The lowest quarterly economic growth rate in six years — at 5% — suggests that the winter of our discontent is upon us, sought to be made glorious summer by the ‘Big Bank Theory’. Public Sector Banks (PSB) account for over 80% of the non-performing assets (NPAs) in India’s banking system. The bi-annual Financial Stability Report (FSR) released by the Reserve Bank of India (RBI) at the end of June 2019, drew attention to two stark facts: the share of large borrowers in the total loan portfolios of banks stood at 53%; and their share in the gross NPAs was over 82%, as of March 2019.

The announcement of four mega-mergers of PSBs significantly increases the moral hazard associated with the ‘too big to fail’ conditions that such mega-mergers create. The merger strategy, if it is one, to strengthen the banking system and ensure what the Economic Survey 2019 describes as the virtuous cycle of saving, investment and exports, certainly misses the woods for the trees. What is at the heart of the banking crisis that has seen NPAs grow from about 3% of the total assets to over 12 % in the last three years? In the wake of the economic slowdown, understanding the structural problems in the financial sector acquires a sense of urgency; if only to make interventions outcome-driven.

Thus far, the government’s solution to address the banks’ NPA epidemic has been two-fold: recapitalisation of banks and mergers of banks. Data presented to the Lok Sabha shows that during the last five financial years (FY15 to FY19), PSBs have been recapitalised to the extent of Rs 3.19 lakh crore. Of this, Rs 2.5 lakh crore was financed by the government and a mere Rs 66,000 crore by the PSBs themselves. While the five mergers in all (one, with Bank of Baroda as the anchor bank, done in 2018), will doubtless bring economies of scale, they will not address the root of the problem. If anything, the mergers might exacerbate it.

The first step is to recognise that a necessary condition for a sustainable solution is to reform the banking and non-banking finance companies (NBFCs) together. The bank crisis manifesting in the mounting NPAs, the twin balance sheet problem, and high profile crony capitalist flights cannot be addressed in isolation; not without addressing the far more dangerous risks arising from the NBFC crisis, typified by the IL&FS meltdown, threatening to bring down other financial, banking, insurance, and audit institutions with them.

Second, in an irony peculiar to our times, the NBFCs have over the past several years been doing what the banks ought to, while banks ventured into infrastructure lending, where angels would fear to tread. It is this functional asymmetry that is at the heart of the finance and banking crisis. Let me elaborate: In the absence of effective regulation, shadow banking — the practice of banking-like activities — performed by the NBFCs has been rampant. Made worse by little board oversight, NBFCs have for some time been in the midst of a liquidity squeeze that threatens to become a full-blown crisis. A sharp rise in short-term repayments, large asset-liability mismatches, and deterioration in asset quality have combined to expose serious structural and regulatory weaknesses in this sector, with its considerable contamination effect on the health of PSBs — direct from the exposure of the banks and indirect from a common set of big borrowers who default.

Let me now turn to the PSBs, whose mergers several people hailed as a bold move by the government. The current state of the PSBs and the liquidity squeeze, as a consequence, poses a severe systemic challenge to accelerating investments and economic growth. For long since their nationalisation, the core lending business of public sector banks was: (a) short-term working capital loans to industry and business, and crop loans to farmers, constituting roughly three quarters of their lending; and (b) short-term retail to households for house construction, or to finance purchase of white goods, education, or marriages, against collateral.

At the turn of the century, under the growing influence of neo-liberal policies of privatisation and the rise of public-private partnerships to finance infrastructure, PSBs rushed in, and aggressively, I might add, to provide term loans to private companies for fixed capital investments: land, building, machinery, and equipment. Term loans now constitute close to 40% of the loan portfolios of the PSBs. The bulk of NPAs by value are long-term loans to corporates. We must, however, be clear that the shift from commercial banking to investment banking did not in itself result in the NPA crisis.

The NPA problem arose from features that characterised term loans, and were not the traditional business of banks: Banks neither had the expertise to assess long-term credit-worthiness of borrowers nor were they equipped to monitor and regulate the end-use of the long-term borrowing. This typified project lending, especially since the bank had mortgage rights only on the assets, and not on the corporate. Diversion of the funds for purposes other than for which they were borrowed became the most egregious and common risk. Though the Insolvency and Bankruptcy Code (IBC), effective since 2016, has helped speedier resolution of existing NPAs, it does not address the fundamental structural dichotomy that afflicts the finance sector.

A fundamental reform necessary is to modernise the banking laws extant to meet the demands of a rapidly transforming economy. There is a need to amend the Banking Regulation Act, 1949, to legitimise universal banking, and eliminate the artificial barrier that separates commercial banking from investment banking. PSBs must be allowed to raise bonds. The shift to universal banking without concomitant changes in the Banking Regulation Act, 1949, is the root cause of the double jeopardy — of the crises that threaten to envelop the banking as well as the non-banking sectors. The public sector banks being owned by the government places on it a fiduciary responsibility — an ethical relationship of trust — of acting in the best interests of the citizens. This alone must guide its actions.

(The writer is Director, Public Affairs Centre, Bengaluru)