YES Bank crisis: Why government must fix the vulnerabilities in financial system

The Modi government has a major problem at hand. No, it has nothing to do with the Citizenship (Amendment) Act or the protests against it. The weak economy is an issue and so are fears about the spread of Covid-19. But the problem I am talking about has to do with the banking and financial system, which has undergone a lot of stress in the past decade or so due to bad loans, bad management and lax regulation.

While there is no panic run on banks or debilitating loss of confidence in the system, the government should be worried about the increasing vulnerability and unviability of key players in the financial system. Consider these facts: in the past oneand-a-half years, two banks and a nonbank lender have failed and had to be placed under RBI moratorium. While Yes Bank is in the process of being rescued, a solution to revive PMC Bank is not yet in place. Last year, DHFL became the first major non-bank lender to be placed under moratorium and is now in the process of being sold.

Some public sector banks are probably bankrupt if not for the implicit sovereign on their borrowings and deposits. One had to be expensively rescued using policyholders’ money from LIC.

Some other non-bank lenders are also in trouble. Credit flow is an issue and with big banks focusing on lending to large nonbank lenders, the smaller ones are getting squeezed out. They are being forced to conserve cash, stop lending and turn away opportunities.

Finance Minister Nirmala Sitharaman’s push to open the lending spigots has eased the situation somewhat but there is still a long way to go. The slowing economy has also not helped matters.

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These kinds of failures could have easily caused political nightmares. PM Modi and the BJP’s success in navigating these potential landmines combined with the weakness of the Opposition means the party and the government have not yet had to pay a heavy political price.

But that could change. If large sections of the public tomorrow start believing their money in the banks is unsafe, it could end up creating a panic of immense proportions.

India has not had a major financial system panic for decades thanks to nationalisation and deft management by the RBI during past crises. Even the massive fraud at PNB in 2018 did not lead to mass withdrawals.

But private banks have become too big to fail. And with the growth of non-bank lenders, the explosion in financial market activity and the interconnectedness of everybody, the stage is set for mass convulsions, if things are not quickly brought under control.

Neither of these scenarios bode well for the BJP. They can point out that most of the banks’ problems began when the UPA was in power and that they have done a lot to strengthen the system. This is correct and one can point to capital infusion into public sector banks and the launch of the Insolvency and Bankruptcy Code in support of the argument. Bankruptcy courts have proved successful in not only recovering money for lenders but also for putting the fear of god among promoters. Banks have also managed to recover a decent amount from the cases settled so far.

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But the problem is that the banking system’s weakness persists and the argument that the Congress is solely responsible is becoming stale. The BJP has had six years to study, understand and act on the weakness and its record on prompt action has been less than stellar.

Recap bonds for public sector banks should have been done in 2015, not in 2017, and the mergers could have been announced anytime in the past six years. This would have front-loaded the reforms and given banks enough time to absorb the mergers and use the money to provide fully for the losses. A lot of market panic and losses

could also have been avoided.

Yes Bank is another classic example of delayed action. It was clear from last year that the bank is going to struggle to raise money. A quick rescue plan put together over the weekend with the markets closed could have made the government and the RBI look strong, nimble and purposeful. Instead, both are now fending off attacks and trying to take “strong action” in a bid to change the narrative.

The government now has a fantastic opportunity ahead of it in the next few years. Crashing oil prices could boost fiscal gains and wariness over supply chain concentration in China can drive FDI inflows to India. Structural reforms, low corporate tax and low interest rates can spur growth and drive the economy towards the $5-trillion target by 2024. The opportunity should not be frittered away by lax regulation and delayed action in the banking and financial sector.

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Views expressed are author’s own.


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