An evening with Vivek Kaul: The big bad world of bad money

On June 25, we had an engaging webinar by Vivek Kaul, author, journalist and an alumnus of ICFAI. The webinar was moderated by Prof R Prasad and Prof Sudhakar Rao.

Vivek’s talk was based on his book: Bad money-Inside the NPA mess and how it threatens the Indian banking system.

Introduction

Bad money refers to non-performing loans (NPL). These are loans where the interest payments/principal repayments are due for more than 90 days.

NPL is not a new problem for India. But the escape of Nirav Modi after his Rs 12,645 crore fraud with PNB gave a face to the problem. This is a great example of identified life, a very important concept in psychology. We take something seriously when we equate it with a person. (When Amitabh Bachchan contracted Covid, people began to take the virus more seriously. The body of Syrian toddler, Alan Kurdi found on the beach made the Syrian refugee crisis more visible.)

Out of the total amount of Rs 10,36,000 worth of NPLs, Rs 896,000 crores are accounted for by the PSU banks. The biggest defaulter is Bhushan Steels.

The NPL problem has much to do with crony capitalism or the nexus between businessmen and politicians. The economist Thomas Powell had mentioned that when people who have the power to make decisions do not have the required knowledge or vice versa, it would lead to sub optimal outcomes. Powell’s doctrine is very much applicable to the bad money problem in India.

When we consider retail loans, NPL makes up only 2% of the total loans for PSU banks. This is not too different from that of the private sector banks. In this case, PSU banks have both the knowledge and the power to make prudent lending decisions. In case of corporate loans, however, the story is different. NPLs account for 20% of the PSU banks’ total loans. This is a classic case of banks having the knowledge but not the power to take the right decision.

Vivek admitted that it is difficult to get hard evidence for a quid pro quo relationship between politicians and businessmen. It is also not easy to separate out exuberance, incompetence and corruption, all of which might play a role, when a wrong loan decision is made.

How did the NPL problem in India become so big?

A bit of history is in order and we have to go back to the period 2004-06, when the Indian economy grew at 9% each year. The economist Hyman Minsky is well known for his hypothesis of financial instability. He argued that periods of economic prosperity encourage borrowers and lenders to be increasingly reckless. This excessive optimism creates financial bubbles and later these bubbles burst.

Encouraged by the rapid growth during 2004-06, many Indian businessmen borrowed a lot of money even as banks became more willing than ever to write loan cheques for them. Unfortunately, the global financial crisis spoilt the party. At the same time, the Indian government following the Keynesian prescription, decided to increase spending aggressively to boost demand. Moreover, the PSU banks were instructed (This happened during the tenure of Finance Minister Pranab Mukherjee.) to continue to extend loans to corporates even though the business environment had deteriorated. Meanwhile, inflation rose to double digits, leading to higher interest rates. Borrowers found it difficult to repay their loans because their projects were not taking off and also because the interest rates were going up.

There were many corporate defaults during the period 2011-14 when Dr D Subba Rao was the Governor of RBI. But under the principle of regulatory forbearance, the bad loans were not recognized by the banks. The can was kicked down the road using two strategies: Evergreening, i.e., giving fresh loans to replace the old loans and restructuring i.e., interest waive offs and postponement of principal repayments. Strangely enough, Dr Subba Rao did not even mention the non-performing loans problem in his book, “Who moved my interest rates?” In the 1990s, 25% of the loans of the PSUs were NPLs. The RBI had hoped the problem would heal over time. NPL did reduce to 3% of loans over time as the economy grew and the loan volumes increased. The RBI probably had similar hopes in 2011 as well. But loan volumes had become much bigger than the 1990s and the same phenomenon could not be repeated.

It was under Dr Raghuram Rajan (who referred to it in his Varghese Kurien memorial speech in Anand in 2014) that banks started recognizing the problem. By March 2018, NPLs had reached Rs 10,36,000 crores.

Privatization of Indian banking

While the government may not be privatizing banks for political reasons, privatization of banking in terms of loans and deposits has taken place by malign neglect. PSU banks accounted for 75% of loans in 2011 but 10 years later, that figure is 57%. PSUs accounted for 75% of deposits in 2011. Today, their share is 61%.

