Thursday, November 13, 2014

India's Banking sector fact of the day

Ruchir Sharma has this stunning factoid about India's banks,
Since the end of 2010, when the Indian economy started to lose momentum, the value of shares in private banks has risen sharply, generating $33 billion in new wealth, while the state banks have destroyed $27 billion. This is the market’s way of pointing out which Indian banks work well, and which don’t.
In view of this and the need to raise alteast $50 bn required over the next five years to meet the Basel III provisioning requirements, he suggests outright immediate privatization. I am not sure for the following reasons

1. While the point about private sector efficiency is undoubtedly true and well-taken, its magnitude may be vastly over-stated by the appalling quality of corporate governance and rampant cronyism that bedeviled Indian banking sector in recent years. I have blogged earlier arguing that an examination of India's banking mess, especially as manifested in the massive portfolio of restructured loans, is certain to reveal scandals atleast as massive as anything uncovered so far. In fact, the shockingly high difference in levels of impaired asset stock between public and private sector banks, despite many of the latter themselves being no paragons of corporate virtues (less said the better of such banks elsewhere), is an even more damning indictment of India's public sector banks. The valuation difference pointed out by Ruchir Sharma is some proxy for the extent of malfeasance that went on in India's public sector banking boardrooms.

2. Sharma talks about attracting long-term foreign capital into banks to broaden India's capital base. While again undoubtedly desirable, controversies, real and imagined, are certain to emerge about whether this is the right time to do that is most likely to vitiate the atmosphere and derail the process. This would limit the very confidence that is expected from such divestment. The gross mis-management and large build-up of impaired asset stock has severely dented market confidence and eroded valuations of public sector banks, as captured in the factoid. At a time when public sector banks command fire-sale valuations, it may neither be desirable nor prudent to privatize these banks.

So, what should be done to resolve arguably India's biggest immediate economic policy challenge? I would suggest a five step process.

1. Immediate administrative reforms, including separation of Chairman and CEO/MD posts and changes in the leadership recruitment process, that would increase operational accountability and freedom as well as reduce government interference. The government would have to step back and assume the role of an investor (rather than as sovereign) and stop meddling with operational activities and goals (only time will tell what is the damage done to bank balance sheets by a target-driven program like Jan Dhan Yojana) of the banks.

2. Aggressive pursuit of the restructured loans, complemented with policies to reform bankruptcy regulations and ease restrictions to encourage second-generation reforms in infrastructure financing markets.

3. Urgent recapitalization, by, say, diverting a major share of the subsidy savings from lower oil and commodity prices. This would help not only boost market confidence in the banks themselves but also improve economic prospects by boosting the anemic credit growth so essential to get the investment tap flowing freely.

4. Implement a medium-term (2-3 years) phased divestment plan, with major part, including strategic sales, back-loaded to a not-too-distant future when the aforementioned reforms restore market confidence, get credit flowing, and raise valuations.

5. A process of stakeholder consultations to prepare the ground for the changes, especially in personnel, that are inevitable with any type of privatization.

Update 1 (18/11/2014)

Good article by Subir Gokarn on how banking woes will constrain economic growth in the coming days. The lesson is simple - even if demand picks up and businesses start investment cycle, it will be held back by paucity of credit.

Update 2 (26/11/2014)

As on September 30, 2014, stressed assets in terms of gross advances for government banks was 12.5% compared to 5.5% for private banks. Of this, formal NPAs stood at 5.32% for PSBs. If an account becomes NPA, it requires a provisioning of 15% whereas a restructured asset requires only a 5% provisioning. From 1 April 2015, banks have to forego this forbearance and classify all recast loans as NPAs with 15% provisioning. 

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