On borrowed time

The Indian government is backing a new bankruptcy code to reform its inefficient banking system and improve productivity in the corporate sector.

Will India have a proper working bankruptcy law in place soon? The country’s premier Narendra Modi certainly thinks so.

At a technology summit in Bengaluru in the first week of October, Modi said his government was actively “working on a new bankruptcy code and a company law tribunal” intended to simplify the tax code, ease the process of doing business onshore, and deal with issues that often varied from state to state, such as how contracts were enforced and how companies were created and governed.

This matters when you consider the underlying purpose of the pending law, which is to prop up and inject world-class levels of expertise, governance and purpose into an often-moribund domestic banking sector.

By any measure, India’s lenders, barring a selection of standout cases in the private sector, such as Axis Bank and Kotak Mahindra Bank, are in a terrible muddle. Public-sector banks (PSBs) control around 75% of the lending industry. Typically, they are bloated (27 PSBs employ a total of more than 850,000 heavily unionised staff), less profitable than their private-sector peers, and wasteful in that regular injections of capital usually generate not gratitude, but calls for yet more state aid.

Most look benevolently on clients, who overborrow to fund stalled industrial projects, typically in industries like power, steel, real estate and infrastructure, and then fail to repay debts. This process of rolling over or “evergreening” loans undermines the financial and economic health of the industry, as well as the country. Stressed assets made up around 11.1% of all lending across the banking sector as at end-March 2015, up from 10% a year ago, according to data from the Reserve Bank of India, though that level is far higher at many PSBs.

Aditya Narain, equity strategist at Citi India, sees this as a “big challenge” as it hurts banks’ profitability, dilutes their capital base and dents their ability to lend.

There are often stark disparities between private and public-sector lenders. In the second quarter of 2015, net interest income grew 18% at private lenders, but half that at PSBs. Kotak Institutional Equities Research notes in an August 4 report that lending grew 19% year on year in the three months to end-June at private-sector banks, but just 6% at PSBs. Total non-performing assets across the banking sector stood at US$39.3bn at end-March 2015, with the highest NPA ratios coming from United Bank of India (21.5%), Central Bank of India (21.3%) and Indian Overseas Bank (19.4%) – all PSBs. More than a third of all NPAs are related to longstanding loans extended to just 30 large state corporations, most of which are accustomed to securing cheap capital on a long-term basis.

After decades of ignoring the problem, or throwing cash its way in the hope that it will simply disappear, the government has finally, under Modi, decided to act. In the past, said Firat Unlu, chief India economist at the Economist Intelligence Unit, PSBs were used “to fund unprofitable ventures, bogging them down when they should be funding a critical expansion of infrastructure”, creating a mountain of toxic loans that corroded the financial sector. Modi’s response was to pledge to put an end to what he described as “lazy banking”.

In this context, Modi’s action is a mix of the reliable and the revolutionary. Over the four years to end-March 2019, Rs700bn (US$11bn) will be injected into underperforming state banks. Yet, this time, the recapitalisation will come with a twist. Some of the cash will be spent on ensuring that India’s lenders meet new Basel III bank capital targets. The hope is that the extra cash will act as a stimulus, creating six powerful and well-run PSBs capable of competing head-on with PSBs. In this context, those who see Modi as a private-sector zealot could not be more wrong: So far, India’s political leader has avoided the temptation to privatise any state lender, no matter how badly run.

Nevertheless, few doubt he has the desire to build a banking system fit for the 21st Century. Already this year, the RBI has pushed through measures that force banks to classify more loans as non-performing and to set aside higher loan-loss provisions. In the last week of September, the central bank said domestic lenders would be allowed – indeed, required – to force tardy borrowers to repay loans, even before they had officially been declared non-performing. Lenders now have the right to convert loan debt to equity and to assert more control over the operations of troubled corporate borrowers.

The final and essential step is the introduction of a proper bankruptcy law, aimed at bringing about the sort of creative destruction on which more open economies thrive. India’s Congress Party, which Modi’s Bharatiya Janata Party unseated in last year’s general election, failed to approve the law during its time in power, but; in opposition, it appears determined not to let it pass. Modi himself has soft-pedalled on the timing of the bill, promising its advent, but declining to set a specific date. Even if the law is approved, the battle may have only just begun. While the reform looks good on paper, “the question is how it will be implemented”, said the EIU’s Unlu. What, he wonders, will lenders do once they have converted troubled loans into equity? Given the tensions that exist in India between capital and labour, it is hard to see this being a cosy cohabitation.

Either way, a powerful and watertight bankruptcy law is essential for a country trapped between the protective laws that still gird its recent agrarian past and the enterprising, high-tech powerhouse it hopes to become.

“Defaults would be a positive step, as they would free up capital and show that the financial system is working as it should,” said the EIU’s Unlu. “The present system, in which forbearance is a regular feature, is unhealthy for banks and businesses alike in the long term. If implemented properly, bankruptcy reforms could be one of the largest and most significant drivers of change in Modi’s first term in office.”

Citi’s Narain points out that, once a robust bankruptcy code is in place, banks will hold many more cards in terms of dealing with their asset-quality issues, and with recalcitrant borrowers. “This is part of the institutional changes that are needed to improve the asset quality environment – both for now, but also, more tellingly, for the longer term,” he said.