Levelling the playing field for banks

Illustration by Shyamal Banerjee/Mint

Live Mint :Viral  V Acharya :Sun, Sep 29 2013. 07 30 PM IST

Over the past year, the non-performing assets (NPAs) of Indian banks have risen steadily. They now exceed 5% of advances. This is a rather high number in an absolute sense, but also in the relative sense compared with banks in other countries. The NPAs are significantly higher for public sector banks than private lenders. The real problems may be deeper as many loans are under restructuring and not yet recognized as NPAs for their full likely losses.

While these balance-sheet numbers suggest concern regarding future losses, market-based data can help assess the preparedness of Indian banks to deal with these losses. At the V-Lab in New York University’s Stern Business School, we estimate the capital needs of banks in future stress. We use market data to assess the downside risk of banks and assess their gearing in a stress scenario by comparing their book liabilities to market value of equity after taking account of the downside risk.

Our estimates suggest that in the event of a minus 40% correction to the global market over a six-month period, as seen in the Great Depression and the Great Recession, publicly traded Indian banks and financial firms will require over $80 billion of equity capital to maintain a market equity ratio of 8% relative to their assets.

To put this number in perspective, let us benchmark it. The required capital need would be over 5% of India’s current gross domestic product (GDP) and over 60% of the market value of equity of these firms. The same number for China is about $480 billion, so 6% of China’s GDP, but less than 35% of the market value of equity of the financial sector.

While a minus 40% correction to the global market is arguably a rather stressed scenario, these numbers suggest the Indian financial sector’s capacity to recapitalize itself in future stress is worth a careful scrutiny. What is somewhat disturbing is the composition of the capital needs we estimate. More than $50 billion of our estimate comes from 10 large public sector banks, and it is twice their market value of equity. This is consistent with higher NPAs at these banks than other banks.

Why have public sector banks done worse than private sector banks in terms of asset quality? And, why are they so vulnerable to future stress?

The seeds of the troubles at public banks were in fact sown in the autumn of 2008. As the Indian banking sector experienced unexpected funding problems in late 2008, some private sector banks heavily exposed to the wholesale markets became vulnerable. Deposits, retail and especially corporate, flooded the public sector banks. Private sector banks could increasingly borrow only at shorter end of the maturity, whereas term deposits flocked the public sector banks.

My research with Nirupama Kulkarni of the University of Berkeley documents that this flight of deposits out of private sector banks was worst for the riskiest private sector banks. In contrast, the flight into public sector banks benefited them indiscriminately. That is, even the risky public sector banks experienced deposit inflows. The flight of depositors was clearly in pursuit of the stronger government guarantees perceived for the public sector banks, since unlike private banks, they would receive ready injection of government capital.

This lack of a level-playing field in deposit funding in 2008 has had deep consequences for leverage and asset-quality decisions of the Indian banking sector over the past five years. Disciplined by the funding problems then, private sector banks have, by and large, operated at much lower leverage, often less than half of the public sector banks, even though their reliance on fragile wholesale funding appears to have survived in case of some banks. The lower leverage has given these banks a greater cushion for absorbing future losses. Their lending since 2009 has also been much more prudent relative to public sector banks.

While the easy lending by public sector banks could be seen as the much-needed stimulus to the economy, such strategy of propping up growth through state-owned banks and finance companies has back-fired worldwide. The housing bust in the US and the current stress in the Chinese banking system from loans to infrastructure are cases in point. To address this vulnerability, two steps are worth considering.

First, some of the public sector banks that have most gearing should be recapitalized now and their debts reduced, as they still have reasonable market values of equity. This could be achieved, for instance, through deep-discount rights issues as my co-authors, Yakov Amihud and Sabri Oncu, have suggested. This will put the burden of further losses on their shareholders rather than on taxpayers in due course. It is also likely to improve their incentives to restructure troubled assets promptly.

Second, public sector banks need to be slowly weaned off their funding advantage coming from government guarantees. In the short run, this could be achieved by requiring them to pay a deposit insurance premium that compensates for the guarantee they cash in on in stress times. They could also be subjected to larger capital buffers given their funding reliance on the state rather than the market.

Over the long run, some of the public sector banks can be privatized or their assets reallocated. Some of them could be acquired by the relatively well-capitalized private sector firms; the ones with worst asset quality could be wound down; and, greater entry of smaller and newer banks can be enabled to maintain healthy levels of competition.

Viral V. Acharya is CV Starr professor of economics, department of finance, New York University Stern School of Business.