Book Review: Pandemonium - The Great Indian Banking Tragedy
On 1st October 2019, Country’s Bankers’ Bank issued an unprecedented statement which reads: ‘The Reserve Bank of India would like to assure the general public that Indian banking system is safe and stable.’
This prompted Tamal Bandyopadhyay to write his book ‘Pandemonium: The Great Indian Banking Tragedy’. The book takes you on a roller-coaster ride in search of the answer. It is a compelling story on the rot in India’s banking system – how promoters easily swapped equity with debt as bank managements looked the other way to protect their balance sheets until the RBI began waging a war against ballooning bad loans.
Tamal is neither a Banker nor an Economist but a keen watcher of the banking industry. He worked as a journalist for twenty-five years that includes his 11-year stint as an expert of the banking segment for the financial newspaper Mint. That has allowed him to understand the banking system. You may agree or not with the prescription provided by Tamal in his voluminous work but you can not question his sincerity.
Tamal had also been able to take a ringside view of the banking industry as a Senior Adviser to Jana Small Finance Bank Ltd and between 2014 and 2018, as an adviser on strategy for Bandhan Bank Ltd.
Tamal has tried to find out the reason for the ailments of public sector banks who has served as the backbone of India’s financial system. Is it the government ownership itself, or the conduct of the leadership? And just when many were rooting for privatisation as a way out, powerful bankers such as Chanda Kochhar and Rana Kapoor exposed the soft underbelly of seemingly more efficient and profitable private banks of India.
In the preface, Tamal refers to Akira Kurosawa’s iconic film Rashomon, a metaphor for different, and often conflicting versions of the same event.
For Indian banking, the metaphor is rather apt. At the best, to use the same metaphor, it is the woodcutter’s story, not the commoner’s perspective. Rashomon would not have become such a great film without Kazuo Miyagawa as its cinematographer.
To chronicle what Tamal calls the great Indian banking tragedy, we need an external, objective and dispassionate observer as cinematographer. If you are inside the system, you may know everything about it, but you may have no sense of its place and function in the bigger picture. For years and years, Tamal has been and still is, a widely read business journalist, across the newspapers, especially on banking and finance. That brings an investigative flair and felicity in his use of language, aided no doubt by his specialisation in English literature.
In Lady Windermere’s Fan, Oscar Wilde had Dumby say, ‘In this world, there are only two tragedies. One is not getting what one wants, and the other is getting it.’ (Later, this quote was redone by George Bernard Shaw in Man and Superman .) Why should there be a great tragedy in Indian banking? Across indicators – prevention of bank failures, number of banks (commercial, payments banks and small finance banks), bank branches and ATMs, deposits, bank credit, gross domestic product (GDP), banking standards, use of technology, digitisation, measures of financial inclusion – there have been improvements over time. Reforms, however, defined, have much to do with competition and efficiency in factor markets (land, labour, capital).
Banking constitutes a critical strand of capital market reform. While privatisation of public sector banks (PSBs) is not yet on the agenda, there has been competition through private sector entry. The competition requires exit, as well as entry. The 2016 Insolvency and Bankruptcy Code (IBC) has ensured an exit for errant promoters. There is a regulator for banks, though less starkly so for non-banking financial companies (NBFCs). Within that broad reform template, there is quite a bit the country has got.
In Part I, of the book which has been aptly titled ‘The Conundrum’, portrays symptoms of the malaise, familiar to most people. Non-performing assets (NPAs) mounted. With development finance institutions (DFIs) having died an unnatural death, banks started to lend in areas where they did not possess expertise. Bond markets did not develop deeply enough and infrastructure projects were financed via debt rather than equity. Compared with real sector growth, financial sector growth was disproportionately high. Add to that the NBFC problem. Hence, there are major issues with
(a) regulatory oversight;
(b) governance oversight within banks;
(c) perverse behaviour of rating agencies. Cutting across all three, there is an information flow problem despite the penetration of private sector banks, which have not always covered themselves with glory.
