Banking Reforms In India: Why Privatization Is Better Than Mergers

0
1668

It does not happen often. Last week, both the Reserve Bank of India (RBI) and the finance ministry had to step in to quell widespread rumours of some public sector banks being closed.

The trigger for such rumours was the Indian central bank’s decision to put a large public sector bank (PSB) with Rs6.28 trillion of assets—Mumbai-based Bank of India—under the so-called prompt corrective action (PCA) framework.

“No question of closing down any bank. Government is strengthening PSBs by (Rs) 2.11 lakh crore recapitalisation plan. Do not believe rumour mongers. Recap, reforms roadmap for PSBs firmly on track,” financial services secretary Rajeev Kumar tweeted even as RBI issued a press release clarifying that “the PCA framework is not intended to constrain normal operations of the banks for the general public.”

The framework is 15 years old now. Introduced in December 2002, it was reviewed early this year and a revised version was put in place in April 2017. This will be reviewed again in 2020.

The PCA framework tracks three key areas of bank operations—capital, asset quality and profitability—through the capital adequacy ratio, or the ratio of capital to risk-weighted assets (CRAR), net non-performing assets (NPAs) as a percentage of loans and return on assets (RoA). Besides, it also monitors the leverage of a bank or the amount of debt used for financing assets.

The framework has laid down three risk thresholds and once a bank breaches the “risk threshold 3”, it becomes a candidate for resolution through tools like amalgamation, reconstruction, or even winding up. Breaching of the first two thresholds makes banks subject to restrictions on dividend distribution and remittance of profits (in case of foreign banks), branch expansion and compensation of senior management, among others.

READ  Exclusive: Amazon in talks to acquire Sequoia-backed app aggregator Tapzo

A bank is placed under PCA framework on the basis of its audited annual financial results and the supervisory assessment made by RBI. However, the regulator may impose PCA on any bank during the course of a year or migrate a bank from one threshold to another if the circumstances so warrant. In the case of Bank of India as well as United Bank of India, this is what happened last week. While Bank of India was brought under the PCA framework, Kolkata-based United Bank of India, which was put under PCA three years ago, migrated from one threshold to another.

To be sure, none of the banks that have so far been put under PCA meets the criteria for being wound up. However, this does not mean that they just have flu. They have cancer; depending on the stage of the disease, they need radiation, chemotherapy and surgery even though RBI statement has attempted to play down the affliction, saying the PCA framework is a supervisory tool which monitors certain performance indicators of banks as an early warning exercise and the objective is to facilitate the banks to take corrective measures in a timely manner to restore their financial health.

So far, 10 PSBs have been placed under PCA framework. They are Indian Overseas Bank, Dena Bank, Corporation Bank, Central Bank of India, IDBI Bank Ltd, Uco Bank, United Bank of India, Bank of Maharashtra, Oriental Bank of Commerce and Bank of India. Collectively, they have a deposit portfolio of Rs25.26 trilion, 30.55% of the total deposits of all public sector banks. Similarly, they have a 30.08% share of the loan book of the public sector banking industry and their share of PSB banking assets is 30.44%. So, there is no point in remaining in a denial mode; we must accept that close to one-third of India’s public sector banking industry is sick.

READ  How investors evaluate founder risk

The situation is unlikely to improve fast. Going by RBI’s December Financial Stability Report, NPAs of Indian banks will rise further even though the financial system as a whole remains stable. Under the Indian central bank’s base case scenario, gross NPAs in the banking sector may rise from 10.2% of advances in September 2017 to 10.8% in March 2018 and further to 11.1% by September 2018.

Earlier, the June report had warned that the banking system’s gross bad loan ratio would rise to 10.2% in March 2018 and for public sector banks, the gross bad loan ratio could be as much as 14.2%. The Financial Stability Report is a biannual reality check of the Indian financial system, in vogue for eight years.

The rise in bad loans would also hit the capital adequacy ratio of banks. Under its base case scenario, two banks may have a CRAR below the minimum regulatory level of 9% by March 2018; and, if the macro conditions deteriorate, as many as six banks may record a CRAR below 9%. The CRAR of the entire banking system may decline from 13.3% in March 2017 to 11.2% in March 2018, the RBI report has pointed out.

The International Monetary Fund (IMF) too has flagged the risks to the Indian banking system on account of its deteriorating asset quality. IMF’s assessment of Indian financial sector’s stability, also released last week, points out that the large banks are sufficiently capitalized but many others are “highly vulnerable to further declines in asset quality and higher provisioning needs”.

READ  Business debt consolidation loans are helping entrepreneurs find solid ground

The need for additional capital ranges between 0.75% and 1.5% of India’s $2.44 trillion GDP. The IMF stress tests covered the 15 largest banks, which account for 71% of the banking assets in India. The list includes 12 PSBs. IMF has urged the Indian government to consider privatization of weak PSBs by selling their viable assets instead of merging them with stronger banks.

This suggestion merits the owner’s attention. Some of the public sector banks are fast losing their relevance. By merging them with relatively strong banks, we will end up eroding the strength of the system. Instead, privatization is a better solution even though politically it is an extremely difficult task.

Privatization will also address the issue of moral hazard of the government. As long as the government remains the majority owner of these banks, it will not be easy to have a law that the Financial Resolution and Deposit Insurance Bill 2017 (FRDI Bill) proposes, asking depositors to sacrifice in case of a bank failure.

Comments

comments

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.