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India needs bad banks, government exit from some lenders: Former central bankers

India should set up bad banks to resolve nonperforming loans, reduce its ownership in some state-run lenders to below 50% and create a greater variety of structures to help grow its banking sector, former Reserve Bank of India Governor Raghuram Rajan and former Deputy Governor Viral Acharya said.

India needs to transform its banking sector to make it an engine of growth as government finances are under "enormous" strain after an already slowing economy was hit by the coronavirus pandemic, Rajan and Acharya wrote in a Sept. 21 paper, listing a number of "implementable reforms" for the sector. "There may be a window of opportunity in which these reforms may be possible since the status quo is untenable," they said.

The former central bankers recommended designing out-of-court restructuring frameworks for time-bound negotiations between creditors of a stressed firm, before seeking resolution through bankruptcy courts. An online platform for selling distressed loans could be created and banks nudged to sell their loans in a transparent manner that would create industry benchmarks.

In parallel, bad banks by both the private and public sectors could be established, they said. The private players could aggregate and recover loans in sectors where government intervention is not needed, while the public sector bad bank could aggregate loans, create management teams for distressed companies and possibly buy and hold distressed assets before demand in the sector returns.

"Creation of a bad bank will reduce risk aversion. Privatization of a few state-owned banks is crucial to get the Indian banking sector on the path to recovery," said Shubhada Rao, the chief of QuantEco Research. "Rajan and Acharya's roadmap resonates completely. It is the need of the hour."

State lenders in poor health

India's lenders, especially state-owned banks, have been struggling with rising bad debts amid a slowing economy. The banking sector's gross nonperforming asset ratio stood at 8.5% even before the pandemic struck — 11.3% for public sector banks and 4.2% for private sector banks. Stress tests by the central bank estimate the aggregate gross nonperforming asset ratio to rise to a range of between 12.5% and 14.7% due to COVID-19, with some analysts suggesting it might climb even higher. The economy was hit hard by a nationwide lockdown announced in March, causing a 23.9% slump in the nation's GDP in the June quarter, marking the worst contraction by a major economy during the pandemic.

Public sector banks are the "key" to the transformation, according to the paper. Rajan and Acharya suggested a holding company structure for government stakes in these lenders, allowing the government to keep an arm's length from their management. They also said the government should cut its stake in some banks to below 50%. It could use an automatic dilution route by allowing banks to raise funds and dilute the government's stake whenever it is unable to inject the capital required to meet regulatory requirements.

"They [state-run banks] cannot keep veering from bouts of crazy lending – where they make losses and deplete capital – to lazy lending – where they lend to the government but not to the private sector," they said. Their limited capabilities may be the main impediment to Indian banking’s progress and that needs to change if India is to have any hope of high rates of growth, they added.

The idea of the government exiting some of the state-owned banks isn't new. "Some of these suggestions have been made earlier as well and the government is already working on it. The finance minister too has indicated the government's policy on strategic and non-strategic state-owned companies in Parliament," said Sameer Narang, the chief economist at state-run Bank of Baroda.

About creating bad banks, Narang said the objective ultimately is strengthen the banks' capital. Whether that is done via recapitalizing the banks directly, or by creating bad banks basically "boils down to the structure. I am not sure if either of them are materially different, if implemented properly."

In addition to proposing lending and risk management reforms, Rajan and Acharya said the government should further open up the banking sector for new players, keep on-tap licensing for banks open at all times, promote greater entry of non-bank players and encourage the development of wholesale banks.

Rajan was the governor of the Indian central bank from September 2013 through September 2016. Acharya was a deputy governor from Jan. 23, 2017, to July 23, 2019. Both resigned before completing their terms under the current Narendra Modi-led government.