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Banking Reforms – Note prepared by Raghuram Rajan

The banking system is overburdened with non-performing loans. Much of the problem lies in public
sector banks (PSBs), but private sector banks like ICICI and Axis Bank, as well as some of the old private
banks, have not been immune. Some of the malaise comes from a general need to improve governance,
transparency, and incentives in the system. However, the difficulties in even some private banks
suggests that “simple” solutions like privatizing all public sector banks may be no panacea. At any rate,
banking reform should tackle four broad areas: (1) Clean up banks by reviving projects that can be
revived after restructuring debt. (2) Improve governance and management at the public sector banks.
(3) De-risk banking by encouraging risk transfers to non-banks and the market. (4) Reduce the number
and weight of government mandates for PSBs, and banks more generally.

Revive Projects that can be Revived

The NCLT will help restructure debt for the largest firms and projects under the Bankruptcy Code.
However, the NCLT will be overwhelmed if every stressed firm or project files before it. Instead, we need
a functional out of court restructuring process, so that the vast majority of cases are restructured out of
bankruptcy, with the NCLT acting as a court of last resort if no agreement is possible. Both the out of
court restructuring process and the bankruptcy process need to be strengthened and made speedy. The
former requires protecting the ability of bankers to make commercial decisions without subjecting them
to inquiry. The latter requires steady modifications where necessary to the Bankruptcy code so that it is
effective, transparent, and not gamed by unscrupulous promoters.

Of course, for many projects, financial restructuring is of little use if the project cannot proceed for
other reasons such as lack of land or permissions or input supply. Any new government will have to give
priority to rectifying these issues. I will not go into details here since some of these bottlenecks are
covered in other notes.

Improving governance and management at the public sector banks.

• Public sector bank boards are still not adequately professionalized, and the government rather than
a more independent body still decides board appointments, with the inevitable politicization. The
government could follow the PJ Naik Committee report more carefully. Eventually strong boards
should be entrusted with all bank-related decisions, including CEO appointment, but held
responsible for performance. Strategic investors could help improve governance.

• Risk management still needs substantial improvement in PSBs, regulatory compliance is inadequate,
and cyber risk needs greater attention. Interest rate risk management is notable for its absence,
which means banks are very dependent on the central bank to smooth the path of long term
interest rates. These are all symptoms of managerial weakness. There is already a talent deficit in
internal PSB candidates in coming years because of a hiatus in recruitment in the past. Outside
talent has been brought in very limited ways into top management in PSBs. This deficiency needs to
be addressed urgently by searching more widely for talent. Compensation structures in PSBs also
need rethinking, especially for high level outside hires.

• Project lending has to be improved


(i) Significantly more in-house expertise can be brought to project evaluation and structuring,
including understanding demand projections for the project’s output, likely competition, and

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the expertise and reliability of the promoter. Bankers will have to develop industry knowledge in
key areas, or bring on board industry experts, since consultants can be biased.

(ii) Real risks have to be mitigated where possible, and shared where not. Real risk mitigation
requires ensuring that key permissions for land acquisition and construction are in place up
front, while key inputs and customers are tied up through purchase agreements. Government
will have to deliver what it is responsible for in a timely way. Where these risks cannot be
mitigated, they should be shared contractually between the promoter and financiers, or a
transparent arbitration system should be agreed to.
(iii) An appropriately flexible capital structure should be in place. The capital structure has to be
related to residual risks of the project. The more the risks, the more the equity component
should be (genuine promoter equity, not borrowed equity, of course), and the greater should be
the flexibility in the debt structure.
(iv) Where possible, corporate debt markets, either through direct issues or securitized project loan
portfolios, should be used to absorb some of the initial project risk. More such arm’s length debt
should typically refinance bank debt when construction is over.
(v) Financiers should put in a robust system of project monitoring and appraisal, including where
possible, careful real-time monitoring of costs. Promoters should be incentivized to deliver, with
significant rewards for on-time execution and debt repayment. Projects that are going off track
should be restructured quickly, before they become unviable.
(vi) And finally, the incentive structure for bankers should be worked out so that they evaluate,
design, and monitor projects carefully, and get significant rewards if these work out. Equally,
bankers who preside over a series of bad projects should be identified and penalized.

