By Hashmat Ali*
Financial sector in India is grappling with covid-19 consequences, which arrived in the wake of a prolonged slowdown in economic growth. The problems faced by financial institutions in India, are unique in nature. It is an absolute fact that posts the subprime credit crisis; global banks have shifted their focus towards more stringent prudential norms to tide over future credit shocks. The problems faced by Indian banks are a tad different from those faced by global banks. For example, the high volume of NPAs banks have and the reasons are quite diversified, ranging from political interference, willful defaults, red tapism and the fraud and so on and many.
No country has ever been able to grow fast without having its financial sector leads the growth. It would not be inappropriate to say that for the financial sector in India it is miles to go before India is at average of OECD and its peers. The ratio of private credit to GDP in India is about 50 percent when the average at the OECD level is about 170. In areas like the northeast, the credit to GDP ratio is even less than 10 percent. This simple fact suggests how much work there is to be done, well of course, there is much to be done.
There is no inherent mechanism for Indian banks to overcome asset-liability mismatch, especially in the case of big ticket or infrastructural lending that too when deposit rates are more volatile and bonds market is not so deep in bringing discipline in this area. Also, there are problems of quality in lending that is a clear pointer that the use of technology to assess credit risks has been sub-optimal. Use of technology can be far higher in the financial sector. The financial institutions in India are not doing enough thinking about data, artificial intelligence, and machine learning. While use of technology has been there for retail lending, there has not been much technology use in large corporate lending.
NBFCs and the overall financial sector will not be able to sustain unless the investment in technology, data and analytics is ramped up to a different level. India has diverse population with diverse needs, diversity also makes for safeguarding the diverse interests and safety in the financial sector for better liquidity creation and streamlining public finances.
Robust Banking system
Banks in India have all along been doing credit liquidity creation and still their role in high cost of credit intermediation can never be overlooked. The average commercial borrower in India incurs about 5.4 percentage points of higher cost for borrowed funds than in other emerging economies. This is driven by higher risk premiums, higher operating expenses of financial intermediaries and crowding out due to government borrowings.
Liquidity window restricted only to banks, led to sharp fall in credit and growth in corporate failures that followed risk aversion and the rising incidence of NPAs, severely hurt the corporate and the bond market. Bank financial statements are not reflecting the true and fair picture of their current state. With banks prevented from declaring loans overdue since the onset of covid-19 as NPAs, their reported numbers today significantly under-state their NPAs position. Apart from not being able to account for loans that have already gone bad, banks are also groping in the dark about how many of their overdue accounts will slip into default, once this prevention is lifted.
Without any hard data, banks have been forced to take discretionary calls on credit loss provision. Should these provisions falls short in the coming quarters, bank profits will take sharp hits which can reduce their capital buffers and raise the need for recapitalization. The underreporting of NPAs does not augur well for the fledgling economic recovery. With capital adequacy worries hovering over them, bankers are not likely to shed their risk aversion anytime soon.
The previous NPA cycle from which the banking system was limping back prior to covid-19 also offered the lesson that sweeping the stressed loans under the carpet, will resurface with redoubled crisis a few years later. Bankers worry of this post facto witch-hunt is hurting their decision-making process. Bankers are worried about getting a fair price for the sale of a bad loan, this is further hampered by the lack of adequate avenues for the capital to purchase or finance the NPA acquisition. Unless we have competitive pools of capital vying to buy NPAs , no amount of tinkering will lead to fair price discovery and balance sheet cleaned of their bad debts. Therefore, bankers are constantly tinkering with various price discovery modes and asking for rebids.
The best way to achieve fair price discovery is to open up the buy side and enable a clear channel for capital to flow for purchase of NPAs. The foreign funds must be permitted to purchase the NPAs and compete with asset reconstruction companies (ARCs). The competitive capital flow will lead to fair price discovery on loan sales. The Indian banks association (IBA) has proposed, and could be a solution to improve the health of the banking sector is to establish an alternate investment fund (AIF) which will help in creating a market for trading bad debt securities in the secondary market. Also, a framework for special assets banks with private sector funded asset management company (AMC), could drive the resolution of NPAs.
In addition, implementation of insolvency and bankruptcy code (IBC), and also, fast tracking the recovery proceedings in the case of NPAs under the existing legal framework, primarily through DRT, SARFAESI ACT 2002 and through lok adalats can be streamlined. For an investment driven economy needs an impeccable banking system that could mobilize and attract savings to capital market. Therefore, a robust banking system is of much significance for a sustainable economic growth.
