One simple insight explains the difference between good banking and bad banking.
Among other loans, the State Bank of India (SBI) also gives out home loans. As of March 31, 2017, the non performing assets (NPA) ratio, or simply put the bad-loans ratio of the bank when it came to home loans, was 0.43 per cent. This basically meant that for every Rs 100 that the bank gave out as a home loan, around 43 paisa was not repaid by the home loan borrowers. This is an extremely safe form of lending for the bank, something that it would like to do over and over again.
The same sort of low bad-loans ratio can be seen in the case of auto loans at 0.65 per cent. For overall retail loans, the figure stands at 0.55 per cent.
The scenario changes when we start looking at lending to corporates. For large corporates, the bad-loans ratio is at 9.67 per cent. For mid-corporates, the figure stands at 19.35 per cent. For small and medium enterprises, the figure is at 7.04 per cent.
The overall bad-loans ratio of India’s largest bank is at 6.9 per cent. What is true for the State Bank of India is also largely true for other government-owned public sector banks. As of March 31, 2016, State Bank of India and its associate banks (which are now a part of the bank) formed around 32 per cent of the total size of Indian public sector banks.
What explains this difference? Why do corporates have such big bad-loans ratios, whereas individuals taking on loans from banks seem to be repaying almost all the loans that they take on? The reason for this difference is the sort of thinking that stems from the heart of central planning. Or what the economist Thomas Sowell, in his book Wealth, Poverty and Politics, calls the separation of knowledge and power.
In central planning those who have the knowledge to take effective decisions do not have the power to do so and those who have the power to take decisions do not have the knowledge to do so.
Sowell makes this point in the context of the erstwhile Soviet Union. He writes:
Central planning authorities in the Soviet Union could assign production quotas to individual factories, but only the manager in charge of each factory’s equipment and personnel, and aware of its surrounding conditions, knew what each factory was or was not capable of producing.
This inevitably led to a mess. Swaminathan Aiyar gives an example of such a mess caused by central planning in the context of glass production in the Soviet Union. He writes in From Narsimha Rao to Narendra Modi—25 Years of Swaminomics:
Soviet planners set physical targets of glass production in terms of weight, factory managers started producing the heaviest sorts of glasses to meet plan targets. This meant shortages in terms of square feet.
The planners then decided to shift the targets from tonnes to square feet in order to correct for this unintended consequence. “Alas, this induced factories to produce the thinnest glasses to meet targets, and much of it shattered.”
Of course the Soviet Union is now dead and gone. The question is, how does this apply in the context of the State Bank of India in particular, and the public sector banks in general?
Let’s say an individual goes to a public sector bank to take a home loan. When he does that, he is asked for a proof of income and other papers required by any bank to process a home loan. Looking at these papers, the bank manager will get the adequate knowledge to figure out whether the individual deserves a home loan in the first place or not. If that is a yes, then the manager can get into deciding what is the maximum loan that the bank can give, given the income and other factors of the prospective borrower. The manager can also check out the credit profile of the prospective borrower on the various credit databases that are available.
Also, the manager will make sure that the loan is only a certain portion of the value of the home being bought. In case of SBI, the average loan to home value ratio stands at 43 per cent. This basically means that for every Rs 100 of home price that SBI finances, it only gives Rs 43 as a home loan, on average.
This means that the bank has a huge margin of safety built into home loans. In fact, once we factor in black money that is paid with every real estate transaction, the real average home-loan-to-home-value ratio is even lower than 43 per cent. This makes the home loans business an absolutely safe form of lending. This is true for other retail forms of lending as well.
This is primarily because the bank manager who has the knowledge of the transaction also has the power to make the decision of whether to give the loan or not. There is no separation of knowledge and power.
The same dynamic does not work when it comes to lending to corporates. In an ideal world, when a corporate approaches a public sector bank for a loan, the bank looks at the financial situation of the corporate, the total amount of loan it is asking for and the purpose for which it wants the loan.
This gives the bank and the manager dealing with the corporate a good idea of whether the project for which the loan is being requested is feasible. At the same time they figure out, given the present earnings of the corporate, whether it will be in a position to repay the loan. Also, having been in the business for a while, the manager would know the past record of repayment of the prospective corporate borrower.
In this case, the manager has the adequate knowledge and is in a position to decide whether to lend to the corporate or not. But this is not how things always turn out. In some cases, the corporate looking to borrow may have political backing. In this case, the knowledge of the manager(s) goes for a toss, and the power of the politician becomes the deciding factor.
Take the case of Lagadapati Rajagopal, founder of the LANCO group and also the richest MP in the last Lok Sabha (2009-2014). In a February 2015 column, Shekhar Gupta wrote in The Indian Express about Rajagopal:
[He] is the same businessman whose company got a Rs 9000 crore reprieve in a CDR (corporate debt restructuring) process just the other day. His bankrupt companies were given further loans of Rs 3500 crore against an equity of just Rs 239 crore. Twenty-seven banks were involved in that bailout.
Now imagine giving a loan of Rs 3500 crore against an equity of Rs 239 crore. This makes for a debt equity ratio of 14.6:1. No bank in its right mind would have given Rajagopal a loan if he didn’t happen to be an MP from Vijaywada representing the Congress Party. Compare this to what business schools teach in their basic financial management classes: Anything beyond a debt-to-equity ratio of 2:1 is risky. And here we had banks not blinking an eye while lending on a ratio of 14.6:1.
This separation of knowledge and power has been one of the main reasons behind the mess in public sector banks. As mentioned earlier, the bad-loans ratio of SBI as of March 31, 2017, was at 6.9 per cent. In the case of HDFC Bank, the best private sector bank, the ratio was at 1.1 per cent. The main reason for this lies in the fact that there is very little separation of knowledge and power at this bank.
This is not to say that all private sector banks are doing well. Some private banks also have a bad-loans problem. But on the whole, it is nowhere as pronounced as it is in the case of public sector banks. The total loans given by public sector banks are 2.9 times the total loans of private sector banks. But their bad loans are 7.5 times that of private banks. If both these set of banks were equally well run, then the two ratios just referred to wouldn’t have been different.