India’s NPA conundrum

GS3 – Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

Context

• The government is amending  the Banking Regulation Act, 1949, which is expected to invest banks with some freedom in resolving bad loans without inviting the prosecutorial gaze of central investigative agencies.
• Finance Minister Arun Jaitley’s budget proposed a measly ₹10,000 crore towards recapitalisation of public sector banks (PSBs). The budget thus steered clear of the biggest constraint to growth today: what the latest Economic Survey labels the “twin balance sheet (TBs) problem.”
• Bank credit growth has slowed, affecting capacity creation and expansion—bank credit grew only 5.1% during year to March 2017, against 10.3% in the previous year.
• The Reserve Bank of India’s (RBI’s) latest Financial Stability Report shows stressed assets (sum of gross NPAs and restructured assets) at 12.3% of assets by September-end 2016.

Background

• India’s leading corporates have too much debt on their balance sheets; this keeps them from making fresh investment. Banks are weighed down by a mountain of bad loans; this comes in the way of credit growth. TBs impacts growth by affecting both the demand for credit and the supply of it.
• One, the non-performing asset (NPA) problem at PSBS cannot be ascribed primarily to mismanagement or bad governance.
• Two, India has not faced the sort of recession that results from TBs, thanks largely to government ownership of banks.
• Three, resolution is impossible without significant debt write-offs.

(Mis)Management Not the Cause

• The TBs problem has arisen primarily because of irrational exuberance on the part of investors, commensurate exuberance amongst banks flush with funds and factors that banks could not have bargained for when they made the loans.
• As the world economy boomed in the mid-2000S and the Indian economy along with it, Indian firms embarked on an investment spree.
• Much of the investment went into infrastructure and related areas such as telecom, power and steel. Banks vied with each other to finance these projects.
• This resulted in a credit boom: non-food credit doubled in the period 2004–05 to 2008–09. Companies raised record levels of debt from the international markets as well.
• As a result, the debt to equity ratio in Indian companies shot up above normal levels. Companies were taking on risk in anticipation of huge growth opportunities.
• Alas, growth opportunities diminished considerably with the onset of the global financial crisis in 2007.
• Projects that had been built around the assumption of double-digit growth were suddenly faced with growth rates half that level.
• Indian companies faced delays in securing land and environmental clearances and this caused project costs to soar precisely when revenues were falling.
• The Reserve Bank of India (RBI) increased interest rates to deal with double-digit inflation, so financing costs rose.
• The combination of lower revenues, higher project costs and higher financing costs played havoc with companies’ cash flows and hence their ability to service debt.
• Soon, other factors exacerbated the situation.
• The collapse in world steel prices following China’s slowdown. There are Supreme Court judgments that impacted the mining and telecom sectors or the failure of Coal India to meet commitments to supply coal.
• In the power sector, spot prices for electricity fell even as the break-even tariffs for power projects increased on the back of inflated project costs.
• With the benefit of hindsight, one can say that banks should not have taken the exposures they did. But when a boom is on—whether in the credit market or the equity market—managers have to be extraordinarily brave not to want a piece of the action.

Why Private banks remain aloof from NPAs?

• The leading private banks are exposed to the very sectors and projects to which PSBS are exposed.
• It is not as if private banks demonstrated superior expertise in appraising projects.
• The private banks did a better job of spreading risk between corporate and retail lending and hence are impacted to a lesser extent by the woes of corporates.
• But, then, in the mid-2000S, infrastructure was the big opportunity and PSBS had the means to fund it.
• The banking system was awash in liquidity and banks had to find avenues for their funds.
• If PSBS had focused on retail loans as much as private banks did, there would have, perhaps, been ended up with a housing bubble (as in the United States) instead of an infrastructure bubble!
• The bottom line should be clear enough. There may have been acts of corruption but, for the most part, the bad loan problem has arisen on account of the exuberance of investors and factors extraneous to banking.

Why is there no Banking or Economic Crises?

• A TBS typically results in a recession. This has not happened in India despite the fact that the ratio of NPAS to gross loans in India today is higher than in South Korea at the peak of the East Asian crisis. Growth has slowed down to 7%, but if this is what TBS means, many advanced countries would love it.
• The Economic Survey mentions three possible reasons.
• Despite the high level of NPAS, there has been no banking crisis.
• Elsewhere, there would a failure of public confidence in banks and several banks would fail. The contraction in credit would result in a recession.
• There has been no banking crisis in India because the banks most affected are PSBS. Depositors have the confidence that the government will ensure safety of deposits.
• Investors in PSB bonds know that the government will ensure that the minimum capital needed is made available.
• High NPA levels have not translated into a loss of creditor confidence.
• The additions to infrastructure that have happened—more roads, ports, power stations, airports, better telecommunications—may have created headaches for investors and banks.
• At the macro-level, however, they have eased supply constraints and helped growth.
• Indian banks did not respond to companies’ woes by forcing bankruptcy. This would have meant seizing assets and trying to liquidate them.
• In India, this is a time-consuming process and results in poor recovery. So, wherever there is hope of a turnaround, banks prefer to keep the firm afloat. They reckon that, once growth accelerates, the firm’s cash flows and debt servicing will improve.
• The Survey notes that this approach worked for banks in the early 2000s. They hoped the same would happen this time. So, they restructured existing loans and extended fresh funds to help them cope until demand recovered.
• By 2014–15, restructured loans accounted for 6.4% of loans outstanding. Despite tighter checks by the RBI, banks continue to evergreen loans (market estimates of unrecognised bad loans are 4% of the total).
• NPAs and restructured assets are 12.6% of all loans. Adding unrecognised loans, bad loans are 16.6% of total loans. At PSBs, the figure is around 20%.

 How the banks managed!

