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How Not to Fix the Banking Sector


How Not to Fix the Banking Sector

The King of Good Times has taken flight!

VJ Mallya’s dramatic March 2016 exit from India to London, the global hub of tax evasion and offshore funds and money laundering, generated plenty of headlines. However, behind the scenes there is a deeper unease about the Indian banking sector. There is a growing awareness that his dramatic departure signalled a set of deeper underlying problems. This malaise was signaled by the announcement of another departure, that of the head of the Reserve Bank of India Raguram Rajan, whose tenure will end on September 4th, to the profound unease of many financial pundits. He left after the shortest tenure of any RBI governor since 1992, after political attacks on him led by the BJPs Subramanian Swamy.

This is perhaps unsurprising, since Rajan was well known for his strong views on what was needed in order to set the Indian banking sector back on track: The large corporate houses were to be made to pay back their bad loans, since this was what was truly holding back the growth rate in India. This earned him praise from international bodies like the IMF. This was a policy to be pursued even if this meant a fire-sale of assets for the corporates that were in debt, leading many commentators to believe that this was why he was pushed out.

This move leaves many uneasy questions unanswered, such as How will such huge unpaid debts affect the Indian banking system? and How much of the Indian banking systems loans are secured with things as flimsy as the value of a brand? It also raises more fundamental questions like - how and why was this allowed to happen in the first place?

To understand these concerns, one has first to explore some fundamental questions about the purpose of Banking: Most pressingly, What is it?

Broadly speaking the mainstream theory is that a healthy financial sector, including banks and stock markets, allocates resources efficiently, and so boosts economic growth, and so in turn eventually leads to a higher living standard for all.

Does this description fit well with the current state of the Indian banking sector? We will examine the reality of the Indian banking sector, on its own terms (that of the mainstream theory of finance led development) in order to answer this. Section by section we will consider whether the Indian banking sector is following its theoretically ideal role, or whether something else is really going on.

1. Efficiency or Political Play?

It seems that Mallya is not an isolated case. His high-profile default is symptomatic of a deeper malaise, with a Credit Suisse report in 2012 listing a huge litany of bad debts owed by India's corporate houses:

Credit Suisse said the cumulative debt level of the top 10 — Adani Enterprises, Essar, GMR, GVK, JSW, Jaypee, Lanco, Reliance ADA, Vedanta and Videocon — had jumped five times in the past five years (40 per cent CAGR). This equates now to 13 per cent of the entire bank loans and 98 per cent of the ‘net worth of the banking system’.

Raguram Rajan blamed the buildup of these bad loans on procedural laxity at the public service banks, and on an overexuberance to lend due to a high level of economic growth. However, the manner of his departure suggests that political intervention on behalf of the borrowing corporate houses is highly likely to have been part of the picture, ironically enough, something he was loathe to mention, even if it clearly did figure in his demise as governor. This seems like Rajan deliberately staying silent on these political influences, despite the considerable evidence for them, like the government's intervention to make public banks keep lending to the failing airline SpiceJet, and the memorandum of understanding between the Adani group and the government on the ill fated Australian coal mine project. This particular silence seems not to have saved Rajan from the retribution he faced for challenging a culture of widespread corruption.

2. Trickle Up Banking

Fountainhead means trickle up

This bad lending is effectively at the expense of the public. Having large business entities in India that are non-viable without this indirect form of public subsidy undermines the overall long-term viability of the Indian economy. These enterprises are able to “crowd out” other enterprises attempting to grow from a more sound economic basis. This worsened economic performance alongside the bad debts themselves ultimately reduce the resource available to the rest of the population, so this is a silent form of rent, or a hidden tax, on the population in general.

This has also led to a more direct process of redistribution: That of moving funds from those that have deposited funds in the state banks, who are often in possession of relatively small savings pots, something, ironicaly, driven by moves towards financial inclusion, to the largest business houses in the country. In this sense the Indian banking sector runs entirely contrary to established theory, and actually undermines economic efficiency, by both misallocating resources and also working to concentrate wealth, rather than distribute it more fairly.

Whatever is said about broadening access to finance, this dynamic of irresponsible re-distribution severely undermines the positive role that finance can have in the lives of those at the bottom of the savings pyramid.

3. De-Securitisation

Banking is supposed to make future yields from assets more secure. However, the Indian banking sector seems not to be achieving that. The huge unpaid debts of the Public Sector Banks threaten the stability of the Indian economy, making them vulnerable to debt-crisis types of scenarios.

