Public banks are being marginalised in the lending arena by new-age financial power brokers

It has been a volatile decade for India’s business community. Quite a few post-liberalisation patterns of doing business in India have been seriously disrupted and with it have withered the fortunes of many business owners who had made their bets early as India opened up its economy over 30 years ago.

High net-worth individuals’ exit from India and the desire to take up alternative citizenship for tax reasons and wealth preservation is at its highest level in decades, only exacerbated by Covid-19 and accompanying mobility concerns. On the other hand, we have seen the rise of a new class of entrepreneurs, represented by India’s startup unicorns, and the simultaneously ballooning fortunes of a few large business groups.

Across a range of industries, capital concentration in India is hitting new post-liberalisation highs as the list of acquisitions (startups, bankrupt firms, infrastructure assets, new contracts and others) of large business groups make headlines every month. For those who believe in competition and churn, this is an alarm bell, a reversal of the flurry of economy-wide entrepreneurial zeal that was witnessed in the few decades after liberalisation. However, for others who have hopes for Indian national champions through economies of scale, this is necessary consolidation, the destructive downside of an inevitable cycle of creative destruction.

One crucial part of this story is the decline of the public sector banking system as the primary engine of India’s economic growth. While public sector banks still make up the majority of lending in India, the long shadow of India’s non-performing assets crisis has left them with a shrinking market share, deeply institutionalised risk aversion (particularly to industrial and infrastructure lending), little confidence in public markets (highly depressed stock prices), and serious doubts about their ability to maintain independence from political and bureaucratic manipulation.

In a world flush with cheap capital from pension funds, sovereign wealth funds, private equity investors, multinational corporations, and multilateral finance institutions, many of India’s largest business groups are choosing to exit the borrowing system of public banks, preferring to raise capital from foreign sources and make long-term business arrangements with multinational companies rather than subject themselves to the politicised financing that often accompanied the public sector banks’ debt.

The new economy and small businesses rarely have the privilege of accessing public sector banks. The past culture of branch-level local public bank lending has deteriorated considerably over the last few decades and it has been a perennially upward battle for public banks to consider funding startups or take large bets on the micro, small and medium enterprises, or MSME, ecosystem.

When public banks have tried their hand at intermediated lending through non-banking financial companies, it has unfortunately led to concentrated forms of on-lending (such as in the case of Infrastructure Leasing & Financial Services Limited) whose scars are still fresh.

Comfortable in lending money primarily to large corporations, the gaping vacuum in access to capital left behind by public banks has been partially, but so far inadequately, filled by smaller financial actors: cooperatives, regional banks, small finance banks, smaller non-banking financial companies, fintech startups, and of course, other forms of informal finance.

Effect of bankruptcy laws

Public banks may still have massive deposits to invest, but at the moment, they have ceased to be the lender of choice for many large Indian businesses looking to borrow or raise money.

The flight from the public banking system is partly a consequence of how they have implemented the new bankruptcy laws. Promoters in financial distress stand to lose their entire ownership stake through bankruptcy proceedings. These businesses were often built on reputations and networks of capital, sometimes undeserved, that promoters had with public banks and the political system more broadly.

Not surprisingly, many promoters have used every trick in the book to try to extend and subvert the new proceedings associated with the Insolvency and Bankruptcy Code. What does not help is that risk-averse public banks invoked the Insolvency and Bankruptcy Code in borderline cases and seem to have little appetite for renegotiation, haircuts and other forms of more benign resolution that bankers typically engage in during such downturns.

The policy paralysis that had affected the bureaucracy in the mid-2010s has now spread to public banks and, as a consequence, growth in industrial lending has plummeted to all-time lows. Beleaguered by a spate of arrests and convictions of their banking colleagues and the relative impunity of senior management and errant borrowers, many mid-level public bank managers would rather send businesses to the Insolvency and Bankruptcy Code, engage in consumer lending, and largely avoid industrial lending than deal with the downside risks that accompany an inevitably politicised lending processes. The businesses they would like to lend to – India’s largest business groups and businesses with good credit ratings – do not always want their money.

