Indian banks need to be stress tested

• The reasons for the banking mess are well known. What India is now battling is the inevitable result of a credit binge sponsored by the previous government. Bankers too misread the growth trajectory of the Indian economy after the quick recovery from the effects of the North Atlantic financial crisis. Individual projects got stuck in the regulatory morass during the last years of the second Manmohan Singh government.
• It is now time to move beyond the game of pinning blame. There is a more immediate concern: what should be done?
• The first task should be to throw more light on the extent of the problem. Reserve Bank of India (RBI) governor Raghuram Rajan deserves credit for pushing banks to reveal the true state of their loan books. These asset quality reviews come just a few months after regulatory changes that push the promoters of defaulting companies to either bring in fresh equity or lose control of their enterprises.
• Recent bad loan disclosures by banks have lent credence to the view that the problems run deeper than what senior bankers are admitting. Some of the estimates of bad loans are indeed scary. Both the RBI governor and the finance minister have spoken about how the worst fears of some analysts are unfounded—or what Rajan described in a recent speech as the “wild claims made by some financial analysts”.
• The central bank needs to do rigorous stress tests of individual banks to quell the worst fears. RBI reveals the results of its systemic stress tests in its Financial Stability Report. The central bank now needs to provide the public similar information on individual banks. This is not just in the interests of transparency. The banks have to raise capital to meet the Basel III norms by 2019—and that will be difficult when there are widespread fears about the financial health of lenders.
• The second challenge is how to deal with the mountain of bad debts that now sit in bank books. Banks will be in no position to fund an economic recovery unless they have adequate capital. One popular demand is that the Narendra Modi government should clean bank balance sheets through some version of the Troubled Assets Relief Programme (Tarp) that the US designed to clean up its financial sector after the collapse of Lehman Brothers.
• There are two major problems here. Tarp dealt with securities that were traded in the market. So, the US government could eventually liquidate its holdings at a profit. An Indian Tarp would mean the acquisition of unfinished power plants that will not be easy to sell. The more potent problem is that such a programme will be seen as a bailout of powerful business houses by the Indian taxpayer.
• There continue to be calls for the finance minister, in the coming budget, to allocate a substantial sum of money as capital infusion into the public sector banks. In a column published in this newspaper on Friday, Montek Singh Ahluwalia even suggested that capital transactions of this type need not be accounted for in the fiscal deficit calculations, if one goes by the standard International Monetary Fund format. But—leaving aside the national income accounting issues—even such a capital infusion will be funded by taxpayers to the benefit of defaulting businessmen.
• As the owner of most of the largest banks in the country, the government will at some point have to bring capital into the public sector lenders. But such a bank bailout should not in effect become a bailout of powerful business groups. The pressure needs to be kept on them to restructure, deleverage, repay their loans—or lose control of their companies.