. This is an idea that I have been advocating for some years.

As important as these initiatives are for addressing the huge need for long-term finance, the key to attracting both domestic and international debt and equity capital into infrastructure at a reasonable cost is to reduce the perceived risk in the sector. For this, it is vital that reforms to mitigate regulatory risk to long term cash flows in the sector be pursued vigorously. This means, in the power sector for example, that we must find ways to reduce, if not eliminate, the risk that state electricity distribution companies keep finding ways to contest, delay or renege on their contractual obligations to buy power from private generators.

It will take a multi-dimensional strategy to address the non-trivial challenges facing our financial sector. Sustained and systematic application is needed to ensure that India gets the system it deserves.

Rajiv Lall is Visiting Faculty, Singapore Management University. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.