India’s Grappling Banking Sector: Viral Acharya and Raghuram Rajan on the way forward

The Indian Banking Sector, struggling with rising NPAs since 2016, followed by the NBFC crisis in 2018, and the COVID-19 lockdown, is grappling to maintain adequate liquidity. The measures taken by the Finance Ministry and the RBI to alleviate the banking problem have failed to add value. In the paper ‘Indian Banks: A Time to Reform?’, Viral Acharya and Raghuram Rajan recommend a few reforms to withdraw the Indian Banking sector from the periodic boom-bust cycles.

One of the startling facts noted in the paper is that India’s credit to GDP ratio is less than 60%, however, the Gross Non-performing Assets (GNPA) to total assets ratio is 8.5% (pre-COVID) expected to reach 12.5-14.7% post-COVID. This implies that there may be some fundamental issues in the way the banks are lending. They are selective but are also witnessing higher NPAs. Though IBC has made the recovery easier, the recovery rate still remains lower. Furthermore, the government’s initiative to consolidate Public Sector Banks for better strategies and credit management has failed to demonstrate affirmative results.

The paper gives out the recommendations in 6 categories:

  1. Dealing with Bad Loans
    • Out of court restructuring framework for time-bound negotiation between the parties
    • 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
  2. 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 the Department of Financial Services in the Ministry of Finance
    • Incentive structures for management need to be strengthened
  3. Alternatives to Ownership Structure of Public Sector Banks
    • Government to bring down its stakes to below 50% distancing itself from the operations of the banks
    • Re-privatisation of select public sector banks
    • Automatic dilutions can be deployed as another intermediate step to reprivatization
  4. Making Better Loans
    • Create better capital structures for project finance
    • Smooth expected provisioning of loan losses can be incorporated in bank regulation with the adoption of IFRS / Ind AS as accounting standard for banks, with loan provisioning front-loaded rather than mostly back-loaded
    • The transition from asset-based lending to (also) cash-flow based lending
    • Transparency around frauds and group exposures
  5. Strengthening Risk Management at Banks
    • Complete external benchmarking of loans to market-based floating rates for all variable rate loan categories
    • Time-bound transition to greater mark-to-market of treasury positions, in order to move banks away from “lazy lending”
    • Index National Small Savings Fund (NSSF) rates to average contemporaneous bank deposit rates
  6. Creating Greater Variety in Banking Structures
    • On-tap licensing for banks can be kept open at all times – with an annual invitation for applications
    • 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 the 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

The recommendations provided are not out-of-the-box per se. Many have already been recommended but gone missing after some time. The paper focuses more on Public Sector Banks. However, these recommendations seem generally acceptable for Private Sector Banks as well. The implementation of these recommendations does not go without challenges. For example Recommendation 2 may take a lot more time in the handing-over process delaying and stretching the problem in the sector and Recommendation 6 requires rural India to be well-equipped before smooth implementation. Another important factor to note is that these recommendations seem to provide for the steps to be taken in the future to avoid such an issue arising again in the sector. It does not seem to considerably showcase how the current NPA levels and the deadlock may be lessened so that these recommendations may be implemented. However, these challenges do not lessen the significance of the paper for the banking sector today.

In conclusion, the paper directly critiques the government’s failed attempts by demonstrating a positive way forward for the Indian Banking Sector. At a time where the fear of bankruptcies in the near future is rising, adopting some, if not all, of the recommendations may be plausible.

*Please read the paper linked in order to understand the recommendations and the explanation of a few concepts such as ‘bad banks’ and ‘lazy banking’.

MSc Finance graduate from the London School of Economics and Political Science (LSE)
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Ria V Vaghela is an M&A Executive at RSM UK and an MSc Finance graduate from the London School of Economics and Political Science (LSE). She has worked at Jefferies, Dial Partners and 7i Capital prior to RSM UK gaining an experience of about 1.5 years. She has also worked as an Editor and Content Writer for The Representative Media. Apart from finance, she is interested in reading books on psychology and economics and also likes to paint and play lawn tennis

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