PNB-Nirav Modi fiasco: When all has been said and done, what kind of a banking system will we be left with?

Listening to comments by bankers expressing various levels of confidence in how resilient they are is fairly depressing. Back in the immediate aftermath of the 2008 credit crisis, the Icelandic banking failures, the Greek and Cypriot banking crises of a few years later, we heard the same refrain: The banks would bounce back, things would get better, etc.

Well, many banks didn’t, and things haven’t gotten much better, especially in Europe. A CARE Ratings report in December 2017 found that measured by non-performing asset (NPA) ratios, India ranked 5th highest, after Greece, Italy, Portugal and Ireland – the PIIGs, as they were dubbed during the European debt crisis.

Government ownership of banks – public sector banks (PSBs) account for more than 70 percent of the system, both on the deposit and credit sides – has made us complacent about their fate. The government, most people believe, will not let them fail. The moral hazard implications of faith in this implicit guarantee are astounding. Which begs the question: How big does the problem have to get before the faith in that guarantee is shaken?

Let’s take a look at the numbers. To begin with, the guesstimated value of stressed assets is currently about Rs 10 lakh crore or Rs 10 trillion. The Reserve Bank of India's (RBI) Trend and Progress of Banking in India 2016-17 reports under existing mechanisms (excluding the Insolvency and Bankruptcy Code, or IBC) that in the period 2015-17, the recovery ratio of NPAs of public sector banks was 25.1 percent.

What about the chances for recovery of this humongous debt? The recovery rate is defined as the reduction in gross NPAs. In monetary terms, that translates to roughly 11 percent of the value of the NPAs. By that reckoning, banks should recover about Rs 1.1 lakh crore. The recovery comes from loans that have collateral – secured loans, term loans and real estate exposures, in the main.

Experts point out that historically, only a quarter of restructured assets become completely viable assets eventually (the gross NPA ratio does not include restructured assets). A CARE Ratings report in February 2018 estimated restructured assets at Rs 1.9 lakh crore at the end of March 2017, or the last financial year.

What that number is likely to be in March 2018 is unclear; in its February 12 2018 directives, the RBI accelerated balance sheet clean-up, instructing banks to recognise losses faster. Look at one other number: At the end of March 2017, Tier 1 capital (equity plus reserves) was Rs 6.48 lakh crore. NPAs in September 2017 were Rs 7.34 lakh crore, more than the net worth of all PSBs.

What about recapitalisation? Between 2008 and 2014 – before the present government took charge – PSBs received Rs 79,700 crore as equity infusion from the government; until October 2017, an additional Rs 51900 crore was added. In the same two periods, PSBs raised Rs 21,300 crore from the markets.

The prospects for the announced Rs 2.11 lakh crore recapitalisation plan look daunting, to say the least. Of the Rs 76,000 crore in equity, Rs 58,000 crore is expected to come from the markets (and Rs 18,000 crore through budgetary support). The remaining Rs 1.35 lakh crore will come through recapitalisation bonds that banks themselves will subscribe to, a cash flow neutral exercise. Whether this will be enough, we’ll know when the NPA numbers for March 2018 become public.

Let’s use some foresight vision, and look to the end of 2020: if the banking system is to be as crucial to India’s economic growth prospects as we hope, what changes should we see? Three scenarios suggest themselves based on other country experiences: restricted size (as a natural or forced fallout), higher capital levels (the bigger you are, the higher the capital standard), and a more efficient resolution regime. These are different conceptually, but are nevertheless connected.

Start with the last. The IBC is thus far the best resolution option we have had, transferring relative power to creditors over borrowers. If politics – be sure that many industrialists have considerable political clout – does not intervene, we should be able to iron out the kinks in the system and have a well-functioning resolution mechanism in place. Think of the US-style of debtor-in-possession model as an example. The IBC is headed in that direction.

PNB-Nirav Modi fiasco: When all has been said and done, what kind of a banking system will we be left with?

File images of Nirav Modi and Mehul Choksi. Facebook and Youtube screengrab.

We cannot have the same capital standards for all banks; larger and systemically important banks – in short, those whose stability impacts the entire system – should have higher capital compared to others. Already, the RBI is issuing differentiated licenses to new banks, so that is not a great leap.

Further, banks discretion in deciding risk weights should also be subject to closer scrutiny, and standards tightened. Look at the number of upward revisions that individual banks have had to make in recognising NPAs after an RBI inspection, and the need for stricter ways of measuring risk-weights becomes apparent.

Restrictions on size in the midst of an NPA crisis can be enforced, as the RBI has done through its Prompt Corrective Action (PCA) framework, by restricting new lending, for example. It will be harder to do during normal times, other than by setting standards on the kinds of risks a bank can undertake; the problem is that such standards can be subjective.

Some measures, however, do suggest themselves as guides for finding objective standards of both size and complexity: Total assets in gross and net terms, total assets as a percentage of banking system assets, as a proportion of GDP. Similar measures can be developed for capital requirements too: equity plus free reserves as a percentage of total assets, a simple leverage ratio – as opposed to a percentage of risk-weighted assets, for example. The RBI is already monitoring that, and it is a part of Basel III norms.

It is probable that many PSBs will have smaller balance sheets by 2020, and that is not a bad thing. It’s possible that the PSB share of the credit market will go down from its present 70 per cent to 50 per cent, as stronger and more nimble private sector banks take the bigger share. Credit growth will still be a proxy for economic growth in 2020; the dominant players may change.

In the book The Hitchhiker’s Guide to the Galaxy by the late Douglas Adams, the cover of that book supposedly says ‘Don’t Panic’. The Indian banking system is in a similarly uncertain and unexplored universe, but the message remains the same – for now.

(The writer, a former journalist, is a communications consultant. He tweets @shrisrinivas)

Firstpost is now on WhatsApp. For the latest analysis, commentary and news updates, sign up for our WhatsApp services. Just go to and hit the Subscribe button.

Updated Date: Mar 08, 2018 16:33:53 IST

Also See