Finance

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

India's banking watchdog is leaving his post at an awful time. 

Sample a few takeaways from the Reserve Bank of India's latest financial stability report: More than 34 percent of loans to the country's metals industry are stressed, meaning they have either soured or been restructured so they can go bad at a more leisurely pace. At 27 percent, construction is faring only slightly better. For India's state-run banks, which dominate commercial credit, as much as 14.5 percent of advances have keeled over or are teetering on the edge.

The ferocity of the problem isn't a surprise. What's perplexing is that RBI Governor Raghuram Rajan, who was pushing lenders to clean up their act, is being let go before he could make any headway. The central bank's stress test offers clues to why Rajan's three-year term wasn't extended. If just three of the banks' top borrower groups stop servicing their debt, as many as eight lenders will see their capital drop below the regulatory minimum of 9 percent of risk-weighted assets.

Stressful Stuff
Defaults by a few big borrowers could make a large chunk of India's banking system insolvent
Source: Reserve Bank of India
*Based on RBI's June 2016 stress test conducted on 60 select lenders.

That's a roundabout way of saying that banks and large businesses have an unhealthy mutual dependence. If some of the steel, construction, infrastructure or textile firms were to follow beer baron Vijay Mallya's Kingfisher Airlines into oblivion, they could take the taxpayer-funded banking system with them. Who would have allowed Rajan to go down that route?

Still, investors won't be fooled by a new watchdog that barks less loudly. Rajan's replacement will have to act decisively. There's no dearth of bad ideas, including setting up a bad bank. In reality, using public funds to recap state-run lenders is the only viable option. But to keep the bond market from turning hostile, it has to be done without blowing out the budget deficit.

Still Struggling
An index of banks in India continues to lag the benchmark stock gauge
Source: Bloomberg

Rajan has rightly rejected the idea of the central bank pressing its own balance sheet into rescue efforts. But the government could still help itself to the monetary authority's equity, and use the funds to bail out troubled lenders. That idea's been on the table since at least February, and has now become a proposal. According to a document obtained by Bloomberg News, the plan is to remove $59 billion from the RBI's shareholder funds and infuse it into struggling financial institutions.

Reducing central banks' paid-in capital is usually seen as cutting them down to size -- and that's the main reason governments as sole shareholders are happy just to take an annual dividend check. 

But if New Delhi has made up its mind to raid the piggy bank, then the new governor may have no choice except to oblige. Rajan's abrupt departure has already dented the central bank's stature; downsizing will only add to the damage.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net