The lack of action on bad loans was finally addressed by some muscular measures. On Tuesday, Finance Minister Arun Jaitley announced a Rs 2.11 lakh crore bank recapitalisation plan with the RBI’s blessings. Banking stocks surged in predictable fashion Wednesday. After several failed attempts, the government decided on the bailout to nationalise losses (haircuts) with taxpayers’ money—exactly what banking rules are meant to stop! But then, the clean-up is critical to revive credit offtake and investments to create jobs and spur growth.
Bad loans nearly trebled from Rs 2.75 lakh crore in March 2015 to Rs 7.33 lakh crore in June 2017 as resolution has been painfully slow. With the Insolvency and Bankruptcy Code, banks cannot ‘pretend and extend’ but must deal with them decisively. Haircuts are inevitable and as Crisil estimates, they could be in excess of Rs 2 lakh crore. As a majority shareholder, the government ends up paying for it all and hence, a surgical restructuring is necessary to strengthen balance sheets and allow private capital at better valuations to share the government’s burden. Undercapitalised banks should be shown some tough love, subjecting them to corrective action.
The NPAs are said to be the bane of the economy, but absence of banking reforms is equally responsible for the sorry parade of falling economic indicators. A Rogoff and Reinhart (2014) study of 100 banking crises shows it takes an average of six-and-a-half years to resolve a crisis. The Indian banking crisis is relatively of less magnitude and may be resolved quickly.
But as past experiences confirm, recapitalisation doesn’t necessarily prevent the rot from repeating. In fact, it often distorts the incentive structure, and erodes discipline. The Centre should separate supervisory and regulatory roles within banks, ensure capital conservation and sale of non-core assets, besides pursuing divestment, consolidation and privatisation. Else, recapitalisation recreates ‘Heads I win, tails the taxpayer loses’ incentives, sowing the seeds of another lending excess.