UPA left the banking system toxic, and Jaitley's moving too slowly to fix it

For a government that has moved simply too slowly in recapitalising public sector banks, it is good to hear Finance Minister Arun Jaitley tell investors in the US that this will happen in three-six months. It will be too little, too late. Between them, Pranab Mukherjee and P Chidambaram have left behind a huge time-bomb for Jaitley to defuse, and so far he is showing no signs of being on top of the problem. The high-growth years of UPA were bankrolled by excessive, injudicious lending by banks, and Jaitley is facing the music now. According to rating agency Icra, gross bad loans and restructured assets (bad loans that have been rescheduled for borrowers) are in the region of Rs 7.4 lakh crore, and this could spike up to Rs 8 lakh crore by March 2016. That’s 10 percent of all loans made by the banking system – enough to sink weak banks.[caption id=“attachment_2287344” align=“alignleft” width=“380”]  Union Finance Minister Arun Jaitley. Image courtesy PIB[/caption] An Economic Times story today (23 June) says the finance ministry is asking banks to present five-year recapitalisation plans instead of turning up at North Block every year with a begging bowl. This will at least make banks think through their capital requirements on a long-term basis. It will also force them to economise on the use of capital - which is actually the costliest form of money. This is the right approach, but again does not go far enough. The fundamental problem with Jaitley’s approach is that he is seeking remedies without changing the structure that creates capital-hungry public sector banks in the first place. What is wrong is the top-down nature of Indian banking, where the ministry has too large a role in deciding what banks should do, and banks themselves are happy to oblige since this takes away the management’s pressure to perform. As the owner of banks, the government should certainly set objectives and deliverables, but North Block does not seem to understand that this relationship is two-way: the owner too has to bring something to the table in this relationship. A capricious and arbitrary owner is not good for public sector banking. To insist that banks must pay out a certain proportion of their profits as dividends to the exchequer, and then deny them capital for growth on grounds of being inefficient, and again asking them to incur huge costs in expanding inclusive banking means the government is setting contradictory objectives without an understanding of how money is made in banking. To be sure, the Jan Dhan Yojana is a good scheme and deserves to be rolled out, but it also needs to be financed in the early stages when costs will exceed revenues from no-balance or low-balance accounts. The UPA’s economic growth record was built on the back of mindless bank lending that was simply unsustainable. If today banks are unable to lend, it is because the UPA years drained them of their capacity to lend or take risks. Banks were forced to lend to all kinds of infrastructure projects that were unviable, not to speak of bankrolling crony businessmen like Vijay Mallya who has left banks saddled with Rs 7,000 crore of dud loans to Kingfisher Airlines. How did banks lend so much for a bad business without adequate collateral? The lasting damage left behind by the UPA has to be fixed by Jaitley. And this requires him to move on several fronts simultaneously. He cannot expect a robust economic recovery if some of his banks are teetering on the edge of bankruptcy themselves. The five areas that Jaitley needs to move ahead on are the following: First, management autonomy. In his budget speech, Jaitley promised the creation of an autonomous bank board. He said: “In order to improve the governance of public sector banks, the government intends to set up an autonomous bank board bureau. The bureau will search and select heads of public sector banks and help them in developing differentiated strategies and capital raising plans through innovative financial methods and instruments. This would be an interim step towards establishing a holding and investment company for banks.” Nearly four months after the budget, even this “interim step” is not in sight. While the investment company may need legislation - which may be a problem as the political climate for getting any law passed in the Rajya Sabha is worsening – surely Jaitley could have moved ahead with the bank board and appointed competent CEOs within the existing structure and signed MoUs on performance as an interim measure. Clearly, North Block is moving too slowly on this reform. Second, there is the recapitalisation effort. This could have been done easily last year when the markets were buoyant, but this did not happen. This year could offer another opportunity if the markets rebound in the second half of the year, but what if they don’t? Jaitley can’t expect easy options to remain forever. He has to find the money somewhere, and one way would be to ask banks to not pay any dividend to the government this year, and use the money saved to recapitalise themselves as best they can till the market improves. Third, the long-term solution, if the government does not want to privatise, is to legislate a golden share where it has 51 percent voting rights, but far less economic rights. The capital can be raised from the market which will have higher economic rights (even entitlement to higher dividends) and lower voting rights. This change may not be easy to pass, but presumably some opposition parties can be convinced that this is the only way to recapitalise banks in a tough fiscal situation without privatising them. Fourth, banks must refocus on their core business and not get diverted into areas that need even more capital – like insurance and other businesses. Public sector banks can raise capital by selling off, or even divesting 49 percent, in their insurance, broking and other subsidiaries. The State Bank, for example, should list its bank subsidiaries instead of trying to merge them with itself. This will allow it to raise capital without diluting the government’s stake in itself. Fifth, mergers, voluntary retirement schemes and hiving off bad loans are unavoidable. Weak banks should be forced to narrow down their focus to conserve capital, and strong banks should be asked to take over some of them. Bad loans should be sold off at discounts to asset reconstruction companies or even floated off into a special subsidiary so that balance-sheets are cleaned up. Just as the US created TARP (troubled assets relief programme), the RBI and the finance ministry should create a company to buy off the bad loans of troubled banks and allow them to start afresh. Jaitley is moving simply too slowly given the nature of the problem left behind by the UPA. He should get a move on.