The scandal over fugitive billionaire Nirav Modi flying away to an unknown destination leaving behind unpaid loans of $1.8 billion has brought the festering bad loan crisis in the Indian banking system to a boil. Public sector banks in India are sitting on a massive pile of bad loans aggregating to about $210 billion. This has crippled lending as banks are in no position to advance credit and large corporate houses, many of whom are in the dock for unpaid loans, are in no position to borrow. Result: Private investment is down in India and this is preventing the economy from moving into a higher growth trajectory. But much before the problem of unpaid loans degenerated into a political slugfest between the ruling BJP and the principal Opposition party, the Congress, the Narendra Modi government and the Reserve Bank of India had begun the process of cleaning upthe mess by passing the Insolvency and Bankruptcy Code (IBC) in May 2016, which shifted the balance of power from the borrowers to the creditors and mandated a resolution of individual cases within 180 days (270 days if 75 per cent of lenders agree to extend the timeline) failing which the assets of the defaulting debtor would be liquidated.

Big fish in the dock

In India, unscrupulous businessmen have often defaulted on loans from public sector banks, misused or siphoned them out and then got friendly politicians to write them off... only to start the process all over again. But the Modi government and RBI signalled the end of business as usual by not only passing a stringent law to bring defaulters to book but also directing lenders to pull the plug on the so-called dirty dozen, 12 large companies that account for a fourth of all bad loans. At one go, the promoter families of large companies such as Essar Steel, Bhushan Steel, Binani Cement, among others, lost control of their crown jewels, which was handed over to a resolution professional, setting in motion the process of either selling these companies to the highest bidder or liquidating them piecemeal. Recently, the RBI added another 28 large companies, which account for 40 per cent of outstanding loans, to the list. Now, more big companies such as Essar Projects, Orchid Pharma, Ruchi Soya Industries, Nagarjuna Oil Refinery and Visa Steel are also on the block. The days of politically connected industrialists skimming off public money to enrich themselves at the cost of society are now decisively over.

Opportunity for foreign investors

“The whole world is looking at India now,” Edwin Wong, the Chief Investment Officer of Hong Kong-headquartered SSG Capital Management and an ex-Lehman Brothers Holdings Inc. banker was quoted in the Indian media as saying. “It could be a once-in-a-lifetime opportunity.” He and several other global funds see massive investment opportunities as RBI pushes banks to resolve the bad loan crisis by invoking the stringent bankruptcy law. “It's getting a lot of attention because there is a timetable for the bankruptcy process,” the same article quoted Wong as saying. “If the government sticks to what they say they will do, things have to happen.” RBI shows its teeth In December, there were strong rumours that the Mumbai-based Bank of India would shut down. The immediate trigger was the RBI's decision to place it under the Prompt Correction Action (PCA) framework. The Finance Ministry and the Indian central bank had to step in to urgently quash the outbreak of public panic. Financial Services Secretary Rajeev Kumar tweeted: “No question of closing down any bank. Government is strengthening PSBs by 2.11 lakh crore recapitalisation plan. Do not believe rumour mongers.” The RBI, on its part, issued a statement saying: “The PCA framework is not intended to constrain normal operations of the banks for the general public.”

One-third of banking sector is sick

Ten public sector banks - Corporation Bank, Central Bank of India, IDBI Bank Ltd, Oriental Bank of Commerce, Uco Bank, Indian Overseas Bank, Dena Bank, United Bank of India, Bank of Maharashtra, and Bank of India - have been placed under this framework. They account for 30.55 per cent of total deposits in all public sector banks, 30.08 per cent of all outstanding loans and 30.44 per cent of all banking assets. The writing on the wall is clear: one-third of India's banking sector is suffering from cancer and will need surgery at the very least to survive.

The framework

PCA, which was introduced in 2002 when the Atal Bihari Vajpayee government was in power, was revised in 2017. The framework looks at three things - capital through the capital adequacy ratio, asset quality through the ratio of capital to risk-weighted assets and net non-performing assets and profitability through return on assets. It also tracks the debt levels of banks. The framework has graded risk thresholds each of which mandate a particular course of corrective action. Any bank that breaches the third and highest threshold is either amalgamated with another bank or wound up. Crossing either of the lower risk red lines also leads to penal action that includes restraining the bank from declaring dividends, placing fetters on expansion and capping senior management salaries.

Bad loans to rise further

The good news is that none of the banks placed under the PCA framework meet the criteria for being shut down. But that tiny sliver of silver lining is where the good news, such as it is, ends. RBI's Financial Stability Report from December 2017 projects bad loans to rise further from 10.2 per cent of advances in September 2017 to 10.8 per cent in March 2018 and further to 11.1 per cent by September 2018. The report, however, adds that the financial system will remain stable. The news gets worse here: The RBI projects that the capital to risk weighted asset ratio of as many as six of these banks could fall below the minimum level of 9 per cent if macro conditions deteriorate by the end of the current month. If conditions don't deteriorate, as they haven't, the prognosis is for two banks to have CRARs of less than the minimum prescribed level. This, and a general decline in the health of banks will bring down the CRAR of the Indian banking to 11.2 per cent at the end of March 2018 from 13.3 per cent a year ago, a precipitous 210 basis points (bps; 100 bps = 1 percentage point) in one year, the December 2017 report says. A December 2017 IMF report also points to the same danger. It says some of India's mid-size and small public sector banks are “highly vulnerable to further declines in asset quality and higher provisioning needs”.

