India Inc walks a banking tightrope

As financial turmoil stalked the west a decade ago, the billionaire banker Uday Kotak looked on with bemusement at the relentlessly bullish lending activity of his rivals in India’s huge state-owned banking sector. Even as risk appetite was drying up globally, India’s state lenders, which dominate the banking system, continued an exuberant rush of funding for long-term projects in roads, power and heavy industries, eyeing what they believed was irrepressible pent-up demand.

“The business was booming, and we kept on asking ourselves: what are we missing?” says Mr Kotak, the founder of Kotak Mahindra, a leading private-sector bank.

It decided against jumping on the infrastructure lending bandwagon, concluding that the long gestation and the unpredictable risk of such projects — many still awaiting multiple government approvals and even land — made them fundamentally unsuitable for bank financing.

Narendra Modi, the prime minister, probably wishes India’s state-owned banks had showed similar restraint. A wave of defaults by struggling infrastructure companies, and others that borrowed heavily during much of the past decade, has left India’s public-sector banks saddled with a huge and growing bad loan burden that represents one of the most serious long-term threats to the country’s economic growth.

Even after the 1990s liberalisation that allowed the entry of new private-sector banks, the state-owned lenders still hold more than two-thirds of banking sector assets. Impaired loans now account for 17.8 per cent of assets, and well over 20 per cent at several banks. As these banks now reel under the weight of $186bn in stressed assets, loan growth in the country has fallen dramatically, to 5.1 per cent in the financial year ending in March — the slowest pace for 63 years — while corporate investment fell in three out of four quarters last year.

Economists believe that cleaning up the banking system is crucial for kick-starting stalled investment, and maintaining India’s long-term development and growth. But resolving these cases will require granting sizeable debt write-offs to over-leveraged corporate borrowers and their high-profile bosses. Until now, both cautious state bankers and Mr Modi’s three-year-old administration have hesitated to take responsibility for such decisions, fearing the potential blowback from any appearances of favouring powerful corporate interests.

“It’s inherently a very, very difficult problem,” says Arvind Subramanian, the government’s chief economic adviser. “In all countries it’s very difficult to write down debts to the private sector. In India, it becomes even more difficult because there has been a history of cronyism. Therefore, even if you have to legitimately write down debts and do it in the right way, it will be seen as cronyism.”


When Mr Modi’s administration took power in 2014, it initially expected that the problem of stressed assets, which had begun to appear four years earlier, would gradually ease as stalled growth picked up.

“There was perhaps that kind of hope that maybe if we can recapitalise the banks so the credit growth will continue, and then as the economy picks up to higher rates of growth then many of the [projects’ problems] will themselves begin to resolve,” says Arvind Panagariya, vrice-chairman of the government’s main policy think-tank, the National Institution for Transforming India.

Amid mounting evidence of the futility of such hopes, the government has been forced to recognise that the ailing banking system is acting as a drag on growth. Under pressure to break the logjam, Mr Modi’s government has thrown the problem to the Reserve Bank of India.

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In May it issued an order that gives the central bank the power to force institutions to accept restructuring agreements for troubled assets, and even to trigger corporate bankruptcies. But critics say granting the banking industry regulator such powers raises potential conflicts of interest, and blurs lines of responsibility, especially if RBI approved restructured loans later go sour.

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“It is very dangerous for the central bank to start making commercial decisions,” says one former RBI official. “The central bank can appoint committees of outsiders, but those committees will have to make decisions. It can’t be the regulator saying ‘this is OK, or that is OK.’”


The ill-fated business projects behind the banks’ stressed loans cover a dizzying range of industries. Thermal power plants had their futures thrown into doubt by a scandal that stalled, for years, the development of coal mines. Toll road providers were hit by unexpected delays on land acquisition and regulatory approvals. Steelmakers faced a wave of Chinese imports, while textile producers were hit by an unexpected fall in demand from western

Darker factors were also in play, says Mr Kotak, who believes that many companies were financially undermined by controlling shareholders who siphoned off funds through related entities. Yet even as warning signs mounted, banks were initially slow to face up to the worsening outlook for their loan book. Instead, in many cases, they rescheduled payments or even extended new loans that could be used to help pay off the old ones, as they waited for overall conditions to improve, and the previous Congress party-led government urged lenders to keep the credit taps flowing.

Ending such complacent practice was a priority for Raghuram Rajan after he took over as RBI governor in 2013. He forced the banks to recognise the extent of the rot in their loan books through a dramatic tightening of regulatory supervision. By the time he left the RBI last September, banks’ estimates of their non-performing loans had risen to 8 per cent of total assets from about 3 per cent when he took charge, and the push for disclosure has been maintained under his successor Urjit Patel.

