Raghuram Rajan, Viral Acharya tell how to reform India’s ailing banking system

Former Reserve Bank of India Governor Raghuram Rajan, and former Deputy Governor Viral Acharya have together suggested ways to tackle problems lurking in India’s banking sector. The duo, who took up academic assignments after their tenures at the central bank, have authored a paper suggesting “reforms that could allow banking activity to grow significantly without the periodic boom-bust cycles it has been subject to”. Even though India has a low credit to GDP ratio, the banking system has among the highest gross non-performing assets (GNPA) to total assets ratio globally, the duo argue in the paper.

How to deal with bad loans?

Raghuram Rajan and Viral Acharya suggest three steps to deal with bad loans — the key overhang for the banking sector. “Out-of-court restructuring frameworks can be designed for time-bound negotiations between creditors of a stressed firm, failing which National Company Law Tribunal (NCLT) filing should apply,” the former central bankers say. They further say that development of an online platform for distressed loan sales should be considered to provide real-time transparency in loan sales. Lastly, Rajan and Acharya say that private asset management and national asset management “bad banks” should be encouraged in parallel to the online platform for distressed loan sales.

Reforming PSU banks

The paper suggests operational independence for boards and management for PSU banks. Rajan and Acharya propose creating a holding company structure for government stakes, a proposal that has been made by a large number of banking reforms committees over the past three decades. The holding company would be responsible for making board appointments. Another suggestion made is for payment by the government to banks for achieving its mandated goals. They argue that banks could reimburse costs for activities like opening bank accounts for all to push lenders to deliver on mandates.

Raghuram Rajan and Viral Acharya add that winding down the Department of Financial Services in the Ministry of Finance is essential for signaling the intent to grant bank boards and management independence. Additionally, they also list longer terms for senior management, better assessment of performance, performance-based promotions and extensions as a reform for the public lenders. The paper also argues about tweaking ownership structures at banks. The duo suggests trimming government stake below 50% in some PSBs and re-privatization of some of these banks.

Improving advances
“The GNPA ratio stood at 8.5% even pre-COVID for the banking sector as a whole, 11.3% for public sector banks (PSBs) and 4.2% for private sector banks,” the paper says. It suggests four reforms for banks to make better loans. Primarily the former RBI Governor and Deputy Governor suggest creating better capital structures for project finance. Further they suggest incorporation of smooth expected provisioning of loan losses in bank regulation with adoption of IFRS. This, they say, would then give incentives to banks to recover on loans by resolving them rather than ever-greening. Rajan and Acharya also suggest transition from asset-based lending to cash-flow based lending and transparency around frauds and group exposures.