Whither or Wither Indian Banking?

The news article, Govt., regulators must take blame for NPAs: SBI chief, in The Hindu (issue dated 13^th January 2016) reported that Mrs. Arundhati Bhattacharya, the Chairperson of SBI, in course of delivering the ASSOCHAM Foundation Day Lecture was of the opinion that the blame for banking industry’s high (and rising?) NPA levels should not be limited to them but all stakeholders should share the blame. This seems to echo the old saying that, “To err is human but to blame it on the other guy is politics”. Mrs. Bhattacharya tries to pin down the other principal stakeholders with specific examples for the increasing levels of NPAs in the banking sector. Specifically, according to her the rising level of NPAs were due to (a) promoters bidding aggressively on the back of good times and some of them were diverting funds, (b) the regulators were letting banks make loans with tenors of as much as 30 years, and (c) the Govt. was permitting policy uncertainty to continue. 

Such a view point either reflects poor knowledge of the role and function of banks and other financial intermediaries in society, or amounts to a clear repudiation of responsibilities by the banking profession in India. Coming from the Chairperson of SBI, the chances of the first possibility is low and that is the reason I find the views of Mrs. Bhattacharya disturbing. Unless, of course, she is preparing herself for a career in politics.

The incidence of NPAs in the banking system is akin to a manufacturing organisation making defective products. Manufacturing organisations set up quality control systems which encompasses design of appropriate manufacturing processes, quality control of their raw material or sub-assembly suppliers, correct operation and control at each stage of the manufacturing process till production of the finished product. The quality is further tested as the product is used so that the quality can be further improved / costs brought down. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

One of the key functions of banks is to produce loans of consistently good quality and the production process in this context consists of having an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and good training, understanding how or why credit risks arise and having clear laid down credit management policy, having a suit of loan products which are in line with the requirements of the potential borrowers and the risk capabilities of the bank, a not too cumbersome loan documentation process (this is extremely tricky since workable debt contracts cannot be complete contracts), monitoring the loans once it is made, and taking corrective action as and when required, entrapping the cash flows etc. All these taken together would ensure a high probability that the loans made are repaid at the time and on the terms agreed at the outset.  Failing which, banks have to have sound processes for recovering loans which go bad inspite of taking all possible measures earlier. Incidentally, RBI’s concerns on controlling NPAs seem also restricted on recovery rather than ensuring that probability of NPAs occurring is reduced. But this is another long story which I will save for another day. As such, one can safely conclude that the high and rising levels of NPAs in banks in India is a direct result of the failure of the banking industries quality control processes.

Keeping NPAs low for banks is critical for various reasons. First, NPAs deliver a double whammy to the bottom line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans. Second, banks being highly leveraged entities have much lower room to maneuver fall in operating margins, something rising NPAs result in. Third, by affecting ability of banks to provide liquidity services to the real economy (since the quantum of lending possible by banks is inversely proportional to rising NPA levels) the income and employment opportunities in the economy start getting drastically curtailed with rising NPAs in the banking industry. Finally, banks hold the institutional memory of credit history of all the actors in the real economy in their records. This institutional memory is hard and very expensive to recreate once lost. When NPAs become so high that a bank has to be closed down, this memory is as good as lost forever. This in turn leads to a break in the payment cycle to and from the various players in the real economy, and hits the real economy really hard by drastically reducing both income and employment opportunities in the economy. This is the primary reason that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones.  

Coming back to the specific issues mentioned by Mrs. Bhattacharya, it is the role of promoters and entrepreneurs to be optimistic about the future without which no society can operate, leave alone grow. And it is the role of banks to appraise loans so as to avoid adverse selection of potentially bad loans. Similarly, design of monitoring mechanisms in loan contracts should ensure that moral hazard problems arising from diversion of funds is avoided by raising early warning signals. I wish somebody had asked Mrs. Bhattacharya in that august gathering the reasons for banks not being in a position to fulfill these basic responsibilities. Isn’t appraising loans and monitoring them, including design and insistence of restrictive covenants, an essential part of credit risk management function of banks?

Mrs. Bhattacharya reportedly also mentioned that “Banks extended loans for long duration as much as 30 years while hoping funds would be recovered in 10 years”. I am not sure what she meant by saying this. A 30 year loan would have a 30 year repayment, it cannot be a 10 year loan nor a 40 year loan (unless restructured).  If it has a call option after 10 years, it becomes a 10 year loan if the call option is exercised but remains a 30 year loan if the option is not exercised.

This brings us to another key function of banks which is to address the maturity mismatch between deposits and loans, ie, its principal Liabilities and Assets. This function enables raising funds from, say, millions of small Saving Bank accounts for making large, longer term loans and investments with both the depositors and the borrowers being better-off, even after the bank as financial intermediary makes a decent profit in the process. This kind of maturity mismatch does create the problem of Asset-Liability management which can lead not just to Interest Rate risk (hits profitability of banks), but to severe liquidity problems (survival of the bank itself may be endangered). But it is part of the banking game which all bankers play all the time. Interest rate risk can be substantially covered by having floating rate interest rates on both deposits and loans. Since interest rates on deposits are sticker than that on loans, there always remains a certain quantum of residual interest rate risk on the bank’s books. However, if banks consider themselves as going concerns (and not gone concerns!), they can work out the risk of having a large Asset / Liability mismatch for a small portion of their total deposits without the overall risk being too large or unmanageable. This would enable financing long gestation projects while the bulk of the funding remains from short term sources. These are the basic skills of the banking profession and I hope Mrs. Bhattacharya does not mean that SBI lacks it!

Handling the credit risks arising from policy uncertainty by the Government is also a skill a banker brings, or is supposed to bring, to the table. This can be handled in various ways, say, by insisting on government guarantees (lazy banking), specifying low leverage levels, or innovative design of loan products (take out financing / refinancing / securitizing loans etc.), restricting the size of portfolio subject to such risks etc.

The disfunctionality of the Indian banking system is neither limited nor reflected solely in the high and rising level of NPAs, but is endemic in nearly every aspect of the industry. It is evidenced by large scale mushrooming of Ponzi schemes in which small depositors keep their hard earned savings with finance companies in the hope of getting a return which would not be negative in real terms because the banking system does not offer them a feasible alternative. Or, the difficulties faced by the smaller end of the market in getting loans which results in incidents like the call money racket recently in TS & Andhra, or the bad name brought on the micro-credit segment by a few unscrupulous operators. In practice it is a myth that private financiers are more expensive than our regular banking players if the transactions costs for delays, paper-work, bribery and worse are factored in. Even opening a simple deposit account at any bank requires tonnes of paper-work which can be quite intimidating (I had to fulfil KYC requirements to continue using by SB account which had been satisfactorily conducted for more than 30 years!).

Banks evolved by providing payment mechanisms to society. Even in this basic function the sheer inefficiency is sought to be remedied by having separate payment banks, inspite of the development negating the concept of economies of scope which is one of the key strengths of financial intermediaries like banks.

Ultimately, the problems being faced by the Indian banking industry can be traced to ineffective, backward looking top management. Unfortunately, the price is being paid by all Indians by way of difficulty in conducting their banking transactions, having few avenues of investment of their savings which give a decent positive real return at acceptable levels of transaction costs, or avoiding wading through a tsunami of paperwork in getting any kind of credit facility.