“One good thing is that unlike Japan, where the problem was swept under the carpet, here it has been recognised, and the framework for continuous recognition in the future has been put in place,” says Romesh Sobti, chief executive of IndusInd Bank, another big private-sector lender.

But while the increased transparency has been broadly welcomed, it has also highlighted the urgent need for a comprehensive solution. The government’s latest economic survey estimated that of corporate India’s 100 biggest stressed debtors 57 require debt reductions of at least 75 per cent if they are to return to financial health.

Among the key stressed accounts has been the Essar Group, controlled by the Ruia brothers, whose steel business has struggled to repay long-term debt exceeding Rs200bn. Other prominent examples include the lossmaking Jaiprakash and Lanco infrastructure groups, whose last published accounts show gross borrowings of Rs691bn and Rs454bn respectively.

Decisions over high levels of debt forgiveness for such groups are ones that most state bankers are simply unprepared to take, given the potential repercussions. Many were deeply alarmed in January when Yogesh Agarwal, former chairman of state lender IDBI, and three of his former colleagues were arrested in connection with a 2009 loan to the now defunct Kingfisher Airlines, controlled by the exiled liquor tycoon Vijay Mallya.

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Mr Subramanian, the chief economic adviser, and many others believe the bad debt logjam could be resolved by a state-backed “bad bank,” which would buy all stressed assets and then restructure them, including necessary debt write-offs. He believes that by selling stressed assets to another arm of the government, bankers now managing portfolios of such loans could get back to their main business of extending new loans.

But Mr Modi’s government is concerned about the optics of a bad bank that falls within its direct ambit giving debt haircuts. It hopes that the RBI’s blessing of restructuring deals will give state banks the cover to act without fear of anti-corruption investigations later.

“Who should be seen as making the decision to write off a loan?” says Mr Subramanian. “At the moment, we are saying, ‘perhaps the RBI is best able because it is closest — regulating the banks — to do that’. With a bad bank, it’s an agency in the public sector that would have to take the decisions. That is the tricky part.”


Whether the government’s roundabout plan to end the paralysis will deliver the desired results remains to be seen, though Mr Subramanian says it would ideally show tangible progress with at least one or two major cases given a debt workout in the next six months. If not, the debate on proper tactics will inevitably be reopened.

Arundhati Bhattacharya, chairman of State Bank of India, the country’s largest lender, argues that banks will also need financial support — or more regulatory forbearance. While SBI itself is adequately capitalised — its bad loan ratio stands at 6.9 per cent — she says, agreements on restructuring by banking consortiums have been held up by smaller players concerned about the impact that resultant writedowns would have on their already strained balance sheets.

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“One problem is the lack of capital to enable them [the state banks] to take the kind of provisions that are required to be taken up front,” she says. “So if . . . you allow the provisions to be taken over a longer period of time, or you capitalise the banks up front, then these deadlocks can be broken.”

In 2015, the government launched a four-year, Rs700bn recapitalisation plan for the state banks, but nearly four times that amount will now be needed, estimate Credit Suisse analysts, who say the stock of impaired loans has now reached Rs10.5tn.

Many believe the government should allow banks to raise funds from private investors — perhaps diluting the government to a minority shareholding in some cases. But Mr Modi’s administration shows little desire to relax controls on state banks, which it can use as tools for social policies.

Others argue the government should simply allow the state banks to lose share progressively to private rivals, as previously happened in the telecom and aviation sectors.

“What is the need to clean things up in a hurry?” asks Rashesh Shah, chairman of the financial group Edelweiss, which includes the largest of India’s existing asset reconstruction companies. “If you take the bad loans away from the banks, they could go back to their old ways very quickly — the moral hazard risk is very high.”

The softness in investment and corporate lending, Mr Shah argues, is largely a result of weak credit demand following the long-running glut of capital spending, noting that manufacturing surveys have shown significant spare capacity for several years.

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Yet some fear such short-term indicators, as well as the healthy official estimates of economic growth, threaten to lull policymakers into a false sense of security, obscuring the need for a long-term solution. “The argument for fixing the banks would be stronger if the numbers were worse. There is no sense of crisis or panic,” says Ashish Gupta, head of India research for Credit Suisse.

But the terms of the debate will change, he adds, if the need for investment picks up before the private banking sector, and India’s still under-developed corporate bond market, are ready to fund it.

For an administration that came to power promising bold efficient governance how it handles the woes of the banking sector is now seen by many investors as a critical test.

“The government underestimated the dysfunctionality of their economic inheritance from the previous administration, and overestimated their ability to fix things quickly,” says Rajeev Malik, an economist at CLSA. “Nowhere is this better reflected than in the banking space.”