28 Aug 2020 21:05 IST

Economy can’t bank on Indian banking to pull itself out of morass

Given the demand deficit, pinning hopes on the banking sector to revive the economy may be misleading

It was first the Chief Economic Advisor, followed by the RBI annual report and then by the RBI Governor – all of them in the recent past have urged banks to shed their ‘risk-averse’ attitude towards lending.

The CEA Krishnamurthy Subramanian in his Bandhan Bank anniversary speech last Sunday said that if banks, which are sitting on a pile of cash, adopt an excessively risk averse approach to lending, then that would hit the revival of the economy. He went as far as to say that the current slowdown in investments and consumption in the economy were caused by the banking sector’s reluctance to lend to the corporate sector.

He said that ever since the NPA crisis blew up on the banking sector’s face because banks had turned increasingly risk-averse, this in turn impacted the investment and consumption cycles, leading to a slowdown.

Making the right noises urging banks to use fintech and data analytics for due diligence to help curb defaults and bad loans, he said banks that were slow in adopting tech saw a surge in bad loans. Talking about the peripheral presence of Indian banks in the global scene, he compared the Indian banking sector to the Indian cricket team in the 1990s – tigers at home and lambs abroad. He lamented the fact that despite being the fifth largest economy in the world only one Indian bank was in the list of top 100 global banks. China has 18 and the US has 12 banks respectively.

Then on Friday, it was the RBI Governor Shaktikanta Das’s turn to rap banks on the knuckles. He said banks turning extra cautious while lending will be “self-defeating” and would hit their bottom line adversely.

He tellingly said that banks not only had a role in spurring growth in the economy but also in “earning its own bread”.

The RBI’s annual report released on Tuesday took a similar line. It said that, “The Indian banking system needs to be liberated from the risk-aversion,”which, it said, is constraining credit flow into the economy.

It cannot be denied that banks play a major role in credit flow in the Indian economy. Even the top corporate houses in the country rely on the banking system for funds. This has become even more pronounced after the IL&FS crisis in 2018 that completely dried up credit from the NBFC or the shadow banking sector. The impact on the real estate sector was even more significant as it relied heavily on NBFCs for credit.

Banks caught in a bind

But how did things come to such a pass? In the early 2000s just when the economy started booming and started recording growth rates of 7-8 per cent a year, there was huge demand for credit from the corporate sector especially from the infrastructure sector. The roads sector – thanks to the success of the Golden Quadrilateral project during the Vajpayee reign – was particularly bullish on its prospects and companies in this sector flocked to banks for credit.

But by the end of the decade the party seemed to be over for this sector. Many of the major infrastructure projects got stuck in regulatory hurdles – land acquisition being a major impediment. Some large companies were at the risk of defaulting but thanks to their political connections managed to get their debt restructured. Banks, too under political pressure, obliged and managed to hide their bad loans problems for a while.

But it was under Raghuram Rajan’s reign on Mint Street that the real extent of the NPA rot in the Indian banking system got exposed. New asset classification norms and various ‘stress tests’ were ushered in by Rajan. Banks' capital adequacy ratios were woefully low and needed massive doses of recapitalisation from the Centre, further straining the exchequer.

Steel, power and roads firms formed a significant percentage of bank NPAs.

Corporate barons such as Vijay Mallya and Nirav Modi decamping to the UK after owing huge sums to Indian banks (in Modi’s case it was outright fraud) and dark whispers of “politician-businessmen” nexus further hit the reputation of banks.

This led to calls for governance reforms in Indian banks and a push to greater privatization of the financial sector led by the then Chief Economic Advisor Arvind Subramanian.

A chicken-and-egg situation?

It is under these circumstances that Indian banks turned increasing risk-shy and excessively cautious. But how much of the current slowdown can be blamed on the banking sector?

Even before the economies world over were hit by the Covid-19 sledgehammer, the Indian economy was spluttering with growth having fallen to 4.5 per cent. The country in the last few years has been in the severe grip of a ‘demand-deficit’. When Abhijit Banerjee, soon after winning the Nobel Prize last year, was asked what was ailing the Indian economy he was quick to point at the falling consumption levels. He further added that the government had to do something quickly to put money into the hands of the people to kick-start the consumption cycle.

The RBI annual report also mentions the anemic demand for credit from the corporate sector. It said that the savings from the corporate tax cut in 2019 had gone into “debt servicing, building up of cash balances and other current assets rather restarting the capital expenditure cycle”.

Given these facts are we right in blaming the banking sector for the slow down and pinning our hopes on this sector to revive the economy?