The current Agenda: Restoring Public Sector Bank Health in India – Influx of funds: What history reveals?

The news that recapitalization of public sector banks with a sum of Re 2,11,000 Crores by public release of a news item by the Central government to clean up the legacy of Non- Performing Assets, to spur credit growth to MSMEs for jobs and growth for the economy, and a push to credit off take in all sectors attracted my attention since RBI Deputy Governor, Mr.  Viral V Acharya touched the effect of non- capitalization or in adequate capitalization for banks in other countries under similar conditions in earlier decades in his speech dated September 7, 2017 delivered at the 8th R K Talwar Memorial Lecture organized by the Indian Institute of Banking and Finance at Hotel Trident, Mumbai^…

Let us analyze his speech which would open up our minds towards the future of the present banks in India with a huge NPAs which grow every other day due to RBI/Other Audits and also failed to lend other genuine borrowers for want of funds. The complete speech is covered in RBI website as under:

https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1046

Now the analysis of his speech:

“In a recent study from the Bank for International Settlements, Leonardo Gambacorta and Hyun-Song Shin (2016) document that bank capitalization has a strong effect on bank loan supply:

a one percentage point increase in a bank’s equity-to-total assets ratio is associated with a 0.6 percentage point increase in its yearly loan growth.

In fact, if a banking system remains systematically under capitalized and new lending is not kept under a tight supervisory watch, then the economy can suffer significantly from a credit misallocation problem, now commonly known as ‘loan ever-greening’ or ‘zombie lending’.

In particular, under capitalized banks have an incentive to roll over loans from financially struggling existing borrowers so as to avoid having to declare these outstanding loans as non-performing. With these zombie loans, the impaired borrowers acquire enough liquidity to be able to meet their payments on outstanding loans.

Banks thus avoid the short-run outcome that these borrowers might default on their loan payments, which would lower their net operating income, force them to raise provisioning levels, and increase the likelihood of them violating the minimum regulatory capital requirements.

By ever-greening these loans, banks effectively delay taking a balance-sheet hit, while taking on significant risk that their borrowers might not regain solvency and remain unable to repay, now even larger loan payments. While unproductive firms receive subsidized credit to be just kept alive, loan supply is shifted away from more creditworthy firms.”

Now the story of the banks in other countries through the ages, nay, decades.

The Japanese story:

• In the early 1990s, a massive real estate bubble collapsed in Japan. On statistical terms, when the Consumer Price Index was 100 in 1970, the land prices were also 100. But the real estate bubble resulted in rise in land prices to 750 in 1992 as compared to CPI of 275 in 1992. Of course, the land prices slide to 320 in 2005 as against 275 for CPI.
• This created problems for Japanese banks in two ways:
• first, real estate assets were often used as collateral;
• second, banks held the affected assets directly, so that the decline in asset prices had an immediate impact on their balance sheets. These problems in the banking system quickly translated into negative real effects for borrowing firms along the lines laid out above.
• Subsequently, the Japanese government introduced several measures to stabilize the banking sector and spur economic growth.
• Among these measures were a series of direct public capital injections into impaired banks, mostly in the form of preferred equity or subordinated debt.
• Bulk of the injections came after 1999, close to a decade after the collapse.
• The economic scale of earlier recapitalization was small relative to that of banking sector’s real estate exposure but these measures failed to revitalize the banks.
• Subsequently, the Japanese government introduced several measures to stabilize the banking sector and spur economic growth. Among these measures were a series of direct public capital injections into impaired banks, mostly in the form of preferred equity or subordinated debt.
• However, as conclusively shown by Takeo Hoshi and Anil Kashyap (2010), bulk of the injections came after 1999, close to a decade after the collapse;
• The economic scale of earlier recapitalization was small relative to that of banking sector’s real estate exposure so that these measures failed. But study by Japanese researchers showed that specifically, they showed that firms were more likely to receive additional loans if they were in fact in poor financial condition. They called it as ‘zombie lending’. Zombie literally means half dead.
• The percentage of zombie firms increased from roughly 5% in 1991 to roughly 30% in 1996.  The researchers estimated that the credit supply to healthy firms could have been 2.5 times higher in 1998 if banks had been recapitalized sufficiently.
• It is estimated that due to the rise in the number of zombie firms, typical non-zombie firm in the real estate industry experienced a 9.5% loss in employment and 28.4% loss in investment was also noticed during the crisis period.
• The theory that’ too little and that too late’ proved positive to Japanese economy.

Let us study European story which literally tailed the Japanese saga.

The European story

• Interestingly, the Euro zone economy has been following a similar path like Japanese economy in the 1990s and early 2000s.
• Starting in 2009, countries on the periphery of the Euro zone drifted into a severe sovereign debt crisis.
• At the peak of the European debt crisis, in 2012, anxiety over excessive levels of national debt led to interest rates on government bonds issued by countries in the European periphery that were considered unrealistic. From mid-2011 to mid-2012, the spreads of Italian and Spanish 10-year government bonds increased by 200 and 250 basis points, respectively, relative to German government bonds.(Bond prices and interest rates are reversely related)
• Due to fall in credit worthiness of financial sector, lending in countries like Greece, Ireland, Italy, Portugal and Spain, popularly known as” GIIPS “countries contracted substantially.
• In Ireland, Spain, and Portugal, for example, the volume of newly issued loans fell by 82%, 66%, and 45% over the 2008–13 period, respectively.
• (The figures have been literally taken from the speech and one can refer to the speech for full understanding and further research.)
• Since this deterioration in the sovereigns’ creditworthiness fed back into the financial sector (Acharya et al, 2015), lending to the private sector contracted substantially in Greece, Ireland, Italy, Portugal, and Spain (the ‘GIIPS’ countries.) In Ireland, Spain, and Portugal, for example, the volume of newly issued loans fell by 82%, 66%, and 45% over the 2008–13 period, respectively.