In Part II, Tamal zeroes in on PSBs as the country’s banking landscape is still dominated by PSBs. Therefore, in unpeeling the malaise further, there have been committees galore, replete with recommendations. Implementation of recommendations, when attempted (read: consolidation and capitalisation), have concentrated on symptoms, not the disease. In the book’s diagnosis, and no one can disagree, the core disease part of the DNA of PSBs has elements of
(1) control over appointments;
(2) multiple channels of control;
(3) lack of independence of boards;
(4) political interference;
(5) perverse incentives and lack of accountability;
(6) conflict between social and commercial objectives.
Though not listed in Part II, the Prevention of Corruption Act (PCA) and vigilance enquiries to be also taken into consideration.
In Part III, Tamal takes us on to– questions that should be asked, but are rarely asked. In this part of the book, Tamal takes us through frauds, and how they were worked. ‘The public sector bankers in India, including the retired, are an embarrassed and a much-harassed lot. The investigative agencies are hounding them for loans that have gone bad, and frauds. Are we replicating the Chinese banking system where many borrowers are dishonest, many bankers corrupt, risk assessment is poor and the legal system weak, leading to large lumps of loans not being backed by genuine collateral? The investigative agencies are quick to file charge sheets and arrest bankers, but in how many cases have they been able to prove their charges? The focus seems to be more on the demonstrative effect. By subjecting them to public humiliation, unending investigation and painting the entire banking community with the same brush, in the process, the Indian economy becomes the biggest loser. The tardy credit growth tells the story – the bankers are a harassed and a scared lot. They know if they do not lend, they will not be charge-sheeted or arrested. And, no one loses his or her job for not lending. But if a loan turns bad, they may end up spending sleepless nights on a carpet at a barrack in Mumbai’s Arthur Road Jail.’
This quote says it all. There is the broad reform template and there can be no quarrels with that. However, as a critical ingredient in that reform template, we have the immediate problem described in Part III, not just one of the richest sections of the book, but also one of the most disturbing. Although the focus is PSBs, this part makes clear in its concluding chapter that the malaise also extends to private sector banks, which are hardly paragons of virtue.
Most of the RBI governors have had impeccable credentials, academic and otherwise. Naturally, they should have thought about the problem, though they need not always have articulated their views in public.
In Part IV, the author quoted the views of four respected ex-RBI governors viz. , C. Rangarajan, Y.V. Reddy, D. Subbarao and Raghuram Rajan. The trouble with this part is that no public servant, former or current, will ever be candid in publicly stated views. So far, we have had a litany of woes, warts and blemishes of the tragedy, skilfully portrayed by the author.
The new dimension in the latest turmoil is its backdrop – this is an acrimonious fight between the finance ministry and the RBI. Things came to such a pass that the government threatened to use a particular section of the RBI Act to ‘direct’ the banking regulator.
The points of conflict have been many – ranging from the government’s uneasiness with the RBI not allowing weak banks to lend (because they did not possess sufficient capital) to the regulator directing banks to move the insolvency court against large defaulters. Disagreements between the central bank and the government on policy issues have occurred many times, but this time, it spilled over into the public domain.
Viral Acharya, one of the deputy governor at RBI was on record, in October 2018, to warn the government of the ‘wrath of financial markets if the independence of the central bank was curbed.
The Economic Secretary Government of India Subhash Chandra Garg did not take a long time to retort with this tweet: ‘Rupee trading at less than 73 to a dollar, Brent crude below $73 a barrel, markets up by over 4 per cent during the week and bond yields below 7.8 per cent. Wrath of the markets?’ That shows the tip of the iceberg called the crisis of trust between the Central Bank and the government.
Similarly, the Indian financial system is no stranger to crises. But a crisis of confidence that forces the RBI to issue a press statement assuring the safety of deposits, tweet on a Sunday and get the governor to issue a statement is something new and alarming. I would love to quote Tamal as a prescription to the problem :
‘PNB and Punjab & Maharashtra Cooperative Bank were hit by outright frauds. In one sense, the scope for fraud cannot be eliminated though it can be reduced. Still, one cannot condone the RBI’s role. Many blame the shift to risk-based supervision for such frauds. While an off-site surveillance system is welcome, it cannot be done at the cost of on-site supervision and transaction testing.
