The Indian economy is facing multiple headwinds. Growth is slowing, unemployment is rising and the country’s shadow banking sector is in the midst of a severe liquidity crisis that has hit consumption.
Recently released data from the government revealed that the quarterly gross domestic product (GDP) growth rate slipped to a 20-quarter low of 5.8% in the first quarter of 2019, with a slowdown evident across several key sectors, including agriculture and manufacturing. India’s official statistics agency has reduced its full-year growth estimate for 2019 from 7% to 6.8%, the lowest in five years.
Incidentally, there are growing concerns that the country’s GDP computation methodology maybe faulty, and that growth may actually be much lower than projected. In the first week of June, the Reserve Bank of India (RBI), India’s central bank, cut its policy interest rate by 25 basis points in an attempt to boost growth and make loans cheaper. This is the third interest rate cut in a row, but many doubt that this will spur investment.
Loan improvements
Against this backdrop, some positive news has trickled in from the country’s beleaguered banking sector. Non-performing assets (NPAs) have steadily declined over the past year, for the first time since 2015, when the RBI embarked on a deep cleanse of bank balance sheets.
The Indian banking sector’s NPAs ballooned by more than four times in size between 2014 and 2018 to exceed $150bn. The source of bad loans can be traced back to the credit boom between 2006 and 2011, when bank lending grew at an average rate of more than 20%. Lax credit appraisal policies combined with adverse macro-economic conditions led to a deterioration in asset quality.
While banks tried to camouflage soured loans, RBI’s asset quality review exercise, initiated in the second half of 2015, forced banks to acknowledge them. Worst hit are the state-backed public sector banks that control more than 70% of the banking sector’s assets. Bad loans as a proportion of total loans for the banking industry, referred to as the gross NPA ratio, sharply increased from 4.3% in March 2015 to touch 11.5% in March 2018. This trend was finally reversed in the most recent financial year in India, where the gross NPA ratio steadily reduced to touch 9.3% in March 2019.
Bureaucracy in bankruptcy
The sentiment in the banking industry is one of cautious optimism. “All NPAs in the banking sector have finally been recognised,” says Rajnish Kumar, chairman of the country's largest public sector bank, State Bank of India (SBI), which is also its largest bank. “If you look at the trend of bank results, it is very clear that NPAs peaked in March 2018. Thereafter, we are on a downward curve. Fresh accretion of NPAs is within the tolerance limit. It may differ from bank to bank but fresh slippages have consistently come down.” SBI’s gross NPAs declined by 22.68% year on year between 2018 and 2019.
Dipak Gupta, joint managing director at Kotak Mahindra Bank, India’s fourth largest private sector lender, says the country's banks need to turn their attention towards consumer loans and loans to small and medium-sized enterprises (SMEs). “Thus far, we have only focused on corporate NPAs because that is where the stress was evident. But if an economic revival does happen soon, SME and consumer segments may get impacted and NPAs may appear here,” he says.
Mr Gupta also points out that while banks have acknowledged NPAs, resolution of the situation is lagging far behind. “The Insolvency and Bankruptcy Code [IBC] has helped streamline NPA resolution but up to now only one-quarter of cases have been resolved. For all NPA cases to be resolved, it may well take between three and five years,” he adds.
Landmark law
The IBC is a critical banking reform introduced in 2016 that consolidated several prior bankruptcy laws into one framework, establishing an infrastructure to administer the complex process of ensuring the time-bound resolution and liquidation of stressed assets. IBC is hailed as a landmark legislation that enables banks to take control of their assets, in contrast to earlier systems in which debtors remained in possession of assets until their resolution or liquidation.
Rating firm Crisil, an S&P Global company, says recovery through the IBC was Rs700bn ($10.1bn) in the 2018/19 financial year, almost twice the amount recovered through other mechanisms in the previous year. After the IBC’s introduction in 2016, India’s insolvency resolution score and recovery rate improved substantially in the World Bank’s Doing Business ranking.
However, in the past two years the IBC process has faced several challenges, especially regarding the time taken to resolve cases and the shortage of special courts and judges to adjudicate bankruptcy proceedings. Timely resolution is a challenge, says Crisil, which estimates that the average timeline for resolving cases is 324 days. Although this is much better compared with the 4.3 years seen earlier, it is still above the 270 days set out in the code. As of the end March 2019, there were 1143 cases outstanding under the IBC, of which resolution in 32% of the cases was pending for more than 270 days, according to Crisil. The firm points out there are a few big-ticket accounts for which resolution has not been finalised for more than 400 days.
