Indian banking system at a crossroads but no clear road map visible yet

The word ‘Pandemonium’ captures it. The meaning of the word, as I find it in the Oxford English dictionary is quite explanatory. It refers to ‘a situation in which there is a lot of noise, activity and confusion, especially because people are feeling angry or frightened’. This kind of pandemonium –a state of situation of noisy confusion and disorder –is not new in India’s banking and financial evolution.

The first one, post-independence during the fifties, had its roots in what we inherited --a large number of legal entities, as many as 737 in number, of diverse size and capability, used to reckless lending and speculative culture, with little or no disciplinary control by RBI. System consolidation with compulsory merger, undertaken rapidly between 1960-65, reduced the number to a manageable lot of about 94 units.

While the first pandemonium was petering out, a second one overtook us. Commercial banks in India were shut out of agriculture and allied sector, that being the holy cow of the politically powerful cooperative sector. But political orthodoxy had to give way ultimately to economic reality. The resource base of the cooperative sector was proving too thin and too inadequate to meet the ever-rising demands arising out of the impact of the Green Revolution.

Also, the clientele of the commercial banks was too elitist, the number of borrowers too few, and stagnating virtually at the same low level throughout that decade. Clearly, the fundamental disequilibrium between what the economy needed and what the banking system was structured and oriented to provide, had to be addressed.

Reality dawned on us, commercial banks stepped in the agricultural sector and, simultaneously, a massive geographical and functional diversification of commercial banking services was pushed through the well-timed step of bank nationalisation.

The next phase had been one of relative stability. We saw a remarkable transformation in the advance portfolio of commercial banks : their involvement with industry ,which was about one third of its advance portfolio , shot up to two thirds : all this was possible because of close collaboration between the term lending institutions and commercial banks, the former being the custodian of the expertise for tecno-economic appraisal as the basis for taking long term financial commitment and the bankers providing working capital finance. It was this clear-cut division of responsibility that saw us through, without much of a systemic hitch, over the years of our planned and state directed development strategy.

That cosy world of state planning collapsed in the early nineties. We migrated to a market oriented competitive system. The process of migration had a mixed record. In commercial banking in particular we started experiencing several hiccups, of which NPAs was becoming worrisome, a few of them persisting with chronic obstinacy.

Well, this has been due to a conjunction of several factors. A few are attributable to some of the decisions of the authorities and a few to the behaviour of the market players.

In the early nineties development finance institutions were dismantled; It was all too sudden, taking little cognisance of the fact that commercial banks, with little in house expertise of appraising viability of large projects in a ‘competitive market dynamics’, would be severely handicapped. Also let us not forget that this came at a time when commercial banks were getting flooded with large investment proposals from entrepreneurs who, freed from the restrictions of the licensing authorities, were tasting freedom with reckless abandon.

Banks had to rely on outside appraisal which, as it is now turning out, was of indifferent quality. In some cases, viability of projects was worked out on the basis of certain assumptions that the government would come out with supportive changes in policy such as land acquisition.

Come to Public Sector Banks. These constitute the largest segment of our banking. They have an extraordinary public responsibility. They have also an entrepreneurial responsibility to maximise profit in order to attract and enlarge capital. It is a judicious balancing of market ambition and public responsibility that is the key to stability in a credit market.

Unfortunately, they have been unable to adapt themselves to the dynamics of the market situation as the government, the owners, had been reluctant, then and even now, to allow them necessary freedom and flexibility to function as mature and responsible market players.

For the PSBs to prosper, the owner has to ensure that they are being managed by people who merit public trust and who are dedicated to the preservation of the integrity of credit. We have to remind ourselves all the while that It is the government as owners and not the Reserve Bank, as the regulatory institution, often depicted as the guilty party, who have to create the necessary conditions.

The inevitable is happening. These PSBs are getting marginalised with a drastic fall in market share. It is indeed tragic that the full potential of these PSBs have not been realised. And over and above, the owner have consistently failed to fulfil its responsibility of providing adequate capital to support the ongoing lending process. And to cap it all, the owner looks the other way around as enforcement agencies swoop down on the employees.

These agencies have little knowledge and understanding as to how lending decisions are taken and how to distinguish between credit decisions taken with commercial judgment and those taken with intentional and fraudulent intentions. All this eats into the morale of the employees, which is as critical a capital as balance sheet numbers.

Tragedy is always depressing but we come out of it through a process of catharsis. In the first pandemonium, it is consolidation of system through compulsory acquisition that saved us, in the second one it was bank nationalisation.

I have often asked myself what will be the catharsis in this current one. I have no doubt in my mind that in the current situation it is the government that must be prepared to go through a process of catharsis, shedding the ownership of bulk of the PSBs while keeping a few in overall national interest. This will contribute substantively to the cleansing of the system with supportive policies for the development of a vibrant capital market.

Will that happen? Nothing like that is in sight. Let me end by quoting what the Finance Minister of the Government of India said at an international gathering.

“Indian public sector banks did not have a worse phase than when the combination of Dr. Manmohan Singh and Dr Raghuram Rajan as Prime Minister and Governor Reserve Bank had.”

Too simplistic an attitude to deal with a complex crisis.

Can anyone see any light at the end of the tunnel?

(Edited excerpts of a keynote address delivered in 2019 at the book launch of ‘Pandemonium’ by Tamal Bandopadhyay. DN Ghosh, a distinguished retired civil servant worked for long in the banking division of the finance ministry)