While the creation of a specialised supervisory and regulatory cadre may help plug some loopholes, market intelligence is something the Indian central bank cannot afford to ignore.
A December 2016 paper of the Bank for International Settlements, the central banks’ bank, says:
Central bank remits necessitate that policy and operational decisions are made with an understanding of the financial market context in which central banks operate. Gathering intelligence on financial markets makes a vital contribution to that understanding. It enhances and extends insights that come from the analysis of market data and published commentary and research, and thereby informs a range of policy and operational objectives.
According to the paper, market intelligence is most important for market operations and analysis, monetary policy analysis, and foreign exchange reserve management. Market intelligence is used to support a very wide range of functions, including financial stability.
Had the RBI had a sufficiently efficient system for gathering and analysing market intelligence, it could have sensed the rot in the banking system even before the CRILC was set up.
Similarly, it could have flagged potential trouble in the NBFCs that were borrowing short and lending long, riding on a liquidity sugar rush after the November 2016 demonetisation. At the same time, the bankers were watching haplessly as they did not have the capital to support lending.
According to Tamal, the Crux of the Problem is
How long will India allow this zombie credit culture to continue? Japan started the so-called zombie credit culture in the 1990s. Europe followed in the wake of Japan, where low-interest rates and the banks’ refusal to write-off bad debt has stymied growth for decades.
Economists claim the European Central Bank’s Outright Monetary Transactions (OMT) programme induced zombie lending by banks, which remain under-capitalised. Italy, Portugal and much other Organisation for Economic Cooperation and Development (OECD) countries have witnessed this.
The basic lesson from Japan’s experience is that if the banks lack sufficient capital, they end up doing zombie lending and evergreening loans. India does not seem to have learnt this lesson (for that matter Japan does not seem to have learnt it either!).
There is an incentive to not declare a loan bad even after the borrower defaults, as the banks need to set aside money to provide for such bad loans. That hits their profits and, more importantly, erodes their capital.
The banking regulator asks the banks to maintain a minimum capital. To ensure that, the banks look the other way to avoid taking a hit on their balance sheets and they hope that borrowers, with the support of fresh money, will be able to get back to profitability and repay their loans.
Credit Misallocations
Zombie banking always leads to credit misallocations. The insolvent firms keep on getting bank credit and stay alive and those who need loans are turned away.
The Japanese story happened when Japan’s real estate bubble collapsed in the early 1990s. The banks were affected as they were holding real estate assets, either as collateral for loans, or had direct exposure to real estate. The government introduced a series of measures to stabilise the banking system and spur growth. But under-capitalised banks preferred zombie lending.
The story of the Indian banking system is more complex but the lessons are much the same: An ultra-loose monetary policy and regulatory forbearance cannot substitute bank capital. The bank must be adequately capitalised. If they are not, we see zombie lending which, in turn, creates zombie lenders.
The NBFC crisis in India is an offshoot of the banking crisis. As under-capitalised banks were not allowed to lend, the NBFCs rushed to grab market share. Easy money was a big incentive for them. Until the RBI launched AQR, the banks were doing zombie lending.
Many observers have asked if the RBI was too aggressive in its mission clean up? In the mid-1990s, the Indian banking industry had an even higher basket of bad loans – as a percentage of their loan book – but they were still nursed back to health without much noise.
In the second half of the current decade, was the RBI under Urjit Patel, too obsessed with the demonstrative effect of what the central bank could do, rather than the effect of the action itself? Could the clean up have been done without exposing bank vulnerability so crudely?
Tamal Cited the Japan Story
While there is no definite answer to these questions, the Indian banking story does, in many ways resemble the story of Japan and of Europe. The banks remained under- capitalised; the RBI kept on devising different restructuring plans for stressed assets and the banks kept on zombie lending until the regulator changed approach and tackled the problem head-on.
