India's banks clean up

By Rashmi Kumar

The collapse of Yes Bank this year came as little surprise to those who had followed the rise and fall of this ambitious, private-sector lender and its appetite for risky loans.

And yet again, a state-owned bank – State Bank of India – was obliged to come to the rescue, raising questions about the best way to handle such bank failures.

Yes Bank’s fall provides another alarming jolt for India’s financial sector, which has gone through a dramatic transformation over the last couple of years, testing the resilience and strength of banks, non-banks and corporations alike, and – hopefully – weeding out the best from the rest.

The industry’s travails started with the default of Infrastructure Leasing & Financial Services, a sprawling infrastructure development and finance company, in September 2018.

The non-banking financial company (NBFC) defaulted on its commercial paper obligations, on its interest payments on non-convertible debentures and in servicing inter-corporate deposits. Its liquidity dried up as shareholders failed to provide sufficient support.

Bankers and investors knew that IL&FS was under stress, but it was regarded as a state-owned entity, so few people realized the real extent of its woes.

“You didn’t expect it to be in trouble,” says Dipak Gupta, a joint managing director on Kotak Mahindra Bank’s board. “You expect a backup mechanism to come out if it gets into trouble – and that didn’t happen.”

IL&FS went under, “and then there were at least two to three dozen such entities with similar types of problems. So then you start expecting each one of them to get into a similar trap. That’s what happened, and I don’t think we’re out of that still”.

After IL&FS defaulted, the government appointed Uday Kotak, founder and chief executive of Kotak Mahindra Bank, as chairman in an attempt to get the infrastructure financier out of trouble.

A liquidity crunch followed soon after IL&FS’s default. NBFCs were – until then – a key source of financing for real estate companies because banks were reluctant to lend to the sector.

IL&FS’s downfall had a domino effect on other NBFCs with a focus on infrastructure or housing finance. They also retreated from lending to property credits as they faced financial woes.

For example, Dewan Housing Finance Corp, another NBFC, defaulted on payments on both bonds and commercial paper in August 2019.

Against that backdrop, cracks started to emerge in other parts of India’s financial system, such as private sector lenders. Yes Bank, which was founded by Rana Kapoor and was among the fastest-growing lenders four years ago, came under scrutiny over its corporate governance even before it had to be bailed out by the government this March.

At ICICI Bank, former chief executive Chanda Kochhar quit in October 2018 over allegations of corporate misconduct; Axis Bank had its knuckles rapped for misreporting its non-performing loan numbers.

Among the cooperative banks, lending irregularities came to light at Punjab and Maharashtra Cooperative (PMC) Bank at the end of September 2019. The lender had excess exposure to one client – Housing Development and Infrastructure – which was facing bankruptcy proceedings.

PMC had failed to disclose a large chunk of bad loans. When its troubles emerged, the Reserve Bank of India stepped in, first limiting withdrawals by depositors to Rs10,000 ($135), before raising the limit to Rs25,000.

Widespread panic among its customers led to a run on the bank.

In a rare move, the RBI even put out a statement on October 1, 2019 to calm nerves, saying the Indian banking system was “safe and stable” and that there was “no need to panic”.

At the end of the same month, the RBI fined another cooperative bank, Jalgaon Peoples Co-operative Bank, Rs2.5 million for non-compliance with rules on reporting NPLs.

Janata Sahakari Bank was fined Rs10 million for breaking similar rules.

The escalating number of cases – and the fact the central bank had to issue a note to soothe the market – raised concerns among international and domestic bankers, investors and corporations about whether or not the Indian financial system was a ticking time bomb.

A big chunk of the investment in India is done through mutual funds. Assets under management of the Indian mutual fund industry have jumped about 3.5 times from Rs7.6 trillion (or roughly $100 billion) as of January 31, 2010, to Rs27.9 trillion on January 31, 2020, according to data from the Association of Mutual Funds in India.

About 70% of the portfolio consists of debt funds, making them among the worst impacted when the country’s debt market tumbled.

“Mutual funds were taking hits on the debt they were holding for the first time in recent memory because companies were defaulting on bonds,” says the head of investment banking at a state-owned bank.

“They had a lot of other exposures that also went sour, meaning they couldn’t do certain kinds of financing, like promoter financing, that they were doing in the past,” the banker adds. “So they have been unable to provide liquidity to the downstream segments of the economy, which are facing a liquidity crisis.”

The investment banker adds that banks are flush with liquidity, but that funds are not flowing to some of the key industries in India, such as NBFCs, real estate and the construction industries, as well as to small and medium-sized enterprises. That has been the main reason for the slowdown in growth in the country.

India’s gross domestic product grew 4.7% in the quarter to December 2019, its slowest pace in six years. But the nation has faced a sluggish economy for much longer, in part due to a dramatic fall in consumption and a banking sector weighed down by bad debts.

India’s GDP is expected to increase by just 5% in the year to March 31, 2020, one of its lowest rates of growth in more than a decade.

Credit expansion has also slowed, even though the RBI cut rates to new lows and pumped more liquidity into the financial system.

Add to that the fact that problems have been detected across the spectrum of the financial industry – in private and state-owned banks, cooperative banks as well as NBFCs – with few immediate solutions in hand, and investors have good reason to be worried.

