No Escaping Hard Task Of Making Indian Banks Robust: Rajan, Acharya

The status quo in the Indian banking sector is untenable and reforms must be initiated to ensure the sector becomes an engine of growth rather than a drag on growth.

That’s according to former Reserve Bank of India Governor Raghuram Rajan and former Deputy Governor Viral Acharya, who have co-authored a paper titled Indian Banks: A Time to Reform?

“With the current enormous strains on government finances, there may be a window of opportunity in which these reforms may be possible since the status quo is untenable,” Rajan and Acharya wrote. “There are strong interests against change,” the authors said, adding they are “optimistic that a middle road is achievable.”

Rajan and Acharya went on to list the reforms, while acknowledging that some of these have been suggested earlier by committees over the years. The reforms, they said, have to be on many fronts, closely monitored, and recalibrated to developments.

Some of the reforms highlighted by the authors are listed below:

Dealing With Bad Loans

• Out-of-court restructuring frameworks can be designed for time-bound negotiations between creditors of a stressed firm, failing which the National Company Law Tribunal filing should apply; the two need to work in tandem as the Insolvency and Bankruptcy Court’s procedural threat serves as the fallback, facilitating meaningful negotiation out of court.
• Development of an online platform for distressed loan sales to provide real-time transparency in loan sales.
• Private asset management and national asset management “bad banks” should be encouraged in parallel to the online platform for distressed loan sales.

Improving The Performance Of Public Sector Banks:

• Operational independence for boards and management, a proposal made by a large number of banking reforms committees over the past three decades, needs to be embraced by creating a holding company structure for government stakes.
• Payment by the government to banks for achieving its mandated goals (such as reimbursing costs for maintaining branches in remote areas or opening bank accounts for all).
• Winding down Department of Financial Services in the Ministry of Finance is essential, both as an affirmative signal of the intent to grant bank boards and management independence and as a commitment not to engage in “mission creep” when compulsions arise to use banks for serving costly social or political objectives.
• Incentive structures for management need to be strengthened with longer terms for senior management, better assessment of performance, performance-based promotions and extensions, as well as some reliance on lateral hiring, which would also bring in state-of-the-art banking ideas and practices.

Alternatives For Ownership Structure of Public Sector Banks:

• State-linked banks can be a first step in altering the ownership structure of some PSBs, where the government brings down its stakes to below 50%, creating distance from operations of banks, and improving governance along the way.
• Reprivatisation of select PSBs can then be undertaken as part of a carefully calibrated strategy, bringing in private investors who have both financial expertise as well as technological expertise; corporate houses must be kept from acquiring significant stakes, given their natural conflicts of interest.
• Automatic dilutions can be deployed as another intermediate step to reprivatisation, whereby the government commits upfront to letting the bank board dilute the government’s stake through raising of fresh capital whenever the government is unable to inject the capital required to meet regulatory requirements.

Making Better Loans:

• Create better capital structures for project finance, for instance, in the form of greater promoter equity and eventual loan sales to long-term investors, while government alters the real conditions under which these loans are made.
• Smooth expected provisioning of loan losses can be incorporated in bank regulation with the adoption of IFRS (International Financial Reporting Standards) / Ind AS as accounting standard for banks.
• Transition from asset-based lending to (also) cash flow-based lending. Banks could rely more on loan covenants for large borrowers, tied to liquidity and leverage ratios (instead of lending purely against assets).
• Transparency around frauds and group exposures would improve market discipline and public enforcement, creating deterrence in egregious asset-stripping, cash-flow siphoning, and related-party transactions; group exposure limits, both at the bank level and the system level, need to be implemented, given increasing risk concentration in several key groups.

Strengthening Risk Management At Banks:

• Complete external benchmarking of loans to market-based floating rates for all variable rate loan categories in order to create an automatic pass-through of monetary policy to the stock of legacy loans.
• Time-bound transition to greater mark-to-market of treasury positions, in order to move banks away from “lazy lending”, where investments in government bonds become a one-sided bet with downside risks managed by regulatory forbearance.
• Index National Small Savings Fund rates to average contemporaneous bank deposit rates to remove the fiscal overhang on transmission of monetary policy.

Creating Greater Variety in Banking Structures:

• On-tap licensing for banks can be kept open at all times — with an annual invitation for applications — to create more vibrant banking with entry of better players.
• Allowing high-performing micro-credit institutions to become small finance banks, and similarly, high-performing small finance banks to become universal banks. Conversely, poorly performing universal banks can be relegated to small finance bank status.
• Promoting greater entry of non-bank players, especially in the area of capital markets and newer forms of lending such as fintech, building on the success in digital payments.
• Encouraging development of wholesale banks that rely on market financing, as a way to provide greater financing for long-term infrastructure projects without expanding the size of deposit insurance.