Banking reform and recapitalisation–Economic Times–08.12.2017

RBI governor Urjit Patel has said that infusion of capital in public sector banks will not be uniform across the banks. Those that have built up their balance-sheet strength would get priority. This makes sense: only such banks would be able to start lending, instead of using the capital received to provide for bad loans. Governor Patel also said that other banks would receive government capital based on the resolve they show to reform themselves and become slim and trim.

This, however, is bluster, for two reasons: no banks is so insignificant as can be allowed to sink, and the real reform required is not in the hands of the banks, but in their ownership structure and policy on senior management remuneration. And a key reform needed to prevent future build-up of bad loans is to let infrastructure projects be funded mainly through bonds, rather than through bank loans.

State-owned banks need more functional and operational autonomy. Ideally, the government must also allow banks to raise capital from the market to an extent that it dilutes its stake below 50%. This will enable banks to overcome the limitations imposed by state ownership such as low pay, short tenures, political and bureaucratic interference and the fear of being hounded by investigation agencies that do not understand banking.

An overhaul of remuneration policy is a must to attract and retain top talent. A three-tier remuneration structure — a relatively low fixed chunk, a larger segment linked to medium-term performance and a more generous component linked to long-term performance — makes sense for senior managers. And the variable part should be subject to clawback, depending on poor performance and mala fide, if any.

With their short-maturity deposits, banks cannot lend for more than five years or so, whereas infrastructure typically needs long-term finance. Deep and fully liquid markets for bonds, interest rate and currency derivatives will help infrastructure companies to raise finance, and allow insurance and pension funds to invest as well. Bond analysts would keep tabs on project costs, too.

This piece appeared as an editorial opinion in the print edition of The Economic Times.
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