Over the next 3-5 years, there’s enough banking capacity to support healthy economic growth
Neelkanth Mishra | Dec 9, 2021, 19:32 IST
This appeared in the Times of India print version on December 10, 2021 (link)
Despite RBI’s official stance staying ‘accommodative’, normalization of monetary policy in India started in September, with the central bank raising the rate at which it takes in surplus banking funds by nearly 60 basis points, triggering deposit rate hikes by banks. Yields on government bonds are back at pre-Covid levels.
As monetary policy normalises, attention will shift to questions we grappled with pre-Covid, one of the most important ones being: Does India’s banking system have sufficient capacity?
Banks’ functional role is to channel savings to borrowers, but in the process they also create money (money-creation is a public-private-partnership), depositors’ trust in them is critical for the system to function, and governments create an implicit if not an explicit safety net for banks. Make regulations too tight, and the economy grows below potential; make them too loose, and before you know it, a crisis is at hand.
Supply of credit keeping up with demand is as important as labour or cement. There is sufficient capacity currently, of course: The ratio of loans they have given to equity capital that the owners of the bank have put in is at record lows, and well below regulatory thresholds set by RBI. This ratio expands as banks grow their loan books, but for now, they can issue more loans if they want to. However, we need to look beyond the next year or two, as banking capacity cannot grow at short notice.
If the economy has to grow at say 11% every year in nominal terms (real growth plus inflation), demand for loans is likely to grow at a faster clip, say at 14-15% a year, particularly as new growth would be dominated by the formal economy. If so, can the financial system meet this demand?
Private sector banks have grown faster than public sector banks (PSBs) in the past decade, growing their share of bank loans from 21% in 2010 to 36% in 2020, as the share of PSBs fell from 74% to 60%.
For private banks, equity capital is less of a hurdle, as their healthy profits can be reinvested, and high vlauation multiples permit periodic tapping of stock markets for more capital. The limit on growth for them being prudence, even if all current private banks grow at twice the nominal GDP growth, their incremental lending may account for less than half of the required growth in banking credit.
Assuming non-banks and bond markets show healthy growth too, a major source of uncertainty for the financial system is growth in credit from PSBs. As documented by RBI’s Internal Working Group (IWG) on ownership guidelines of private sector banks, there has been a noticeable drop in PSB’s risk-taking since 2015. Their private sector peers have a lower share of bad loans despite taking substantially more risk, implying more efficient utilization of capital.
Greater risk-aversion in PSBs is easy to understand: For a loan officer, there is little upside from issuing a higher-risk loan that earns good profits for the bank, but much to fear should it go bad. This is hard to address.
Thus, the argument that the economy needs new investments in the financial system to sustain its growth had some merit, and was perhaps the trigger for the IWG’s recommendation in the report published in October 2020, that large corporates and industrial houses be allowed to be promoters of banks.
This was despite acknowledging concerns related to “conflicts of interest, concentration of economic power” and heightened risks of “misallocation of credit, connected lending, extensive anti-competitive practices and exposure of the government safety net established for banking to a broad range of risks”, and that “all experts except one” consulted by IWG advised against it.
This recommendation did not make it to the list accepted by RBI last month. It is unclear if this exclusion was only because the necessary prerequisites that IWG had also recommended were not in place, like “a strong legal framework for connected lending and enabling framework for consolidated supervision”. However, the potential capacity of India’s financial system has been boosted meaningfully in the last two years, which may also have forced a rethink.
Start with the decision to privatise two PSBs. More important than the possible infusion of fresh private capital into these firms is the change in incentives to grow. This can also hopefully trigger better governance and performance in the remaining PSBs.
Setting up of the new development finance company announced in the budget speech this year, with a lending target of Rs5 trillion within three years (this is 3% of total outstanding private credit in FY21), is also intended to supplement financial capacity.
Add to this the surge in equity investments in technology-enabled financial firms (FinTech). Even if they do not lend direclty, through better use of data and analytics, these firms identify lending opportunities, making the risk more palatable for otherwise risk-averse lenders like PSBs.
A few IWG’s suggestions that were accepted also help add to equity capital in the system. Promoters’ stake can now be 26%, higher than the 15% permitted earlier, and one group is already preparing to infuse more capital into its bank.
Similarly, non-promoter shareholding threshold being raised to 15% from 10% earlier is a potential opportunity for getting more private equity investments into some of the smaller private banks. Several existing licensed firms are also progressing from being payment banks to small finance banks, onward to becoming universal banks some years down the line.
Put together, these trends provide reasonable certainty that the financial system can meet the growing demand for credit for the next three to five years, making it less important, if not unnecessary, to take on the risk of issuing licenses to industrial houses.