How to make Indian banking viable

Mark a few banks down a notch in your mind. Normally, you would wait for a signal to do that from the rating agencies, but you know how they are.

They will warn you of an oncoming tsunami after it has hit the shore and wrought devastation.

The Reserve Bank of India (RBI) has just allowed banks to go a bit easy on provisioning norms for non-performing assets (NPA) in response to their urgent supplications.

Recall that when the global financial crisis hit and multiplying NPAs needed restructuring, the provisioning rules had to be eased.

And when the crisis eased and the Indian economy was back on the rails of good growth, the RBI tightened the norms once again, arguing that it was time for provisioning for a rainy day.

According to the latest fiat, if a bank has played by the rules till September 30, 2010 made 70 per cent provision for NPAs then that's it.

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The RBI will study international practices and advise later on what to do with incremental NPAs.

And if these go down then the excess provisioning can be transferred to a rainy-day fund, for use when systemic trouble affects the entire industry.

The bottomlines of several banks would have looked fairly poor if they had to stick to the 70 per cent norm.

Leading the pack of supplicants for relief, like students demonstrating for grace marks, was the biggest of them all, State Bank of India (SBI), followed by the likes of United Commercial Bank and Bank of Maharashtra (what company for mighty SBI to keep!).

SBI flouted the earlier norm with impunity and then, with a change of guard and the new chairman saying how long you can keep fighting the teacher, the latter has relented and made life easier.

What seems lost in the present discourse is that if banks' bottomlines look unlovely as a result of higher provisioning then they do not automatically become weaker. In fact, the opposite.

A poorer bottomline - and poorer payout - means more cash retained and greater intrinsic health.

Shareholders of banks depending on dividend income (like the government) may be hit, but valuations may not change since higher provisioning will be seen for what it is -greater intrinsic strength.

A poorer bottomline may not be good for a public issue but the scope for that, in the case of public sector banks, to bring in fresh capital is limited for several reasons.

So, it is best for banks to make adequate provisions. If the resultant poor profitability is socially embarrassing for bank chiefs or harmful for their bonuses then so be it.

In any case, as the economy slows, the need for additional capital will slacken and bank lending growth will be affected.

Forecasts for the current year's growth are being marked down and the next plan's target of 9 per cent-plus growth looks distinctly unrealistic.

Though none feels happy about reining in growth, it is sensible to do that. High global commodity prices, India's inability to grow enough food and the inability to store it lead to high inflation.

Consumer sentiment at the middle-class level is not excessively buoyant. The green light is not on for the wealth effect, and property and stocks are not booming.

The demand right at the bottom and at the top of the pyramid is booming. Enabling banks to meet the burgeoning credit demand is not the consideration of the hour; ensuring that banks' asset books are healthy is.

There is an additional reason for being strict about provisioning for bad loans. The stricter the provisioning norms, the lower are the incentive for bank managers to let NPAs grow.

The easier it is to restructure NPAs (there is much scope for corruption in this), the greater will be the incentive to let NPAs pile up. The flavour of the moment is to take a radical new look at eliminating corruption.

Interestingly, not all banks are in a tight corner. HDFC Bank and Axis Bank have announced encouraging results and are among the leaders in provisioning.

They and perhaps a handful of better-run public sector banks form one category and SBI, ICICI Bank and the less efficient public sector banks form the other category.

It should be clear that the performing and the underperforming banks stretch across ownership categories, with Axis Bank straddling the two worlds by being a private-sector bank with some public-sector development categories.

To take Indian banking a step forward, it is necessary to have banks run along private-sector lines with some public-sector development goals. For this, an incentive and regulatory structure can be created.

For example, a tidy reward for maintaining operational no-frills accounts, that is, rewards for an energetic effort to spread banking at the grass roots level, should make it viable for a bank to go all out to do that.

Also, making loan write-offs and rescheduling scientific - dependent on the monitoring of drought or flood via satellite data - should make inclusive banking sustainable and profitable.

Which is why it is a pity that the powers that be are moving very slowly towards making progress in issuing new banking licences. The idea was floated in the name of furthering inclusive banking.

With microfinance in trouble, quick action for bringing in fresh blood into banking at the bottom of the pyramid is all the more necessary.

In fact, banking licences for a couple of better-run microfinance institutions should serve many goals in one go.

Travelling down this road can go a long way in marking a watershed in Indian banking, the way the bank nationalisation did.