Privatize or not?

Is privatization of public sector banks the answer? Much of the discussion on privatization seems to
make assumptions based on ideological positions. Certainly, if public sector banks are freed from some
of the constraints they operate under (such as paying above the private sector for low skilled jobs and
paying below the private sector for senior management positions, having to respond to government
diktats on strategy or mandates, or operating under the threat of CVC/CBI scrutiny) they might perform
far better. However, such freedom typically requires distance from the government. So long as they are
majority-owned by the government, they may not get that distance.

At the same time, there is no guarantee that privatization will be a panacea. Some private banks have
been poorly governed. Instead, we need to recognize that ownership is just one contributor to
governance, and look at pragmatic ways to improve governance across the board. There certainly is a
case to experiment by privatizing one or two mid-sized PSBs, and reducing the government stake below
50 percent for a couple of others, while working on governance reforms for the rest. Rather than
continuing a never-ending theoretical debate, we will then actually have some evidence to go on. Some
political compromises will be needed to allow the process to go through, but so long as the newly
privatized banks are not totally hamstrung in their operational flexibility as a result of these
compromises, this will be an experiment worth undertaking.

Merge or not?

An alternative proposal to improve governance is to merge poorly-managed banks with good banks. It is
uncertain whether this will improve collective performance – after all, mergers are difficult in the best of

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situations because of differences in culture. When combined with differences in management
capabilities, much will depend on whether the good bank’s management is strong enough to impose its
will without alienating the employees of the poorly-managed bank. We now have two experiments
underway -- with State Bank having taken over its regional affiliates, and the merger of Bank of Baroda,
Vijaya Bank, and Dena Bank. The performance of the latter merger will be more informative. Thus far,
market responses suggest skepticism that it will play out well. Time will tell.

De-risk banking by encouraging risk transfers to non-banks and the market.

Too many risks devolve onto banks, including risks such as that of interest rate volatility that banks
elsewhere typically lay off in markets. Too much project risk stays with banks because other financial
instruments such as equity and subordinate debt cannot be issued cheaply. Risk also returns through
the backdoor; Banks do not make loans to housing developers because of their intrinsic risks.
Nevertheless, they make loans to NBFCs, who make loans to developers. To prevent risk from returning
to bank balance sheets, NBFCs must be able to raise money directly from markets. Financial market
development, addressed in Professor Prasad’s note, will help banks focus more on risks they can
manage better and thus bear more effectively, while sharing or laying off what they cannot. Banks will
have to complement financial markets rather than see them as competition. The use of financial
technology will be especially helpful to them in this endeavor.

Reduce the number and weight of government mandates for PSBs

Uncompensated government mandates have been imposed on PSBs for a long time. This is lazy
government – if an action is worth doing, it should be paid for out of budgetary resources. It also is
against the interests of minority shareholders in PSBs. Finally, it does not draw the private sector in to
compete for such activities. The government should incentivize all banks to take up activities it thinks
desirable, not impose it on a few, especially as the privileges associated with a banking license diminish.

Along these lines, requirements that banks mandatorily invest in government bonds (the SLR
requirement) should continue to be reduced, substituting instead with the liquidity coverage ratios and
net stable funding ratios set by Basel.

Among the more dangerous mandates are lending targets and compulsory loan waivers. Government-
imposed credit targets are often achieved by abandoning appropriate due diligence, creating the
environment for future NPAs. Loan waivers, as RBI has repeatedly argued, vitiate the credit culture, and
stress the budgets of the waiving state or central government. They are poorly targeted, and eventually
reduce the flow of credit. Agriculture needs serious attention, but not through loan waivers. An all-party
agreement to this effect would be in the nation’s interest.

Finally, the government should keep its banks well capitalized, conditional on improvements in
governance and management efficiency. This is simply good accounting practice, for it prevents the
government from building up contingent liabilities on bank balance sheets that a future government will
have to pay for.