When the State Bank of India started offering mortgages in the UK last month, it was as if a dream had started to come true for Duvvuri Subbarao.

India’s central bank governor has pinned his hopes on four global financial institutions emerging one day from India’s largely state-owned banking sector.

Their rise would be testament to India’s conservative macro-prudential regime that has kept the banking system under state control and largely out of trouble in the financial crisis. It would also be a long overdue reflection of the scale of India’s economy and the ambitions of New Delhi.

Yet SBI’s offer of mortgages to British homeowners coincided with a rude reminder of realities back home.

At SBI’s head office in Mumbai, the country’s largest lender has reported that non-performing assets are on the rise and a capital infusion of Rs79bn ($1.8bn) from the government is on its way.

India seems almost certain to produce its own equivalents of HSBC, Citigroup and China Construction Bank.

But for the moment, the wings of its banks are clipped by their balance sheets. As well as being weighed down by rising NPAs, they face possible high-profile business failures like Kingfisher Airlines , the task of bringing millions of poor people into the banking system and demands to finance India’s yawning infrastructure needs.

Many lenders require urgent recapitalisation. By one estimate, they need to raise Rs2.7tn in equity capital within five years.

The strains of financing the fastest-growing large economy after China have not gone unnoticed. Last year, Moody’s downgraded its outlook for India’s banking system to “negative” from “stable”, airing its worries about asset quality, capitalisation and profitability.

Since then, policymakers have given strong hints of the magnitude of the capital injection needed to meet international regulatory standards and support India’s growth.

One senior official says private sector banks will have to find a “few trillion rupees” to meet Basel III capital adequacy norms. Public sector banks have requested more money from the Congress party-led government, which already faces criticism for its widening fiscal deficit. Delhi, in turn, has agreed loans from the World Bank to bolster its banks’ capital base.

Tranches of new capital are on their way to help public sector banks meet new capital requirements to be introduced at the beginning of next year. Pranab Mukherjee, finance minister, wants to go beyond Basel III by lifting banks’ tier one capital above 8 per cent of risk-weighted assets against a requirement of 6 per cent. This will prove costly for the government, and the fiscal implications will alarm economists.

Last year, Delhi extended capital support to the tune of Rs202bn to public sector banks. Among the recipients were Bank of Baroda, Union Bank of India, Oriental Bank of Commerce, UCO Bank and Dena Bank.

Bank recapitalisation now tops the priorities of Manmohan Singh, the prime minister, alongside his concerns about fiscal profligacy and his impatience to introduce much-needed tax reform.

As the national budget on March 16 approaches, expectations are running high that Mr Singh will give fresh momentum to economic reforms in the two years left of his term in office. He badly needs to find ways to return India’s growth back to 9 per cent and prevent it sinking further below the current 7 per cent. The prime minister could do far worse than to take some weight off the banks’ shoulders. If he does not, and is somehow stymied by India’s coalition politics, an overstretched banking system could invite systemic risk.

Nowhere is this more important than infrastructure finance. Rather than expecting commercial banks to meet all the economy’s needs with short-term loans, Mr Singh and his team must allow alternative financing mechanisms, such as bonds. With few better prospects than India’s economy over the next 30 years, they could also do a much better job of attracting foreign capital. For too long, Mr Singh and his team have bandied about staggeringly large figures to estimate the investment opportunity to modernise India’s infrastructure. The favourite is $1tn. But such estimates are meaningless without plans translating more readily into delivery of roads, railways and ports.

With the exceptions of new airports in big cities such as Delhi, Mumbai and Bangalore, a metro in the capital and cheap mobile telephony, far too little has been done to take India’s infrastructure out of the 1950s and to build cities of the future for its 1.2bn people.

Mr Singh is well aware of the shortcomings. His current battle is over the power sector, where plants are starved of coal in spite of the state-controlled Coal India being the world’s largest producer of the commodity.

Now is the time for the prime minister to remove the barriers to insurance companies, pension funds and longer-term debt instruments from financing infrastructure. He should also lift restrictions on financial products such as credit default swaps and derivatives. After all, in responsible hands and tightly regulated, these should reduce risk rather than multiply it.

To attract foreign funds with the prospect of returns well above 6 per cent, he might consider state assistance, such as an offer to reduce currency hedging risk or to allow debt securitisation.

Liberalised financial markets, as much as repaired bank balance sheets, will give Indian lenders a far better chance of expanding overseas and providing mortgages in other parts of the world in the years to come.

(James Lamont is the FT’s South Asia Bureau Chief)

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