People wait in in line for a bank branch to open in Delhi. (Photographer: Anindito Mukherjee/Bloomberg)

Indian Banks' Poisoned Chalice

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(Bloomberg Gadfly) -- As if the distress caused by India's cash ban wasn't enough, somebody started a rumor on Monday that Axis Bank Ltd., the country's third-largest private sector lender by assets, would have its license revoked.

Axis had to issue a statement to quell the speculation. But while this may have been a brief panic, the message to investors and analysts is clear: Operational and reputational risk for India's banking system has surged uncontrollably since the government's Nov. 8 move to outlaw 86 percent of the country's cash.

What should have been a cornucopia of new deposits from old cash has become a poisoned chalice. Lenders don't have enough banknotes to meet even the restrictive withdrawal limits the central bank has set for depositors. People have died waiting in ATM queues, and bank staff fear the wrath of crowds. Safety concerns are rising amid pressure from authorities to expand card and online-payment systems that are still rudimentary. Even the ATM networks, running on outdated software, aren't very secure.

To top it all, the taxman is waiting in the wings, ready to confiscate any unusual surge in deposits that people don't surrender voluntarily.

Instead of sympathy for lenders, there's schadenfreude. Some feel bank employees have colluded with the holders of ill-gotten cash to give their unaccounted wealth safe passage. The poor, and their bank accounts, are suspected to have been used as mules.

The initial premise of demonetization was that a big chunk of cash would be too tainted to dare return to the banking system, and canceling those liabilities would generate a bumper profit for the government. With most old currency deposited into accounts or exchanged into new money, however, that hypothesis has been shredded. Banks -- and bankers -- are in the crosshairs for robbing the nation of its demonetization rewards.

Reporting requirements have gone through the roof: The government wants to know how much of lenders' fresh deposits are old legal tender, and how much is new. Axis Bank suspended 19 employees for allegedly exchanging old banknotes illegally and asked KPMG to do a forensic audit. That, one suspects, is the genesis of the whisper campaign.

As banking regulator, the Reserve Bank of India ought to be keeping a lid on operational risks, lest they overwhelm the system and scar its reputation. But the monetary authority is too busy shoring up its own sullied credibility to be of any real assistance. The barrage of befuddling rule changes it has unleashed since Nov. 8 -- including a temporary but ham-handed confiscation of banks' excess liquidity with no compensation -- have made things worse, and investors have been forced to change their minds about the impact of the cash ban.

Amid the chaos, discussions about improving the governance of India's dominant state-run banks, and selling or shuttering the weakest of them, have come to a standstill. The more urgent task of cleaning up their compromised balance sheets has also lost the steam it had gathered under previous RBI Governor Raghuram Rajan. If a month ago there was fond but foolish hope that banks would get a big one-time recapitalization boost, now there's despair about how long they can go on fighting fires without any chance of a revival in credit demand.

It's hard to believe Prime Minister Narendra Modi didn't think through these unintended consequences. What's even scarier is the possibility that he did, and topped up the banking industry's chalice regardless.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

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