The government is rescuing bust public sector banks with Rs 1,35,000 crore of recapitalisation bonds as part of a Rs 2,11,000-crore package. RBI governor Urjit Patel calls this “a monumental step”. It could more accurately be called a decision to let the pigs keep feeding at the public trough. It does not reform the woeful practices that have led to bad lending and bust banks.

After a lending spree in the 2000s for infrastructure and industrial projects, almost one-fifth of all public sector bank loans are stressed, and over one-tenth are non-performing (payments are not coming). If banks disclosed in their accounts the full extent of bad debts, the losses would wipe out their equity capital. So, they have resorted to accounting tricks to put off the evil day.

They cannot lend more for want of supporting minimum capital required by law. The government rescue will enable them to write off unrecoverable debts, and start lending again. It will also enable zombie companies, whose debts are written off, to invest and grow again. The government hopes this will revive investment and spur the economy.

Alas, a rescue of this sort is not a reform. Chief economic adviser Arvind Subramanian has spoken of four ‘R’s in the new approach to public sector lending. The first is Recognition: setting iron-clad norms (as the RBI has done) for recognising doubtful and bad debts in bank accounts. Second is Resolution, or disposal of bad loans through bankruptcy tribunals, which will either devise revival schemes entailing sacrifices (or “haircuts”) by all parties, or decree liquidation. This process has begun, but its speed and effectiveness have yet to be proved.

The third R is for Recapitalisation, giving banks enfeebled by losses the capital to lend again. The fourth R is for Reform. Here, alas, nothing has been announced.

Without reforms, recapitalisation may simply encourage continued bad behaviour by banks. Subramanian says one reform could be to maximise recapitalisation of the best public sector banks and minimise that of the worst. This would be cowardly half-baked reform, but better than nothing.

A big-bang reform would be privatisation. Private sector banks have mostly thrived even as public sector banks have sunk. Private banks can take quick decisions, resist government pressures to lend to dubious schemes, and accept genuine mistakes. But public sector spending always gives procedure priority over performance, with tragic consequences. Alas, privatisation remains a political no-no.

Subramanian has long talked of bank paralysis caused by fears (in today’s anti-corruption mood) of the four Cs — courts, CVC (Central Vigilance Commission), CBI (Central Bureau of Investigation) and CAG (Comptroller and Auditor General). No reform has been proposed to overcome these.

Bank nationalisation in 1969 led to a culture where banks lent in pursuance of government pressures, legitimate or otherwise. This included risky infrastructure projects lacking many clearances or clarity about cash flows, and suffering from excessive debt-equity ratios. It also meant acceding to informal (and often corrupt) political pressures to lend to cronies, bend rules for them, or forgive their debts. This last pressure has diminished in today’s anti-corruption mood but has not disappeared.

This culture had perverse incentives. The biggest gainers were crooked businesses that habitually inflated project costs, routing all purchases of capital equipment through benami subsidiaries that creamed off 30%. This inflated the amount of borrowing needed by the project and could render a project unviable at birth. Crooked businesses put in just 30% of the project cost as their own equity, and recovered this through project inflation at birth. So, the entire project risk was borne by lending banks, which sank when projects ran into bad weather or bad luck.

Banks should but don’t have the expertise to evaluate all Detailed Project Reports of promoters. Banks typically appoint an affiliate of the State Bank of India (which has the credentials) to screen the proposal and certify it. The SBI affiliate goes through the motions, collects its 2% fee, and signs off with zero liability if its assessment turns out to be rubbish. Bank managers happily lend with certification that protects them from CVC investigations. Herein lie the seeds of many bad loans, culminating in huge losses and recapitalisation.

Public sector banks must create or purchase the expertise for excellent project evaluation. Certification agencies are needed, but their track records must be scrutinised, with penalties and prosecution in suitable cases. Banks must insist on global tendering for equipment to thwart cost inflation by promoters.

Greater diligence in project screening and a quick exit for bad promoters must be the two main aims of purposive bank reform. Recapitalisation is only a palliative.