Mobilizing financial resources
Mobilize more household savings to markets even as foreign investments have an important role to play in India’s economy. The country can meet the bulk of its capital requirement through domestic savings. A more deep and liquid capital market would be needed to ensure that more capital flow to productive projects and high growth firms, especially MSME. The overall depth of financial markets in India in terms of securities issuance is about 130 of GDP compared to an average of about 260 percent among its peers. The turnover ratio, measured as the value of total shares traded as a proportion of market capitalization of stock market has declined from 140 percent in 2010 to 30 percent in 2019, both equity and debt instruments lagging, with mutual fund assets under management being equivalent to only 11 percent of GDP compared to its peer economies at 28 percent.
Economy needs massive investment. It is logical to invite global funds to bridge the gap in public infrastructure and other capital investments. The strong foreign portfolio as well as FDI flows into the country would be much needed. India’s net foreign capital inflows would also need to rise from 1.7 percent to about 4 percent of GDP to achieve the target of 5 trillion dollar economy. Assets-liability mismatch has created many problems for the Indian financial system. Since infrastructure assets pay off in long term, they cannot be financed by the short-term liabilities of commercial bank borrowings. Large concentrated corporate exposures in banks have underlined the importance of well functioning corporate bonds market as well as modern development finance institution for long term finance.
To close theses gaps India need to undertake measures to make various assets category across bonds and equity instruments more inclusive and attractive with simplicity; like choosing a right fund to invest from thousands of mutual funds schemes and deciding the right asset allocation between equity and debt and rationalization of taxes among others, Are some of the aspects that can be made simple and convenient. In addition, measures to strengthen and widen the range of investments vehicles, such as pension & insurance products, alternative investment funds and mutual funds products could also be streamlined.
Regulating the systematic risks
Financial sector in emerging markets tend to be bank dominated, their lending has to expand with development, so are other such as legal, governance, supervisory & regulatory reforms must occur. Well governed private and public financial institutions are critical for financial market to work successfully. Poor governance and regulatory capacity were responsible for the problem at DHFL, IL&FS and YES bank. Better disclosure and prudential regulation would have reduced credit risk.
A lot has been done to strengthen supervisory skills and governance, yet most of the bank failures in recent times are on account of misgovernance and failure of regulations. The recent deceptions committed by some private sector banks and NBFCs are an indication of poor efficacy of regulation and surveillance. The RBI must look for fixing accountability on those departments that failed in enforcing financial discipline. The legacy concentration on corruption should reduce and investigative agencies should look the contrast between a commercial decision and a criminal act in mind. For the efficient functioning of the market and financial system, the financial market regulator SEBI should decrease the offer size in large issuance, make the derivatives trading especially credit derivatives more deep and liquid. Launching more structured products such as exchange traded fund (ETF) and better accessibility of an IPO to individual investors, and addressing the information asymmetry in disclosure by listed companies can help broaden market, and enhance the trust of market participants in the system.
SEBI should enforce the listed companies to just give the number of one-to-one meetings with select investors every quarter. Such meetings that allowed the content in public domain are essential for protecting the interests of the small investors and for efficient price discovery. The recent spillovers by collapse of LVB, PMC, and YES bank multiplied the crisis resulting in mounting bad debt in the system. Time and again has proved that there have been regulatory lapses by the RBI. The moot question is whether the RBI is equipped to face the challenge of corporate and industrial houses owned banks considering the inherent credit risk. The RBI’s panel recommendations to convert select NBFCs into banks lacks vision and prudence and it may enhance the regulatory and supervisory burden on the RBI. At a time, the financial sector facing multiple issues emanating from debt default, bank failures, financial frauds, liquidation and diversions, adding more payers in the banking space would enhance the systematic risks.
How can the banks make good loans when it is owned by the borrower? Even the Raghuram Rajan and viral Acharya are of the view that giving banking licenses to industrial houses will vitiate the economic and financial discipline. Corporate ownership of banks raises the risk of inter-group lending, diversion of funds and reputational exposure. Also, the risk of contagion from corporate defaults to the financial sector would increase significantly. Given the recent instances of houses using banks as captive fund pools for financing other group entities and related parties, we could expect the competitive banking environment would deteriorate with these new licenses.
What the economy badly needs now is a strong financial system consisting of very sound and healthy corporate bonds market and banks with high professionalism, well-regulated and supervised private sector banks and NBFCs without any scope for having any systemic risks. The resolution to the existing bad debt crisis of the dilapidated banks is to professionalize the ARCs and bring them under effective and meaningful regulation and supervision under a highly independent regulator accountable to parliament. There is also a need to streamline and deepen the capital market, foreign exchange market, bonds market and commodities market, with operational convenience and efficiency is crucial to ensure a multidimensional growth to fast forward India to a 5 trillion dollar economy.
*Writer is a research scholar in Finance.