What is the bad debt situation in India’s banking system like? Per one account, such bad debts amount range from $75 to $150 billion!
Based on data I have used previously, in writing opinion pieces, and academic articles, I have found that as interest rates have risen from 5.7 percent in 2003-04 to 8.5 percent in 2013-14, a steady and continuous rise, simultaneously the average debt to equity or leverage ratio of India’s public limited companies has risen from 8.5 times debt to equity in 2003-04 to 12.7 times debt to equity in 2013-14.
As interest rates, which reflects the price of money, have gone up in India, corporate indebtedness levels have significantly increased. But, so have the level of bad debts in India’s banking system. Why?
Reason # 1: The first reason is based on the internal retentions idea. In a piece published some time ago, I had shown a negative relationship between profits and interest rates, and a negative relationship between interest rates and gross corporate savings.
As interest rates went up, firms had higher costs and lower profits, leading to a decline in internal funds for investment. To keep growing, in a booming economy, and needing funds, firms kept borrowing, even though at higher rates, and debt to equity ratios went up. As internal finances worsened, because of the impact of RBI’s monetary policy, the ability of firms to repay loans worsened and led to banks’ bad debts.
Reason # 2: The second reason is based on the idea of adverse selection, based on a credit quality and cost of money rationale. As interest rates have gone up, firms have become less profitable and their credit ratings have slumped.
Low quality firms would possess internal information about possible performance decline, hide these facts, and seek to borrow more at higher interest rates, knowing that they would eventually default. Conversely, banks would earn higher premium rates from lower quality borrowers, and as rates increased would find such lower borrower numbers also rising. Increases in such borrowers would eventually increase the size of the bad loans portfolio.
If such a contingency has transpired, then the RBI has been lax in its audit and supervision of banks’ credit appraisal and lending processes, as patently unworthy firms have been given more loans. Many, if not all, of the Basle financial regulatory requirements will have been breached as such loan amounts increased.
The entire credit evaluation and banking supervision process of India’s bank will be found to be flawed, for having allowed patently un-creditworthy borrowers to be lent large sums. Popular press has it that commercial banks in India have been incompetent, with diffused accountability and control mechanisms. The banking inspection and supervision process of the RBI will have also been culpable.
Reason # 3: The third reason is based on a political economy of financial sector corruption idea. Firms borrowed more because banks willingly lent them more, irrespective of project or business viability.
The franchise bidding for natural monopolies idea, suggested by Professor Harold Demsetz in 1968, states that a contract to serve a particular area for a particular time, say by of electric utilities, could be given for a fixed fee to be recovered by the utilities over time.
The collusion hypothesis suggests that there could have been franchise bidding by top bankers to land the top jobs in India’s banks. There might have been a quid pro quo between bankers, their appointing authorities in Government, and banks’ large corporate customers such that bankers would provide unworthy customers large amounts as loans.
These loans would have been provided in the full knowledge that they would go bad and add to the banks’ bad debts. Hence, interest rates would hardly matter as, irrespective of such rates, certain firms would be lent vast sums of money that would not be eventually recovered. The Ministry of Finance and the RBI have been mute bystanders to this possible corruption scenario.
There is no clamor by the Indian public to investigate yet another scam on them, but there should be vocal public debate on this issue. The level of corporate indebtedness, and its appallingly low quality, can bring down India’s economy. Indian banks and corporations may have perpetrated a mega-sized fraud on the Indian public. What is immediately needed is a Commission of Inquiry, with its own Special Investigation Team, to go into the causes and depths of the banking and financial sector crisis in India.
The foundations of India’s economy are threatened because of a lack of liquidity and finances for growth. If the collusion contingency were to have occurred, then it would require a criminal investigation, and judicial assessment of evidence, to ascertain the nature of the scam carried out and appropriate sanctions applied.
Sumit K. Majumdar 
Posted on May 3, 2016