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The Unfinished Agenda: Restoring Public Sector Bank Health in India (Viral V Acharya, Deputy Governor, Reserve Bank of India - September 7, 2017 - Speech delivered at the 8th R K Talwar Memorial Lecture organised by the Indian Institute of Banking and Finance at Hotel Trident, Mumbai)

The Unfinished Agenda: Restoring Public Sector Bank Health in India (Viral V Acharya, Deputy Governor, Reserve Bank of India - September 7, 2017 - Speech delivered at the 8th R K Talwar Memorial Lecture organised by the Indian Institute of Banking and Finance at Hotel Trident, Mumbai) - News and Press Release - Dated:- 8-9-2017 - Good evening, friends. I am grateful to the Indian Institute of Banking and Finance (IIBF) for inviting me to deliver the 8th R K Talwar Memorial Lecture. Every institu .....

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wrecked brother, Seeing, shall take heart again. I hope that I can do some justice today to the rich legacy left behind by Mr Talwar, considered as the State Bank of India (SBI) s greatest Chairman, the father of Small Scale Industries in India, a banker ahead of his times who put tremendous emphasis on a comprehensive credit appraisal culture at SBI, and someone who had the courage to stand up against political pressure on his bank to undertake targeted lending to undeserving borrowers (an epis .....

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the year, I will focus on what remains, to my mind, the most important unfinished agenda in the journey we have embarked upon to resolve our stressed assets problem, viz., that of restoring public sector bank health in India. I will indirectly end up conveying why bank credit growth and transmission are weak at the present. I would like to contend that a primary cause for the recent slowdown in our growth is the stress on the banking sector s balance-sheet, especially of public sector banks. As .....

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Figure C) is raised to international standards and made commensurate with the low loan recoveries in India. When bank balance-sheets are so weak, they cannot support healthy credit growth. Put simply, under-capitalized banks have capital only to survive, not to grow; those banks barely meeting the capital requirements will want to generate capital quickly, focusing on high interest margins at the cost of high loan volumes. The resulting weak loan supply (see in Figure D, the steady decline in lo .....

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as a strong effect on bank loan supply: a one percentage point increase in a bank s equity-to-total assets ratio is associated with a 0.6 percentage point increase in its yearly loan growth. In fact, if a banking system remains systematically undercapitalized and new lending is not kept under a tight supervisory watch, then the economy can suffer significantly from a credit misallocation problem, now commonly known as loan ever-greening or zombie lending . In particular, undercapitalized banks h .....

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of them violating the minimum regulatory capital requirements. By ever-greening these loans, banks effectively delay taking a balance-sheet hit, while taking on significant risk that their borrowers might not regain solvency and remain unable to repay, now even larger loan payments. While unproductive firms receive subsidized credit to be just kept alive, loan supply is shifted away from more creditworthy firms. Adequate bank, more generally, financial intermediary, capitalization is thus a pre .....

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the early 1990s, a massive real estate bubble collapsed in Japan (see Figure 1). This caused problems for Japanese banks in two ways: first, real estate assets were often used as collateral; second, banks held the affected assets directly, so that the decline in asset prices had an immediate impact on their balance sheets. These problems in the banking system quickly translated into negative real effects for borrowing firms along the lines I laid out above. Subsequently, the Japanese government .....

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l estate exposure so that these half-hearted measures failed to adequately recapitalize the Japanese banking sector. Table 1. Capital injection programmes in Japan (in trillions of yen) Legislation Date of injection Amount injected Financial Function Stabilization Act 3/1998 1.816 Prompt Recapitalization Act 3/1999-3/2002 8.605 Financial Reorganization Promotion Act 9/2003 0.006 Deposit Insurance Act 6/2003 1.960 Act for Strengthening Financial Functions 11/2006-3/2009 0.162 Source: Hoshi and Ka .....

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percentage of zombie firms increased from roughly 5% in 1991 to roughly 30% in 1996. In related work, Mariassunta Giannetti and Andrei Simonov (2013) found that banks that remained weakly capitalized after the introduction of the recapitalization programmes provided loans to impaired borrowers, while well-capitalized banks increased credit to healthy firms. The authors estimated that the credit supply to healthy firms could have been 2.5 times higher in 1998 if banks had been recapitalized suffi .....

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ballero, Takeo Hoshi and Anil Kashyap (2008) showed that, as a result of these spillover effects, healthy firms that were operating in industries with a high prevalence of zombie firms had lower employment and investment growth than healthy firms in those industries that did not suffer from zombie firm distortions. They estimated that due to the rise in the number of zombie firms, typical non-zombie firm in the real estate industry experienced a 9.5% loss in employment and a whopping 28.4% loss .....

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dered unsustainable. For instance, from mid-2011 to mid-2012, the spreads of Italian and Spanish 10-year government bonds increased by 200 and 250 basis points, respectively, relative to German government bonds. Since this deterioration in the sovereigns creditworthiness fed back into the financial sector (Acharya et al, 2015), lending to the private sector contracted substantially in Greece, Ireland, Italy, Portugal, and Spain (the GIIPS countries), as shown in Figure 3. In Ireland, Spain, and .....

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ldings, in addition it created gambling-for-resurrection incentives for weakly capitalized banks from countries in the European periphery. These banks sought to increase their risky domestic sovereign bond-holdings even further as they were an attractive bet to rebuild capital quickly given zero risk-weights. This incentive led to a crowding-out of lending to the real economy, thereby intensifying the credit crunch (Acharya and Steffen, 2014). This vicious cycle of poor bank health and sovereign .....