• Such a “financing strategy,” the Survey notes, can help under one of two conditions.
• One, companies’ cash flows improve and this enables them to eventually service debt.
• Two, even if particular projects and companies do not recover, the Indian economy could, and NPAs as a proportion of gross domestic product (GDP) could fall.
• This would render the problem manageable. Unfortunately, neither has happened.
• From 2012 to 2015, the earnings before interest and tax (EBIT) of IC1 companies (that is, those with an interest coverage ratio of less than one) remained steady at ₹25,000 crore per quarter.
• However, by the end of 2015 EBIT had fallen to ₹20,000 crore per quarter. By September 2016, earnings had fallen to ₹15,000 crore per quarter.
• These companies have had to continue borrowing in order to continue their operations. Stress has spread from large corporates to micro, small and medium enterprises (MSMEs).
• Hopes that the bad loan problem would be resolved by rapid economic growth have also not been borne out.
• Private investment has contracted as companies with high debt are in no position to invest and public investment has not risen sufficiently to offset the contraction.
• With bad loans eroding profitability, banks have chosen to increase their margins in order to offset some of the stress arising from their bad loan portfolio.
• The spread between the average term deposit rate and the base rate increased from 1.6 percentage points in January 2015 to 2.7 percentage points in December 2016.
• The increase in spread is causing the better borrowers to seek resources from outside the banking system.
• At the same time, MSMEs, which do not have the same access to non-bank resources, are facing higher lending rates.

 What are the deficiencies in the amendment?

• The crimp is PSBs’ lack of balance-sheet muscle to tackle the volume of NPAs. The International Monetary Fund’s (IMF) 2017 Article IV report on India shows that while aggressive NPA recognition by PSBs turned their return on assets negative in 2015-16, aggregate provisioning coverage ratio still remained low, indicating weak capital bases.
• The IMF report also shows that PSBs are content writing off loans rather than recovering them—a commentary on the numerous, though deficient, stressed asset resolution mechanisms. The short point is this: banks are unlikely to get aggressive with NPA resolution unless there is capital within sight.
• The government, on its part, has drawn up a three-pronged plan to meet its capital infusion responsibility: limited capital infusion depending on performance criteria, merging some of the larger banks, and asking banks to source balance capital from capital markets. All these measures are time-consuming and the pace of capital flow is likely to determine the speed of resolution.
• The other problem lies in the wording of the amendment. The government has inserted Section 35AA in the Act, which states: “The Central Government may by order authorise the Reserve Bank to issue directions to any banking company or companies to initiate insolvency resolution in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.” This is followed by a paragraph stating, “Without prejudice to the provisions of section 35A, the Reserve Bank may, from time to time, issue directions to the banking companies for resolution of stressed assets.” The RBI will also create committees of experts to advise banks.
• It arose two issues
• First, the amendment does not explicitly insulate bankers from future persecution, nor is there any implicit signal. The Prevention of Corruption (Amendment) Bill, 2013, which includes provisions for such a shield, is stuck in Rajya Sabha. Therefore, till there is clarity on where the buck stops—the Centre, the RBI, the committee of experts appointed by RBI or the bankers—progress is likely to be slow. Therefore there are risks of government being accused of cronyism.
• Second, the amendment is unclear about how the Centre proposes to take the resolution forward: will the government monitor each individual asset resolution or provide an umbrella order enabling the RBI to calibrate its action depending on the merits of each case? The central bank (or its appointed committee) will be exposed to scrutiny from investigative agencies, which may be detrimental for any central bank.
• Finally, if all the above do fall into place, there is still one snag: capacity constraint at the National Company Law Tribunals. Of the 700 cases filed with the tribunals, only 70 have been admitted. Moreover, the National Company Law Appellate Tribunal has ruled (as reported by this newspaper) that the 14-day deadline for admitting or rejecting a proposal is not binding, though once admitted, the case has to be resolved in the mandatory 270-day period.

 Is a ‘Bad Bank’ the Answer?

• The “financing strategy” has run its course. What do we do now?
• The Survey thinks that leaving it to individual banks to resolve the bad loan will not work.
• Bank management is reluctant to write off debt for fear of facing the wrath of investigating and oversight agencies.
• There are problems in getting banks to agree on the level of write-off in a given case. Banks do not have the capital to make the necessary write-offs.
• The Survey, therefore, proposes the creation of a Public Sector Asset Rehabilitation Agency (PARA) to tackle bad loans.
• The government will have a 49% stake in PARA.
• This should help overcome the incentive problems that managers at PSBs face. Moving all bad loans to one agency should help overcome the coordination problems we now face.

What are the constraints?

• Managers at PARA may not have to look over their shoulders while making write-offs.
• But the government, as the dominant investor, cannot avoid scrutiny and the inevitable controversy where large corporates are involved.
• Setting a sale price for the transfer of bad loans can pose problems of coordination amongst banks as formidable as the ones we face now.

 Way forward

• A better course would be to create a mechanism that enables PSB management to resolve bad loans without fear of a witch-hunt.
• The Banks Board Bureau has created an oversight mechanism for vetting loans but this is said to be meant only for “Scheme for Sustainable Structuring of Stressed Assets (S4A)” resolution.
• The authority must be empowered to approve any type of resolution.
• Second, the authority must be backed by an act of Parliament as otherwise the vetting authority itself could be exposed to investigation.
• Third, the government must infuse capital into PSBs necessary to cover write-offs.
• The government’s dithering on recapitalisation rests on the premise that the bad loan problem owes primarily to bad governance and mismanagement. This premise is erroneous as also the Economic Survey argues.
• The government must move ahead swiftly on recapitalisation in the knowledge that India’s recapitalisation cost—at 0.5% of GDP—over two decades is among the lowest in the world.