Banking Reset 2.0: Tectonic changes are underway in Indian banking

Dinesh Khara is an optimist. Despite the once-in-a-lifetime black-swan Covid-19, he sees “demand coming back with a vengeance.” The State Bank of India (SBI) chairman’s optimism is, however, not shared by the Reserve Bank of India (RBI). The summary of the chapter on ‘Policy Environment’ in its Report on the Trend and Progress of Banking in India 2019-20 (T&P 2019-20) ends with the line: “The challenge is to rewind various relaxations in a timely manner, reining in loan impairment and adequate capital infusion for a healthy banking sector.”

Tectonic changes are in play now, some which were set in motion in 2018-19, like the four sets of mergers of state-run banks. This was unprecedented and led to the rearrangement of 25 per cent of the banking system’s assets in a single swoop — never before has a similar development of this magnitude happened anywhere in the world. It led to the management bandwidth of these banks being preoccupied with merger execution-related issues. Then came the pandemic, the lockdown and the concerns that they brought in their wake. 

Towards the end of the calendar year, an Internal Working Group (IWG) of the RBI made a case for large corporate groups being permitted to spawn banks. If approved, it will mark the re-entry of India Inc into commercial banking 40 years after the last round of bank nationalisation in 1980. There is also the new regulatory approach for non-banking financial companies (NBFCs) which is to have a four-layered structure — base, middle, upper, and top. This envisages a progressive increase in the intensity of regulation.

All this, even as the triggers and fallout of three outlier events — the mess at Yes Bank and PMC Bank, and more recently, the DBS Bank-Lakshmi Vilas Bank merger — play in the background. Taken together, the “reset button” has been pressed in banking. 

Then again, there is the larger setting of the economy. The Central Statistics Office has projected a sharp contraction of 7.7 per cent during 2020-21 in its release of the first advance estimate of gross domestic product (GDP). This is also in line with the RBI’s estimate of a 7.5 per cent contraction estimated in December 2020. (It had revised upwards its previous forecast of minus 9.5 per cent).

Nominal GDP is projected to decline by 4.2 per cent, and is pegged at Rs 194.8 trillion for the year. After the gradual slowdown witnessed in the economy since 2016-17 in the immediate aftermath of demonetisation, this steep decline is primarily on account of Covid-19 and the lockdowns in its wake.

On the books

How the Centre proposes to address the RBI’s observation in its T&P 2019-20 on “adequate capital infusion for a healthy banking sector” should soon become clear. The Centre has earmarked Rs 20,000 crore in the first supplementary demands for grants for capital infusion in state-run banks, but post-Covid, much more may be needed, even as there are competing interests for a much smaller pool of government revenues. Just how bad is the situation?

In 2019-20, the RBI had deferred the last tranche of banks’ capital conservation buffer (CCB) of an additional 0.625 per cent to 2.5 per cent in March 2020, from 1.875 per cent in March 2019. The CCB had been introduced after the financial crisis of 2008, to ensure that banks have an additional layer of usable capital to be drawn down when they incur losses.

The aforementioned relaxation had left banks with Rs 37,000 crore in extra capital, on the back of which they could have increased lending by Rs 3.5 trillion. It was widely expected that the central bank may not extend the relaxation again. It did, to April 1, 2021. The grapevine had it that the Centre’s finances were already stretched and it did not want a fresh recapitalisation burden, hoping that banks would use the additional resources to lend. So, what’s in store now? 

It depends on how you look at the emerging plot. The CCB is a hygiene measure, and post-pandemic, it is all the more important. But this will put further pressure on recapitalisation. Or, the view can be taken that since a nascent recovery may be on, it’s better to leave money on the table for banks to lend, even as it eases pressure on the fisc. This brings up the issue of non-performing assets (NPAs).

The RBI is of the view that accretion to NPAs, as per income recognition and asset classification norms, would have been higher in the absence of the asset-quality standstill, provided as a pandemic relief measure. Given the uncertainty induced by Covid-19 and its real economic impact, the asset quality of the banking system may deteriorate sharply, going forward. 