“The lack of enough bankruptcy courts is delaying NPA resolution. Lots of litigation is being accepted, quite unnecessary in many instances. For example, the Essar Steel case has been going on for two years now,” says Abizer Diwanji, partner and national leader for financial services at EY in India. He says creditors need to consider outside court settlements, adding: “We need to educate banks and creditors that resolution is more important than going to courts.”
Bank benefits
The new law has hugely benefited banks, according to Mr Kumar at SBI, which is dealing with several NPA cases under the IBC process. “The relationship between bankers and borrowers is on a more level playing field. Earlier, bankers did not have any remedy and borrowers had no fear. Now the fear of losing control is there,” he says.
However, he acknowledges that there are flaws. “It’s a new law and evolving. There have been delays, that is true. But considering it is a new law, we haven’t done too badly. While infrastructure bottlenecks are there, the positive impact on improving the environment of the borrower and financial discipline of the borrowers cannot be underestimated,” he says. More National Company Law Tribunal (NCLT) benches – bankruptcy courts – are needed to avoid logjams, and time discipline needs to be maintained, he adds.
Amitabh Chaudhry, who recently took over as managing director and CEO of Axis Bank, India’s third largest private sector bank, approves of the power shift between banks and promoters (those who organise the operations of a company). “IBC is taking more time and resolving all issues will take some time," he says. "But the most important thing is it is changing the behaviour of the Indian promoter. Earlier they knew that their assets could never be touched. Now they realise that once the NCLT [is involved], the asset is out of their hands, and that bankers may not be interested in giving loans. This is influencing promoter behaviour in a positive direction.”
Modi's modus operandi
In May 2019, the Narendra Modi-led Bharatiya Janata Party (BJP) was re-elected to power with a huge majority. All eyes are now on new finance minister Nirmala Sitharaman, who will be presenting her maiden budget on July 5, 2019. Expectations are high for comprehensive banking sector reforms and a recapitalisation programme.
The banking industry is abuzz with expectations of an announcement of further consolidation among public sector banks. In 2018, the government set in motion the first ever three-way merger between Bank of Baroda with its smaller (Vijaya Bank) and weaker (Dena Bank) peers. The amalgamated entity that came into being from April 1, 2019, is the country’s third largest bank after SBI and private lender HDFC Bank. SBI, which had absorbed five of its associate banks and the Bharatiya Mahila Bank in 2017, is ranked the 57th largest by Tier 1 capital in The Banker’s 2019 list of the Top 1000 World Banks. HDFC Bank is in 76th place. With the merger, Bank of Baroda, which is currently in 182nd place, will be catapulted up nearly 100 positions, ahead of Mumbai-headquartered ICICI Bank, which is ranked 98th globally.
Banking industry experts have long advocated consolidation of state-run banks to create larger and stronger entities that can efficiently service domestic customers and compete with global companies. In February 2019, after meeting the RBI board, former finance minister Arun Jaitley reportedly said: “I think India needs fewer banks and more mega-banks, which are strong because in every sense, from borrowing rates to optimum utilisation, the economies of scale as far as the banking sector is concerned are of great help.”
A move to consolidation?
More consolidation can be expected among public sector banks, according to SBI's Mr Kumar. "There are too many banks doing the same thing. We need stronger and better banks that may operate in a niche segment but don’t clone each other,” he says. The Bank of Baroda merger, he adds, will provide critical learning for future mergers. “Here, two stronger banks, Bank of Baroda and Vijaya Bank, are merging with one smaller and weaker bank, Dena Bank. We cannot merge a large weak bank with any other bank. After all, it is the responsibility of the larger entity to make the merger successful,” says Mr Kumar.
He adds that the two main challenges during bank mergers are integrating different cultures and integrating IT systems. With the IT systems across SBI and its associate banks largely being similar, the merger took place in less than six months. The Bank of Baroda-anchored three-way merger will take longer, despite having the same core system.
“Consolidation is only beneficial to the banking sector if the merged entity can display higher levels of efficiency. Operational efficiency, enhanced risk management and capital management should be the key focus areas for the top leadership,” says banking industry consultant Ashvin Parekh, who runs an advisory firm. He suggests that the Indian government should consider reducing its shareholding in public sector banks, which would help in raising capital as well.
