BANKING What India Could Learn From East Asia < http://www.feer.com > India's relative insulation from the global economic downturn provides it with an invaluable opportunity to revamp its financial system. As East Asia discovered so painfully, the health of the banking system underpins that of the economy as a whole By Joanna Slater/MUMBAI Issue cover-dated September 13, 2001 TO ANYONE IN ASIA, the story has a familiar ring: After years of reckless lending, a state-run bank collapses under the weight of bad loans and bad judgment, triggering a government bailout. This time, however, the setting is not Tokyo or Jakarta, but New Delhi. And the institution in question is the 53-year-old Industrial Finance Corporation of India, or IFCI, an ailing project-lending bank. Early last month, the Indian government agreed to orchestrate a $215 million rescue package. The bailout was the latest sign that all is not well in India's financial sector. Two banks had to be revived in the wake of a stockmarket scam this past spring. The country's largest mutual fund faced a payment crisis in June. Three weak government-owned banks are on life-support. Taken together, it's a humbling wake-up call for a country that has prided itself on avoiding the financial excesses of its neighbours in Asia. Now it seems that the self-congratulation was misplaced. While India escaped the worst effects of the region's economic crisis, it hasn't used that opportunity to get its own house in order. Hidden losses, political meddling and ineffectual bankruptcy laws still plague the country's banks. That's especially true of the splintered state-owned sector, which accounts for 80% of total banking assets. More trouble has arrived in the form of an industrial slowdown that is suffocating the very businesses to which banks are most vulnerable--steel and textiles, for example. While India's problems aren't on the scale of those of Thailand or Korea, there are lessons it could glean from the traumatic financial reforms taking place elsewhere in the region: Consolidate while you can, tackle bad loans early and warn weak banks not to count on a government lifeline. Regrettably, very little of that is happening. Regrettable, because although there may not be a looming financial crisis, the weaknesses of India's banks still act as a significant drag on its economy. A vibrant financial sector would make "a dramatic difference in the economy's growth rate," says Leo Puri, a principal at McKinsey & Co. in Mumbai, who estimates that India could boost GDP growth by 1%-2% through judicious bank restructuring and reform. Without it, India's target of 8%-9% growth for this year is probably wishful thinking. The ultimate goal of such changes would be to get capital to the places where it is really needed. Despite ten years of economic reforms, many Indian banks are still saddled with the baggage of the country's command-economy past. IFCI, for example, was one of several financial institutions whose role was to implement government policy by investing in key infrastructure projects. Likewise, the role of state-owned banks was to mobilize deposits and make loans to certain "priority" sectors like agriculture, with little regard for profit. Even today, 40% of their loans must go to such sectors. For such banks and their older private-sector counterparts, it's been a tough decade (see story on page 52). Competition from younger, nimbler private and foreign banks intensified. Regulatory norms were tightened. Companies began defaulting on their loans as they struggled in the new environment. Banks' balance sheets started to deteriorate. A joint study by credit-rating agencies Standard & Poor's and Crisil estimated that non-performing loans are actually 20%-25% of total loans at India's commercial banks. That's about double the reported figure, since it takes into account India's relatively lax definition of "non-performing" and also the practice of "ever-greening" loans, or advancing fresh funds to prevent defaults. To a certain extent, the balance sheets of Indian banks are buttressed by their large investments in government bonds, which are required to account for 25% of their assets. Nevertheless, the S&P study estimates that India's commercial banks require $13 billion in order to absorb their bad loans and stay solvent. That's a small figure by the standards of other Asian banking wrecks--South Korea, for example, has already spent 137.5 trillion won ($107.5 billion). However, given the large and growing size of its fiscal deficit, the Indian government could ill-afford such an expense--and that makes reform even more imperative. Consolidation is a critical first step. Across Asia, banks are realizing the benefits that come with size: In Korea, Kookmin Bank and Housing & Commercial Bank merged in July, while in Singapore, a spate of mergers finished with the union of United Overseas Bank and Overseas Union Bank in August. In the latter case, the government played a key part in encouraging the process. In India, that role would have to be even larger, since the real challenge lies in the government's own commercial banks--a sprawling collection of 27 different institutions. That situation is "clearly not sustainable," says Roopa Kudva, director of Crisil in Mumbai. Experts say the 27 banks could be reduced to about six, along with a few niche or regional players. Getting there, however, will be no easy matter. Bank mergers usually mean reductions in staff and a loss of power for managers, a combination that is sure to generate fierce political opposition. Merging to become larger, more efficient institutions is only the first part of the