If you read between the lines, it is clear that the Indian banking system is extremely vulnerable to large corporate defaults. This is an indirect way of saying crony capitalism is endangering the system

The Reserve Bank of India's latest Financial Stability Report (FSR), released yesterday (30 December 2013), makes for chilling reading. It shows the extent to which the UPA government (and, to a lesser extent, the regimes before that), has allowed the banking system to be debauched, increasing systemic risks by encouraging crony capitalism.

The real scary statement in the FSR, the first one put out after Raghuram Rajan became RBI Governor, is the one which points out that the failure even one large company or a large corporate group could danger the entire Indian banking system. The report said: "Failure of a major corporate or a major corporate group could trigger a contagion in the banking system due to exposures of a large number of banks to such corporates. The analysis shows that interconnectedness in the banking sector could cause losses due to contagion, over and above the direct losses on account of the failure of large corporate groups."

The FSR puts a figure to the potential crisis scenario: if one major corporate group goes belly-up as a result of which none of the money lent to it can be recovered (ie, a 100 percent default), it could wipe out "over 60 percent of the banking system's capital." If only 40 percent of the money lent is salvageable, "over 50 percent of the banking system's capital" can be erased in one shot.

What this means is simple: one damaging crony relationship between one major bank and one corporate group can threaten the whole system. This tells us how much the banking system has been compromised in recent years by the close linkages between government and crony capitalists. This is highlighted by the fact that in some banks, loan exposure to a single borrower accounts for a quarter of the total banks' capital."In the Indian context, a bank's exposure to a single borrower can go up to 25 percent of the bank's total capital, while its group exposure limit can go up to 55 percent of the bank's total capital. These exposure norms have evolved in the context of the country's growth and development requirements, but are on the higher side by international standards," says the report with classic understatement.

Lending 55 percent of your entire capital to one single corporate group is not just about exposure being on "the higher side", but rank vulnerability to a crony going bust. It is irresponsible for any bank management to do this.

Signs of banking stress have been rising all through UPA-2 after a period of relative stability in corporate finances that began under the NDA in 2001-02. This stability lasted till the last years of UPA-1 in 2007-08, thanks to strong growth in business revenues. But things started deteriorating dramatically for India Inc after this despite continuing high growth for some more years. Says the FSR: "Deterioration in all dimensions (leverage, liquidity, profitability, sustainability, and turnover) was witnessed during 2007-08 - 2008-09 with profitability and leverage contributing significantly to overall stress. After marginal improvement in 2009-10, stress increased again. Demand and efficiency factors contributed more towards increase in risks. Sustainability, leverage and profitability also contributed to stress. Though there is some improvement in profitability4 towards the second half of 2012-13, other stability parameters deteriorated."

Little wonder companies are not investing.

These and several other statements in the report indirectly suggest a huge rise in crony capitalism during the UPA's two terms, though one can't presume this was a purely UPA phenomenon. What is clear is that under UPA-2's benevolent welfarism, crony capitalism flourished, endangering the financial system like never before at a time when the government's ability to rescue the system are low, and the world economy is barely out of the woods.

In just six months, between March and September 2013, the banking system's stressed assets - which means loans that could go bad anytime - has risen from 9.2 percent to 10.2 percent of the advances portfolio, but the interesting part is this: "The largest contribution to stressed advances comes from the PSU banks." If public sector banks are contributing more to the bad loan portfolio than private banks, it means they are either worse managed or are more tolerant of crony bad loans than private ones. Or both. A case in point: when Kingfisher loans went bad, ICICI Bank exited quickly in July 2012; the public sector banks are still struggling to recover their dues. Crony capitalism is tougher to ward off in public sector banks.

Here are more statements that point to the crony nature of loans to India Inc. The FSR says that "medium and large-sized industries contributed more towards stressed advances than micro and small-sized industries." It is logical to assume that the big boys get more loans and also have bigger political clout. And they are the ones going into default - not the smaller guys who are starved of credit anyway.

Another measure of the banking sector's vulnerability to cronies is the ratio of stressed loans between corporate and retail. The FSR report says this: "Industries recorded the highest share in restructured standard advances and with relatively high gross non-performing assets (GNPAs) contributed the highest

share of stressed advances in the banks' loans portfolio, followed by services. Retail segment fared much better in terms of GNPA and restructured standard advances ratios." The term "restructured" advances means banks have been changing the terms of loan and interest payments in favour of the borrower in order to prevent a loan from going bad. Retail borrowers are the good guys here, not crony corporates.

Another tell-tale sign of cronyism is the vulnerability of sectors that typically need huge amounts of capital and friendly tweaks in government policies to make money. These are typically infrastructure, heavy and basic industries, mining, and aviation, among others. Guess what the FSR says? "Five sectors, namely, infrastructure, iron and steel, textiles, aviation and mining together contribute 24 percent of total advances of SCBs (scheduled commercial banks), and account for around 53 percent of their total stressed advances." In short, politically favoured sectors with the highest dependence on government favours and policies - which is where crony capitalists operate best - account for half of the banking industry about-to-go-bad loans. They got a quarter of bank loans, but account for half its bad loan problems.

And guess which group gives the stock market more heart-burn? The report notes: "It has also been observed that the equity prices of the companies in which the promoters had pledged significant portions of their shares are relatively more volatile than the broader market during times of correction."

Clearly, crony capitalists who have pledged their shares with banks fiddle with their shares more than the rest.

The days of crony capitalism are clearly numbered, not because politicians and corporates have learned their lessons, but because if this trend is not arrested, the Indian banking system will be up the creek without a paddle.

The UPA government simply does not have the capital to strengthen banks' balance-sheets, Last year, instead of putting in the capital itself, it forced the Life Insurance Corporation to invest in public sector banks' equity.

In other words, instead of derisking the financial sector by insulating one segment from another, the UPA is now making the insurance sector too vulnerable to bank failures.

What can be more irresponsible than that?