10 October 2012

Why India's Banks Shouldn't Be But Still Are In Business

There's an excellent article in Bloomberg Business News here about about the effects on bank capital of India's business restructuring regime. Some time ago I wrote at length (if not ad nauseam) here and then here about India's antiquated insolvency regime. Some of India's opaque and insider-dominated systems for dealing with corporate insolvency provide no judicial or independent administrative oversight. (Others do have limited oversight but few utilize them.) Instead, lenders (almost always banks in India) simply roll over the debt of insolvent firms with little regard to replacing ineffective management. Shareholders even retain their interests while general creditors often go unpaid because of India's inefficient legal collection laws. See the Bloomberg article describing how the pilots of rollover champion Kingfisher Airlines have gone without pay for seven months!

But why do the banks agree to this? After all, on any honest accounting their balance sheets are taking a beating. Why doesn't the Reserve Bank of India step in like the FDIC would in America? And what about the creditors of the banks? Why aren't they concerned that their loans to India's banks are at risk?

Let's look at my three questions in reverse order.

As far as the last question, India's banks--unlike large and mid-sized U.S. banks--are depositor financed. And, unlike institutional bondholders who understand the risks of deteriorating bank balance sheets, crores of depositors do not.

To ask the second question is virtually to answer it; the RBI is part of a government system that can't bear to permit its constituencies to pay the price for public or even private financial mismanagement. If Bloomberg is right, however, that governmental reluctance to expose banks and the shareholders of corporate debtors to the natural consequences of their business failures may be coming to an end.

The first question is also an easy one: Why not? Why not permit insolvent borrowers to roll over their debts when the alternative is to realize a massive loss at once? After all, the borrower just might turn things around. And even if it doesn't, the bank's shareholders also seem virtually immune to financial elimination. Who knew how valuable the absolute priority rule was?

In any event, stay tuned. India's fragile coalition government is striving as best it can under the political circumstances to bring a bit more of market forces to bear in retailing. Let's hope it can do the same in India's financial industry.

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