Bad loan management, PSB reforms: Rajan, Acharya make key suggestions

A new research paper by former RBI Governor Raghuram Rajan and former deputy Governor Viral Acharya talks about a range of issues including management of bad loans, winding up of the Financial Services Department in the Finance Ministry and reforms in public sector banks. The paper examines what holds Indian banking back and suggests implementable reforms that could allow banking activity to grow significantly without the periodic boom-bust cycles it has been subject to.

Here are the key reforms highlighted by Raghuram Rajan and Viral Acharya in the research paper:

Bad loan management

The duo says that 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 can be applied. "Two need to work in tandem as the Insolvency and Bankruptcy Court's (IBC) procedural threat serves as the fall-back, facilitating meaningful negotiation out of court."

The paper also suggests development of an online platform for distressed loan sales to provide real-time transparency in loan sales. "Banks could be nudged to sell loans, and average prices for each class of loans could serve as objective "marks" for recording bank recoveries and losses, as well as guiding write-downs."

It further adds that the national public sector "bad bank" could serve as a vehicle to aggregate loans, create management teams for distressed firms, and possibly buy and hold distressed assets in a sector like power till demand returns.

Improving performance of PSBs

On improving the performance of the public sector banks, Rajan and Acharya suggest that the operational independence for boards and management needs to be embraced by creating a holding company structure for government stakes. The holding company should make professional and diverse board appointments to each bank and these directors should be empowered to guide the bank towards its objectives.

The government can also encourage the banks by paying them for achieving its mandated goals (such as reimbursing costs for maintaining branches in remote areas or opening bank accounts for all). "These payments should be available to all banks so that both private banks and public sector banks compete to deliver on mandates."

Winding down the Department of Financial Services in the Ministry of Finance is essential both as a signal of the intent to grant bank boards and management independence, the paper added.

"Incentive structures for management need to be strengthened with longer terms for senior management, better assessment of performance, performance-based promotions and extensions, as well as some reliance on lateral hiring, which would also bring in state-of-the-art banking ideas and practices," it said.

Ownership structure of PSBs

State owned banks can be a first step in altering the ownership structure of some PSBs, where the government brings down its ownership to below 50 percent. It is expected to create distance from operations of banks and improve governance along the way. The paper also suggests reprivatisation of select PSBs.

Reform in credit operations

The banks should focus on a cash flow based lending approach rather than an asset-based approach, the economists said. "Banks could rely more on loan covenants for large borrowers, tied to liquidity and leverage ratios (instead of lending purely against assets). This would set up "trip-wire" points for enhancing loan collateralization, rather than requiring it from the beginning," the paper said. "In case of small borrowers, reliance on GST invoices and utility payment bills, among other cash-flow information, can facilitate such a transition," it said.