There is a declining trend in the banking sector’s returns on equity as banks are not lending to the private sector. The ROE of the top five banks has declined from 25-30 percent in 2006-7 to 10-15 percent today, the advance to deposit ratio (ADR) has slipped from 70 percent plus to 40-50 percent, while private credit to GDP has shrunk from 27 percent of GDP to 17 percent. Why are banks not lending?

There are four main reasons for banks' declining appetite for lending. On top is the lack of contract enforcement – due to the judicial system’s shortcomings, banks find it extremely difficult to recover bad loans. The second impediment is that businesses (especially SMEs and retail segment) run two financial books (where the documented is usually a fraction of the actual) which makes it extremely difficult for banks to assess credit risks based on cashflows.

The third is the concentrated ownership structure of banks – especially in ‘Seth’ owned banks. This makes them extremely risk-averse. These banks don’t look at lending as a service they are bound to provide. And last but not least, is the crowding out of private credit by government borrowing which is growing due to the persistently high fiscal deficit and higher interest rates consequently.

In the early 2000s, with the banking sector’s deregulation and privatization, banking lending was growing. At that time, the government was running a low fiscal deficit, and market interest rates nose-dived. That was the time when bank lending to the private sector grew and within the private sector, the share of SMEs peaked at 20 percent in 2005. This was the time when consumer lending started picking up as well. However, after the economic downturn in 2008, the twin deficit ballooned and interest rates increased significantly, bank note-performing loans (NPLs) grew – especially in the SME segment. Later the recovery was hard due to weak implementation of the law of the land which made banks risk-averse thereafter.

The government's domestic debt has increased from 28 percent of GDP in 2007 to 46 percent in 2022- the majority of this debt is financed by commercial banks. The KIBOR averaged 10 percent since 2008 which made lending riskier.

Having said that the inclination of lending to the private sector – especially SMEs has been higher for some banks compared to others. One differentiating factor is the thinking of the owner of the bank. In most cases, the ownership of banks is concentrated. Those who are owned by trusts have an inclination towards doing the main purpose of banking- channeling the savings to the lenders. Even in concentrated ownership banks, there are banks where Seth's personal influence in decision-making is less.

However, in banks with a typical Seth mentality, the general attitude is too skewed toward the bottom line. There are examples where lending decisions are based on the interest of the owner in other businesses – if a bank owner has a cement factory, he may not dole out a loan to the competitor and vice versa. There are incidences where the credit line of good customers is halted due to some other matter or dispute of the borrower with Seth.

These banks have little or no interest in SME lending and consumer products like credit cards. They are generally not interested in exploring new avenues like digital banking. Branches of such banks are less cozy and the digital consumer interface is not user-friendly.

However, they can only be complacent and choosy if the treasury is the bread earner. And that is till the time the government is the dominant borrower. Once the system has ample liquidity and better recourse of recovery, better-run banks would start lending; and the Seths would have to follow.