The current banking crisis is based on a repeated story. Banks give credit driven by multiple compulsions, not just a sound business case. Poor disclosure requirements and supervision help in hiding the bad performance of these loans. But bad news has a way of getting out in financial markets. In response to the crisis, the RBI and the banks have been clamping down on lending, and the economy is adversely affected by sluggish credit offtake.
An easy solution is to get the taxpayer to pick up the tab on bad news. The taxpayer is asked to give money to the banks so that the current stakeholders can start afresh. This can be disguised in various ways. Money can be taken from the RBI since its excess capital belongs to the ministry of finance. Money can be promised on future dates by issuing government-guaranteed bonds. But all these trace back to the same source of financing: The taxpayer.
First, it is not fair to dump the costs of a bad banking system on taxpayers. This creates a moral hazard by incentivising bad banking practices. Second, this is an inefficient answer to the deeper need for banking sector reforms. Banks misallocating capital leads to an inefficient use of that capital, and we end up with a lower GDP growth rate than what could have been obtained with a better banking system.
Indian banking was in a similar situation in the late 1990s and early 2000s. The then finance minister, Yashwant Sinha, had a budget announcement to put Rs 10,000 crore into starting an asset reconstruction company, which was wisely not put into action. Merely rescuing the banking system from an existing crisis will only clear the way to another crisis. Policy should go into the causal factors and not be content with superficial actions. We should ask why India regularly gets into banking crises. Four issues appear to dominate.
The first problem is weak banking regulation. It is popular to criticise public-sector ownership. But a technically sound banking regulator can keep banks robust even if they are owned by the government. Countries have a sequence of going through a banking crisis, reforming their banking regulations, and then coming out with a stronger banking sector. The Percy Mistry Committee (2007), the Raghuram Rajan Committee (2008) and the B.N. Srikrishna Committee (2013) add up to a full plan for structural banking regulation reforms, and need to be implemented.
The second problem is the bankruptcy code. A technically sound bankruptcy law is required to improve recovery of bad loans. The new proposed law requires the development of institutional infrastructure for sound enforcement. The thinking on the implementation of the law is not yet mature. The ministry of finance needs technical teams and detailed hard work on bankruptcy reforms, similar to what was done in the last decade on financial sector reforms.
The third problem is the stock of stalled projects. Large projects are stuck in a tangle between various government agencies on issues such as fuel supply, state dues, etc. While we can push a narrow legal argument that the developer is bankrupt and the project should go through insolvency resolution, it may disincentivise the private sector to do business with the government in the future. A healthier approach would be to initiate a committee mechanism to solve the tangle and to apportion the loss as a one-time fix.
The fourth problem is fiscal. Improved banking regulation and supervision, better bankruptcy processes and resolving stalled projects will ultimately cause bad news to be revealed for banks. Banks will need a lot of equity capital, which the exchequer is not able to fund completely. Ideally, some public-sector banks should be privatised. Then the private buyer would face the task of finding capital. The government would earn from the sale, which can then be re-invested as equity capital into other public-sector banks. Any bank recapitalisation claims over and above this would need to be taken into account in fiscal planning.
India’s banking crisis is the product of institutional failures, which have been in a repeated cycle over several decades now. We should resist action-oriented proposals that postpone tackling these failures head on. A fully-fleshed-out multi-pronged strategy that takes into account the whole problem is required to solve it once and for all.