Resolving Stress in the Banking System.

Ordinarily, in a city like Bangaluru, we would talk about startups. Today, however, I want to talk about the resolution of financial distress. I want refute the argument that monetary policy has been too tight. Instead, I will argue that the slowdown in the credit growth has been largely because of stress in the public sector banking, which will not be fixed by a cut in the interest rates. Instead, what is required is a clean-up of the balance sheets of public sector banks, which is what is under way and needs to be taken to it’s logical conclusion. Specifically, I want to describe what the banks have been doing in India to change the culture surrounding the loan contract.

PUBLIC SECTOR LENDING vs PRIVATE SECTOR LENDING.

The data indicate public sector bank non-food credit growth has been falling relative to credit growth from the new private sector banks since early 2014. This is reflected not only in credit to industry but also in micro and small enterprise credit. The relative slowdown in credit growth, albeit not so dramatic, is also seen in agriculture, though growth is picking up once again. Whenever one sees a slowdown in lending, one could conclude there is no demand for credit- firms are not investing. But what we see here is a slowdown in lending by public sector banks. The immediate conclusion one should draw is that this is something affecting credit supply from the public sector banks specifically, perhaps it is the lack of bank capital. Yet if we look at retail loan growth, and specifically housing loans, public sector bank loan growth approaches private sector bank growth. The lack of capital therefore cannot be the culprit. Rather than across the board shrinkage of public sector lending, there seems to a shrinkage in certain areas of high credit exposure, specifically in loans to industry and to small enterprise. The more appropriate conclusion is that the public sector banks have been shrinking exposure to infrastructure and industry risk right early from 2014 because of mounting distress on their past loans. Private sector banks many of which did not have these past exposure, were more willing to service the mounting demand for both their traditional borrowers, as well as some of those corporate’s denied by the public sector banks. Given, however, that public sector banks are much bigger than private sector banks, private sector banks cannot substitute fully for the slowdown in public sector bank credit. We absolutely need to get public sector banks back into lending to industry and infrastructure, else the credit and growth will suffer as economy picks up.

THE SOURCES OF LENDING DISTRESS: BAD FEATURES.

Why have bad loans been made? A number of these loans were made in 2007-08. Economic growth was strong and the possibilities limitless. Deposit growth in public sector banks was rapid, and a number of infrastructure projects such as power plants had been completed on time and within budget. It is at such times that banks make mistakes. They extrapolate past growth and performance to the future. So they are wiling to accept higher leverage in projects, and less promoter in equity. Indeed sometimes banks signed up to lend on project reports by the promoter’s investment bank, without doing their own due diligence. One promoter stated about how he was pursued then by banks waving cheque books, asking him to name the amount he wanted. This is the historic phenomenon of irrational exuberance, common across countries at such a phase in the cycle. The problem is that growth does not always take place as expected. The years of strong global growth before the global financial crisis were followed by a showdown , which even extended to India, showing how much more integrated we had become in the world. Strong demand projections for various projects were shown to increasingly unrealistic as domestic demands were slowing down. Moreover, a verity of governance problems coupled with the fear of investigation slowed down bureaucratic decision making in Delhi, and permission for infrastructure projects becomes hard to get. Project cost overruns escalated for stalled projects and they became increasingly unable to service debt.