The tremors in Indian banking

The growing pile of bad assets at United Bank of India (UBI) should be seen as an advance storm warning rather than localized turbulence. One-tenth of its loan book is in trouble. The public sector lender now has a level of capital adequacy that is at the bare minimum prescribed by global capital adequacy rules. It will need a capital infusion from the government if it is to lend more.

The Kolkata-based bank has never been known for its financial good sense. But its current woes deserve attention. There are two reasons why other Indian banks could be headed for trouble in the coming quarters. First, more loans could turn bad unless there is a rapid recovery in the economy. Two, there could be losses in the bond portfolios of banks in case the Reserve Bank of India decides to push up interest rates further in its long battle against inflation.

 

Private sector assessments are more openly worrisome. Two recent reports by credit rating agencies say that stressed assets as a proportion of total loans will climb by March 2015. Standard and Poor’s says that stressed assets of Indian banks will likely be at 12% of total loans by March 2015. India Ratings and Research, a unit of Fitch Ratings, has painted an even gloomier picture: stressed assets of Indian banks will touch 14% of total loans two years down the line. In effect, what the two rating agencies are saying is that the extent of the bad loan problem in the Indian banking system will be much worse than what it is in UBI right now.

India is battling the inevitable consequences of a credit bubble when bank lending grew much faster than the nominal gross domestic product after 2004. Financial services secretary Rajiv Takru had in June pulled no punches when he accused banks of having indulged in reckless lending based on inadequate due diligence. Bankers hit back—in private, of course—that they were forced to lend to infrastructure projects of business groups with strong political connections. They also pointed out that they were blindsided by the policy mess in several areas, the best example being the power sector in which banks funded the creation of electricity generation asset

There is an element of truth in both sides, so it is best to step away from judging such a competitive blame-game so that we can look at the underlying structural problems. Bank lending usually moves in tandem with the business cycle. But there are episodes when it outpaces the underlying economy. In fact, Claudio Borio of the Bank of International Settlements (BIS) pointed out during a recent conference hosted by the International Monetary Fund on rethinking macro that there is a credit cycle separate from the business cycle; Hamlet without the Prince is how he described macroeconomics without the financial cycle in a recent paper. India is clearly coming out of an episode of excess lending. 

 

What now? It seems action will be needed on several fronts. The first will be capital infusion of perhaps $50 billion (given that outstanding bank credit is around $1 trillion) so that banks can continue to fund economic activity after taking the inevitable hit because of growing stressed assets; the eventual introduction of the Basel III capital norms should bloat the bill even more. The second is that the regulators will have to ensure that there is a smooth resolution process so that capital currently locked in unproductive ventures is released for better use. The third is that banking capacity will have to be increased with the introduction of new banks so that they quickly get into the lending game. The fourth is perhaps the most important: the banking authorities need to accept the problem rather than live in denial.

It must be said that India is far better off right now on these four counts than it was during the two previous episodes of banking stress in the early 1990s and the early 2000s. Another positive is that India is perhaps not headed for a banking blowout that many suspect is already taking place in China as a result of the credit splurge after the 2009 stimulus in that country, if only because the ratio of credit-to-GDP in India is very modest.

 

But the global experience since 2008 shows that banking tremors can lead to a lot of damage in the real economy. It is important to act quickly rather than let the problems fester.

 pratima kumari

pgdm 1st sem