Indeed, private sector banks have done much better than their public sector counterparts. Kotak Mahindra Bank (KMB) is only a tenth of the size of SBI. Yet, KMB’s market cap (Rs 340,000 crore) is comparable to that of SBI. HDFC Bank’s market cap is more than that of all the non SBI PSU banks combined. Vivek also gave the example of UTI Bank which was promoted by UTI but under a private sector banking license. Axis Bank, as the bank is now called, has done much better than the other PSU banks in terms of market cap.

The cost of poor management of PSU banks

What is the cost of bad money? The government is pumping in money into the PSU banks. This means that capital is getting diverted from other more productive uses.

Vivek explained that had the PSU banks been managed better, their market cap would have been much higher. The government could have sold the shares in tranches and financed the increased spending during the pandemic. Unfortunately, this option is not available and the result is a steep increase in taxes on items like petrol.

Meeting social objectives

Vivek keeps hearing about the social responsibility of the PSU banks and why they should not focus only on profits. Social objectives should not be confused with giving instructions to PSU banks on how they should be doing the lending. These banks should be given autonomy to run their operations well, generate profits and increase their market cap. The government can meet its social objectives by incentivizing the PSU banks suitably. The government itself could meet some of these objectives by selling the shares of well-run PSU banks and raising the necessary funds.

Q&A session

Black money and Bad money

Yes. There are linkages. Many businessmen inflate their project costs from say Rs 15,000 crores to Rs 25,000 crores. They may make a down payment (equity) of Rs 5000 crores. But from the loan of Rs 20,000 crore, they can easily siphon off Rs 5000 crores as they only need Rs 15,000 crores from the bank for the project. This becomes black money. (This phenomenon is also called over invoicing. Exporters siphon money out of the country using a technique called under invoicing. The invoice value is less than the actual value and the buyer parks the difference in a secret account of the exporter.)

Good money and bad money

Yes. There are linkages. Due to bad money, bailouts are required. When good money is diverted from other areas to rescue banks, there are opportunity costs. When restructuring of defaulting corporates happens through resolution (sale of the whole company) or liquidation of assets (sale of the company piece by piece), haircuts (discounts on the loans outstanding) are often given, i.e., part of the face value of the outstanding loan is written off. It is society which bears the cost of these write offs. In case of Bhushan Steel, the largest defaulter in history, the haircut was Rs 21,000 crores. (The company was sold to Tata Steel.)

On Cryptocurrency

Cryptocurrency is not only about technology. Most currencies start off as a private entity but are taken over by the government at some point of time. It is governments which have the right to create money out of thin air (fiat money). Why would any government give up this right? Already, there are signs that the US and Chinese governments have started a crackdown on cryptocurrencies. (Governments are also toying with the idea of launching their own digital currency.) Lack of alignment with the government of the day means that the long-term future of cryptocurrencies is bleak. Moreover, when cryptocurrencies are used for illegal payments such as ransomware, we can hardly expect the government to be a silent observer. (The secrecy surrounding crypto currencies makes them ideal for illegal transactions.)

One of the touted advantages of bitcoin when it was launched, was its limited supply and it could not be created out of thin air. While that may be so, there is nothing to prevent the creation of other cryptocurrencies. That is precisely what we have been seeing.

It is correct to put restrictions on how much the government can expand the money supply. But during times of crises such as the pandemic, if governments expand the money supply, they cannot be faulted. The government is answerable to the public unlike the people who manage cryptocurrencies.

On lending to small businesses

Loans to MSMEs have not really grown in recent years while those to large businesses have grown slightly. Banks are more willing to give loans to large businesses than small businesses as it is assumed that the larger borrowers are more likely to survive. Banks do not understand MSMEs so well. Moreover, there may be political pressure to lend to larger businesses even when there are concerns about their creditworthiness. There is no such pressure in case of small businesses. Incidentally, when small businesses default, banks are more likely to take prompt and stringent action. In the case of large businesses, due to political compulsions, the penal actions taken are often small and delayed.

