Top 5 takeaways from ‘Indian Banks: A Time to Reform?’: Paper by Raghuarm Rajan & Viral Acharya.

MSME Lending in India

The Indian Credit Market is highly volatile and the country is currently facing an incredibly low credit to GDP ratio. It has a very high ratio of gross non-performing assets (GNPA) to total assets and is also facing a historically low loan recovery percentage. Despite this situation, many sectors around the country are claiming resurgence. However, a deeper analysis of the patterns over a longer time reveals that these sectors experiencing significant credit growth have routinely experienced subsequent growth slowdowns as ‘rapid credit booms have been followed quickly by busts.’

This is not unheard of; In fact the boom-bust cycle of credit growth that preceded and continued through the global financial crisis lasted for roughly eight years from 2005 to 2013. Yet, as we stand at the brink of a new economic downturn, the resolution to prevent these endless cycles has not been explored. This detailed paper encompasses research on the impacts of banking reforms and aims to suggest a variety of implementable reforms that could allow banking activity to grow significantly without allowing history to repeat itself.

Here are our Top 5 Takeaways from this Paper:

This paper primarily focuses on reforms towards bank governance and ownership, especially for public sector banks, in addition to regulatory and market reforms. The research work delves into the problem statement and then into suggested solutions while bridging the two topics through insights on current challenges that stem from institutional complexities and deep incentive problems.

1. Why banking has become more difficult in India over the past few decades:

As India evolved from a mostly nationalized and bank-dominated economy to a more decentralized and market-financed economy, the relationship between public sector banks (PSBs) and governments experienced some pressure– from development, competition, and the exhausted fiscal resources of the government.

Highlighting the problems arising from PSBs, here issues of poor loan underwriting standards and resolution appear systemic compared to the relatively characteristic governance issues that have occurred in private banks. This results in a cascading effect of de-prioritising PSBs for long-term investment needs and corporate financing. A crucial step towards reforming involves monitoring loans and better managing market risks.

2. Addressing the elephant in the room: Bad debts

A strategy most commonly used by banks is to apply a ‘band-aid to a bad loan’. Trying to keep it current and hoping that time and growth will set the project or firm back on track where solutions include making new loans while allowing the borrower to continue payments on old ones. While this can work in some cases, on facing larger and potentially unpayable debt, the promoter loses interest, does little to fix existing problems, and the firm goes into further losses. 

Thus to  change the current system of tackling bad debts, the first step is to address the problem: Through an honest recognition of loan losses. The quoted paper promotes the continued practice of NPA classification accompanied by loan provisioning, which ensures the bank sets aside a buffer to absorb likely losses. Ultimately, the solution encompassing the aforementioned ideas lies in the development of an online platform for distressed loan sales to provide real-time transparency for the same.

3. The focus towards the creation of better loans

In the last five years, the historically stable category of micro,small and medium-sized enterprises (MSMEs) has experienced a boom in credit supply. The concept of OECN has emerged and is serving as an inspiration to current lenders to pursue MSME lending and devise products around this concept. While this paper speaks about improving capital structures for project finance and smooth provisioning of loan losses to improve the loan quality, it emphasized on the transition from asset-based lending to (also) cash-flow based lending. The idea is to make banks more reliant on loan covenants for large borrowers, improve liquidity and leverage ratios rather than purely assets.

4. Strengthening  risk management at banks

While the looming risks of frauds and NPAs have more priority, market risks are often overlooked- especially the risks pertaining to interest rates.

In the past, banks have been lax in managing the interest rate risk in their sizable government bond holdings. In one way or another, investing in government bonds – a form of lazy lending for under-capitalized banks seeking to make quick gains – is a strategy whose risks are not managed by banks. Ultimately, once underwritten, loans are subject to little monitoring and resolution and the onus is on the RBI to provide relief in loan loss recognition and on the government to recapitalize when losses are recognized. The problems arising from this long-standing practice involve solutions ranging from market-to-market accounting to indexing bank loans to floating interest-rate benchmarks. In essence, there is no escaping the challenging task of making India’s banking sector robust in terms of improved standards for loan underwriting, monitoring and recovery along with a better capacity to manage risks.

5. Creating Greater Variety in Banking Structures

There are a number of successful areas in the Indian financial system and history has taught us that the most successful endeavours are the ones furthering the ideas of inclusion. The report sheds light on how “UPI has facilitated a greater number of payment transactions and this paved the way to introduce a new concept of easy payments that can be a building block to much lower transaction costs in banking and thus greater financial inclusion.” The rise of FinTechs has brought on a wave of technological disruption that existing and new players must contemplate to integrate into their lending operations. It also indicated that the creation of the payment bank license was a first step in including non-financial firms in the financial system. While this experiment is still work in progress, regulators have to consider a measured expansion of the financial system to include non-financial players and new technologies, using regulatory “sandboxes” for calibrated experimentation. This definitely moves the needle for tech platforms that have the ability to lower transaction costs through operational efficiency and seamlessly interact with the Fintech ecosystem.

For a deeper understanding of the research insights, read the full research paper here.