Business & Partnership

India’s banking industry crying for reform

While India has regained its position as the world’s fastest growing large economy – with the uptick in GDP expansion at 6.7% in Q3 of 2017-18 – sustaining it critically depends on more credit flows to revive investment, writes N Chandra Mohan
Mar 17, 2018
By N Chandra Mohan 
While India has regained its position as the world’s fastest growing large economy – with the uptick in GDP expansion at 6.7% in Q3 of 2017-18 – sustaining it critically depends on more credit flows to revive investment. 
The banking industry, however, is hobbled in its ability to supply funds to industry as it is sinking under the burden of non-performing loans, rising incidence of frauds like the USD 2 billion fraud perpetrated by high-profile international diamond merchant Nirav Modi who has since fled the country with his family. Typically, NPAs (non-performing assets) surge when there is a cyclical bust and bankruptcies soar. None of this has happened in India but banks cannot lend as provisioning against bad loans has risen substantially. 
The Nirav Modi fraud was possible as bank officials issued fraudulent letters of undertaking so that the diamantaire could raise funds from abroad. This was transmitted using the SWIFT infrastructure without originating a corresponding transaction in the core banking system. This has been going on since 2010. The fraud came to light accidentally when the merchant’s official showed up at the bank branch in Mumbai demanding a fresh letter of undertaking. Clearly this fraud was due to “failure of internal controls and non-adherence to “four eyes principles”, that former RBI deputy governor S S Mundra presciently warned about in September 2016. 
India’s banking travails stem largely from the public sector banks (PSBs) that account for 70% of the industry. According to the Reserve Bank of India’s latest Financial Stability Report, gross NPAs of PSBs hit 13.5% of gross advances in September 2017. This rose to 16.2% if restructured stressed advances are included. The enormity of this problem surfaced in 2015 when the RBI asked banks to recognize bad loans and clean up their books. The provisioning for deteriorating asset quality sent these banks’ operating earnings into negative territory. 
The seeds of the bad loan problem date to the mid-2000s when the Indian economy boomed in line with global trends. The bullish mood of those times triggered what the Economic Survey termed “over-exuberant investments” by India Inc especially in infrastructure projects through public-private partnerships. India’s banks, led by those state-owned, financed this investment boom. 
The ratio of credit to GDP rose sharply from 25% in 2001-02 to 52% in 2016-17. Globally, this level of credit doesn’t appear excessive as ratios in China, Brazil and Japan were higher when they boomed. Yet by 2010, many such investments stalled and PSBs were left holding the can. 
Industries like mining, iron and steel, infrastructure and aviation that absorbed a significant share of total advances, accounted for more than half the stressed bank advances. Many of these projects didn’t take off as the rosy growth assumptions on which they were based didn’t materialize. Many faced difficulties in land acquisition and obtaining environmental clearances. If the balance sheets of Indian industry were stressed as a result, this was reflected as NPAs in the books of state-owned banks. 
All this seriously impairs the ability of the Indian banking system to supply credit to boost investments and GDP growth. Accordingly, the major policy focus of the NDA government is to resolve bad loans and recapitalize public sector banks. Simultaneously, to enable corporates to clean up their stressed balance sheets through de-leveraging, a new bankruptcy code has kicked into effect.  The new policy regime is that all large loans of USD 308 million are to be classified as NPAs when they are restructured. Such NPAs would have to be resolved within 180 days, failing which they would attract provisions of the new bankruptcy code. A more durable solution for the banking industry’s woes, however, is to reform the management and governance structures of PSBs with progressively less state control over time.
(The author is an economist and commentator based in New Delhi. He can be contacted at

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