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y of 2012, saying that the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. There is now ample empirical evidence that the announcement of the OMT programme significantly lowered sovereign bond spreads, as shown by Figure 4. By substantially reducing sovereign yields, the OMT programme improved the asset side, the capitalization, and the access to financing of banks with large GIIPS sovereign debt holdings. Due to its positive effect on banks capital, .....

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rlying growth momentum remains weak. Unemployment is only falling very slowly. And confidence in the overall economic prospects is fragile and easily disrupted, feeding into low investment. An important reason why the positive financial developments did not fully transfer into economic growth is as follows: An indirect recapitalization measure like the OMT programme produced Treasury gains for banks (much like our policy-rate cuts do); such a measure allows the central bank to benefit banks that .....

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he announcement but remained nevertheless weakly capitalized, extended loans to existing low-quality borrowers at interest rates that were below the rates paid by the most creditworthy European borrowers (high-quality public borrowers in non-GIIPS European countries, e.g., Germany), a strong indication of the zombie lending behaviour. Such lending did not have a positive impact on real economic activity of the zombie firms: neither investment, nor employment, nor return on assets changed signifi .....

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ared to a scenario in which the proportion of zombies stayed at its pre-OMT level. At extremis, for an industry in the 95th percentile increase in zombie firms, healthy firms invested up to 40% less capital and experienced employment growth rates up to 15% lower. The Indian story: Can we end it differently? In many ways, the problems experienced in Japan and Europe have been rather similar. Both regions went through a period of severe banking sector stress (although triggered by different causes .....

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arking a panic on financial markets when disclosing more transparent information about the health of banks. In Europe, introducing proper recapitalization measures has been challenging due to the political circumstances and constraints of the Eurozone. In contrast to a single country like Japan, 19 member states have to come together in the Eurozone and decide on a particular policy measure. In addition, even if a particular policy is helping the Eurozone as a whole, it might not be optimal for .....

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mon man. With this overall objective, let me first turn to what I consider the positives of the balance-sheet resolution agenda that the Reserve Bank and the Government of India have embarked upon. I will then highlight the unfinished part of this agenda - its Achilles heel - the lack of a clear and concrete plan for restoring public sector bank health. Resolution of Stressed Assets To address cross-bank information asymmetry and inconsistencies in asset classification, the Reserve Bank created .....

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ized as NPAs. In the absence of an effective, time-bound statutory resolution framework, various schemes were introduced by the Reserve Bank to facilitate viable resolution of stressed assets. While the schemes were designed, and later modified, to address some of the specific issues flagged by various stakeholders in individual deals, the final outcomes have not been too satisfactory. The schemes were cherry-picked by banks to keep loan-loss provisions low rather than to resolve stressed assets .....

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Ordinance 2017 (since notified as an Act) and the subsequent actions taken thereunder, have made the IBC a lynchpin of the new resolution framework. There were legitimate concerns that if the Reserve Bank directs banks to file accounts under the IBC, it would enter the tricky domain of commercial judgments on specific cases. However, the approach recommended by the Internal Advisory Committee (IAC) constituted by the Reserve Bank for this purpose has been objective and has allayed these misgivin .....

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in place a viable resolution plan within the timelines, these cases also will be referred for resolution under the IBC. The Reserve Bank has also advised banks to make higher provisions for these accounts to be referred under the IBC. This is intended to improve bank provision coverage ratios (see Figure C) and to ensure that banks are fully protected against likely losses in the resolution process. The higher regulatory minimum provisions should enable banks to focus on what the borrowing compa .....

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as the first signs of incipient stress are evident or when covenants in bank loans are tripped by the borrowers. Once a default happens, the IBC allows for filing for insolvency proceedings, time-bound restructuring, and failing that, liquidation. This would provide the sanctity that the payment due date deserves and improve credit discipline all around, from bank supply as well as borrower demand standpoints, as borrowers might lose control in IBC to competing bidders. Whither are we headed on .....

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ry few days, I wake up with a sense of restlessness that time is running out; we have created a due process for stressed assets to resolve but there is no concrete plan in place for public sector bank balance-sheets; how will they withstand the losses during resolution and yet have enough capital buffers to intermediate well the huge proportion of economy s savings that they receive as deposits; can we end the Indian story differently from that of Japan and Europe? The Government of India has be .....

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announced. However, given the correctly recognized scale of NPAs in the books of public sector banks and the lower internal capital augmentation given their tepid, now almost moribund, credit growth, substantial additional capital infusion is almost surely required. This is necessary even after tapping into other avenues, including the sale of non-core assets, raising of public equity, and divestments by the government. The Cabinet Committee on Economic Affairs has recently authorised an Altern .....

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in-principle approval by the Alternative Mechanism. This could provide an opportunity to strengthen the balance sheets, management and boards of banks and enable capital raising by the amalgamated entity from the market at better valuations in case synergies eventually materialize. All of this is good in principle. There are several options on the table and they would have to work together to address various constraints. What worries me however is the glacial pace at which all this is happening .....

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asing stock markets is plentiful? What are the bank chairmen waiting for, the elusive improvement in market-to-book which will happen only with a better capital structure and could get impaired by further growth shocks to the economy in the meantime? Can the government divest its stakes in public sector banks right away, to 52%? And, for banks whose losses are so large that divestment to 52% won t suffice, how do we tackle the issue? Can the valuable and sizable deposit franchises be sold off to .....

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