As of the end of March 2018, direct government ownership at public sector banks was the lowest for SBI at 58%, but for nine banks it was upwards of 80%, touching 93.1% for United Bank of India. Privatisation is a long-suggested reform measure for the state-owned banks, as it would free them of governmental interference, it is argued, and help improve their efficiency, governance, performance and human resources policies.
Independent banking analyst Hemindra Hazari says, however, that public sector banks are essential for the growth and development of a diverse country such as India, to provide credit to sectors such as agriculture and to service rural customers. Private sector banks, which predominantly focus on the urban market, have different priorities and cannot replace public sector banks, he adds. Furthermore, he notes that the recent turmoil at three of the top five private sector banks in the country highlights a failure of governance at these banks.
Private sector reforms
Over the past 12 months, ICICI Bank, Axis Bank and Yes Bank has seen their long-standing senior management replaced under controversial circumstances. At Axis Bank, the RBI was not in favour of renewing the fourth three-year term for the bank’s managing director and CEO, Shikha Sharma, because of performance issues. The bank saw a surge of bad loans under her watch – gross NPAs grew from 0.96% in March 2009 to 5.28% in December 2017 – and the bank was also found to have under-reported NPAs for two years in a row. At Yes Bank too, the banking regulator refused to renew the term of CEO Rana Kapoor, who co-founded the bank in 2003, unhappy with the accounting and business practices. In 2016, Yes Bank’s NPAs were $630m more than the $113m it reported. The divergence widened to almost $1bn in 2017.
Notably, in May 2019, the RBI appointed its former deputy governor, R Gandhi, to Yes Bank’s board for two years. Local media speculated that the banking regulator took this unprecedented step not only in light of the aforementioned governance issues but also because of concerns regarding Yes Bank’s high exposure to shadow banks and other stressed firms.
At ICICI Bank, the saga was different. Chanda Kochhar, who had successfully led the bank since 2009 and established it as a retail banking leader, faced allegations of impropriety. One of these alleged that she was complicit in extending a loan to a company that had links with her husband. The loan eventually soured. While the board initially supported her, Ms Kochhar finally resigned in October 2018.
Ever since the mid-1990s, when new private sector banks were first set up in India, they have been held up as role models of efficiency, agility and prudent risk management, especially when compared with their slow public sector counterparts. But the recent troubles highlight a critical failure of corporate governance at these banks. It is worth noting that despite being aware of all the issues, the boards of all the three banks had recommended a renewal of their CEOs tenure. Mr Hazari says: “There are inadequate checks and balances to the powers of strong CEOs. Boards appear to be obligated to the CEO and ignore their shortcomings. This is almost a systemic problem that afflicts most private enterprises in India.”
Recapitalising state banks
One area set to come under scrutiny in the coming months is the recapitalisation of India’s public sector banks. At present, five out of the country's 19 state-owned banks have operational curbs and lending restrictions set by the banking regulator because of their poor financial parameters, while many others have thin capital buffers that do not allow for much room for growth. In 2019, the government had injected an unprecedented Rs1600bn-worth of capital into the state-owned banks but it seems that more capital will be needed to enable the NPA-laden banks to support credit growth and help them meet their regulatory capital requirements.
“If India has to grow at 7%, the banking sector needs to grow at 20%,” says Mr Diwanji of EY, estimating that public sector banks will need an injection of Rs2800bn to achieve this growth. He suggests that public sector banks should try to raise funds by offloading their portfolios and exploring alternate sources of capital. “While the government should plan a recapitalisation package, public sector banks should try to access the capital markets to mobilise capital. Additionally, the government should work on developing a deeper and transparent corporate bond market to create alternate sources of funds,” says Mr Diwanji.
With challenges aplenty on both the economy and banking front, the task for the Indian government and regulators is certainly a tough one. However, there are opportunities galore, especially with the digital arena taking off. The government’s twin thrust on digital identification and cashless transactions, combined with a focus on financial inclusion, has opened up the banking sector in new ways.
“Banking awareness has gone up and suddenly we find that the bankable population has significantly increased,” says Mr Gupta of Kotak Mahindra Bank. In the aftermath of the shock of the demonetisation policies in 2016 and 2017, when the government withdrew high-value bank notes that comprised more than 85% of money in the system, cash circulation is now back to earlier levels. However, Mr Gupta points out that while cash is back in the system, it is accompanied by an exponential rise in the number of digital transactions. “This is an exciting time. Today there is a huge opportunity to offer new products and services customers, both through new and traditional channels,” he says.
