This will worsen credit allocation and growth by deepening the problem of connected lending which will crowd out young and more efficient entrepreneurs
By Abhiman Das & Ejaz Ghani
Reserve Bank of India (RBI) is exploring the possibility of allowing large industrial conglomerates to own banks. This will tantamount to RBI influencing credit allocation, and a central bank should shy away from this.
Policymakers are concerned about the slow pace of growth in credit volume that has constrained India’s growth trajectory. But, allowing industrial conglomerates to own banks will not lead to a sustainable increase in the volume of credit growth. India’s slow pace in the volume of credit growth is due to connected lending that has resulted in large and less efficient firms to access more capital, leaving less room for more efficient and new firms to access bank loans.
Allowing large corporation to own banks will further deepen the existing problem of connected lending and crowd-out young and more efficient entrepreneurs. An increase in the volume of bank lending will occur only if banks lend more to more efficient firms, so that the more efficient firms can grow faster, and reverse the trend in non-performing loans. Faster credit growth and economic growth go hand in hand, and India will experience this virtuous circle, only when connected lending is reversed.
Global experience has shown that corporate ownership of banks increases the risk of connected lending, diversion of funds, corporate defaults and the risk of contagion from large corporate defaults to the entire banking system. Empirical evidence shows that connected lending in India has contributed to large corporate defaults in the past. The problem of connected lending and corporate default is much more pronounced in India compared to other developing countries. A large number of big private business houses were already heavily indebted and stressed even before the pandemic. Many large corporate leaders—Vijay Mallya, Nirav Modi, Mehul Choksi, Jatin Mehta, Sandesara brothers—have already fled the country, without paying their debts.
India’s twin balance-sheet problem—large corporate defaults and bad loan-ridden banks—are related, and is a consequence of connected lending that is widely prevalent. Indian corporates have already crossed the Lakshman Rekha that separates banks from private corporations. Besides, RBI has been weak in the supervision and management of the financial institutions.
How severe is the problem of connected lending and financial misallocation in India? Firms need three factors of production—capital, labour and land—to produce output. We estimated the degree of financial misallocation in India, during the last two decades, using data from millions of enterprises in the manufacturing and services sectors in more than 600 districts in India (see Ghani et al, “A detailed anatomy of factor misallocation in India”, Policy Research Working Paper Series 7547, The World Bank).
Financial misallocation is much more pronounced in India compared to land and labour market misallocation. The majority of bank loans in the manufacturing sector are taken up by large and less efficient conglomerates that create less than 20% of jobs in the manufacturing sector. Small and more efficient firms, which create 80% of jobs in the manufacturing sector, have access to a very small share of bank loans. The value of bank loans going to small enterprises is barely 2-6% of the value of total bank loans in the manufacturing sector.
There is also a huge spatial and geographical diversity in the allocation of bank loans within India. Bank loans largely go to Gujarat, Haryana and more developed states, and very little to lagging states like Bihar and Uttar Pradesh. There is also a considerable variation of financial misallocation across 600 districts in India. These differences in financial misallocation within India are much larger than the differences found in other developing countries.
Improving credit allocation
We computed an index of financial misallocation for both manufacturing and service sectors in India. Financial misallocation in India’s manufacturing sector is far greater than in the services sector. This may explain why the manufacturing sector has grown at a much slower pace compared to services. Empirical results also show that poorly functioning banks have engaged much more in and connected lending. The two go together, hand-in-hand, and explains why India has so few start-ups in the manufacturing sector, as bank lending misallocation has constrained India’s entrepreneurship.
Banks can improve capital allocation through several channels, including better evaluation and monitoring of firms, lower transaction costs for financial intermediation, and internalising the externalities generated from information collected and processed in the financial markets. The empirical evidence we examined from a large group of developing countries reinforces the classical theme of development economics: reduce financial market distortions and inefficiency (see “How financial markets affect long-run growth: a cross country study”, Policy Research Working Paper Series 843, The World Bank).
This is also corroborated in one of our recent study on India’s infrastructure development and finance. It is the initial financial sector development that decides the level of economic activity, not vice versa (See, Infrastructure and Finance: Evidence from India’s GQ Highway Network, hbs.me/37s5gGH, 2019, Harvard Business School).
Growth requires more efficient firms to access more bank loans to produce more output. Unfortunately, connected lending that is widely prevalent in India has enabled large industrial conglomerates to access more bank loans. This has crowded out access to bank loans to new, young, and often more efficient enterprises. The problem of connected lending and capital misallocation, resulting in lower economic growth and lower job creation, will only worsen if large industrial conglomerates are also allowed to own banks.
Policymakers need to pay more attention to addressing the underlying causes of misallocation in bank loans that have resulted in the volume of bank lending and resulted in a high level of non-performing loans. Accelerating India’s economic growth calls for marching ahead with stronger policy reforms to promote competition and innovation, and enable more efficient firms to access more capital, and grow faster, rather than enabling large conglomerates to continue to dominate.
Banks will need to rework on their lending model and shift the less efficient focus of their lending from large firms to new and more efficient entrants. Banks can play a big role in promoting entrepreneurship, growth and job creation. RBI should shy away from influencing credit allocation by allowing industrial conglomerates to own banks.
Das is professor of Economics, IIM-A and Ghani was former lead economist at World Bank
Views are personal