Maharashtra Economic Development Council महाराष्ट्र आर्थिक विकास मंडळ

The Bank Bailout: Creating more problems than it solves

January 23, 2018

The government has recently announced an aggressive Rs. 2.11 lakh crore capital infusion plan for the NPA affected public sector banks (PSBs) over a two year period. Out of this, Rs. 1.35 lakh crore will be via the issuance of recapitalization bonds which are a restructured financial product involving no cash flow. Of the remaining Rs. 76,000 crore, Rs. 18,000 crore will come from the Budget and Rs. 58,000 crore will be raised from the market. Even though some experts have hailed this a monumental step which has become necessary in the current scenario, a closer look reveals that unless accompanied by fundamental reform in the banking sector, such a move is tantamount to only sweeping a nagging socioeconomic issue under the carpet.

The reason Indian PSBs need to be bailed out so often, is primarily that they belong to the public sector, and so, are subject to constant political interference regarding their lending activities. Manly PSBs are now ignoring their raison d'être - providing their clients with a high quality banking service - and are toeing the government line out of sheer expediency. This is not always in the best interests of their customers. Unless PSBs are allowed to be genuinely independent of government diktat or shrink into oblivion as private banks expand their sphere of influence and market forces play out their role, such periodic recapitalizations are meaningless. Also, in India, recapitalization is less about boosting the bottom-line of banks and more about saving them from insolvency.

Of course, this is not to absolve the PSBs of all responsibility. After all, they do not have – and do not even seem to be making a concerted effort to develop – adequate in-house expertise for accurate project evaluation. They also seem to be unable or unwilling to purchase this expertise from third party vendors. This is also a key factor leading to their inability to distinguish the good loans from the bad (and convince the government accordingly), leading to a huge rise in NPAs in the financial system. By end June 2017, the total bad loans of the country’s 38 listed commercial banks crossed Rs. 8 lakh crore and accounted for nearly 11% of the total loans given by the banking sector.

The effect of such a massive bailout on the economy as a whole will not be too sanguine. After all, so far India has stuck to the path of fiscal consolidation reasonably well. On the global front, where credit ratings matter, it will be hard to claim that the country has a long run strategy of fiscal responsibility when there is such a massive and sudden increase in public debt, which could lead to inflationary expectations and macroeconomic destabilization. The global perception will also be that the government is keeping itself open for similar financial calls on the exchequer in the future, and so is not to be fully trusted regarding its assurances of fiscal prudence. That is likely to impact the inflow of much needed foreign capital into the economy.

Unfortunate as it sounds, one of the biggest gainers from India’s banking system has been shadowy businesses who happen to have the right political contacts. As far as the NPA issue goes, such a bank bailout is not the solution – in fact, it may even aggravate the problem. The PSBs will not be incentivized to function as they are intended to, and they could even get a misplaced confidence that should their balance sheets turn unhealthy in future from inevitable and prolonged political meddling, the government is always there to bail them out. Needless to say, all this will occur ultimately at the expense of the taxpayer and the nation’s global image.

From a political viewpoint, the proposed bank bailout is certainly a deft move. Even from the short-run economic perspective, it makes some sense … after all, one cannot wait endlessly for PSBs to resolve their issue of stressed assets, especially when green shoots are now becoming visible in some key sectors of the economy. However, from the long-run economic point of view, some deep introspection needs to be done as to the implications of such a bailout, not only on the efficacy of the banking sector but also on the fiscal credibility of the nation. Resorting to financial engineering and accounting sleight of hand is not the way to boost the strength and sustainability of the PSBs, and that of the economy, as a whole.

The Bank Bailout: Creating more problems than it solves

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