Indian state-run banks must find a way to not drown in bad debts
There is a war coming. It's the war for capital, for the Indian public sector banks (PSBs).
Banking is one of the fundamental pillars on which an economy is established. It brings people with excess money (depositors) close to the people who are short of funds (borrowers), ensuring that capital gets allocated optimally in the economy.
It is this flow of credit which powers new businesses and propels an economy forward. Like any other industry, the profitability of the banks depends largely on the quality of the assets they hold, and loans and advances - money lent out to borrowers on interest. Obviously, this business is not without its own risks.
Some people aren't always able to pay their debt. Sometimes your dream venture fails to kick off, sometimes you aren't able to find a good job, and sometimes, you never have the intention to pay!
Whatever be the story, when a borrower doesn't make payments on his/her loan for a period of 90 days past the due date, the loan is classified as a non performing asset (NPA). In simple terms, this means that the bank recognises that there is a chance of a default on that loan.
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| The State Bank of India has been "asked" to consider a merger with its five associate banks. |
The level of gross NPAs plaguing the banks has widened to 15.43 per cent from 6.76 per cent a year earlier. In other words, one can say that the number of people not paying back their debt has more than doubled over a year. Now that can't be a good thing.
Imagine you lived close to a river, like I once did. Once the rains arrive, you see the water level of the river increasing week after week. As you see the threat of a flood becoming more and more imminent, you start preparing for the calamity - you buy the bare essentials and find a place for your family to stay.
But there are no free lunches, so you will have to bear the cost of these contingencies which will reduce your accumulated corpus. Something very similar happened with the banks in India.
The Reserve Bank of India (RBI), sensing the threat to the larger economy from rising NPAs, rapped the banks on their knuckles and asked them to get their act together by March 2017.
The banks were asked to work towards maintaining provisions for NPAs and the target provision coverage ratio was at least 70 per cent. This meant that for every $100 increase in NPAs, banks had to put aside at least $70 to absorb the losses in case of default. This provisioning ate into the banks' profits.
Punjab National Bank (PNB) posted the biggest ever loss in the Indian banking industry, ending the last quarter (Q4) of 2015 with losses of nearly $800 million. The (dis)honour were closely shared with Bank of Baroda (Q4 2015 loss of nearly $500 million) and Bank of India (Q4 reported loss of nearly $225 million).
But the story doesn't end here. You put aside some money and were able to see off the flood this time. But what if this is an annual, perpetual problem? In that case, the best thing to do would be to invest in adding one more floor to your house, which would substantially strengthen your defence against the wrath of nature.
In case of banks, this equates to the need for additional capital - something the bank owns, without the obligation of paying someone back. The higher risk the bank faces, the higher is their capital requirement. It's like the closer you want to live to the river, the more investment you are required to make against the risk of a flood. And if you don't want to make that investment, then better maintain distance.
While the banks were somehow managing the provisions, there was need to infuse more capital. Both the RBI and the global Basel III standards need them to raise more capital in order to be able to successfully face the kind of risks they are facing today. The PSBs which were once thought of as agents of change on a mission to create a new class of entrepreneurs are now caught in the fire like damsels in distress.
The government of India plans to rescue the PSBs through mergers. Mergers, simply put, are deals which combine two businesses into one, usually with the intention of increasing overall profits. To ensure the continuous flow of credit in the economy, the government is planning to create six large institutions out of the nearly two dozen banks.
It believes that the mergers will improve the efficiency and service delivery of the PSBs, giving the customers a wider use of the ATM network and the larger banks a wider capital base, enabling them to offer big ticket loans on their own. (Do you feel a resemblance to the countless movies in which two families decide to marry their wards, not because they are in love but because it is mutually, financially beneficial?)
India's largest lender, the State Bank of India (SBI) has been "asked" to consider a merger with its five associate banks. Rumour has it that the government is also looking at combining three other state-run lenders - UCO Bank, Bank of India and Indian Overseas Bank with Canara Bank.
Mergers are not entirely alien to the Indian banking industry. Be it, Global Trust Bank's takeover by the Oriental Bank of Commerce or the merger of New Bank of India with PNB, the RBI has never allowed any major bank to fail since the economy opened up in 1991.
But, while the intentions of the government are no doubt noble, mergers done without proper analysis of the pro and cons, and without business considerations at the core, can be disastrous for the banks involved and also for an economy which is barely managing to stay on its feet as others around it get swept by the wave of global economic uncertainty. Of all, the most important factors to be considered are:
1. Oligopoly (and other market forms with greater monopoly power) is always more difficult to control or regulate than other forms of market. Considering the fact that the banks are extremely fundamental to the well being of an economy, giving them too much market power can be dangerous.
2. Combining banks to form bigger banks can also lead to the too big to fail problem. The West is already experiencing this issue. The government can't split them, can't effectively regulate them and can't let them go under when things go bad.
3. The true nature of the bank will not change as long as the government is the majority shareholder. Therefore, it may not really mean much in terms of operational efficiency since the management style as well as compensation and recruitment would be according to government norms. The merger would simply multiply the size of the balance sheet without really changing the culture, unlike the case with other mergers where a different culture comes in.
4. Mergers don't always go well as planned. For instance,
a) In economic and political circles, the planned merger between Deutsche Bank and Dresdner Bank had been celebrated as Germany's advance into the premier league of the international financial markets. It failed so spectacularly, that it was called "a disaster for Germany as a financial centre".
b) The Bank of America and Merrill Lynch merger in 2008 came to be known as the "$50 billion deal from hell".
c) During the financial crisis, JP Morgan bought Bear Stearns at what many people call "throwaway prices" at the request of the government. Despite that, when asked recently, Jamie Dimon, the head of JP Morgan, said he regretted buying the Wall Street firm.
d) In India itself, the ill-conceived merger of Indian Airlines with Air India has created a mess so large that I don't quite expect Air India to become profitable in my lifetime.
The point being, yes we need some banks to merge. But doing it for the heck of it should be avoided. I hope we do it the right way and for the right reasons.