recipe. Freeing the public-sector banks from the heavy hand of government interference is another. Already the government has announced it intends to reduce its stake in each of these banks to 33%, but has provided no roadmap for how and when it will do so. With every delay, however, its banks become less competitive. Though some of the stronger state-owned banks have hired outside consultants to revamp their business and invested in technology, they are still very much in a government straitjacket. For example, one executive at a state-owned bank speaks longingly of the ability to choose directors "who can really make a difference in a competitive environment." Even senior executives are appointed by the Ministry of Finance. If your job future depends on government approval, "then your ability to withstand government pressure is much attenuated," says Janmejaya Sinha, vice-president of Boston Consulting Group in Mumbai. Political interference is part of the explanation for the other problem dogging India's banks: bad loans. "It's an open secret that many of these projects that used to be funded had compulsions other than commercial considerations," says Ambreesh Srivastava, a director at ratings agency Fitch in Singapore. Unlike their counterparts elsewhere in Asia, Indian banks didn't have a weakness for investing in real estate or the stock market. Instead, their bad loans tend to be concentrated in heavy industries, infrastructure projects or "priority" sectors. It's safe to say that the Asian Crisis helped scare Indian bankers into looking at the problem. "One of the things we learned from the rest of Asia is that you have to improve asset quality," says Anil Khandelwal, executive director of the state-owned Bank of Baroda. And to its credit, the Reserve Bank of India has tried to be pro-active about the situation by regularly checking up on banks and creating its own debt restructuring mechanism. However, these are baby steps. Experts fear that if India's industrial slowdown continues, the level of non-performing loans will continue to rise. Some have suggested that India needs an asset-reconstruction agency charged with selling off bad loans--something along the lines of the Korea Asset Management Corporation. But as elsewhere, the success of such an agency depends on effective bankruptcy laws and a relatively speedy judiciary process. India currently has neither. As the rest of Asia has painfully learned, nothing focuses a government on financial reform like a crisis. Some observers in India sound almost wistful that such a crisis isn't yet looming, given the government's relative apathy on banking reform. "The government has no clear agenda for the evolution and development of the financial system," says McKinsey's Puri. Finding a way to deal with weak banks is one item on that elusive agenda. Three state-owned banks--UCO Bank, Indian Bank and United Bank of India--have been chronically sick for much of the last decade despite receiving cash infusions from the government. While the Finance Ministry has been taking a tougher stance of late, few believe these banks will actually close. An oft-cited story is that deposits at Indian Bank continue to grow, irrespective of its dire state, because there is an assumption that the government is obliged to come to its rescue. Without bold moves from the government, the banking sector will limp along--a creaky state of affairs where no one wins, least of all the Indian economy. And if India can learn anything from the rest of Asia, it's this: It is better to take tough decisions before they're taken for you. ---------------------------------------------------------------------- ---------- BAD LOANS REDEFINED Are the bad loans in India's banking system much higher than reported? Internationally, a non-performing loan is one on which no payments of interest or principal have been made for 90 days. For Indian commercial banks, the same is true only after 180 days; for the project-lending institutions, an NPL is where the principal payment is in default for over a year or interest payments are in default for more than 6 months. ---------------------------------------------------------------------- ---------- IDBI'S BRAVE NEW WORLD By Joanna Slater >From its towering office building at the southern tip of Mumbai, the Industrial Development Bank of India, or IDBI, has a bird's-eye view of the city. It's a fitting perch for the country's second largest bank, created by parliament in 1963 to oversee India's economic development. These days, however, IDBI's main concern is nursing its own financial health. For IDBI the years since India's economic opening-up have been full of hazards. A project-lending bank specializing in infrastructure, it invested in capital-intensive industries like steel in the early 1990s, businesses that have since suffered deep setbacks. At the same time IDBI lost its traditional source of funds--preferential government loans--and was forced to raise money on the open market. So while bad loans are up--now 15% of assets--profits are tumbling. Though the state-run bank says it's in no need of a bailout, it "expects some special dispensation from the government," says V.P. Singh, the bank's executive director, in view of its role in promoting infrastructure. The bank has two options: transform or crumble. The former is the route followed by ICICI, a fellow project-lender that successfully moved into new businesses. With the help of Boston Consulting Group, IDBI is attempting to become a regular commercial bank, which should give it the supply of low-cost funds--consumer deposits--that it requires. Time, however, is of the essence.
