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HomeEconomicsHere’s how RBI reforms can devise a two way strategy for dealing with the banking crisis

Here’s how RBI reforms can devise a two way strategy for dealing with the banking crisis

By Ajay Shah

Various solutions are being proposed for the banking crisis. Merging PSU (Public Sector Undertaking) banks does not change anything. A big PSU bad bank is the politically attractive choice, but one that does not solve the problem. It would make sense to remove barriers to non-bank finance, so as to support the economy at a time when bank credit will not grow, and simultaneously undertake RBI (Reserve Bank of India) reforms.

The problems of banks in India have long been the subject of a cover-up. But the bad news is increasingly slipping out. There is now an increasing sense that we can count the sound banks on our fingers, and the rest of Indian banking is either bankrupt or has inadequate equity capital.

Some people like the idea of merging PSU banks. But the merger of two weak banks gives a bigger weak bank. If we merge a weak bank into SBI (State Bank of India), we are grabbing a chunk of SBI’s equity capital. India will benefit from putting SBI’s equity capital to work through SBI’s management capabilities, rather than using it to pay for the rescue of a failed bank.

There is also the matter of public shareholders. Company law and SEBI (Securities and Exchange Board of India) regulations are making it increasingly difficult for promoters to abuse the interests of public shareholders. How will we justify, to the public shareholders of SBI, that this was the best use of their money?

In the private sector, mergers can create value as there are scale economies. As an example, if two banks have 100 employees each, of which 10+10 are IT staff, the merged bank may be able to get by with only 15 IT staff, which makes it possible to eliminate five positions. This kind of restructuring is infeasible in the public sector.

The biggest issue is the long game. The journey of other PSUs is instructive. The end outcome was privatisation for VSNL (Videsh Sanchar Nigam Limited), CMC (Computer Management Corporation), and UTI (Unit Trust of India), and irrelevance for MTNL (Mahanagar Telephone Nigam), BSNL (Bharat Sanchar Nigam Limited) and Air India. To the extent that we are able to privatise some PSU banks in the future, that is a better outcome. Privatisation is easier for small firms. From this point of view, it is better to keep a PSU bank small.

Some people like the idea of making a big PSU bad bank. The bad assets in Indian banking are perhaps worth 30% of par value. But the big PSU bad bank will buy up NPAs (Non-Performing Assets) at the full par value. It will be very bankrupt from inception. The Ministry of Finance will use taxpayer resources to fill this hole over the coming 10 years.

The big PSU bad bank dumps a large cost upon the taxpayer. Nobody knows how big the problem is. If the bad assets range from Rs. 10 trillion to Rs. 20 trillion, taxpayers are going to be asked to pay between Rs. 7 trillion and Rs. 14 trillion. For a comparison of an alternative use of taxpayer money, a dense metro system for Bombay costs Rs. 5 trillion. The taxpayer does not have a seat on the table and is unable to protest against the big PSU bad bank proposal. The Indian budget process does not work effectively and is often unable to shoot down bad ideas.

Other than the taxpayer, everyone else loves the big bad PSU bank.

RBI likes this as all sins are forgiven, no RBI reforms are undertaken. The taxpayer pays to clean up Indian banking once again, and RBI can gear up to give us the next banking crisis.The banks like this for the same reason. All sins are forgiven, and banks can gear up to give us the next banking crisis.

The incumbent promoters like this. Their bad companies are not put through bankruptcy process: Instead they get to deal with a sleepy PSU bad bank for the next decade. They get back to dealing with a banking system that favours incumbents.

The bad bank is a bad use of taxpayer money. It removes the pressure to reform, and exacerbates India’s fiscal stress. We should solve problems at the root cause, instead of asking taxpayers to pay for the losses associated with repeated banking crises.

Way forward

A two-pronged strategy is required.

The first element is to address the financing problems of the Indian economy. Private sector bank credit is growing slowly, and a disproportionate fraction of this is going to bankrupt firms, thus choking bank credit access to healthy firms. The magnitudes involved are however, smaller than those seen in banking crises elsewhere in the world, as private sector bank credit in India is only around 50% of GDP (gross domestic product)

We need to bring more financing to healthy firms. For this, four non-bank channels of financing need to be opened up. They are capital account liberalisation, NBFCs (Non-Banking Financial Companies), the bond market and distressed asset funds (ARCs). All four areas have been choked by mistakes in regulation. Financial sector reforms can reverse these mistakes.

The second element of the strategy is RBI reform. Why are we getting a banking crisis every decade? Why are banks underpricing credit, and then running into trouble when a certain proportion of NPAs inevitably surface? This is because of technical failures of bank regulation and supervision at RBI.

There are problems in the working of the RBI board, the process through which regulations are made, the process through which licensing and investigations are done, and the quasi-judicial process through which punishments are awarded. RBI has agreed to implement the `FSLRC Handbook‘ (Financial Sector Legislative Reforms Commission) which solves all these, but has not followed through with the implementation. The role and function of RBI requires reform, so as to focus RBI upon its two deliverables: price stability, and soundness of banks.

The second element of the strategy is RBI reform. Why are we getting a banking crisis every decade? Why are banks underpricing credit, and then running into trouble when a certain proportion of NPAs inevitably surface? This is because of technical failures of bank regulation and supervision at RBI.

There are problems in the working of the RBI board, the process through which regulations are made, the process through which licensing and investigations are done, and the quasi-judicial process through which punishments are awarded. RBI has agreed to implement the `FSLRC Handbook‘ (Financial Sector Legislative Reforms Commission) which solves all these, but has not followed through with the implementation. The role and function of RBI requires reform, so as to focus RBI upon its two deliverables: price stability, and soundness of banks.

The second element (RBI reforms) is a five-year process. This will give us a destination where India is able to safely have a banking system. Open entry for private and foreign banks will then be possible. The first element (opening up to non-bank channels) can yield results in 2017 itself.


Ajay Shah studied at IIT, Bombay and USC, Los Angeles. He has held positions at the Centre for Monitoring Indian Economy (Bombay), Indira Gandhi Institute for Development Research (Bombay) and the Ministry of Finance, and now works at NIPFP.

This article was originally published by Ideas for India.

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