A large part of the banking system is owned by the government. Indeed, India is unusual among large economies because of the large government ownership of banks. Unlike some of the large private banks, PSBs lack the balance sheet health and strength to attract capital from the market. So, the government needs to infuse capital but its own fiscal weaknesses prevent it from doing so in a liberal fashion.
Viral Acharya’s maiden speech as RBI deputy governor, on ‘Some Ways to Decisively Resolve Bank Stressed Assets’, was delivered at an IBA conference in February 2017. He spoke about resolving the bad loan problem in a time-bound, decisive manner.
Some banking sector analysts found the proposal too academic and infeasible in the Indian context while ‘status quoist’ bankers also did not see merit in what he proposed. His suggestion was to create special structures to deal with stressed loans, keeping in mind the possibility of revival of the companies that had borrowed money from banks.
One such structure is a private asset management company to handle the creation, selection and implementation of a feasible resolution plan for a quick turnaround of the largest troubled companies in telecoms, metals (iron and steel, in particular), engineering- procurement-construction and textiles within a fixed time frame.
One or more credit rating agencies would rate the resolution plans in which the promoters of these companies would have no say. The banks had to choose from among those resolution plans to ensure adequate credit rating of the restructured entity, and take a deep haircut which would be approved by the government and accepted by the vigilance authorities. Of course, the resolution would have to pass through the insolvency law.
In sectors such as power, which suffer from excess capacity and need long-term solutions, the plan was to create a quasi-government body such as a national asset management company with a minority government stake. This would raise debt, possibly government-guaranteed, and manage the asset reconstruction companies and private equity firms responsible for turning around stressed companies.
The proposal was a radical departure from measures that RBI had adopted to resolve the bad loan problem before the insolvency law was put in place. It shifted the focus from banks to the larger economic scenario, taking notes of the fact that a banking crisis could morph into a larger crisis that hits industrial growth in Asia’s third-largest economy.
Acharya had a point. He did not look at the health of the banking sector in isolation. He wanted to treat the zombie lenders and zombie borrowers – sick banks and sick industries – simultaneously.
If we want to save the banks first and take care of industry later, it could be too late to boost economic growth and create jobs. We can have healthy banks but who will they lend to? So, there has to be an attempt to dissect the economic viability of underlying assets and find ways of restructuring them to become productive.
The proposal also called for a significant restructuring of PSBs, including raising private capital, sale or securitising of assets, merging banks and getting rid of the non-performing workforce by offering voluntary retirement schemes and inducting a younger, digitally-savvy talent pool.
It spoke about ‘tough love’ and allowing market forces to decide which banks should survive.
Political Animal
Nobody looked at Acharya’s proposal seriously because the PSBs are political animals. While RBI looks after regulations and supervision, the PSBs are run by the government in power. The problem does not lie in the public sector character of these banks but in how they are governed. As we know, IDBI Bank Ltd has been ‘privatised’ by giving its majority ownership to the state-owned LIC, while 13 PSBs have been merged to create five relatively large banks.
Will it change the way they are run? What will happen to other PSBs such as UCO Bank in West Bengal, Punjab & Sind Bank in Delhi, Indian Overseas Bank in Tamil Nadu and Bank of Maharashtra in Maharashtra? Given the state of their balance sheets, can they fend for themselves?
There are too many questions. Is there a crisis or is this a game being played by India Inc.? The bottom line is, the bank crisis spilled over to the real sector and created a crisis of confidence.
What lies in the future? Should development financial institutions be revived as a concept? Should the new landscape of banking be one of co-existence of big banks and small banks? Should we have more banks or fewer banks? Will the bad banks and good banks continue to cohabit due to the government’s indulgence?
If all state-owned banks cannot be capitalised on, the government must choose who should live and who should die. Can a few of these be privatised?
The quality of assets of the Indian banking system showed marginal improvement in the financial years 2019– 20 and 2020–21, leading optimists to believe that the phase of bad-loan recognition is over and it is time for resolution.
But balance sheets of banks will deteriorate again, quite severely, following the impact of the general lockdown prompted by the Covid-19 pandemic. Even before the lockdown, the NPAs of Indian banks as a percentage of the loan book was the worst among the G-20 nations after Russian Federation.
