Why India’s banking sector is among the most vulnerable in G-20 economies today (Live Mint Summary-13th March 2018)

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Why India’s banking sector is among the most vulnerable in G-20 economies today

Live Mint

The context:

  • The capital adequacy ratio of India’s banking system is much worse than that of peers.

Poor situation in banks:

  • A high bad loans, poor accounting standards and growing evidence of lax supervision and banking fraud highlight the deep rot at the core of India’s financial system.
  • In 2009, India had among the lowest ratio of non-performing assets among the largest economies of the world, which form the elite G – 20 club. Eight years later, it has among the highest ratio of such assets.
  • India’s central bank has been prodding banks to recognize such toxic assets over the past few years.
  • The rise in bad loans and the lack of adequate provisions has put Indian banks in a tight spot now.
  • India’s banking sector lags those of most other large economies in terms of capital adequacy.

What is capital adequacy? 

  • Capital adequacy refers to the ability of a bank to withstand significant losses on its risky assets. India fares poorly in this regard despite a relatively conservative loan-to-deposit ratio.
  • The RBI has set 9% as the minimum threshold for total CAR.
  • Total CAR refers to total equity and reserves of a bank, expressed as a percentage of its risk-weighted assets.
  • All of India’s bad loans may not have been accounted for yet.
  • While the bad loan problem is more acute among state-owned lenders such as SBI, even private banks may not be fully accounting for their share of toxic assets.
  • If the pile of bad loans grows even bigger, India’s capital adequacy ratio could slip to dangerously low levels despite a generous bank recapitalization announced late last year.

According to IMF report:

  • Indian banks may find themselves to be much more vulnerable to financial shocks than their counterparts in other large emerging markets.
  • Under an adverse stress scenario, nine out of 12 state-owned banks will breach “hurdle rates”, i.e. rates prescribed by Reserve Bank of India for various capital adequacy ratios.

Measures taken by the RBI:

  • A committee to examine the weakness in state-owned banks and to suggest reforms was set up by the Reserve Bank of India under the chairmanship of P.J. Nayak.
  • The committee had flagged the issue of inadequate compensation for top management in state-owned banks compared to peers in private banks.
  • This affects the ability of state-owned banks (or public sector banks) to attract and retain talent.
  • While overall employee costs of state-owned banks remain bloated, top executive compensation continues to suffer, pointing towards inefficient functioning.

Recommendations:

  • The Nayak committee had recommended diluting the stake of the government in PSBs below 50%, so that banks could be freed from external vigilance emanating from the Central Vigilance Commission, the Right to Information Act, and from government constraints on employee compensation.
  • It also proposed creation of a Bank Investment Company to act as the holding company for various PSBs. However, there has not been much progress in reforming the way PSBs are governed.
  • The newly constituted Banks Board Bureau too has been unable to make much of an impact.
Key recommendations of PJ Nayak committee Status
Repeal various acts such as the Bank nationalization Act (1970, 1980), SBI Act, SBI subsidiaries Act, etc. to allow government stake in PSBs to fall below 50%. Not implemented.
Create a Bank Investment Company (BIC), which would act as a holding company for various public sector banks (PSBs) and hence improve autonomy in functioning of PSBs. Not yet created.
Set up a Bank Boards Bureau (BBB) until the creation of BIC. The Bureau would advise the government in appointing board members to banks, bank chairman/CMD and executive directors. BBB was set up in 2016. However the extent of authority enjoyed by the Bureau remains questionable.
RBI should designate a specific category of investors as authorized bank investors (ABI), and allow them to hold upto 20% in banks without regulatory approval. Not implemented. RBI caps the shareholding by a single entity at 10%.

Conclusion:

  • The government needs to undertake structural reforms to overhaul the way in which state-owned banks are managed.
  • This will improve the Indian financial system and promote growth and investments over the long term.