Is trust driving the banking system, economy?

Is trust driving the banking system, economy?

banking system

Ever since the discovery of huge NPAs in banks’ balance sheets after the asset quality review by the Reserve Bank of India (RBI), there hasn’t been much effect on the Indian stock market. The performance of both Nifty and Sensex has been on an increasing trend since 2014 which is quite paradoxical considering the situation of the Indian banking sector.

The Indian banking sector is burdened with a huge NPA of Rs 8,40,958 crores and a majority of it lies with public sector banks. The country’s GDP as per the 2016 census of IMF is $2.26 trillion and the current revenue of the government has decreased from Rs 15.51 lakh crore (March 2018) to Rs 71,450 crore (April 2018). This means that a huge portion of the government’s revenue is going towards recapitalisation of banks and not for the benefit of India which is still suffering from poverty, literacy, unemployment and inequality.

Banks are the backbones of any economy to function at its best as they maintain the flow of funds to keep the system running. What if banks fail to perform this function? Will the economy still survive? The answer is an obvious “no”. So, why is there no effect of troubled banks on the stock market? Why are the sentiments of people so strong about our economic performance?

The answer is simple: the public trusts the Indian banking system as a safe haven for their money/deposits. This belief is so strong that for them, the government is the cause and solution of any problem. They are least bothered about how solutions are achieved. This is where the problem starts because it helps political parties to leverage their trust and misuse their money.

With the government’s plan for recapitalisation, the problems of the banking sector will get solved but the solution is only temporary. The bigger questions are: ‘How did it all start?’ and ‘How to ensure it won’t happen again?’

Broadly there are three reasons behind the accumulation of NPAs: negligence of banks, negligence of government and no backtracing of how the funds are being utilised by corporate borrowers.

In order to increase the size of their balance sheets, banks have lent huge amounts of money to corporate borrowers without bothering about their true creditworthiness. The government has also played a huge role in it by using its influence to convince banks to grant the loans despite the risk. Even the RBI has faltered in terms of regulating the banks and allowing the problem to reach such an alarming stage.

Handling of an institution which runs its business mostly on the deposits of common people so recklessly is like playing with fire. But this does not bother the banks which enjoy massive support from the working population which deposits its hard earned money without checking for NPAs and the government pumps taxpayers’ money into the system to ensure that it remains safe. In a way, we give funds to banks to do business and rather than getting returns, we only end up paying for its safety.

When the 2008 financial crises happened, the Dodd-Frank Act and Basel III reforms came up. The Dodd-Frank Act made banks responsible for the public and prohibited them from getting involved in risky businesses like hedge funds, speculative trading etc, whereas the Basel III reforms protected banks from failing by maintaining huge capital.

We haven’t reached such a crisis in India, so recapitalising has become a habit for banks. But this doesn’t mean we won’t face one because the real reason for not having a crisis is not the government’s macroeconomic policies but the faith of the people who do not question how their tax money or deposits are being utilised. How long can our failure to question save the Indian economy?

Overvalued stocks

As per analysts, Indian stocks are overvalued as corporate performances are not supporting their valuations. Their PE ratios are as high as 20 times where there hasn’t been much growth in their earnings since 2014, resulting in the formation of a bubble in the stock market.

The main reason for overvalued stocks is the rising GDP growth rate which makes investors believe in the performance of the companies. Consumption and investment are two major drivers of GDP in India and both depend greatly on the government’s fiscal policy, RBI’s monetary policy and performance of the Indian banking sector.

Now, there comes the risk associated with inflation which might happen because of increased oil or commodity prices or due to overheating, impacting the consumption. The larger part of the risk lies with the banking system which is already suffering from capital shortage due to mounting NPAs. To top it all, the savings rate has not picked up yet, resulting in decline in savings/deposits of banks.

Therefore, there is a need for stricter laws and regulations along with a compliance check that monitors the robustness of the banking system. Consolidation of banks’ balance sheets, recapitalisation and privatisation are all short-term remedies. For a long-term solution, we need a system that has stringent guidelines on lending and credibility of the borrower.

Loans taken on behalf of a company should be strictly evaluated taking into consideration its valuation and impact of changing the economic scenario. Banks should also have a system to backtrace whether the funds are being utilised for the purpose for which they were taken. Lastly, accountability of the bank’s management should be clearly defined to keep a check on corruption. All these will bring positive changes in the lending pattern of banks and make it a sturdy system.

(Ghatak is Associate Professor and Deshwal is research scholar, Institute of Management, Christ Deemed-to-be University, Bengaluru)