India needs urgent reforms to its financial system because banks have created a major crisis by lending unwisely to big borrowers who lack the ability or intention to repay their debts.

The financial system in the economy is like the circulatory system in the human body. And banks form its beating heart. If banks falter, the flow of money stops and the economy suffers the equivalent of a heart attack.

In India, banks are not doing terribly well. They have lent unwisely. As a result, many loans have “become overdue” and a number of borrowers are not in a position to pay back their debt. This has made many a loan a non-performing asset (NPA). When borrowers are in default or in arrears on scheduled payments of principal or interest for specified period, usually 90 days, the loan is classified as NPA. All banks around the world have some NPAs but, if they become too large, banks can collapse. If the banks are big enough, this can cause the meltdown of the entire financial system.

According to CARE Ratings, India had the fifth highest NPA ratio in the world, ranking only after Greece, Italy, Portugal and Ireland. India’s NPA ratio stands at 9.85%, while major economies such as Britain, the US, Japan and Germany have ratios less than 2%. According to the latest Financial Stability Report of the Reserve Bank of India (RBI), the NPA ratio is set to deteriorate to 12.2% by March 2019, which would put India in fourth position, overtaking Ireland. As per the RBI, 11 public sector banks are under the prompt corrective action category, which means that the poor quality of balance sheets have to be addressed immediately to avoid potential meltdown.

India’s banking industry could be said to be in what economists call secular decline. This occurs when adverse long-term trends threaten an entire business model. This secular decline has led to much introspection within the government and its various regulatory bodies. The Financial Sector Legislative Reforms Commission (FSLRC) has proposed a new Indian Financial Code. This code would streamline India’s confusing regulatory framework and hold various actors in the financial system accountable. Currently, the country’s regulatory framework is a bit like the US with overlapping mandates and multiple regulatory power centers, but none of them having the power or the ability to oversee the financial sector effectively.

Consequently, astute observers like Chaitanya Kalbag of The Economic Times are rightly asking whether the “NPA black hole” could “suck in the country’s entire banking system.” A systemic collapse is certainly a possibility. Already, India’s weak banking sector has led to anemic credit supply. Most banks are not in a position to lend. Therefore, businesses cannot borrow money for capital expenditure or growth plans. In turn, this leads to lower employment and slower economic growth. Therefore, the economy is not exactly in rude health.

ARE NON-PERFORMING ASSETS A SYMPTOM OR DISEASE?

Many argue that the Indian NPA crisis is a result of a deeply flawed banking system renowned less for its acumen, professionalism and prudence and more for its inefficiency, corruption and mismanagement.

Most banks are operated by the government. These state-owned or public sector banks occupy the commanding heights of the economy. They disbursed 69% of the total loans in 2016-17. Politicians and bureaucrats form a vicious nexus that controls these banks. This means that appointments to top positions and sanctions for key loans are a result of patronage, not process. It leads to vicious crony capitalism, where those with connections to the politician-bureaucrat mafia “laugh their way to the bank.”

Private banks in India face huge problems too. Many of them have corporate governance issues. Yet the big bosses of some of these banks have recently fallen on their swords. Chanda Kochar, the celebrity woman CEO of ICICI, had to leave her throne in June this year. Shikha Sharma, the CEO of Axis Bank, is bowing out at the end of the year. Even Rana Kapoor of Yes Bank will be gone by January 2019. In public sector banks, the nameless and faceless head honchos have largely avoided such fates.

Banks are not the only financial institutions in trouble. In India, the Non-Banking Financial Company (NBFC) has emerged as a powerful entity in recent years. Stocks of NBFCs had been going up for the last few years. Thanks in part to high oil prices and a crashing rupee, these stocks have now plummeted and the NBFC party is over for now. This has a spillover effect on the banks because they were betting on NBFCs.

As per Rashesh Shah, chairman and chief executive officer of Edelweiss Financial Services, for the last three to four years, “the best part of bank portfolios was exposure to NBFCs, which were growing at 25-30% in the last five years.” As if this was not bad enough, the default of the Infrastructure Leasing and Financial Services (IL&FS) has sent shudders in India’s poorly governed financial system. Such is the dire state of affairs that the government is reportedly on the verge of canceling licenses to 1,500 smaller non-banking finance companies because they lack adequate capital. It will also become more difficult for a new NBFC to get approval.

This may avert a full blown financial crisis, but small borrowers will find it more difficult to get loans. Those in the countryside will be hurt most. Even today, 66% of India’s 1.3 billion people live in rural areas. Most of the time, they take loans from private moneylenders or NBFCs. They will now have less cash. Consequently, they will buy fewer goods and services, lowering private consumption and putting a brake on India’s economic growth.

The opposition has gone to town with the IL&FS crisis. It has accused Prime Minister Narendra Modi’s government of bringing India to the “verge of economic collapse.” The Nehru family-led Indian National Congress has called this crisis the “Lehman Brothers moment of India.” They are of course referring to the collapse of Lehman Brothers in 2008, which remains the largest bankruptcy in American history and which triggered a global financial crisis.

The current woes of the financial system are a symptom of crony capitalism that has plagued India from the earliest days of liberalization in 1991. Like in other communist or socialist countries that relied on Soviet patronage, liberalization in India did lead to growth but it also led to the emergence of oligarchs. In particular, the Congress-led coalition ran the most corrupt government in India’s history during its second term from 2009 to 2014. The financial crisis that India is experiencing today is because Modi failed to break the politician-bureaucrat-plutocrat nexus that lies at the heart of the financial crisis. That nexus is the true disease that ails India.

OTHER REASONS FOR THE FINANCIAL CRISIS

While the chronic disease is the politician-bureaucrat-plutocrat nexus, there are other ailments that have exacerbated the current situation.

