The
article was first published in GARP Risk Intelligence, August 22, 2017;
Co-author: Anisha Sircar
Central bank deputy governor Viral Acharya is latest
to sound the alarm, advocating “tough love” with defaulters
The June 2017
Financial Stability Report of the Reserve Bank of India (RBI) (https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/0FSR_30061794092D8D036447928A4B45880863B33E.PDF),
highlighting the outcomes of stress tests on Indian banks’ balance sheets,
concluded that India’s financial system is healthy overall, but there are
rising concerns about the banks’ non-performing assets (NPAs).
They are the No.
1 priority of the RBI, the central bank’s deputy governor, Viral Acharya, said
at the Delhi Economics Conclave on July 22.
The business of
banking inherently involves risk-taking. A loan is by definition exposed to the
risk that the borrower will not ultimately return the principal and/or
interest, as per the loan agreement. In its definition of a NPA, the RBI says
that “an asset, including a leased asset, becomes non-performing when it ceases
to generate income for the bank . . .”
It is axiomatic
that NPAs are undesirable, and when at high levels, they constrict banks’
ability to extend credit. The ratio of non-performing to total loans is often
used as an indicator of the health of a banking system and the broader economy.
For the first
two decades after liberalization of the Indian economy, non-performing loans
were managed well, falling from 14% in the early 1990s to 3% 2004, attributed
to policies implemented by the RBI to curb the post-reforms NPA crisis.
However, since
late 2011, bad loans have been rising sharply and have evolved into a major
threat for the banking sector and the economy at large.
Figure 1
Source: World
Bank; http://data.worldbank.org/indicator/FB.AST.NPER.ZS
“Credit Shock”
Concern
The RBI report
predicted a further rise in the Gross NPAs of Scheduled Commercial Banks (the
dominant players of the financial system, under which public sector banks,
private banks, foreign banks and regional rural banks are classified) from 9.6%
in March 2017 to 10.2% in March 2018.
Even more
telling was the prediction that “a severe credit shock is likely to impact
capital adequacy and profitability of a significant number of banks” by the
same year.
The solvency of
a bank – the ability to meet its long-term fiscal obligations – when extended
to the potential of disrupted asset quality of banks at a macroeconomic level,
can lead to impaired credit growth in the entire economy. In the long term,
this can also hamper macroeconomic factors such as GDP growth.
Furthermore,
bailing out banks with high NPAs would require infusion of capital by the
government, potentially becoming a burden on taxpayers.
Banks with
higher retail portfolios (that is, more consumer-oriented) and lower “legacy
loan” clients (whose assets have been on the books for long periods of time)
usually have better NPA ratios.
Public-sector
banks are more exposed to NPAs because their portfolios tend toward
infrastructure, real estate and telecom, which are significantly hampered
during economic downturns. Private-sector banks are often more vigilant and
prudent in their credit appraisal, risk management and loan recovery.
In this light,
India’s NPAs are concentrated and growing fastest in public-sector banks. The
trend in other banks has also been upwards, but at a lower rate than the public
banks. (See: Galloping Non-Performing Assets Bringing a Stress on India's
Banking Sector; https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2947557).
Government and
Central Bank Actions
Capital
infusion, setting up Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate
Tribunals (DRATs) in 1993, and the SARFAESI (Securitization and Reconstruction
of Financial Assets and Enforcement of Security Interest) Act of 2002 did not
help banks and financial institutions recover NPAs.
Over the
decades, the RBI has also come up with schemes such as Corporate Debt
Restructuring, Strategic Debt Restructuring, 5/25 Scheme, Sustainable
Structuring of Stressed Assets (S4A), and the Joint Lenders’ Forum (JLF).
The
“Indradhanush” road map was laid out by the government in 2015 to recapitalize
banks by asking them to officially recognize top defaulters as non-performing
accounts, and make provisions for them, as well as to inject Rs. 700 billion
into state-run banks. However, the challenges kept mounting until it reached
proportions that threaten the stability of the entire banking system.
