India has said yes to Yes Bank's (YB) business unusual by asking the top government-controlled State Bank of India (SBI) to inject capital into it. It looks like a halfhearted bailout whose details are still in the making.
YB was bankrupt with high non-performing assets (NPAs) and eroded capital. It underreported NPAs and misled the RBI on the prospects of mobilizing equity from investors. YB's ratio of gross NPAs jumped to over 7 percent in the quarter ended September from 3 percent in March, well above that of peer average. YB's ambitions and aggression set new heights for private banks in India, making it a darling among foreign investors. As India's economy slowed in recent years, YB's outsized risk exposure turned into a bane. YB struggled to raise enough fresh capital to shore up its fragile balance sheet.
The bank's increasingly edgy depositors and corporate bondholders made the RBI action a fate accompli.
YB's problems were the result of aggressive lending and widely prevalent shady accounting practices in India's banking sector. YB took them to newer heights, making big loans against tough to value or seize collateral such as "personal guarantees" by tycoons. YB was also highly exposed to the real estate market, hit hard by the 2016 demonetization move, and troubled shadow lenders.
The RBI seized control of YB last Thursday by replacing its board and temporarily restricting withdrawals. The Bank's former chief Mr. Rana Kapoor was arrested. RBI has published a draft restructuring plan enlisting the SBI to lead a rescue designed to prevent a loss of confidence in the financial system. The other measures of the RBI's draft plan include a new board and an assurance that YB employees would work under the same salary and terms of employment as before. There is a 30-day deadline to complete the rescue.
Once the RBI finalizes its draft plan, the SBI will likely reveal its hand. The capital infusion would happen with SBI paying at least Rs 10 per share, instead of the face value of Rs 2. It is a bitter pill for SBI as it tries to clean up its own books and accelerate new lending. SBI will invest $332 million into an enterprise that urgently needs $2-3 billion to survive. There's a promise of more, but for now SBI will cover roughly half of YB's exposure to just one client on the brink of bankruptcy: Vodafone Idea Ltd. If you were a YB depositor, how assured would you feel with this rescue plan?
YB's rescue comes at a very delicate moment for India's economy where the 4.7 percent growth in the last three months of 2019 was only half of the country's rate of expansion three years earlier. Domestic demand has slowed sharply due to stress in the financial sector and lower credit growth. Bad debt posed a risk to India's economy even before the coronavirus outbreak hit. Those problems could now deepen given the expected further slide in growth.
Even if restructuring calms anxieties in the short-term, broader financial stability risks will remain. India is in a triple balance sheet problem involving banks, corporates and shadow banks. Fear of a collapse in confidence on the banking system may have prompted, at least on the surface, the RBI rescue move. After all, the Lehman Brothers episode in the US in 2007 is still fresh in the policy makers' mind. That failure of a systemically-important financial institution with some $700 billion of liabilities created a seismic shock to the entire global financial system. YB is not as big, accounting for about 2.3 percent of total bank loans and 1.6 percent of bank deposits domestically. However, the restrictions on withdrawals could stoke public doubts causing savers to lose trust in all but a handful of blue-chip Indian banks. Once withdrawal restrictions are lifted, depositors could look elsewhere.
At the end of the day, the goal is to trigger a virtuous cycle for banks such as a mutually reinforcing capital and borrowing on the one hand and lending and profit on the other. The Indian financial system will be moving backwards if deposits fly from private to the inefficient public sector banks because of the excesses perpetrated by a few connected financial marauders. If the restructuring plan fails, there may be no alternative to a merger with SBI. After years of forcing banks to acknowledge their soured exposure, take firms to the bankruptcy tribunal or restructure them outside of courts, India still cannot get out of the financial sector doldrums.
One reason is that the repeated relief measures are symptomatic of wider credit risks in India's financial system. The restructuring plan will need to address the moral hazard risks from the SBI infusion of funds to save a private bank from bankruptcy. The speed of restructuring will be critical for avoiding damage to confidence in private banks. The government will need to dismantle the rescue measures as soon as the financial market conditions allow. An exit strategy that can be quickly implemented is a key to avoiding banks and other financial institutions assuming that they will continue to benefit from government support for an extended period, possibly at the expense of their competitors.
Experiences across countries suggest several important principles for successful bank restructuring and systemic bank crisis resolution. Bank restructuring is a long process requiring substantial financial and human resources, public and private, over a long period of time. It cannot be done without deep changes in the rules of the game as well as attitudes. The approach needs to be comprehensive and credible. Segregation of non-performing loans from bank balance sheets to loan recovery agencies can be useful in easing the stock problem of banks. But it has risks. Recapitalization of viable banks may be unavoidable, but this must be done in a way as not to undermine incentives for private equity injections and rewarding poor management of banks. The draft restructuring plan of RBI falls short on these counts.