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India's private banks are rightly in the cross-hairs

But the authorities should also take a tougher line with failing state-backed lenders

Indian banking regulators must keep an eye on both private and state-owned institutions for irregularities.

It has long been an article of faith among advocates of economic reform in India that the country needs more private banks, and fewer government-owned ones.

The argument has been built on the performance of a clutch of private banks that started operations at various times since the mid-1990s: stellar records on the stock market, valuations that go up to four times book value, vastly better customer service than state banks through the use of technology, and a history of innovation.

This has presented a sharp contrast to the 21 government-controlled banks which account for 70% of assets in the system. They have been dogs in the market, their unionized employees care little for customers, and their managements seem to have little ability to assess credit risk. So these banks are up to their ears in bad loans -- only two state banks reported post-tax profits in the year to March. Aggregate losses during the year exceeded $13 billion, at the rupee-dollar exchange rate of the time.

The Narendra Modi government has devoted much effort to trying to stop the rot in the state-controlled banks, so far with limited success. Billions of dollars in public funds have been pumped in as capital year after year, new bankruptcy rules have been legislated to facilitate loan recovery, some weak banks have been forced to merge with stronger ones, and more than half of lenders have been put in tight operating straitjackets by the banking regulator.

So it has been seen by many as a no-brainer that the country needs more private banks, and the privatization of at least some government-owned lenders. But the story of good and bad has got complicated.

Recent months have seen the Reserve Bank of India, the banking regulator, crack down on private bankers too. High-profile chief executives of Axis Bank and Yes Bank are on their way through the exit door after the RBI denied them fresh long-term tenures. Before changes at the top were ordered, the two banks had under-reported bad loans to the extent of a billion dollars in one case and $600 million in the other, which RBI forced them to make public.

A third private bank chief executive, Chanda Kochhar of ICICI Bank, resigned earlier this month in the wake of allegations of undisclosed conflicts of interest. Her businessman-husband allegedly had substantial dealings with prominent businessmen who were bank customers. The bank's board of directors did not cover itself in glory, first backing Ms. Kochhar and only belatedly ordering an independent inquiry that is still in process. She has denied any conflict of interest, asserting that she did not know of her husband's business dealings.

This has fueled a growing debate on the performance of private sector boards, and whether independent directors are fulfilling their role of keeping a check on management. The debate has been sharpened by dramatic events that have engulfed the Infrastructure Leasing and Financial Service Company, or IL&FS, and its reported $17 billion debt mountain.

The infrastructure development company, which has defaulted on a series of loans, is large enough, with its 300-plus subsidiaries, to be considered systemically important. But while three subsidiaries are listed, the parent entity is closely held -- a structure that does not encourage transparency. The biggest shareholder is the state-controlled Life Insurance Corp., India's leading insurer, followed by Orix, a diversified Japanese financing company, and the Abu Dhabi Investment Authority.

The company's board was dominated for three decades by a powerful chief executive, Ravi Parthasarathy, an ex-Citigroup banker who stepped down on health grounds in July, even as his company began defaulting.

With him in the chair, the board approved dividend payouts and executive pay hikes even as profits turned into losses. The music stopped when short-term loans could not be rolled over. Parthasarathy has so far offered no comment.

IL&FS's opaque structures made even the basic facts hard to grasp. That might partly explain another systemic failure -- credit rating agencies handed out top ratings just weeks before the defaults began. Half the debt is owed to banks. The rest is split between mutual funds, which have now been put under redemption pressures, and shadow banks, which face liquidity challenges.

In a development which will hardly reassure creditors, the Serious Frauds Investigation Office is looking into improper fund transfers between IL&FS group companies.

Meanwhile, the central bank has not covered itself in glory, since it failed as the regulator to take action before the defaults began, such as insisting on the injection of fresh equity. It has, at least, responded promptly to the crisis by pumping cash into the system to limit contagion.

The scandal has tarnished the positive image of private sector financial entities. There was widespread relief last week when the government took control of IL&FS, replacing the independent directors with a handpicked group charged with preventing the company's financial problems from provoking a system-wide crisis. The new part-time board chair is a well-regarded private banker, Uday Kotak.

The problems in private banks have come in handy for left wing ideologues and for the political class, which remains committed almost across the board to persisting with the primacy of government banks, despite the cost to the exchequer of the endless capital injections. The already miniscule chances of a structural overhaul have become even less likely than before.

On the positive side, the central bank's actions against the chief executives of Yes and Axis have sent out a message that the regulator is ready to intervene at non-state lenders..

Among wealthier bank customers who are primarily the clients who have migrated to private banks, confidence in their lenders remains unshaken. Their healthy levels of capitalization go well beyond the minimum stipulated and their gearing ratios are therefore conservative, in sharp contrast to IL&FS. Despite the new shadow on their internal practices and governance standards, private banks remain vastly superior to their government-owned counterparts.

In part this is because the private banks that do not do well -- such as Global Trust Bank and Times Bank -- are taken over or merged with others. Those that remain independent are the good performers. It would make a difference if the government's banks could be similarly culled; but no political party is about to venture down that risky road.

T N Ninan is a columnist and former editor of Business Standard.

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