In recognition
of the escalating nature of the NPA issue, the Banks Board Bureau was set up in
February 2016 to improve the governance of public-sector banks. In August 2016,
the Indian government issued the Insolvency and Bankruptcy Code 2016 (IBC),
which empowered the RBI to speed up the recovery of NPAs in the banking system.
Significant
Defaulters
In October 2016,
the Insolvency and Bankruptcy Board of India was set up, consisting of the
National Company Law Tribunal (NCLT) and Debt Recovery Tribunal to oversee
proceedings – the former for companies and limited liability partnership firms,
and the latter for individuals and partnerships.
Within a month,
the RBI came out with a list of “willful defaulters” responsible for the
preponderance of problem loans. As it turned out, 12 companies accounted for
around 25% of the entire banking sector’s NPAs.
However, after
several banks (particularly State Bank of India) published personal details and
photographs of willful defaulters and their guarantors, the RBI cracked down on
them, surmising that the banks were not limiting their disclosures to the worst
cases. In April 2016, then-RBI governor Raghuram Rajan contended, “Sometimes
you default on your credit card bill. Would you like that default to be put up
in public? If every time you defaulted, it was put up in public for your
neighbors and relatives to see and no reason was given, you might have some
concerns.”
In a landmark
move announced in May 2017, the government issued an ordinance to amend Section
35 A of the Banking Regulation Act – allowing the RBI to oversee individual
cases and directly pressure borrowers into repaying their loans.
Finger Pointing
The NPA crisis
has been plagued by a blame game. The center has been blaming the banks for not
doing enough to tackle the NPA issue; and the reluctance from the banks’ side
seems to stem from an incentive to under-report: Classifying loans as
“sub-standard assets” would entail provisioning, which hampers the banks’
ability to lend.
Banks are also
wary of creating a negative or aggressive public image, particularly with respect
to large corporate loans. Lenders are wary of enquiries by vigilance committees
later on, who look into the writing-off of loans on the earliest signs of
frailty. This is when the onus is shifted to the RBI – to prevent the
under-reporting of bad loans, more thorough and regular inspections into banks’
classified loan categories seems like a plausible preventive measure.
Even though the
central bank has been instructing other banks and setting up committees to
resolve the NPA crisis, inadequacies and flexibilities in the implementation of
regulations have so far not yielded any substantive outcomes.
Such haircuts
are usually invoked when other resolution strategies don’t work and there is
minimal hope of recovering the loans. The intensity of this haircut reflects
the challenges faced by India’s banking sector – in many senses, the veritable
backbone of the economy.
No Quick
Fix
Recent steps
taken by the RBI will take time to show results. The institutional changes may
indeed bring about faster outcomes than other restructuring mechanisms so far,
but recoveries will still entail taking losses from loans that have not seen
the light of day, until now. It is important to note that this is no ordinary
crisis: this is a large and complex multi-billion-rupee debt bankruptcy, and
requires well-thought-out solutions from the political economy.
Acharya, who is
on leave from New York University’s Stern School of Business and has been
studying global banking crises for years, has been warning that failure to take
decisive action will lead to the kind of financial stagnation that Japan
suffered in the 1990s “lost decade,” which has had lasting after-effects.
Italy is
currently confronting a banking crisis that is seen as cautionary for India.
The establishment of “bad banks” to work out non-performing assets helped Ireland
and Spain, and now Italy is looking to the European Central Bank for guidance
along those lines.
Acharya’s
approach involves establishment of bad banks and taking a hard line with
defaulters, which he characterises as “tough love,” to prevent NPAs from
becoming unmanageable.
In the final
analysis, transactions between honest borrowers and lenders can lead to NPAs.
It becomes calamitous when problems are allowed to grow and fester for years
and inflict significant pain on bank balance sheets. The resulting
macroeconomic credit crunch can then affect money circulation, investments,
development and overall economic growth, as India has experienced since 2011.
The roots of the NPA problem are widespread, and only time will determine
whether the new strategic tools are equipped to solve the crisis at hand.