Vivek recalled a famous saying that if a borrower owes $100 to a bank, it is the borrower’s problem. If the amount involved is $ 1 million, it becomes the banks’ problem. And, if it is $ 1bn, (as the Economist has put it) it becomes everyone’s problem.

Bad money in other countries

The phenomenon of bad money is not limited to India. The US had the savings and loans crisis in the 1980s. We have seen similar phenomena in Sweden and Malaysia too.  Sweden’s financial crisis (1990-1994) was the result of a housing bubble that deflated during 1991 and 1992, and resulted in a severe credit crunch   and widespread bank insolvency.

Concept of bad bank

Creation of bad banks alone will not solve the problem. A bad bank will work properly only if it is incentivized to do so. If it is managed like a typical government institution, we cannot expect it to succeed.

Banks do have systems in place to check the growth of bad money. For example, outstanding amounts in the 31–60-day category are put in a special mention account. But these systems cannot work effectively in an environment of exuberance and political compulsions.

Similarly, there are good officers in the PSU banks. But are they being allowed to function the way they would like to? Banks cannot be run from Delhi by the IAS officers.

On the total value of haircuts

When NPAs are more than 4 years old, they qualify for technical write offs. That means they are taken off the books but efforts to recover the money continue. Some 15-16% of NPAs have been written off so far. Recoveries vary based on the timing and the industry. In case of steel, recoveries have been good (>80%) because the business cycle was favorable. In case of Bhushan Steel, the recovery was only 63% (of the debt of Rs 56,022 crore) as the steel industry was not doing well then. In case of textiles (e.g., Alok Industries), the recovery was low because the sector is not doing well. In general, with average capacity utilization being around 70%, we cannot expect valuations to be high. So, haircuts are large today. Moreover, for an effective liquidation process, there must be a market for distressed assets and accepted methods for valuation. Our bankruptcy process is still in its early days and it will take some time before a mature ecosystem is in place.

On the low interest rates in India

The assumption is that RBI will lower interest rates, loans will pick up and there will be more investments leading to higher GDP growth. But loans can be given only when there are adequate savings. If interest rates are so low and indeed lower than the rate of inflation, people who depend on interest income will have no option but to cut down on their consumption. This will not only be bad at an individual level but even at the level of the economy. Vivek agreed that low interest rates can hurt the economy.

Are our banks safe?

Vivek felt that a better question to ask is: Is our money safe? We can take simple steps in this direction. We should not keep all our money in one bank. Maybe, we should choose one good PSU bank, one good private sector bank and a bank in our locality, where we can get personalized service. Keeping all the money in a local or cooperative bank where the service is good, is not an advisable strategy. A Google search (bank name and Gross NPA) will easily tell us which banks are unsafe. i.e., gross NPA>10%.

On India’s taxation system

India’s taxation system is heavily skewed in favor of the non-salaried rich. It is always preferable to keep a simple tax structure with the same rate for different types of income. Thus, allowing indexation and lower capital gains for investments in stocks/ real estate is unfair when interest income does not enjoy similar benefits.

On what to do with India’ s growing forex reserves

The forex reserves are growing because imports have fallen much more sharply ($ 90 bn) compared to exports ($ 30 bn) during the pandemic. For example, oil imports have fallen as we have needed to commute much less during the pandemic. Foreign travel (tourists and students going aboard) has also decreased. This situation may not persist forever. Moreover, all these reserves do not really belong to the government. Investors have brought money into the country and this has been purchased by RBI by selling rupees. These reserves may flow out of the country if investors choose to exit by selling rupees and buying dollars.

On teaching ethics and corporate governance in Business Schools

Teachers are competing with Netflix for the attention of students! So, these subjects must be taught in a more interesting way, using good content. The classes should be driven by examples. The theory and principles should be inferred from these examples. Prasad added that in our online MBA program, this is exactly the route we are taking. We are also using short nano and micro case studies as the attention span of students is limited. Each of these case studies emphasizes one key principle rather than several principles.

A great session by a very thoughtful and knowledgeable thought leader. Great moderation by Prasad and Sudhakar.

We thank Dr. Vedpuriswar for bringing out the highlights in the form of this note