Is it change or continuity for the banking sector?

What will the new RBI governor bring to a sector grappling with inflation and non-performing assets?

The top expectations from the new RBI Governor appear to be much the same as were from his predecessor — one, now mandatory, is getting inflation down and the other, the eternal demand for getting the tenuous interest rate cut-bank lending-corporate investment link working. But to the question whether expectations are for change or continuity, one would need to understand the RBI’s own views on both these themes, best exemplified by what the outgoing Governor has had to say in his final days.

Inflation, non-performing assets

On inflation, Raghuram Rajan has maintained that in India, it is inflation expectations that are crucial for controlling non-food inflation, a task the RBI could take legitimate credit for, through its measures in getting inflation down without choking demand (as alleged). With the RBI Governor’s successor also having a reputation to live up to, it may probably be unrealistic to expect large rate cuts only looking to inflation numbers. But how things will pan out in the new Committee mode will be watched with interest.

As for the bank lending imbroglio, Raghuram Rajan has been consistently pointing out that (a) high lending rates were due to high credit-risk premiums which, in turn, were due to high NPAs, and (b) banks, particularly PSU banks, were not lending because of impaired balance sheets rather than lack of demand caused by high interest rates. These would also explain why the RBI aggressively went after balance sheet clean-up, another contentious issue. In any case, as he pointed out, banks did not fully transmit the 150 bps repo rate reduction. Therefore, even if rate cuts do happen in the future, any major uptick in bank credit may still be unlikely until such time as banks are ready to lend.

As to the task of repair of bank balance sheets, what is in store? The RBI believes that growth in fresh NPAs is abating, helped also by the slowdown in lending; but apparently things will get worse before they get better (going by the projections for March 2017). If all this suggests that nothing dramatic is likely to happen soon with bank lending, the recent policy measures of the RBI queer the pitch further.

Policy measures

Take, for instance, the RBI’s guidelines on restriction of bank credit to large borrowers and permitting banks to take up additional credit enhancement to corporate bond issues up to 50 per cent.

Though positioned as bond market development strategies, they raise questions on what banks should be doing (or not doing).

Large borrowers (those with exposure of ₹25,000 crore or more from banks, progressively reducing to ₹10,000 crore by 2019) will now need to look to markets and not banks, for additional funding.

While it may be unrealistic to expect infrastructure and core sectors (roads, power, ports, and steel) to be able to successfully access markets, the issue for banks is that it limits a profitable business segment for them at a time when they are looking to re-start lending.

The other policy guideline — allowing banks to offer credit-enhancement of corporate bond issues up to 50 per cent (up from 20 per cent) — also suggests that the RBI is happier with banks being enablers rather than purveyors of credit.

Is the RBI being overly protective in its belief that corporate stress is creating systemic risk through bank balance sheets, or is it just uncomfortable with bank lending? Interestingly, even retail credit seems no panacea, going by what Raghuram Rajan feels about the current asset build-up, when he cautions banks about credit quality problems with too many banks chasing fewer opportunities.

A lot on Patel’s plate

All said and done, the banking system seems to be at the crossroads today. The old banking model, which Raghuram Rajan dubs a ‘grand bargain’ — where “banks get the benefits of raising low-cost insured deposits, liquidity support and close regulation by the central bank, in return for maintaining reserves with the central bank, holding government bonds and lending to the priority sector” — is in question. Its core functions are under threat or already in part moving away to non-bank players, with public sector banks being the most vulnerable. As for PSU banks themselves, deficits in capital, human resources and governance await speedy action. The free market economist in Rajan comes to the fore when he dispenses advice on how government mandates such as rural financial inclusion or targeted lending should be managed — through a system of proper incentives and direct subsidies, such that the most efficient banks get to take up the cause, whether they are from the public or private sector. Far-reaching thoughts, but clearly all these leave a lot more on Rajan’s successor, Urjit Patel’s agenda than what one would like to believe.

The writer is an independent consultant

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