The current banking challenge is the most intractable one even before COVID-19: Urjit Patel

In his first interaction with a journalist after stepping down from the Reserve Bank of India (RBI), former Governor Urjit Patel spoke about his new book, Overdraft: Saving The Indian Saver, with Puja Mehra in a conversation on invitation from the Pune International Centre. Edited Excerpts.

What made you decide to write this book?
My teacher Professor T.N. Srinivasan used to say that in India our macroeconomic challenges always had microeconomic sources. In the banking sector in India, which I have observed at various distances over the last 30 years, it’s the other way round. Our macroeconomic problems have created financial sector crisis periodically. The current banking challenge is the most intractable one even before COVID. We have a tendency to make a premature pronouncement of victory over any challenge that we desire to solve. We get tired very quickly. Look at our fiscal policy — from very high levels of fiscal deficit we would have a couple of years of very modest declines. So, from a very high level we could go to a slightly lower high level and everyone says, ‘Oh, we have now had too much fiscal consolidation so let’s go back to our usual norm’. Ditto for bad debts. This does not lead to good outcomes; it just accentuates problems by storing them up.

You write, “The regulator in our system does its work by constantly looking over its shoulder. High professional integrity notwithstanding, the RBI’s reputation has been that of a soft regulator”? Why “soft”?
The regulator is perceived so because of its actions to be pliable for rollback of the regulations that it puts out. Once a regulation has been issued why is there an expectation that with enough pulls and pressures things will get diluted? That’s the credibility part of the regulator which I have described as being soft. Legally, important parts of the Banking Regulation Act are not applicable to the government banks. That does tie the hands of the banking regulator in important ways.

We are seeing a rising clamour seeking restructuring of loans. You have called the phrase ‘restructured standard asset’ an oxymoron.
The restructuring of assets started in this particular phase before COVID. My reference is, for example, to February 2020 when the real estate commercial sector was allowed restructuring, which basically means that you kick the can down the road. You effectively increase the repayment period; maybe by making it into a new loan, evergreening etc. The consequence is that the banks’ balance sheets once again don’t convey the true nature of their asset book. What a restructured standard asset label does is that it gives an NPA [Non-performing Asset] a veil of false legitimacy to hide the true nature of the asset. In a way, this increases the risk premium for the entire sector. This phrase has been used, I think, since 2001 when the Corporate Debt Restructuring mechanism started. You know how that contributed to all the problems of the pre-2014 NPA cycle. We need to be very careful. We need to be very cautious on how we proceed down this road. It always gives you a short term gloss of cleanliness, but everyone knows that it is basically done to hide the bad assets. It makes the banks’ balance sheet untidy and adds to the sector’s risk perception.

Is this what you are talking about when you caution against U-turns?
Yes, and there have been other instances which were of regulatory policies which had been put in place after 2014 to help with financial stability. Those have also been reversed since 2019. There has been a series of these things that have happened including defining what constitutes a default. Over the last year-year and a half, we have seen fair bit of reversal in this ecosystem of resolution and liquidation.

The discomfort the February 2018 circular may have caused among large defaulters can be guessed from what you write. What was the logic of referring cases for Insolvency and Bankruptcy Code (IBC) resolution within a day of default and refusing special concessions or exemptions selectively for the power or the real estate sectors? Have the Supreme Court’s decision to strike down the February 2018 circular and the RBI’s replacement circular of June 2019 hurt the IBC reform?
What has happened is that instead of having a rules-based process by which assets are recognised, resolved, and liquidated, if necessary, we go back to an ad hoc approach. It’s not very clear on what basis this is done. Frankly, every sector, if not every borrower, can come up with a good reason on why he or she did not service the loan. It is possible to do that at any point in the economic cycle. But no one mentions the years of over-borrowing and reckless lending. Servicing a loan on time is part of the contract between the bank and the borrower. It is costly to violate the principle that you have to do your debt servicing at a point in time. Once you go down this path of discretion and non-transparency, it is unfair on those sectors and borrowers who don’t get a chance to have their loans recast or NPAs restructured as standard assets. There is a certain iniquitous nature to this. Further, by locking up finance to help inefficient borrowers, we undermine growth. Most countries have a rules-based system. I don’t know why we should be an exception that this sector deserves that, then another sector should get something else in terms of forbearance.

You write of the collective failure before 2014 of government, the RBI, banks and other stakeholders in preventing the NPAs build-up. Then, the IBC process was started and began to show early results. From what you write, the reform had support from the government initially. It may have found the public mood against cronyism around the 2014 general election hard to ignore. Yet, rollbacks happened. Why?
How strong is the public mood? It’s not clear to me. The impact of this is felt in only two ways. One, if you don’t clean up NPAs, you have lower growth — whether it is a developed country or an emerging market. Whether this connection is made by the general public I am not clear. Second, financial instability is felt. In the last few years, we had episodes that needed major interventions to engender and keep up the confidence. The work that started from 2015-2016 onwards helped. Maybe because that kind of major instability has been averted, the pressure to follow up has again receded. The underlying corrosive impact of lower growth because of misallocation of capital, lack of adequate risk capital in the banking system is only felt with a lag and, more importantly, is an indirect impact. The connecting of dots may not be easy. That’s probably the reason why there is not that much of pressure to finish the task. In terms of the stakeholder interests, it is very clear to not only me but everyone else why there should be the pulls and pressures not to finish the task.

