Infrastructure lending has led to most bad loans.

Photographer: Rakesh Bakshi/AFP/Getty Images

India's Banks Need the Tools to Get Tough

Dhiraj Nayyar is a journalist in New Delhi. Trained as an economist, he has worked at the Financial Express, India Today and Firstpost.com. He is editor of "Surviving the Storm: India and the Global Financial Crisis."
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That India's banks are groaning under a pile of bad loans is no secret. Nonperforming assets account for an estimated 11 percent of their total loan portfolio, significantly lower than reeling Greece's 32 percent but around the same level as crisis-prone Portugal (11 percent) and Spain (9 percent). The fact that state-owned banks account for 70 percent of all loans in India makes this the government's problem to solve.

To its credit, Prime Minister Narendra Modi's administration has sought to address the issue more than once, most recently with a string of announcements last Friday. Yet it's concentrated mostly on injecting public funds to recapitalize state banks. The amounts provided -- $1.1 billion in the most recent round -- are constrained by the government's own fiscal pressures, though it could always sell off part of its shareholdings to raise more money.

The real issue, however, isn't money -- it's the apparent inability of India's banks to take decisive action against defaulters. Bad loans are most often written off, indefinitely restructured, or, in rare cases, converted to equity on terms favorable to the defaulter. The cost of defaulting -- often willfully -- simply isn't high enough, thus creating a systemic moral hazard.

There are two ways to attack this problem. First, India needs a modern bankruptcy law that can break the cycle of continuous restructuring and give companies facing temporary difficulties a means of surviving and eventually repaying their loans. Companies that aren't viable must be shut down and banks should be able to confiscate collateral to balance their books. Unfortunately, while Modi's government promised in February to craft just such a law, the ongoing gridlock in the country's Parliament means it's unlikely to see the light of day anytime soon.

Meanwhile, banks must go after defaulters more stringently and seize their assets -- including personal assets. That's the only way to deter owners who think they can get away with running shabby businesses while keeping their jets and lavish Mumbai flats, exploiting what are ultimately taxpayer-funded bailouts.

QuickTake India's Aspirations

Of course, for state-owned banks to have that freedom, they need to be liberated from political control and influence. While Modi's government has ruled out full privatization, it's taken some welcome steps in this direction. In one of last week's announcements, it declared that it would set up an independent holding company -- called the Bank Board Bureau -- to take over the shareholding of all public-sector banks. In theory, this company would have incentive to appoint top-class management and to follow best practices in the banks it controls.

In practical terms, the exact contours of the Board remain fuzzy. If the holding company turns out to be an adjunct of the government, staffed by bureaucrats, any changes may be superficial.

Still, the government is at least thinking creatively. More thought should also be put into the role of banks in the Indian economy. A significant proportion of stressed loans come from lending in the infrastructure sector. Commercial banks are a poor instrument for infrastructure lending since most of their borrowing is short-term (deposits) while lending for infrastructure is very long-term, with uncertain returns.

The government needs to develop alternate avenues of financing for infrastructure. Of course, funding projects directly is one option. But what India really needs is a vibrant bond market -- something it lacks because a state that borrows and spends too much has crowded out the private sector from that space. Now that the government has gained some control over its fiscal deficit, it should move to liberalize the bond market. For a start, it must hand over the task of regulating government securities from the central bank to the securities regulator, so that there's a unified regulator for all bonds.

Recapitalizing banks is necessary. But unless the government simultaneously attacks the root causes of the bad-loan problem, India's banking system will constantly require new bailouts. The rot runs too deep for half measures. 

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

To contact the author on this story:
Dhiraj Nayyar at dhiraj.nayyar@gmail.com

To contact the editor on this story:
Nisid Hajari at nhajari@bloomberg.net