- What is the trilemma?
- A hypothetical scenario
- Pitfalls of not recognizing bad loans
- Way Forward
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The Indian banking system has become an unintended victim of the COVID-19 pandemic. The Public Sector Banks (PSBs) entered the crisis quite fragile and are likely to be seriously hit. The virus will have a 10% negative swing in the economy impacting various sectors. The moratoriums and knock-on effects from these sectors will flow directly to the banks and add up to already existing bad loans.
What is the trilemma?
- The government and the regulator (RBI) face a trilemma:
- have a dominance of government banks (public sector banks) in the banking sector.
- retain independent regulation.
- adhere to public debt-gross domestic product (GDP) targets.
- The government along with RBI cannot hope to achieve all three points at the same time.
- A maximum of two out of the three can be achieved.
A hypothetical scenario:
- If the government wants public PSBs to dominate the banking system and at the same time, ensure that the public debt doesn’t go up.
- In this scenario, RBI will have to compromise on independent regulation.
- To dominate the banking system, PSBs will have to increase lending at a fast pace.
- This will lead to an accumulation of bad loans (loans that haven’t been repaid for 90 days or more).
- Given that recoveries of bad loans are minimal, the government as the owner will have to invest more money into the PSBs to keep them going.
- If the government puts more money into the PSBs, its expenditure will go up.
- It will have to borrow more money and the public debt to GDP ratio will substantially rise.
Pitfalls of not recognizing bad loans:
- RBI can dilute some regulations to help the PSBs in not recognizing bad loans.
- In such a case, the government need not invest in the PSBs immediately.
- PSBs will have a greater market share and the public debt to GDP ratio will not rise right away.
- But when RBI dilutes regulations, it leads to a bigger problem of Non-performing assets (NPAs) and Bad loans, which hits the banks a few years later.
- This was the case of how PSBs accumulated peak bad loans of ₹8.96 trillion, as of March 2018.
- The government then has to recapitalize the banks in the years to come.
- In the process, it pushes the public debt to GDP ratio up, which is the situation government is avoiding.
1. Decline in share of PSBs in lending:
- The decline in the share of government banks in the banking sector should not be resisted.
- In the last decade, the share of PSBs in overall lending has dropped sharply from 75.1% to 57.5% at present.
- If the trends continue, it will present fewer headaches for government and RBI in the decades to come.
2. Slashing govt. shareholding:
- The govt. should consider bringing down its holdings in PSBs to below 50%, but above 26% shareholding.
- RBI has the same rule for private banks where a promoter cannot hold more than 26% and no other owner could own more than 5%.
- By the move, the government remains the owner but the banks’ management then get decision-making autonomy.
- Needless interference and the paralysing fear of vigilance goes away.
- Further, by bringing ownership down to 26%, the government’s need to provide capital to these banks goes away.
3. Other reforms:
- Large Non-Bank Finance Companies (NBFCs) should be converted or acquired by banks to mitigate systemic risk.
- The ease in licensing to NBFC would continue to spur financial innovation but NBFCs over a certain size should be converted into banks.
Failure to address the underlying weakness in the financial system, while at the same time asking banks to ramp up (increase) lending, despite their unwillingness to take on credit risk, could adversely affect their balance sheets. This weakness in the financial sector could slow down economic recovery. The Banking system needs a regulatory overhaul and restructuring to the core to stand tall in the present times.