First, the irrational exuberance that affected much of the world in the mid 2000s also touched India. The country enjoyed high octane growth in that period. Many businesses embarked on an aggressive expansion spree on the back of credit by banks. Even India’s most reputable corporate house fell prey to the dominant zeitgeist. Tata Steel’s $13.1 billion purchase of Corus in 2007 remains the poster child for this profligate era. Needless to say, this purchase — like many others 10 years ago — has turned out to be an unmitigated disaster.

In India, problems with companies resulted in even greater troubles for banks. Until very recently, lenders enjoyed little legal protection. Banks could rarely recover loans from those with political connections. Forgiveness and haircuts were the norm when things went south for big borrowers. This created a classic case of what economists call moral hazard. Borrowers could rack up debt safe in the knowledge that losses would be borne by taxpayers while gains would be theirs alone.

Socialism on the downside and capitalism on the upside created perverse incentives that unscrupulous wheeler dealers like Vijay Mallya and Nirav Modi exploited to the hilt. Both these gentlemen have now fled abroad with their cash, and their banks have little hope of recovering the gargantuan loans they took out. J. Paul Getty’s quip, “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem” holds true in most countries, but especially so in India. In a nutshell, the politician-bureaucrat-plutocrat nexus has robbed the people of India and is literally laughing all the way to the bank.

Second, the policies of the Congress-led government of 2004-14 exacerbated the grim financial situation. In 2013, India Today damned the government with a simple headline, “UPA report card: Nine years, nine scams.” It captured the avaricious and parasitic nature of that Congress government. It did not bring in any reforms to the banks. Neither lending nor the recovery of loans were a focus of attention. When the global downturn inevitably arrived, the sectors such as mining, steel, power, infrastructure, real estate et al. that had over borrowed ended up in a hot soup.

Third, demonetization and the introduction of the Goods and Services Tax (GST) has put businesses under great strain. In 2016, the Modi government withdrew currency notes of Rs500 and Rs1000 denomination. In India’s traditional cash-based economy, this created havoc for traditional businesses. Similarly, the rollout of GST with terrible government circulars, asphyxiating red tape and aggressive implementation has also shaken up traditional businesses. Most of these have avoided the tax net so far and the GST has increased their cost base. These two disruptive measures have delayed economic recovery and elongated the business cycle. In turn, businesses find it harder to pay back loans to the banks, putting further strain on India’s financial system.

THE WAY FORWARD

Despite the banking crisis or perhaps because of it, authorities have taken a few good measures. Under Raghuram Rajan, the previous governor of the Reserve Bank of India, the RBI toughened its norms of classification for NPAs. As a result, banks have far less discretion to roll over stressed assets. Rajan has admitted that the RBI should have begun the NPA clean-up earlier, but it is now finally underway in earnest.

© mirbasar

In defense of public sector banks, we have to cut them some slack for approving lending for infrastructure projects, social sector initiatives and other government schemes, which they have been forced to engage in thanks to diktats of bureaucrats in New Delhi. Furthermore, India lacks a well-developed bond market, particularly for junk bonds. This means that banks participate in the riskier spectrum of lending compared to, say, Germany or Japan. Naturally, this increases their risk profile and makes them vulnerable to meltdown.

In the light of the risks that Indian banks face, the Modi government passed the Insolvency and Bankruptcy Code in 2016. This code has been a revolutionary change, giving banks far-greater powers to recover their loans. They can now declare loans to be in default and initiate insolvency proceedings at the National Company Law Tribunal (NCLT). There are too few of these and not enough professionals to adjudicate these proceedings, but the lenders can finally claw back loans from defaulting borrowers and safeguard the hard-earned savings of hundreds of millions of Indians.

Now, the Modi government and the RBI together have to ensure a controlled unwinding and institute further reforms.

First, the government must open more branches of the NCLT, make the process more efficient and hire more insolvency professionals. Second, the government ought to institute long-term structural reforms and avoid knee-jerk reactions such as the privatization of public banks. Indian institutions are far too fragile and compromised. Any hasty privatization will inevitably lead to more crony capitalism. Third, India needs to develop a bond market, so that risky projects can raise capital directly from public markets and are not reliant on banks. This would improve the risk profile of Indian banks considerably. Fourth, the government must consolidate public sector banks, but ensure they do not become “too big to fail” as in the US.

Fifth, the Modi government must bring in better governance for public sector banks. It is high time for legislative changes giving clear mandate and operational autonomy to the RBI to replace boards, force a merger or even revoke the license of state-run banks. The regulator must also have power to fine errant executives and prosecute them in criminal courts. Those who are criminally delinquent or malfeasant with savings of the hundreds of millions of poor Indians must end up in prison. India has no choice but to break the politician-bureaucrat-plutocrat nexus that has flourished for too long.

Sixth, the government must not only regulate banks better, but also reform the state-run public sector banks themselves. These institutions are currently caught in a time warp. While the world has moved on from 1991, their operating processes, management structures and the way of doing business have remained the same for decades. To keep pace with the demands of the Indian economy, public sector banks need better selection, evaluation and promotion mechanisms. They also need professional management structures that safeguard independence from politicians and bureaucrats. These worthies have only too often pressured bankers to give dud loans to their cronies, leaving the banks in duress and the taxpayer in distress. That must change.

Finally, the government has to regulate not only public sector banks, but also the private sector better. Recent scandals in India’s private banks and its NBFCs, as well as the global financial crisis of 2007-08, clearly demonstrate that an unregulated or poorly regulated financial system presents grave risks to the economy. In the Indian context, the relationship between the management of private banks and the titans of the corporate world is highly incestuous, exacerbating risks to an already frail sector. Therefore, the government has no alternative but to draft rational regulations and create effective regulatory institutions for the financial system to function and the economy to flourish.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.