Context

The RBI’s latest Financial Stability Report (FSR) has given the banking system a reasonably clean bill of health. It’s a significant achievement, considering the stress of the previous decade, the shock of the pandemic and the associated slowdown of the economy.

Two indicators of banking system’s progress

• 1] Reduced NPAs: Successive waves of recapitalisation have given banks enough resources to write off most of their bad loans.
• As a result, they have been able to bring down their gross NPAs (non-performing loans) from 11 per cent of total advances in 2017-18 to 5.9 per cent in 2021-22.
• Even after these large write-offs, most banks retain comfortable levels of capital.
• 2] Credit growth doubled: During the decade when banks were under stress, non-food bank credit growth had been declining, reaching just 6 per cent in 2020, its lowest point in six decades.
• Since then, credit growth has nearly doubled.

Concerns

• Role of credit in supporting GDP growth: The problem is that very little of this credit is going to large-scale industry or for financing investment.
• Reluctance of banks to provide credit to industry: Over the last decade, banks have increasingly shifted away from providing credit to industry, favouring instead lending to consumers.
• This trend is continuing — in the year ending March 2022, consumer loans grew at 13 per cent, whereas loans to industry grew at just 8 per cent.
• Banks favoring MSMEs in industry loans: Bulk of the industry loans has been extended to the smaller firms (MSMEs), which benefitted from the credit guarantee scheme offered by the government in the wake of the pandemic.
• Reduced lending to private sector investment: A related problem is that there has been little lending for private sector investment.
• Over the last one year, bank lending to infrastructure has grown by 9 per cent, up from 3 per cent in 2020, but this was fuelled mainly by public sector capital expenditure.

Why is there so little lending for investment by large firms?

• Demand side reason: On the demand side, private sector investment has been sluggish for nearly a decade.
• The boom-and-bust of the mid-2000s had saddled firms with excess capacity, giving them little reason to expand their production facilities.
• In addition, the global financial crisis had shown the dangers of ambitious expansion supported by excessive borrowing, leading firms to conclude that it would be prudent to scale back their plans and instead focus on reducing their debts.
• Supply side reason: On the supply side, banks have learned similar lessons.
• During the period 2004-2009, rapid GDP growth in the Indian economy was fuelled by an unprecedented lending boom.
•  Subsequently, many of those loans turned bad, leading to high levels of NPAs on bank balance sheets.
•  As a result of these financial problems, banks for a decade were unable to extend much in the way of credit.

Challenges

• On the positive side, firms seem to have finally used up much of their spare capacity.
• Fundamental problems not resolved: But on the negative side, the fundamental problems that led to the difficulties of the past decade still have not been resolved.
• No framework for risk reduction: There is still no framework that will reduce the risk of private sector investment in infrastructure, certainly not in the critical and highly troubled power sector.
• Nor is there any reassurance for the banks that if problems do develop, they can be resolved expeditiously, since the Insolvency and Bankruptcy Code has been plagued by delays and other problems.

Way forward

• We need deep structural reforms — to the infrastructure framework, the resolution process, and indeed, in the risk management processes at the banks themselves.
• In the event that these reforms do not materialise, there may continue to be shortfalls in credit, investment, and ultimately in economic recovery and growth.

Conclusion

A healthy balance sheet of the banking sector is a necessary but not a sufficient condition for economic growth. The important question is whether banks and firms will once again be willing to take on the risk of investment in industry and infrastructure.

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