A ticking time bomb?

Last Updated: Wed, Jan 01, 2014 06:18 hrs

The problem of asset quality has become increasingly significant in the Indian banking system. However, as was reported in this newspaper on Tuesday, there is a striking asymmetry in the nature of the problem across different categories of banks. Over the past five years, while private sector banks have seen some improvement in the ratio of their non-performing assets (NPAs) to outstanding credit, public sector banks as a group have seen a marked deterioration. The latter collectively account for over 86 per cent of NPAs, while providing about 75 per cent of credit.

In response, the Reserve Bank of India has proposed some measures, including early recognition of problem assets and information sharing between banks. These will be finalised in a few weeks based on public feedback. While such measures may help alleviate the problem, a robust solution must recognise and respond to some structural characteristics of government-owned banks, which have contributed to the build-up.

An important one is the level of independence and autonomy that a typical bank enjoys in making its credit decisions. Anecdotal evidence suggests that various channels of influence play a role in making credit decisions, thereby diluting the effectiveness of the credit appraisal process. Occasional revelations, such as the loans-for-bribes case involving Money Matters Financial Services and Punjab National Bank a few years ago, might be merely the tip of the iceberg. These tendencies are reinforced by the criteria for the appointment of independent directors on the boards of public sector banks, which are seen less as effective governance mechanisms and more as opportunities for extracting rents. Another issue is that of incentives.

Given the relatively short tenures of chairpersons and executive directors, the immediate recognition flowing from an acceleration of credit growth perhaps outweighs the negative impact of asset quality problems, which usually materialise during the successor's tenure. This has contributed to the well-known succession effect, in which a new chairperson makes provisions for all the bad assets from the predecessor's term, thereby cleaning the slate for his or her term, but also making the earnings pattern volatile.

These structural factors require a much deeper examination of the government's role as owner of banks. The philosophical dimension of this issue relates to the fulfilment of the social mandate for which banks were nationalised in 1969 and again in 1980. Has this been fulfilled and to what extent? Is the current situation one in which the social mandate itself is being compromised by weak governance and incentive mechanisms? The fact that the government is now seeing new private banks as agents of financial inclusion is one indicator that it is not completely satisfied with the performance of the banks that it owns. The practical aspect of the issue relates to the need to enhance the capital of banks saddled with high NPAs.

If the government wants to preserve majority ownership, it perforce becomes the predominant source of new capital. It clearly does not have the fiscal space to do this, now or in the next couple of years. How is it going to reconcile the need for control with the imperative of more capital?

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