Notes Amitabh Chaudhry, managing director and chief executive officer of Axis Bank: “The number of restructuring requests will not be very large. So, the fact that your restructuring number is low does not mean that slippages might not happen. Slippages might still happen. So, we will see two kinds of stressed pools which banks will declare, after the third quarter.” 

Adds Khara: “We have already taken stock of the current stock of special mention accounts (both SMA1 and 2), and we are focussed on completing the restructuring. We have got time till end-March 2021 for carrying out the restructuring. Internally, we are targeting to complete the restructuring exercise by February.”

Devil in the details

The period between March 1, 2020 and August 31, 2020 was allowed to be excluded from the 30-day review period calculation or the 180-day resolution period under the ‘Prudential Framework on Resolution of Stressed Assets’ dated June 7, 2019 — if the review or resolution period had not expired as on March 1, 2020. 

A fresh layer of complexity is that the RBI is yet to state the date which the June 7 circular will apply for exposures under Rs 1,500 crore. As of now, it has only said that this will cover exposures of over Rs 2,000 crore (from June 7, 2019); and for those in the Rs 1,500-2,000 crore range, from January 1, 2020.

The June 7 circular states that “restructuring of loans in the event of a natural calamity, including asset classification and provisioning, shall continue to be guided as per the extant instructions.” It was pointed out that “the Covid-19 pandemic should be seen as a force majeure and a natural calamity in the health space”. The tricky part is that if the RBI were to treat Covid-19 as a force majeure, all contracts could be opened up. Says a top lawyer: “A few contracts have adverse material changes incorporated in them, but these have not really been tested.”

Then, there is the Insolvency and Bankruptcy Code (IBC). Fresh initiation of insolvency proceedings had been suspended on defaults arising during the one year commencing March 25, 2020, to shield companies impacted by Covid-19. Assuming that a fresh extension is not given to this relief, the IBC will kick in. Will it be deferred again?

“The IBC is being seen as a recovery mechanism by banks. It’s not. It is a resolution tool,” says a senior banker. And this is where the M S Sahoo panel’s suggestion of two options on prepacks — with and without a ‘Swiss Challenge’, and a quick amendment of the IBC, preferably by an Ordinance — fits in. This is to fast-track the process of arriving at a consensus on stress resolution created due to Covid-19, and to clear the backlog of insolvency cases.

In 2019-20, the amounts recovered from all modes of redress — IBC and Debt Recovery Tribunals — was Rs 172,565 crore, or 23.2 per cent of the sums involved. This was much better than the Rs 118,647 crore, or 16.3 per cent, recovered in 2018-19.

This is not to imply that there is no room for optimism. Says Choudhry: “There is an incremental improvement in sentiment (quarter-on-quarter), and this applies to most business segments, including corporate credit, and small and medium enterprises.”

During the peak of the pandemic, he adds, funds were being used mainly for refinancing or to manage the liquidity crunch. “Now, the working capital cycles are coming back, especially on the manufacturing side. We are seeing activity levels picking up quite substantially.” Private banks have raised nearly Rs 60,000 crore in capital so far. It is their state-run peers that are in a spot.

There is yet another aspect. While sectoral buoyancy may be returning, it is unlikely that all banks will be able to service their needs, given the limitations of capital. It is pertinent to note that in its T&P 2018-19, the RBI had for the first time highlighted the sharp fall in both the incremental and outstanding credit of state-run banks. In 2016-17, the share of private banks in incremental credit was almost 100 per cent. 

Between 2015-16 and 2019-20, the Centre pumped in Rs 3.56 trillion into these banks through both direct subscription to equity shares and recapitalisation bonds. Their market capitalisation is just above Rs 4 trillion. With valuations low, the Centre’s stake in state-run banks is going northward, in some cases well above 90 per cent.

Also, the reduction in liquidity coverage ratio (LCR) for banks to 80 per cent, from 100 per cent earlier, is to be gradually restored in two phases — to 90 per cent by October 1, 2020 and 100 per cent by April 1, 2021.

This is the context in which the IWG’s stance needs to be viewed. If India Inc is to be provided fuel for growth, it would necessarily mean that banks should have it in the first place. And if banks spawned by borrowers themselves are to play this role, it brings in its wake another set of complications — such as inter-connected lending.

We have hit the “reset” button, but the operating system has also been changed.