In an article on banking reforms, former RBI Governor Raghuram Rajan and former RBI Deputy Governor Viral Acharya explained why India’s banking sector is currently in shambles. The paper examines the challenges facing the sector and the reforms that could enable significant growth of the banking sector.
Rajan and Acharya argue that the degree of competition seen in the banking industry today can be attributed to two “big deals” 50 years ago. The first of these large markets, according to Rajan and Acharya, was between the government and the banks, where the latter had access to low-cost demand and term deposits to the RBI’s liquidity facilities as well as to some protection against competition. In return, they had to accept certain obligations such as government financing, monetary transmission, opening of banks in unbanked areas and granting loans to priority sectors.
The second deal was between public sector banks and the government. These banks took on special services and risks for the government and were compensated by the government “standing behind the public sector banks,” according to the document.
But these deals are now under pressure as India has moved from a nationalized, bank-dominated economy to a decentralized, market-funded economy. Investments in areas such as infrastructure have increased. Since the government is inconsistent in making such investments, private entrepreneurs have accepted them, Rajan and Acharya said.
However, private investment is risky, say former RBI members. “While banks have financed a considerable number of large projects over the past two decades, loan losses have become enormous. Ideally, more of these losses should have been absorbed by risk-absorbing funding from corporate bond and equity markets. It seems, however, that many Indian business risks are still found on banks’ balance sheets, especially those in the public sector, ”Acharya and Rajan said.
They said deposit financing is not as cheap as it once was. As households become more sophisticated, people are less and less willing to put money into low-interest accounts.
The first market is threatened because deposits are no longer cheap and the government cannot anticipate funding. The second market is threatened because public sector banks are in a worse risk position than the private sector, Rajan and Acharya said. “As low-risk companies migrate to market finance, these banks find themselves with both very large risky infrastructure projects and loans to medium, small and micro enterprises (MSMEs). The alternative to taking these risks is to dive into competitive retail lending where private banks have a strong presence, ”they said.
With limited lending options and the country’s infrastructure needs, PSBs increasingly choose to lend huge amounts to large projects, especially in infrastructure.
They also pointed out that PSBs once had the best talent, but the hiring freeze has decimated the middle management ranks, while private banks and multinationals continue to poach talent.
“With the government strapped for funds, its ability to meet the capital needs of public sector banks under the Second Big Market has been eroded. Ironically, however, with inadequate government support, undercapitalized public sector banks tend to revert to government funding rather than taking risks on new business or personal loans. These “lazy loans” (a term coined by Dr Rakesh Mohan) constitute a serious obstacle to the growth of the productive sectors of the economy, even if they provide the security of the banks on paper, “the document said.
Rajan and Acharya said: “We cannot go back to revive the two agreements – it means reversing development and bottling the genius of competition, which would not be desirable for the economy even if it were possible. . Instead, the best approach may be to develop the financial sector by increasing efficiency, competition and variety. Public sector banks are the key to transformation.