'Grand bargains' 50 years ago to lazy lending: Rajan, Acharya explain why Indian banking is in shambles

In a paper on banking reforms, former RBI Governor Raghuram Rajan and former RBI Deputy Governor Viral Acharya have explained why the Indian banking sector is in shambles currently. The paper looks into the challenges faced by the sector and the reforms that could allow significant growth in banking.

Rajan and Acharya say that the degree of competition seen in the banking sector today can be traced back to two "grand bargains", 50 years ago. The first of these grand bargains, Rajan and Acharya say, was between the government and banks where the latter received access to low-cost demand and time deposits to RBI's liquidity facilities as well as some protection from competition. In return they had to accept certain obligations such as financing the government, monetary transmission, opening banks in unbanked areas and extending loans to priority sector.

The second bargain was between public sector banks and government. These banks took special services and risks for the government and were compensated by the government "standing behind the public sector banks", said the document.

But these bargains have now come under pressure as India moved from a nationalised and bank-dominated economy to a decentralised and market-financed economy. Investments in areas like infrastructure have grown manifold. Since the government is not consistent in undertaking such investments, private entrepreneurs have taken them up, said Rajan and Acharya.

However, private investment is risky, say the former RBI members. "While banks have financed a considerable number of large projects in the past two decades, loan losses have become huge. Ideally, more of these losses should have been absorbed by risk-absorbing financing from corporate bond markets and from equity markets. It seems, however, that many of corporate India's risks still end up on bank balance sheets, especially public sector ones," said Acharya and Rajan.

They stated that deposit financing is not as cheap anymore as in the past. With households becoming more sophisticated, people are increasingly unwilling to put money in low-interest bearing accounts.

The first bargain is threatened as deposits are no longer cheap and the government cannot pre-empt financing. Second bargain is under threat because public sector banks are in a worse risk position than private sector, said Rajan and Acharya. "As low-risk enterprises migrate to financing from the markets, these banks are left both with very large risky infrastructure projects and with lending to medium, small, and micro enterprises (MSME). The alternative to taking these risks is to plunge into highly competitive retail lending where private banks have a strong presence," they said.

With limited lending options and country's need for infrastructure, PSBs are increasingly choosing to lend huge amounts to large projects, especially in infrastructure.

They also pointed out that PSBs used to have the best talent but hiring freezes have decimated middle-management ranks, while private banks and MNCs continue to poach talent.

"With the government strapped for funds, its ability to support the capital needs of public sector banks as part of the second grand bargain has been eroded. Ironically, however, with inadequate support from the government, undercapitalised public sector banks tend to revert to financing the government rather than taking risks on new corporate or retail lending. Such "lazy lending" (a term coined by Dr. Rakesh Mohan) is a serious impediment to the growth of productive parts of the economy, even if it keeps the banks relatively safe on paper," said the document.

Rajan and Acharya said, "We cannot go backwards to revive the two bargains - that means reversing development and bottling the genie of competition, neither of which would be desirable for the economy even if feasible. Instead, the best approach may be to develop the financial sector by increasing efficiency, competition, and variety. Key to the transformation are public sector banks."

Also read: Raghuram Rajan, Viral Acharya suggest scrapping of Financial Services Dept in Finance Ministry for PSBs' independence