Rather than fix this complicated ecosystem and engage in a meaningful reform of public sector banks and financial markets, there is an increasing tendency to bypass public banks altogether. The new power brokers are the ones who can speak the language of foreign capital: the startup founders who can sell their visions to venture capitalists, the business houses who can attract investments from big tech – Facebook, Amazon, Apple, Netflix, Google – and offer them credible political mediation in India’s unpredictable business environment, the soon-to-be startup unicorn whose initial public offering valuation can be spiked with a quick dose of private equity, the real estate conglomerate who can deploy large amounts of money in Tier-1 India in building green-certified commercial real estate for hungry environmental, social and corporate governance funds, and the consultants and investment bankers who can broker these deals between international capital and Indian businesses.

Erosion of lending practices

Mediating and controlling access to capital has always been important, but the cast of characters and financial institutions who can do so has changed dramatically in the last decade, as can be seen with a whole host of former banking luminaries joining private equity firms and multinational companies as advisors.

Perhaps one of the most problematic consequences of this transition has been the erosion of regional and local lending practices among large financial institutions. Ten districts in India accounted for 54% of credit disbursal in the country by the end of March 2020. Before nationalisation, banks like Syndicate Bank made their reputation on their knowledge of small borrowers and businesses and their borrowing requirements and ability to pay.

In the last few decades, many larger financial institutions, including public banks, have been running after bigger ticket loans to the detriment of their branch and local operations. Elaborate checklists, regulatory requirements, and paperwork have led to the administrative costs of lending going up at public banks, yet another reason to avoid small loans.

The question that looms large over the banking system is this: can India’s scheduled commercial banks really deliver access to capital to businesses, big and small, formal and informal, across the length and breadth of the country?

Digitisation of banking activities and more permissive policies towards non-banking financial companies’ lending have led to major technological innovations; startups like Aye Finance are revolutionising targeted local lending to businesses and many private banks are exploring co-lending operations with smaller financial entities whose networks and local knowledge make them more effective lenders to micro, small and medium enterprises. But public banks still seem quite tentative in pursuing relationships with smaller entities and seem to be largely partnering with non-banking financial companies associated with large business houses, which has naturally raised concerns.

Lending to small businesses in India should not be a niche activity where organisations such as the Small Industries Development Bank of India are occasionally consulted during policymaking. It was and should be a core competence of every large bank. Yet, the last thirty years of the public sector banking evolution has largely moved in the other direction.

Perils of economic centralisation

Economic centralisation comes in various forms: lending only to proven, credit-worthy businesses in certain geographies, restricting who can access foreign capital markets, pushing the majority of debt in the country though public banks which can be nudged toward political priorities, encouraging multinational corporations to partner with local established firms rather than strike out on their own. As India recovers from the ravages of Covid-19 and the long shadow of the non-performing assets crisis, there exists an opportunity to reshape how banks lend to Indian businesses.

But so far, the rhetoric of fiscal stimuli and growth of micro, small and medium enterprises has lagged well behind the ability of banks to push money to such entities. There seems to be little acknowledgement that excessive economic centralisation among a few corporations could also have negative consequences, especially when these corporations parachute in at the end of traditional value chains as distributors and squeeze margins from small businesses.

India may aspire to build national champions like Japan or South Korea, but is leaning dangerously toward enabling a new generation of oligarchs in the mould of Russia or Mexico. We can only hope that the emerging financial environment will enable creative upstarts to genuinely compete with established incumbents rather than simply providing them more fodder for acquisitions.

Rohit Chandra is an Assistant Professor of Public Policy at Indian Institute of Technology, Delhi.

The article was first published in India in Transition, a publication of the Center for the Advanced Study of India, University of Pennsylvania.