Wednesday, January 1, 2014

A ticking time bomb?

B S :Editorial Comment  |  New Delhi  Jan  1, 2013

Re-examine government's role as owner of banks

The problem of asset quality has become increasingly significant in the
 Indian banking system. However, as was reported in this newspaper 
on Tuesday, there is a striking asymmetry in the nature of the 
problem across different categories of banks. Over
 the past five years, while private sector banks have seen
 some improvement in the ratio of their non-performing 
assets (NPAs) to outstanding credit,public sector banks
 as a group have seen a marked deterioration. The latter
 collectively account for over 86 per cent of NPAs, while 
providing about 75 per cent of credit. In response, the
 Reserve Bank of India has proposed some measures,
 including early recognition of problem assets and
 information sharing between banks. These will be
 finalised in a few weeks based on public feedback.
 While such measures may help alleviate the problem,
 a robust solution must recognise and respond to some
 structural characteristics of government-owned banks,
 which have contributed to the build-up.

An important one is the level of independence and autonomy

 that a typical bank enjoys in making its credit decisions. 
Anecdotal evidence suggests that various channels of influence 
play a role in making credit decisions, thereby diluting the 
effectiveness of the credit appraisal process. Occasional 
revelations, such as the loans-for-bribes case involving Money
 Matters Financial Services and Punjab National Bank a few 
years ago, might be merely the tip of the iceberg.

 These tendencies are reinforced by the criteria for the
 appointment of independent directors on the boards of 
public sector banks, which are seen less as effective 
governance mechanisms and more as opportunities for 
extracting rents. Another issue is that of incentives. 

Given the relatively short tenures of chairpersons and
 executive directors, the immediate recognition flowing
 from an acceleration of credit growth perhaps outweighs
 the negative impact of asset quality problems, which
 usually materialise during the successor's tenure.
 This has contributed to the well-known succession
effect, in which a new chairperson makes provisions
 for all the bad assets from the predecessor's term,
 thereby cleaning the slate for his or her term, but 
also making the earnings pattern volatile.

These structural factors require a much deeper 

examination of the government's role as owner of banks.
 The philosophical dimension of this issue relates to 
the fulfilment of the social mandate for which banks
 were nationalised in 1969 and again in 1980. 
Has this been fulfilled and to what extent?

 Is the current situation one in which the social 
mandate itself is being compromised by weak 
governance and incentive mechanisms? 

The fact that the government is now seeing
 new private banks as agents of financial inclusion 
is one indicator that it is not completely satisfied 
with the performance of the banks that it owns. 

The practical aspect of the issue relates to the 
need to enhance the capital of banks saddled 
with high NPAs. If the government wants to 
preserve majority ownership, it perforce becomes
 the predominant source of new capital.
 It clearly does not have the fiscal space to do this,
 now or in the next couple of years.
 How is it going to reconcile the need for control 
with the imperative of more capital?

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