Why The Issue Of Indian Banking Sector Consolidation Is Grabbing Eyeballs
In a paper published in April 2019, researchers at the Reserve Bank of India (RBI) found that more of Indian banking sector consolidation in the country’s struggling banking sector will help lenders lower costs and efficiently scale their operations. The same paper finds that India had 19 cost-efficient banks in 2005, falling to a low of 12 before recovering to 14 by the end of 2018.
While banking sector consolidation is an issue that has long been debated in finance ministry and banking circles, whether it will bring much-needed respite to India’s banks in these troubled times is moot. India’s banking sector is going through stressful times with piling bad debts and reducing profitability. Indeed, India (10.3%) and Italy (9.9%) have the worst bad loan ratios among the world’s top 10 economies.
How Did The Indian Banking Sector Get Here?
The worst-affected are the public sector banks (PSBs) whose average bad loans at the peak of the crisis stood at 75% of their net worth.
At the very root of the crisis, is a fundamental shift in the nature of lending since the year 2000 – from short-term working capital loans to long-term loans. This has led to a serious asset-liability mismatch in the banking sector – the average tenor of assets (loan portfolio) has grown rapidly in comparison to liabilities (deposits).
This plays out in the form of growing non-performing assets (NPAs) due to the four features of bank loans for fixed capital formation.
Banks’ ability to assess long-term credit-worthiness of borrowers is limited and they rely on credit-rating agencies that provide ratings when the concerned company intends to raise debt capital directly from the market.
Banks’ capacity to monitor use of long-term loans by borrowers is limited. Since these are project-specific loans, lenders only have a claim on assets of the project and not the parent company, thereby, creating a lack of accountability for the parent.
For borrowers as well, recovery of such loans translates to “winding up” the companies. Winding up proceedings in India takes many years to reach a conclusion and banks face the prospect of making large loan-loss provisions that stay on the books for many years with little hope of recovery.
This has led to the phenomenon of “ever-greening”, a problem that the RBI has only now acknowledged.
This has left PSBs with weak balance sheets as they provide for reasonable haircuts on resolution of stressed assets. With a great need to restore the health of India’s banks, the Government announced recapitalization measures for banks under RBI’s Prompt Corrective Action framework.
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In FY2019, the Government had infused Rs. 1.06 lakh crore in PSBs and in FY2018, the amount stood at Rs. 88,139 crore. In this year’s budget, the finance minister has set a target of Rs. 70,000 crore for recapitalization of PSBs.
Not A Quick Fix To The Problems Of The Sector
As banks struggle to come out of the crisis and increase their business, banking sector consolidation will slow down the process as each of the merging banks come with their own technology, cultural and people-related legacies. Cutting through these to gain synergies, efficiency, cost-saving, economies of scale and most importantly, the ability to raise capital will take some time.
Despite these concerns, the Government has pushed forward with consolidation. In May 2019, heads of all PSBs were tasked with readying their consolidation plan to be tabled before the alternative mechanism (AM) of the Government, a group of ministers formed to fast track bank consolidation.
Public sector insurer Life Insurance Corporation of India (LIC) took over IDBI Bank in January 2019 after losses grew three times to Rs. 4,185 crore for the third quarter ending in December 2018. Similarly, State-run Bank of Baroda (BoB) emerged the third-largest lender after merging with Dena Bank and Vijaya Bank in April this year.
Both BoB and Dena Bank respectively have 8.44% and 16.18% exposure to infrastructure, thus creating more stress for the combined entity. Similarly, Dena Bank’s (67.52%) high cost-to-income ratio, an indicator of cost-efficiency is higher than that of BoB (45.56%).
Another issue is that of the high cost of funds for the weaker entities as they compete against fleet-footed private banks which are able to reach new customers through the use of technology. In fact, most PSBs have a net interest margin (NIM) of less than 3% vis-a-vis HDFC Bank that enjoys a NIM of 3.87%.
It may be worthwhile studying how the combined banking entity derives the benefits that are so highly talked about before the merger as the Indian economy can’t afford a longer waiting period for the banking sector turnaround.