Discussions on Indian banking have, over the last couple of years, focused almost entirely on a single issue – the level of non-performing assets and ways to bring this level down. But as we were discussing NPAs, quiet changes have taken place that will alter the very foundations of Indian banking. These changes are likely to have profound implications on the shape of banking over the next decade or more.
Specifically, I see three major changes that will fundamentally alter the face of Indian banking and finance sector:
- Adoption of a new monetary policy framework based on inflation targeting;
- A new insolvency and bankruptcy code that's recently been upheld as constitutional by the Supreme Court; and
- RBI’s regulation on limiting bank borrowing by single corporate to Rs 10,000 crore.
I will argue that the combined effect of these three will alter the very fabric of Indian banking.
Leverage In The High-Inflation Era
After liberalisation in 1991, we had a monetary policy—earlier called the credit policy—which had no explicit inflation target, or any other specific target for that matter. For a decade before and nearly 25 years after liberalisation, we had WPI inflation averaging over 6 percent with bouts of over 8 percent. With such persistent high levels, high inflation expectations were deeply-embedded in the Indian business psyche.
The rational response of a company to the expectation of high inflation is to over-leverage the balance sheet.
High real-GDP growth along with high pricing power—that comes with inflation—would encourage corporations to make investments, leveraging themselves to the hilt. Inflation was counted on to bail out an over-leveraged balance sheet as it deflated the real of debt. The only potential downside was a slowing down of growth or other challenges such as policy changes that could hurt the business’ economics. But even if the business stumbled along the way, there was precious little that lenders could do, in the absence of a bankruptcy law. Company owners could brazen through all bad patches along the way without any fear of losing control. Thus, over-investing and over-leveraging was the rational strategy for companies where all the upside accrued to the owners with no real downside. A very good example of this behavior is the period of 2003-2008 where we had exceptionally low inflation and interest rates. This was also the period which saw the most egregious over-leveraging of corporate balance sheets in Indian history.
At that time, it was rational to believe that the low inflation will not sustain, and a bout of inflation would devalue debt sooner or later.
The new monetary policy framework changes this calculus profoundly.
Three Simultaneous Changes
With this framework, for the first time in our history, effectively the state has committed to maintaining low inflation (4 percent of CPI) as its explicit policy target. This policy framework structurally moves inflation downwards and will ensure that there will be no bouts of high inflation as the policy action would curb inflation quickly. Thus, debt deflation will be a thing of the past. Companies cannot count on inflation bailing them out of over-leveraged positions. Legally establishing the framework will also fundamentally alter inflation expectations.
Add to this, the new bankruptcy law. Any miscalculation on borrowing and defaults now pose a serious threat of owners losing control of the company. As bankers become more effective in using the bankruptcy law and as company law tribunals develop capacity, the challenge to corporate control will become serious.
Finally, the RBI has capped the total borrowing from the banking system for a single borrower. This limit, currently set at Rs 10,000 crore (effective from April 1, 2019), will mean that for all large investments, companies will have to go to the bond markets to raise debt capital. Indian bond markets are skewed and only very highly-rated companies (with a rating of AA and above) can raise large amounts of debt. This is unlike the banking system, where even new projects and companies with a low rating would be given loans.
Also Read: The Regulatory Dilemma With NBFCs
Pivot Toward Consumer And SME Credit
The combined effect of these three factors would be that companies will be far more cautious in leveraging their balance sheet and committing to large investment projects. In the short run, the overall demand for credit for large investments will come down. In the long run, we can expect corporate borrowing to become more disciplined, and hence robust. There may be an economic downside in the near-term, as falling investments will reflect as a fall in domestic capital formation, which may eventually impact GDP growth. We need sustained private sector investment to maintain high real GDP growth. However, this should not be seen as an argument against the monetary policy framework or the bankruptcy law, but a short-term price to be paid to sustain much-needed reforms.
In response to the slowing demand for investment-related credit, banks will have to reorient their business towards consumer and small and medium enterprises.
Indian banking, which had a large-company and investment-led credit model will have to transform itself into a small-customer credit model. This is the inflection point at which it stands. This transformation in banking will also have an impact on the structural economics of businesses.
The system may settle down at a lower return on equity.
Hopefully, the banking system will also become more stable and not susceptible to NPA cycles as it has been in the past.
Of course, this whole logic depends on the underlying factors remaining intact.
- It assumes that the 4 percent inflation target is not moved upwards in the interest of growth, as some have argued.
- It also assumes that the bankruptcy law retains its bite and is not weakened by litigation and amendments.
The resolve of the state to stay put on these reforms will determine the extent to which they change banking.
Recently, many banking analysts in India have discovered beauty in the so-called ‘corporate’ banks. From what we can see today, most banks will actually move away from being corporate banks and so the ‘buy’ call on them may be short-lived or will have to wait much longer!
Harsh Vardhan is Executive-In-Residence at the Centre of Financial Services, SP Jain Institute of Management & Research. The author thanks Rajeswari Sengupta for discussions on these matters.
The views expressed here are those of the author and do not necessarily represent the views of Bloomberg Quint or its editorial team.
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