Why you should care

India is a major driver of the world economy. But it can’t perform to its full potential until its banks are healthy again.

Indian Prime Minister Narendra Modi promised many things in his eagerly anticipated Independence Day speech, but the newly elected leader was mum on the one thing businesspeople in India and abroad want to know perhaps most of all: how to revive India’s banks.

“I was out in India in February, and when I’d sit down with companies … that was the only issue they were talking about,” says Rick Rossow, an expert on Indian business at the Center for Strategic and International Studies in Washington. “Behind closed doors people were really getting panicky about it.”

What they’re panicking about is the state-owned banks’ nearly trillion dollars in bad debt. Unless Modi and his government can figure out how to write it down, the government-owned banks won’t be able to lend enough money to support the economy, and his government will fail to make good on his central pledge of the 2014 campaign: reviving the economy.

…the modus operandi has been the same: lend money to those who didn’t deserve it, or price loans lower than what they should have been…

“The health of the banking sector is definitely a first-term project,” says Sadanand Dhume, an expert on South Asia at the American Enterprise Institute in Washington. “It’s a hugely important economic issue.”

Fixing it will require a series of financial maneuvers to write down bad debt, as well as injecting new capital. But the government doesn’t have enough cash to give banks what they need, which could force Modi to consider the politically charged step of inviting in the private sector and dramatically downsizing the government’s role in the lending business. Good-governance advocates endorse the idea, but he’d face vocal opposition. Modi’s leadership will be key, and so far he hasn’t spoken publicly on the issue.

Prime Minister Narendra Modi addressing the nation on 68th Independence Day from a podium pointing his finger towards the right of frame

Prime Minister Narendra Modi addressing the nation on 68th Independence Day

Modi inherited a sick banking sector, which is mainly owned by the government, and that’s the underlying problem. The banks lent freely during the go-go years of the last decade to personal and political friends, but when the economy hit the skids in 2009, borrowers lost the ability to repay. As a result, the number of “bad” loans — those not being paid back — has been mounting, particularly in the crippled real estate market.

India’s central bank has estimated that bad loans will amount to a full 5 percent of all bank lending in the country by the end of this year. According to a report by the Center for Strategic and International Studies, that is a good bit higher than Asian neighbors, most of which hover around 2 percent. And an article in DNA India pointed out, “Even if the percentage appears to be small, the actual numbers are huge” — the equivalent of $935 billion.

The soured loans have stifled lending, a familiar picture for banks in the United States and Europe from the financial crises of the last decade. When banks stop lending, businesses can’t get money and stop expanding, markets gets spooked and the economy can spiral downward. In India, it has raised borrowing costs and stymied investment.

Any serious banking reform has to hinge on getting the politician out of the decisions of giving or making a loan.

— Sadanand Dhume, expert on South Asia at the American Enterprise Institute in Washington

Indian banks face less risk of collapse than those in the U.S. or Europe. A benefit of state-run banks is that “it kind of insulates India from those kinds of panics,” says Dhume. So they’ve continued to limp along, wounded, as a major drag on the country’s economy.

Banker Sudhir Kumar Jain’s arrest in Bangalore earlier this month has come to symbolize all that is wrong with India’s banking industry. According to India’s Business Standard newspaper, Jain, the chairman of the state-run Syndicate Bank, is accused of taking bribes in exchange for expanding the credit limits of certain private companies, in violation of rules and regulations.

“Jain was the last in a series of alleged corruption cases involving top officials of government-run banks and the modus operandi has been the same: lend money to those who didn’t deserve it, or price loans lower than what they should have been, or give breathing time to errant borrowers,” wrote Indian columnist Shyamal Majumdar.

Jain’s alleged indiscretions are but an extreme example of the way political and personal incentives, instead of sound financial evaluation, drive lending decisions at many state-owned banks.

Critics blame the fact that the board of governors running India’s state-owned banks — which make up roughly three-quarters of the banking sector — are appointed by the government. The practice started when banks were nationalized in 1969 under then-Prime Minister Indira Gandhi.

As the P.J. Nayak report, commissioned by the Central Bank of India and released this spring, observes, “many of the provisions in the Bank Nationalisation Acts are anachronistic and a powerful source of governance ills,” allowing politicians to “intervene in diverse areas such as banks’ capital structure, board composition, retirement of directors and the reconstitution, amalgamation and transfer of bank shares.”

The Nayak report called for the government to reduce its stakes below 50 percent, giving private investors a majority stake. But for populists who believe the banking sector should help promote public interest, the proposal, which would amount to de facto privatization, bordered on sacrilege.

India’s central bank chief, the well-regarded Raghuram Rajan, has suggested a middle ground. Already, Rajan and his Reserve Bank have taken smaller steps, such as tightening rules for restructuring bad loans and threatening penalties if banks don’t sell off those loans to force them to come clean about their bad assets and gradually get them off their books.

“The whole point is, can we get the governance structure straight and can we distance the governance structure from succumbing to some of the political interests that are around?” he told Indian journalists earlier this month. “There are a number of suggestions in the [Nayak] report that can be implemented without necessarily … changing the ownership.”

In the meantime, a stronger economy could help erase some of the bad loans that banks are sitting on, Rossow says.

Still, Dhume insists, “Any serious banking reform has to hinge on getting the politician out of the decisions of giving or making a loan.”

Headshot of Raghuram Rajan

Raghuram Rajan

Dhume says he expects Modi’s policy toward bank governance to start taking shape early next year, when the government issues a full-year budget. It will be a test: Will Modi succumb, like his predecessors, to the temptation of controlling the banks?

This OZY encore was originally published Aug. 26, 2014.

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