Why Raghuram Rajan's NPA move may either bring Indian banking to life, or push it into a coma

If bank nationalisation of Prime Minister Indira Gandhi symbolised the political thought of that time, a clean-up and a gradual withdrawal of state from managing banks may well be the mark that Narendra Modi could leave behind.
Four decades of state-directed lending has come full circle — from the idea of making credit available to the poor which was not possible when rich businessmen controlled banks, to crooked entrepreneurs gaming the system, breaking banks and leaving the bill for the taxpayers to pay.

BEHIND THE CURVE

Matters have come to such a head that the Reserve Bank of India Governor Raghuram Rajan’s zeal to clear the mess that’s hobbling the economy by March 2017 has divided the house in the middle. His surgery may either bring Indian banking back to life, or push it into coma. In fact, some feel that he is behind the curve in administering the medicine.

“There are a lot more companies that should be declared NPAs but have not yet been declared NPAs,” says Neelkanth Mishra, strategist at Credit Suisse. “Companies have operating profits which are much lower than what are needed to cover their interest, which means that they are still getting loans from banks to service their interest and keep their loans alive. So, we think that the RBI has not been stringent enough.

It is grim — the stressed assets of banks are at 11.3%, which means that the capital they have is not enough to cover the loss of value of their assets. Investors don’t believe the value that banks are assigning to assets so their shares are trading at lower than their book value.

What’s the way out? Banks can keep funding the poorly structured assets and wait for the economy to gather momentum to get their money back, or recognise the loss of value and find another manager to run the company better and recover their dues. “Our option, when we look at stressed loans, is either carry them as a zombie, pretend and lend, or accept surgery. If we have a structural solution of capacity creation then the second is better. Otherwise, we are down the path of first,” said Uday Kotak, vice-chairman of Kotak Mahindra Bank.

International experience shows that when the bad loan recognitions are postponed banks lose their ability to fund an economic revival — as it happened in Japan with ‘zombies’ after the 1989 crash. And the other is like Sweden, or the US where asset values are written down, new buyers found, and additional capital is invested. Furthermore, if banks are laden with bad assets, their ability to lend is crippled as they focus on recovery of loans and some even gamble away to compensate for the losses.

“There are two approaches that zombie bank managers take as they struggle to bring their institutions back to life,” writes Yalman Onaran in ‘Zombie Banks’. “They’ll hoard cash and give a few new risky loans, and wait for the slow profit-building to pay for the losses overtime. Or they will take much bigger risks with the hope that they can make windfall profits to plug the holes.”

State-run banks’ reluctance to lend is reflected in the credit numbers. Government banks’ credit growth slowed to 6.7% December last, from 19.1% in the same month in 2013 while private sector banks’ credit growth accelerated to 20.5% in the same period from 16%.

Governor’s advocacy of surgery may appear to be an option, but it comes with some immediate costs. Banks are reporting record losses and are on course to record more in the coming quarters as they race to complete the exercise by March 2017. The Indian industry, which is not used to this kind of shock treatment, is resisting it. Bankers say public perception is turning adverse.

The RBI says the “recognition of NPAs was the anesthetic needed for the surgery,” says Deepak Parekh, chairman of HDFC. “I only wish to caution that too much of anesthesia can also result in a patient becoming comatose! The banking sector cannot afford another quarter like the one just gone by.”

In the December quarter, of the 40 listed banks, 10 banks had gross bad loans of more than 8%, while 22 banks had in excess of 5%. In a matter of 40 days, they lost more than `1.8 lakh crore in market capitalisation.

Morgan Stanley estimates that Indian banks will need `2.5 lakh crore in capital by 2019 while the government’s estimate is at `1.8 lakh crore. Capital may have to be found from both the government’s coffers and from private capital. “Desperate times require desperate measures,” says Nilesh Shah, MD, Kotak Mutual Fund. “You have the Japanese and European experience of tackling NPAs through central bank funding. You have the Chinese experience of using FX reserves to manage NPAs; you have the American experience of rail road bonds. There are ‘n’ number of experiences in global markets for us to learn to manage our NPAs.”

INVESTOR REACTION

Despite the fact that the problem has been lurking, investor reaction to the losses borders on panic as if there is no future for banks. The government’s fiscal commitment is making investors doubt whether it would be able to meet the capital needs. But all is not lost, say bankers.

“Many of these accounts have solid assets behind them,” says Arundhati Bhattacharya, chairman, State Bank of India. “Most are working units, with dealers, suppliers, and employees.” But the timing and dosage of medicine may not be appropriate given that the economy is still growing at a pace lesser than its capacity, and that the government may not be able to bring up enough funds.

Instead of bringing back the banks to health, Governor Rajan’s shotgun surgery could push them to a tipping point without helping the economy.

Yes, there may be a few more quarters of bad numbers. But this may well be a journey that could end up happily. “I think what is happening now is good in the long term for the banking sector and for the economy,” says S Naganath, President and CIO at DSP Blackrock Mutual Fund. “The problem is being addressed in a focussed manner and within a defined time-period. Once it’s done, the outcomes will be very positive for the economy.”

With scores of banks set to enter, life could only get complicated given that they may make transactions zippy with all the technology available. So, state-run banks have to do more to remain relevant.

“You cannot just throw people at it. You need to change the processes; you need to use big data; you need to have a very robust credit bureau; all those things require new-age banks. They require new ways of solving a problem,” says Credit Suisse’s Mishra. “Some of the private sector banks are taking a lead. They realise that this competition is coming in the next 3 to 5 years. They are already transforming. And, the new banks realise that is where the opportunity is and that is where they are headed.”

SBI chairman Bhattacharya has a solution that can set off another cycle of prosperity to penury of four decades — cut government ownership below 51% and unleash the animal spirits.