What are going to be the long-term implications of the NPAs remaining poorly resolved?
One is that large amount of capital is locked up. Unless bad debts and NPAs are resolved or liquidated they are in a state of suspended animation. Not only I but others have called these ‘living dead’ borrowers who survive in name but there is hardly any productive activity. The other is that it increases the borrowing cost of everyone in the economy, including for the good borrowers. It is in this cycle of NPAs that for the first time good borrowers have felt the impact of the large load of NPAs that the banks have been carrying because they have not fully benefited from the cuts in interests rates that have taken place over the last year and a half. My book does not deal with the pandemic’s impact. The higher cost of borrowing for the economy is even felt by the government. In part because markets expect the government will have to borrow one way or the other to recapitalise the banks that it owns which is 60-65% of the banking system. So, it increases the cost of capital for everyone.

That borrowers, especially large borrowers, need not be unduly worried about their assets being taken over by someone else or eventually sold and liquidated by the bankers reinforces a poor incentive structure. In a way, the wrong kind of borrower is more attracted to borrow from the credit markets. Some productive borrowers in the economy are probably getting crowded out in the bargain. The relatively unproductive borrowers who are not borrowing prudently and are not debt-servicing on time are getting credit. In other words, misallocation of finance. The consequences are fairly deep. And these run for a long time the longer the clean-up process. At the best of times these things take, given the size of NPAs that we have, it would have taken five to ten years to work through this. We are now in the sixth or seventh year of this problem. Now, of course, we have the COVID-induced problems that will come about.

It is not good for the credit culture if some borrowers don’t have to repay on time. If you are a small borrower and you don’t pay your loans on time, the banks without much fuss make sure one way or the other you lose out. It is the relatively larger borrowers that have this privilege.

The worry is that the rollback has become quite serious. Within three years if people are talking about a post-IBC world, then it is amazing that possibly the most important structural reform, to my mind, in the last six years, and it took about two years of hard work by the government to put in place, and that reversal is being, in a way, accepted. The durability of this reform has been — regrettably — short. The loss of credibility on account of the roll-back is quite high, and so is the cost to the economy. Credibility is something you can’t touch or feel but you experience it directly by its adverse impact through lower growth. I have laid out the mechanisms by which you get lower growth when you have this kind of overhang of NPAs in the banking system.

You have identified India’s macroeconomic management as the underlying driver of the NPA problem. Are you saying that a macroeconomic problem is turning into a banking problem? Is it too ambitious then to expect that a government will successfully resolve the NPA problem without resolving first the macroeconomic problem?
It does not necessarily require for the large macro problem to be solved straightaway. In fact, the longer the NPA problem persists in the current from, it will add to the fiscal cost. But that problem won’t be durably solved unless you also address the macroeconomic problem. If, say, you let the whole resolution and liquidation process work out, but the government at some point decides that the economy needs to be stimulated and it doesn’t have the fiscal elbowroom then it again drumbeats and encourages its banks to go out and lend more, then we are back to where we were.

The reason why there is a rollback is not because the macro problem has become larger. The macro problem has stayed more or less where it is. We have a situation where the fiscal backdrop has become so problematic that there is very little elbowroom for conducting countercyclical policies for stimulating the economy when there is a relative slowdown. We have ended up using the banking system more and more…. to stimulate the macroeconomy. That kind of fiscal dominance has now resulted in fairly pernicious effects in the banking sector and a risk to the saver.

In the concluding chapter, you write, “why should Indian governments do anything differently? Where is the fun in owning banks if control over operations, managing them and determining their regulation is not possible?”. You don’t seem optimistic about the “likelihood of meaningful privatisation” of government-owned banks.
The point is that if the government owns these banks the temptation to use them as a tool for day-to-day macroeconomic management is just too high. It is very tempting that if I need to boost investment and growth then I have a direct instrument that is even more so than monetary policy because you can use your ownership of intermediaries to increase lending and investment and hope that leads to higher growth. It takes a lot to give up that kind of instrument away which is what would happen if you were to privatise all these banks. The government would lose a very important instrument in its toolkit for, what I call, tactical macroeconomic management. It’s a large and important pivot for the government.

One of the main points that I make is that given the state of public finances of the country it will be difficult for the government to have a dominant banking sector and keep to its fiscal targets, which it has not been doing anyway. And, thirdly to have independent regulation because one of the touchstones by which additional regulation is put into effect is what is the implication of this on government banks and then the government fiscal balances because government may have to put in the money to recapitalise the banks. I call this the trilemma in the book. This is becoming a tightening constraint at each point in time going forward. The risk to the economy is that we should not get into a situation where the standard of banking regulation is determined by the state of government banks and the fiscal balance of the government. The regulations and capital requirement should be primarily determined by financial stability considerations.

The other risk that I point out in this area is that we may risk having the dual regulatory system where some strictures are diluted for the government banks and things are kept as they are for private banks. I hope that doesn’t happen. But if the fiscal situation becomes even more difficult and recapitalisation funding becomes even more of a challenge then that is the kind of regulatory risk that may come about.

Source: Puja Mehra is a Delhi-based journalist