Through the past decade and more, corporate India continued to leverage by taking on more debt. The banks changed their preferred asset class from steel to infrastructure, to telecom, and the RBI kept on displaying forbearance. In an easy money regime, treasury profits have helped banks clean up their balance sheets at periodic intervals. But if this story continues, at some point, there won’t be anybody to lend to, barring the government. That is the last bastion – signalling fiscal dominance and debt stagnation.
If the government as the majority owner wants to run banks as an agency for social good, let it not pretend these are commercial entities. Alternatively, it should put in place enabling conditions to allow the banks to run as business enterprises.
DBS Bank Ltd, the largest bank in Southeast Asia by assets, was set up by the Singapore government as a development financial institution in 1968. It is run by its board. The government has nothing to do with operations, except for earning handsome returns on its investment.
What should the government do with the PSBs? Vitor Gaspar, Paulo Medas and John Ralyea, all officials of the IMF’s fiscal affairs department, have made some interesting suggestions at the IMF Blog in May 2020. Although they have written on the role of state-owned enterprises in saving lives and livelihoods in the time of the Covid-19 pandemic, the points they make are relevant even otherwise.
In a time when governments are facing increasing demands and struggle with high debt, a core principle for state-owned enterprises is not to waste public resources. We make four main recommendations for how countries can improve the performance of state-owned enterprises:
Tamal says that Governments should regularly review if an enterprise is still necessary and whether it delivers value for taxpayers’ money. For example, Germany conducts biennial reviews. The case for having a state-owned enterprise in competitive sectors, such as manufacturing, is weaker because private firms usually provide goods and services more efficiently.
Countries need to create the right incentives for managers to perform and government agencies to properly oversee each enterprise. Full transparency in the activities of the enterprises is paramount to improve accountability and reduce corruption. Including state-owned enterprises in the budget and debt targets would also create greater incentives for fiscal discipline. Many aspects of these practices are in place, for example, in New Zealand.
Governments also need to ensure state-owned enterprises are properly funded to achieve their economic and social mandates, such as in Sweden. This is critical in responding to crises – so that public banks and utilities have enough resources to provide subsidised loans, water, and electricity during this pandemic – and in promoting development goals.
Ensuring a fair playing field for both state-owned enterprises and private firms would have positive effects by fostering greater productivity and avoiding protectionism. Some countries already limit preferential treatment of state-owned enterprises, like Australia and the European Union. Globally, a potential way forward is to agree on principles to guide state-owned enterprises’ international behaviour.
The stakes are high. Well-governed and financially healthy state-owned enterprises can help combat crises such as the pandemic and promote development goals. However, to deliver on these, many need further reforms. Otherwise, the costs to society and the economy can be large.
Half a decade has been lost since the RBI decided to remove the tumour of bad loans in 2015. The RBI’s desire to act decisively was not to the liking of the government. If the government continues to remain in denial about the state of public sector banking, India will go the Japanese way. It is high time that both government and the central bank aligned their actions to recognise the mess and clean up banking, once for all.
The government uses its clout as the majority owner to make the PSBs act in an unsustainable manner. Meanwhile, the RBI goes overboard, tinkering with regulations to make up for supervisory failures.
Many say that excessive regulations stifle India’s banking industry in somewhat the same way that over-regulation has prevented the free development of the labour market. As a result, while the informal economy is the biggest source of employment, a large section of the population continues to depend on informal sources of finance – they do not have full access to the formal banking system.
At the end of this book, Tamal tries to seek an answer to a question: Has India let down its banking system or, is it the other way round? Probably, the blame should be shared.
The banking regulator could have encouraged competition by allowing many more banks to set up shop. It has not done so and hence, financial repression continues. The banks too have not explored the phenomenal opportunities that the world’s second-most populous nation offers.
There are millions of borrowers and savers in the hinterland of India but very few banks seek to identify and exploit the business opportunities there. Some banks go there only under compulsion; while others stay away.
Everyone ends up losing at the end.
