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A Tale of Banking Decisions Gone Awry

A Tale of Banking Decisions Gone Awry

Partha Chatterjee

One economics and business related news that has shocked the nation in recent times is that of the write-offs by the public sector banks. According to some news reports, the write-off is in the tune of Rs. 1.14 lakh crores over the last three years. There are two principal reasons why this has caught the imagination of the masses — the size of the write-off, which is more than three times this year’s budget allocation in school education, literacy and higher education put together, and the fact that the banks are publicly owned.

The first thing to note is that writing-off of bad loans by banks is perfectly legitimate and is regularly done by banks worldwide. What is unusual is the quantum of write-offs and the increase in recent years.

What led to bad debt?

Clearly, some bad investment decisions were taken. While trying to understand why and how these bad decisions were taken, one has to keep in mind that in most cases, it is not because of some risky trade by a banker whose pay depends on the deals he made. Of course there are career concerns, but at the end of the day the bankers in this case are government employees (technically PSU employees) who receive fixed salaries. So, in understanding how these bad decisions were taken, government ownership of banks matter. It raises the question of whether they were purely business decisions or was some other objective being fulfilled.

While I am not ruling out corruption and nexus between businesses and political leaders as possible causes that led to bad decisions and bad debt, it is important to note that interventions by the government, even if it is not mala fide, can lead to decisions that lead to bad debt. For example, when you talk to officials in these banks, you understand that often projects (particularly infrastructure) and even more so in the power sector were funded in spite of the expected return on investment in these projects being abysmally low or even negative, just because that was a priority of the government.

The other issue is the fact that there is very little chance that the banks would be able to recover the loan, even partially, when someone defaults. Part of the reason is that the bankruptcy laws are antiquated and going through the judicial system in India is a nightmare for any entity. However, again the problem is compounded because of government ownership of banks.

While private banks can renegotiate or even go after a defaulter somewhat aggressively, the incentive for government-owned banks simply does not exist. This causes a severe moral hazard problem.

When the costs of default are so low, the chances of default increases.

The existence of this huge moral hazard is the reason that this needs to be dealt with urgently and firmly. As the RBI Governor points out there is a need for “deep surgery.” Merely recapitalizing the banks will not solve the problems and it will be a matter of time when the situation repeats itself. I am not arguing that recapitalization is not necessary, it is indeed necessary to ensure that liquidity does not dry up.

What more can be done?

First, there has to be an attempt to recover as much as possible. Writing-off loans does not mean the end of the liability of borrowers and every attempt should be made to make the wilful defaulters pay. This will obviously help to minimize the loss in the current episode, but taking this path is vital to reduce the moral hazard problem and thereby avert similar episodes recurring in future. However, here again, government owned banks lack incentive as well as wherewithal.

A well laid down bankruptcy process limits the downside for all involved and hence, recovery rates will be higher.

The passage of a good bankruptcy bill in the parliament is also essential. A well laid down bankruptcy process limits the downside for all involved and hence, recovery rates will be higher. If the judicial process is simplified and shortened, that will also reduce cost associated with recovery, and provide better incentives to banks to attempt to recover the loans.

However, the deepest and the cleanest surgery possible is for the government to sell the government-owned banks. Clearly, this doesn’t seem to be a favoured option by the policy makers right now. However, if we think through this, it may not appear to be that drastic. One of the main objectives for  nationalizing the banks was to increase banking penetration and incentivize savings. It is not clear how much the nationalized banks have succeeded in this goal. With the post offices doubling up as banks, as proposed, and the advent of new technology, there is a far better chance of achieving near universal banking than operating many nationalized universal banks. This will take care of most of the issues discussed above and taxpayer’s money can be better deployed in other areas such as education and health.

Partha Chatterjee is currently serving as the Head of the Economics Department at Shiv Nadar University. Prior to this, he was an Assistant Professor at NUS Business School. He has completed his Ph.D. from the University of Minnesota, and his research interests lie primarily in Macroeconomics, International Economics, and the emerging economies. He is also an ad hoc reviewer for the Journal of Mathematical Economics and Applied Economics, along with being a member of the American Economic Association and Econometric Society.

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