“This is a time of churn,” says Akhilesh Tilotia, Axis Bank’s head of strategy and new initiatives.

“Many of the previous business models of banks and NBFCs have come into question, especially because their approach of lending long and borrowing short has not quite worked out.”

The realization has led to a number of changes in the last year. For example, ICICI has worked hard to shore up its reputation in the aftermath of Kochhar’s fall from grace, putting new management in place.

Axis Bank appointed Amitabh Chaudhry as its new chief executive in January 2019, hiring him from HDFC Life, an insurance company that he had led for nine years.

Yes Bank’s chief executive Ravneet Gill, who was brought on board in March 2019 after leading Deutsche Bank’s India business, has seen the lender through a turbulent period; it is now under the control of the Reserve Bank of India.

At the state-owned banks, the government has renewed its focus on consolidation. Five of State Bank of India’s associates were merged with the parent in 2017, while Dena Bank and Vijaya Bank were brought under the Bank of Baroda umbrella in 2018.

Finance minister Nirmala Sitharaman promised further consolidation last year when she said the government would create four banks from 10 state-run lenders.

State bank mergers became a more urgent matter after a $2 billion fraud was uncovered at Punjab National Bank in early 2018 and allegations were made of shady lending by Bank of Baroda to the Gupta brothers in South Africa.

“We have seen significant movement taking place,” says Tilotia of the numerous management changes in the last year. “Where the equilibrium is, when the dust settles on some of these issues, is an open question. But this will throw up some interesting opportunities. Some market spaces can get vacated and hence some market spaces will be created.”

According to Kotak, India’s financial and real estate sectors are undergoing a “significant cleansing process”, while simultaneously also witnessing the “Darwinian survival of the fittest”.

But senior bankers in India are adamant there is no liquidity crisis, even in the wake of Yes Bank’s failure.

“The banking community saw this coming,” says the head of investment banking at a state-owned bank. “It was evident in Yes Bank’s stock price fall in the past year, so we all knew some bailout had to happen. But liquidity with banks is ample, and will remain ample. However, pushing this liquidity to sectors that are hungry for capital will remain a challenge.”

Nitin Chugh, chief executive of Ujjivan Small Finance Bank, admits the spate of negative headlines from the country’s financial sector has shaken the confidence of international investors. But within all the bad news, there are lessons to be learnt too.

“All these [incidents] have taught everybody to take risk management and governance very, very carefully and seriously,” he tells Asiamoney.

“It was a setback; it was avoidable; but now that it has come out in the open, [the firms] that had to go through it have gone through it.”

Kotak adds: “One of the most important things in financial services is not about the ability to say yes, it is as much about the ability to say no [to lending to high-risk credits].”

India’s banks and non-banks would do well to pay heed.

India stood out for a handful of things in 2019, none of them very positive. On the economic side, growth stumbled, bad loans grew and the government struggled to revive GDP.

On the political front, the ruling Bharatiya Janata Party (BJP) came out with two controversial measures.

The first was in August 2019, when Delhi revoked Muslim-majority state Jammu and Kashmir’s constitutional autonomy and split it into two federal territories, tightening the government’s grip on the region.

The second came last November, when Narendra Modi’s government passed a citizenship law allowing migrants of nearly every south Asian faith to get citizenship status in India, except Muslims.

Modi’s two announcements triggered protests in the capital New Delhi: scores have been injured and many killed in clashes.

In Mumbai, the financial hub of India, Asiamoney found that while bankers privately admitted their concerns about these developments and how they could hurt international investor sentiment in the longer run, they were more worried about how the Modi government would revive the economy.

“Some of the [economic] issues are not easily controllable,” Dipak Gupta, joint managing director on Kotak Mahindra Bank’s board, tells Asiamoney. “How do you fight a demand problem, when in the short term, you just can’t do it? You need long-term solutions, and the government has been trying various things.”

Gupta cites the example of the corporate tax rate cut, announced in 2019 to give a fillip to long-term investment.

“Did it get fuelled? Yes,” he says. “But it’ll take time. You cannot see it manifest into growth and immediate demand overnight. And it’s not just one solution that will get us there.”

The Reserve Bank of India has taken some action too. It cut rates by about 135 basis points over five straight monetary policy meetings in 2019, before standing pat. It has also taken steps to boost lending to micro, small and medium-sized enterprises and the real estate sector.

In addition, parliament is reportedly planning to pass a bill amending India’s banking regulations to bring the banking-related operations of cooperative banks under the direct purview of the central bank and thus avoid a repeat of the débâcle at Punjab and Maharashtra Cooperative Bank in 2019.

The fraud at PMC forced the RBI to publish an unprecedented note calling for calm among investors and financial markets.

Akhilesh Tilotia, Axis Bank’s head of strategy and new initiatives, says the RBI’s signal that the system was stable was a good move and helped inspire some confidence. But there’s still a long way to go for both the central bank and the ministry of finance to get a stronger handle on the goings-on at cooperative banks or state-backed lenders.

“If there are frauds, how do you prevent those frauds from happening?” asks Tilotia. “If there are corporate governance challenges, what sort of penalties get put and what sort of checks and balances can come in? I think those are systemic issues that the government continues to focus on and those are the right sets of things to focus on.”