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Business Commentary/Dilip Thakore

Something is rotten in India's financial system

That there was something seriously wrong with India's nationalised banks and financial institutions was a suspicion firmly lodged for over a quarter century in the subconscious of most right-thinking people in this country.

Because though there has been a sustained cover-up effort in government and industry -- the prime beneficiaries of nationalisation -- to present an illusory picture of banking and lending according to prudential norms, a constant stream of news reports and bazaar gossip about bank scams and a graft-driven lending has created constant suspicion that all has never been well with the government-owned financial institutions which dominate India's financial system.

Now in this new age of economic liberalisation and business literacy in the media, the poor credit assessment, substandard project appraisal skills and the reckless lending practices of the nationalised banks and financial institutions are slowly and inexorably coming to light.

According to latest data from the Reserve Bank of India, on March 31,1997 public sector banks doubtful of non-performing assets aggregated a massive Rs 169.31 billion equivalent to an estimated 17 per cent of all advances. This figure represents a 43 per cent increase over the NPAs of Rs 113.82 billion in fiscal 1994-95.

In short, with each passing year, the NPAs of the public sector banks are climbing as a growing number of loans made on the basis of criteria other than project bankability turn sour.

Nor are slipshod and/or graft-driven management and lending practices limited to the nationalised banks which harbour 95 per cent of the public's bank deposits estimated at Rs 3.16 trillion within their leaky vaults. This contagion has also affected term lending institutions such as the Industrial Development Bank of India -- one of the largest term-lending institutions in the world -- and the Industrial and Finance Corporation of India.

Both these term lending institutions are almost wholly owned by the Union government. But while the quantum of their NPAs are a carefully guarded secret, their small percentage of equity shares in the market are being heavily hammered by investors fearful of a huge hidden inventory of bad debts.

Then there is the curious case of the government-owned Unit Trust of India -- reputedly the largest mutual fund in the world with over 40 million unit-holders. The theory behind mutual fund and/or investment trusts such as the UTI is that its managers invest the unit-holder's money in a wide spread of equities, debt instruments and even real estate thus making the unit in the investor's hand virtually risk free.

Now it transpires that the UTI's flagship scheme US-64 which has over 22 million unit-holders has a negative net asset value, the market value of its investments is lower than the par value of Rs 10 per unit despite the UTI having been investing for 34 years. If the trust's portfolio managers had minimal competence, mere inflation would have ensured that the NAV would be above par value.

Instead, through the simple expedient of concealing the scheme's NAV, the UTI management has been augmenting the number of unit purchasers by declaring high dividends and unit re-purchase prices. Those redeeming their units are paid off by the income derived from new purchasers. If a non-banking financial company or an individual were to do likewise, they could be sentenced to jail for fraud.

This sorry state of India's government-dominated financial system is rooted in constant political and finance ministry interference with the businesses of the nationalised banks and financial institutions. The NPAs of the public sector banks and term-lending institutions which have debilitated the rupee, rocketed interest rates and have belatedly made Indian bank managements extraordinarily risk averse, are the inevitable consequence of politically directed lending and crony capitalism.

The nation's hitherto comprehensive industrial licensing system made intense lobbying in New Delhi and the state capitals mandatory for businessmen and entrepreneurs. And once licences were awarded, politicians had a vested interest in directing institutional loans and bank credit to the favoured few.

Protected against foreign competition by huge import tariffs, for over four decades industrial licencees made hay -- selling shoddy goods and services to captive consumers -- in the sunshine of Indian socialism.

But such a closed system without production efficiencies and price discipline was too good to last. Despite captive markets and high prices, the recipients of politically directed loans have saddled banks and institutions with huge NPAs which are now coming to light in the new age of economic liberalisation and transparency.

And as a growing number of loans turn sour, bank managements are becoming increasingly risk averse and are turning down high-potential project proposals from genuine entrepreneurs and proven professionals thus adversely affecting economic growth and employment.

Politically directed lending and the crony capitalism system of development also necessitated the appointment of pliable individuals to apex level positions in public sector banks and term-lending institutions.

The unfortunate consequence is that the nationalised banks and institutions are inevitably headed by mediocre paper-pushers who lack the basic skills of project appraisal, credit assessment and calculated risk-taking ability.

The nationalised banks and institutions seldom attract the brightest and best from the management institutes and premier colleges because of poor pay scales and lack of autonomy.

Therefore, the top management of these institutions is usually made up of promotee clerks obsessed with procedural correctness, paper-work, over-collateralisation and excessive obsequiousness towards politicians and bureaucrats.

Under the erroneous belief that their deposits in the nationalised banks and financial institutions are underwritten by the Union government, lay citizens tend to be unconcerned about the parlous state of the nation's financial system.

But such complacency is unwarranted. The growing number of institutional loans and advances morphing into NPAs are vetoing or skyrising the cost of credit for capable and competent entrepreneurs and corporates. This has adverse effects on economic and employment growth, exports and the value of the rupee. And intensifying economic stagnation could depress business confidence and precipitate a run on banks and financial institutions.

The issue can no longer be evaded, the RBI and the economic ministries need to act with speed and caution to unscramble the mess that is India's financial system and work towards reprivatising it.

Dilip Thakore