China faces the possibility of its own debt meltdown, and is considering root and branch reform of its banking sector to try and deal with it. China's slowdown is affecting the rest of the BRICS countries, including India. It is perhaps not suprising that Raghuram Rajan, the person who has been calling out the problems of the banking sector, enjoys a greater sense of public credibility than a government that has seemingly focussed instead on the manipulation of growth statistics.

4. Jobless Financialisation

If you look at India's position in the world economy, via its export profile, it is clear that India is still caught in an economy dominated by rent seekers, making their fortunes out of the extraction of natural resources, rather than the creation of value. With gems, oil and agricultural products making up 44% of exports, and engineering and pharmaceuticals making up only 33%, it is clear that "Make in India" is yet to reposition the country.

What is more, rent-seeking enterprises feature heavily in the list of indebted companies, either directly as natural resource extractors, or indirectly through their speculative actvities in relation to land, which we featured in a previous brefing.

This nexus of rent seeking, seeking out access to cheap resources, political influence on banks, and banks issuing loans for the wrong purposes, often ends up promoting economic activities that generate little-to-no employment, and little-to-no actual manufacturing or value creation. This is because the economic model that results is based on natural resource extraction and inward investment for that purpose, as well as a great deal of speculation on land. For instance CAG audits of land acquisition in Orissa and Rajasthan have found that the majority of the land acquired is either unused or is being used for speculation. There is also enormous amounts of land lying vacant in Special Economic Zones.

These kinds of speculative activities are associated neither with job creation nor value addition. So this is a political-economic dynamic that helps lock India into a static advantage of natural resources, rather than developing dynamically some form of comparative advantage in skilled manufacturing.

5. A Laundry at Home and Abroad

Rather a lot of Laundry

This government has made much of claims to bring back the black money. However, despite the revelations of the Panama papers,(including major BJP election funder Adani's elder brother) there is little chance that this drive towards cleaning up financial systems will extend domestically into a thorough investigation of the public banking system or how large corporates were allowed to run up such huge tabs.

This is because the beneficiaries also contribute to election campaigns, and because loans from public sector banks are notoriously open to political influence. The "Committee to Review Governance of the Boards of Banks" (the PJ Nayak committee) report placed the onus on dealing with these questions on reform of the governance structures of the public sector banks. But if the issues are deeper and more political, then this level of reform will never address the issue of political influence from the political classes who oversee the very mandate for existence of these banks. Indeed, it might well be worth investigating these linkages between political funders, offshoring and domestic public sector loans and land allocations to corporates in a single framework of enquiry, using the Panama papers as a source, as well as search engines on corruption now available on the internet. This is a topic ripe for a crowd-sourced investigation.

6. First Things First

Given the politicised manner of Rajan's exit, and the litany of political interventions around loans from public sector banks, there seems little prospect that there will be a cleaning up of the banking sector, or any serious attempts to address problems of black money at home or abroad, until the issue of political funding for elections and for parties and candidates more generally is placed within a legal framework designed to keep black money out of politics, and more generally reduce the space for any party to be able to buy election results, and policy thereafter. This being a long political tradition, as the recent revalations of the Essar Tapes illustrate. This is an issue already causing big waves in the political life of India's foremost ally. Reform of the banking sector before these political funding reforms are set in motion would most likely be to place the cart before the horse.

Any serious attempt to get to grips with the problems of the Indian banking sector would need to take up a wide range of issues:

  • Public banks should be shielded from political influence, but at the same time be made more transparent and publically accountable towards a mandate to support economic growth within a coherent financial and industrial policy and planning framework.
  • A strategic mandate for financing from public banks: Not funding rent seeking, but rather value adding and job creating enterprises.
  • An independent investigation and enforcement agency for economic crimes that is insulated from political pressure.

It is only by simultaneously making banking more accountable, whilst also integrating it into a wider economic, fiscal and growth policy, that banking in India can actually start to function the way it is supposed to.

The big question is "How will this happen?" Perhaps it needs the uncovering of yet another huge corruption scandal, involving political funding, in order to set that ball in motion. However this seems unlikely given that the recent revelations around Essar seem to have encouraged rather than prevented the exit of Raghuram Rajan. In the wake of his announced departure, there have been moves not to clean up the bad loans, but rather to bail out the public sector banks, and by implication the corporate houses with bad debts.

So another global banking crash is perhaps more likely to generate action. This is a possibility that cannot be discounted. Given that the instability-, inequality- and jobless-growth- generating characteristics of the current Indian banking sector seems unlikely to be tackled via pressure from the inside, this currently seems the most likely candidate for forcing a change. Unfortunately this means that for the time being, India needs to live with a severely compromised banking system, overseen by cosy relationships between certain loan-hungry corporate houses and a government willing to cater to them, seemingly at almost any cost.