Brandishing the stick

As briefly mentioned earlier, the Banking Regulations (Amendment) Act 2017 and the IBC gave RBI the powers to direct banks to initiate insolvency proceedings against defaulting borrowers and give directions for resolution of stressed assets. Subsequently, the government amended the IBC to ensure that delinquent promoters and wilful defaulters were barred from participating in the resolution process. This was done to avoid the moral hazard of defaulting promoters bidding for and winning back control of their companies even as banks and other creditors took big haircuts. The RBI also got into the act, directing banks to provide 50 per cent provisioning for secured assets and 100 per cent provisioning for unsecured ones in cases that came up for bankruptcy resolution.

Cleaning the Augean Stables

The Nirav Modi fraud has brought the chickens home to roost, but it is only the tip of the iceberg, the most prominent among several such cases. Kingfisher Airlines promoter Vijay Mallya had earlier escaped to the UK leaving behind unpaid loans and interest of about $1.5 billion as well as thousands of unpaid employees. More cases, such as those involving the promoter of Rotomac Pens and Simbhaoli Sugars, have also come to light in recent weeks. Reuters obtained RBI data through the Right to Information Act to show that over a period of five years to March 2017, public sector banks reported 8,670 cases of loan fraud involving an amount of $950 million.

Recapitalisation and reforms

In October last year, the government announced that it will infuse $35 billion into public sector banks in order to help them out of the bad loan crisis they were facing and lift credit growth in the Indian economy, which had fallen to a 25-year low on account of the twin balance sheet problems. Of this amount, more than half will be in the form recapitalisation bonds, the details of which will be announced by the Finance Ministry soon. This will have to be accompanied by several far reaching and deep reforms like strengthening the boards of banks, resolving the issue of NPAs and changes in systems and procedures to ensure that similar problems don't recur in future. “Reform agenda is the highest priority, which has to be implemented along with capitalisation. A whole lot of reforms will come so that genuine borrowers don't suffer and get hassle-free, need based credit,” Rajiv Kumar, Financial Services Secretary in the Ministry of Finance, told Indian media, adding that these reforms would focus specially on ensuring adequate flow of credit to micro, small and medium enterprises, job creation and financial inclusion. The RBI's directive to banks on recognising NPAs and provisioning for them has increased the amount of bad loans in public sector banks by 250 per cent between March 2015 and June 2017. The government has also asked all public sector banks to check all NPAs more than $5.5 million and directed them to address all their technological and operational risks within a given timeframe. Public sector banks have also been directed to rationalise their foreign operations. Further, the government will soon enact a law, called Fugitive Economic Offenders Bill, to seize assets and recover dues from bank loan defaulters who leave the country without paying back their loans. A Special Court has been proposed to deal with cases of such fugitive corporate defaulters.

Need for fewer, larger banks

And finally, the Modi government has given public sector banks in-principle clearance for state-owned banks to amalgamate through an alternative mechanism. A panel comprising Railways & Coal Minister Piyush Goyal and Defence Minister Nirmala Sitharaman under the chairmanship of Finance Minister Arun Jaitley has been set up to vet proposals from banks in this regard. This panel will report on the proposals to the Cabinet every three months and seek approvals for the same. RBI Governor Urjit Patel had hinted at this on April 25 last year when he said the Indian banking system would be better served by consolidating and merging banks to deal with the issue of stressed assets. “As many have pointed out, it is not clear that we need so many public sector banks. The system could be better off if they are consolidated into fewer but healthier banks,” Patel said at the Kotak Family Distinguished Lecture at Columbia University, adding that “some banks can be merged, as a quid pro quo for timely government technical injection”.

What to avoid

Experts had lauded the initiatives taken by the Modi government and the RBI to clean up the mess in Indian banking but have warned that any overkill will stifle lending and be counter-productive. They point out that the decision to inspect all NPAs above $5.5 million can cause panic among bankers and prompt them to stop lending altogether. A few high profile arrests of senior bankers as well as more routine investigations by government agencies have affected the functioning of some banks.'' This could be one of the reasons why public sector bankers seldom agree to take haircuts to settle bad loans. They can never be sure when investigative agencies will open or reopen an old case of lending on charges of fraud or favour. Therefore the proposed reforms must have strong safeguards protecting bankers so that they are able to take commercial decisions without fear. Governance norms in public sector banks also need to keep pace with developments in the sector. The P.J. Nayak Committee on banking reforms had said in its 2014 report: “Government officers and regulators may not possess the skills to appoint the top management of commercial banks. Banking is a very specialised activity, and top management needs to combine strategic foresight with a good commercial knowledge of sectors to lend to, prudent risk management and human resource skills.” This is critical and needs to be addressed along with the other proposed reforms. Privatisation not politically feasible Many of the problems faced by public sector banks - political interference in appointments and lending decisions (earlier rampant but thankfully at a minimum under the Modi dispensation), slow decision-making processes, fear of action by the Central Vigilance Commission and other investigative agencies - can be addressed by privatising public sector banks. But as Jaitley has publicly admitted, any move in this direction needs a broad-based political consensus that is currently not possible to achieve.

Well begun but long road ahead

Experts are unanimous that the initiatives taken by the Modi government and RBI can clean up India's banking sector and set the stage for higher growth in the economy. But they caution that the road ahead is full of potholes. They question whether the government will be able to build a consensus across India's political fault lines to insure these reforms against future political interference from rival political parties. They also say it will be difficult to inculcate a “private sector mindset”, if privatisation is not possible, in a sector that has long been used to working under the thumb of the ruling party at the Centre. But they also add that if the announced reforms are carried out to their logical conclusion, it will make the Indian banking sector much healthier and, in future, lead to the emergence of Indian banking behemoths that can match their global counterparts in size as well as financial heft.