“This vicious cycle of poor bank health and sovereign indebtedness became a matter of great concern for the European Central Bank (ECB), as this cycle endangered the monetary union as a whole. As a result, the ECB began to introduce unconventional monetary policy measures to stabilize the Euro zone and to restore trust in the periphery of Europe.

Especially important in restoring trust in the viability of the Euro zone was the ECB’s Outright Monetary Transactions (OMT) program, which ECB President Mario Draghi announced in his famous speech in July of 2012, saying that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Post OMT scenario

“Post OMT, expectedly the bond yields fell and the assets side of the banks’ balance sheet improved but even then, financially weak banks continued to finance borrowers at a cheaper rate of finance as compared to borrowers from countries like Germany who paid higher interest for their loans. This is similar to zombie lending and hence zombie borrowers were created.

In particular, healthy firms in industries with an average increase in the proportion of zombie firms invested up to 13% less capital and experienced employment growth rates that were about 4% lower compared to a 10 scenario in which the proportion of zombies stayed at its pre- OMT level.

At extremis, for an industry in the 95th percentile increase in zombie firms, healthy firms invested up to 40% less capital and experienced employment growth rates up to 15% lower.”

This situation arose because of under capitalization of weaker banks.

Let us go back to our original issue of adequate capitalization by the Central Government of the public-sector banks. The economic pundits agree that this decision has been wisely taken.

Central Government expects the following in addition to infusion of fresh capital unlike the happenings in Japan or Europe.

Definite steps will be taken alongside capitalization to enable Public Sector Banks having 70% market share in the banking space to contribute through enhanced credit off take.

The expected steps are: I have simply put the public announcement of the Central Government verbatim:

• “The stage has been set with a ‘MUDRA Protsahan’ campaign across the country. There will be a strong push on enabling growth of MSMEs through enhanced access to financing and markets, and a drive to finance MSMEs in 50 clusters.
• While Ministries concerned will spearhead and provide momentum, banks will undertake speedy processing of loan applications in a hassle-free manner.
• Fintech companies will be roped in to cut down the appraisal process and generate quality loan applications. MSMEs will be handheld by extending support through:
• Compulsory TReDS (Trade Receivables Electronic Discount System) registration by major PSUs within next 90 days, for shortening the cash cycle. Sector-specific Mudra financial products, such as Mudra Leather, Mudra Textiles, etc.
• 100 bank-approved MSME project templates for speedier credit ü Revamped udyamimitra.in portal, so that banks compete for financing MSME projects
• Drive for registering MSMEs on the GeM (Government electronic Marketplace) portal and e-commerce platforms
• It may be recalled that aggressive loaning to sectors with excess capacity and poor due diligence created large stressed assets, which grew to 11.9% by March 2014.
• Asset Quality Review (AQR) carried out in 2015 for clean and fully provisioned bank balance-sheets revealed high incidence of NPAs.
• Expected losses on stressed loans, not provided for earlier under flexibility given to restructured loans, were reclassified as NPAs and provided for.
• PSBs initiated cleaning up by recognizing NPAs and provided for expected losses. Gross NPAs in PSBs rose rapidly from 2015, from 5.43% (Re. 2,78,466 crore) in March 2015 to 13.69% (Re. 7,33,137 crore) as of June 2017.
• Provisioning for expected losses grew substantially. From 2014-15 to 2017-18 Q1, Rs. 3,79,080 crore provisioning was made, whereas during the preceding ten years total provisioning was Rs. 1,96,937 crores only.
• This was the right approach to dealing with expected losses on account of stressed loans.”

Conclusion

The public announcement of the Central Government about infusion of unheard of amounts of capital resulted in the research of the previous economic history of countries like Japan and European nations. I could find a speech given by Mr. Viral V.Acharya, Deputy Governor of RBI. The relevant facts have been given in my article. It is expected that having learnt from history, India will lift our banking system from sick category to profitable one which would usher in great offtake of credit and resultant economic miracle.

Reference

Acharya, V.V., T. Eisert, C. Eufinger, and C.W Hirsch (2015), ‘Real effects of the sovereign debt crisis in Europe: Evidence from syndicated loans’, CEPR Discussion Paper No 10108.

Acharya, V.V., T. Eisert, C. Eufinger, and C.W. Hirsch (2016), ‘Whatever it takes: The real effects of unconventional monetary policy’, Working Paper, New York University Stern School of Business.

Acharya, V.V. and S. Steffen (2014), ‘The greatest carry trade ever? Understanding Euro zone bank risks’, Journal of Financial Economics 115, 215–36.

Bain & Co and Institute of International Finance (IIF) (2013), Restoring Financing and Growth to Europe’s SMEs, Washington, DC.

Caballero, R.J, T. Hoshi, and A.K. Kashyap (2008), ‘Zombie lending and depressed restructuring in Japan’, The American Economic Review 98(5), 1943–77.

Gambacorta, L. and H.S. Shin (2016), ‘Why bank capital matters for monetary policy’, Working Paper.

Giannetti, M. and A. Simonov (2013), ‘On the real effects of bank bailouts: Micro evidence from Japan’, American Economic Journal: Macroeconomics 5, 135–67.