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The Bad Loans Problem: An Approach to a Solution

Hemant Kumar Manuj

Author: Hemant Kumar Manuj

Date: Thu, 2017-03-16 17:47

The issue of the bad loans (BL) problem in India has been festering like a sore for several years now. It is now being recognised by the Government, the Reserve Bank of India (RBI), and the influencers of public policy as an important issue that needs a fast resolution. To my mind, this is the single biggest economic issue that needs to be resolved by the policy makers today. This has been holding up private investments for several years and is likely to choke any growth in demand and jobs in the economy in the coming years. This issue has clouded the various constructive measures taken by the current, as well as the previous governments, for inducing corporate demand. Beyond the obvious economic dimension, there are dimensions of social and political impact as well.

Let’s evaluate a framework for resolution of the BL problem. There should be three steps in the framework to systematically resolve the BL problem.

1.  Identify the reasons that led to the BL problem. There are systemic reasons and specific reasons for the banking loans turning into non-performing assets (NPAs), and these will require different approaches to the solution. Here I deal with the systemic reasons only.

2. For the systemic reasons, the policy makers need to develop the appropriate solutions with the sole objective of getting the maximum sustainable benefit to the broader economy. Each solution would have its costs and benefits to various stakeholders. Hence there should be clarity, in advance, as to what is expected of the solution.

3. Building the buy-in of the stakeholders and a swift implementation of the proposed solution.

Now I elaborate on the first two parts of the step. The third step is not covered by me in this article.

1.    Reasons for the BL problem: 

There are principally two system-wide factors that have led to the BL problem.

Firstly, the exuberant level of leveraged growth in the corporate sector post the global financial crisis (GFC) was not supported by an adequate level of "what if" analysis by the investors. It may be argued that there have been sharp and unprecedented regulatory and policy level developments in the last few years, adversely affecting the safety and returns of private investments. However, in hindsight, the majority of corporates and banks failed to swiftly develop and implement a strong alternate plan to deal with a sharply changed environment and thereby protect their risk capital.

Secondly, as already observed, there have been some very significant and unanticipated developments in the regulatory and policy environment. The changes have been brought in by the governments as corrective measures to ensure long term transparency and efficiency in the core sectors of the economy. However, it can definitely be argued that these changes needed to be supplemented with other measures which could have ensured a smoother cycle of transition. The governments (mainly Central, but also State) have failed to timely enact and implement supplemental laws/ policies to enhance, or at least protect, the prevailing contracts surrounding the operation of the sunk-in investments. The stalling of a significant portion of the large private sector projects could be directly linked to the cancellations of existing contracts, delays in award of fresh contracts, and delays in implementation of supportive policy measures.

While the BL problem can be attributed to both the investors (including lenders) and the Government, the former had very little leeway to act in the absence of the enabling steps to be taken by the latter.

The RBI has come up with several measures to get the lenders and the borrowers to work towards resolving the bad loans. For instance, subventions were provided in the form of allowing more flexible rescheduling of project completions, and certain types of restructuring (5/25, S4A, Strategic Restructuring). However, these could have helped only as temporary measures, till the projects got back into fully operational mode. As a pre-requisite for these measures, therefore, it was essential to have strong corrective policy measures swiftly enacted by the Government.

Apart from the above, the policy makers failed to realise the critical importance of a stressed asset market, while urging the lenders and the borrowers to transact in stressed assets. Since there is a virtual absence of an independent price clearing mechanism, the banks are forced to agree to subjective prices for sale of stressed assets to either the Asset Reconstruction Companies (ARCs) or any other counterparty. The absence of adequate capital and effective competition in the private markets represented by ARCs and the environment of post facto investigations of the transactions by the government agencies has further constrained the transactions.

2. Proposed solution:

The solution needs to be developed,  keeping in mind the reasons behind, and the prevailing circumstances surrounding, the BL problem, as presented above.
Since the factors, cited above, have largely emanated out of the difficult and unprecedented regulatory and policy conditions, it is imperative that the Government steps in as the principal "rectifier" of the problem. Secondly, it would be very much within the domain and the interests of the government's wider role to restart the overall economy by strengthening the balance sheets of the corporates and the lenders.

This would mean, basically, that a National ARC be formed to buy a significant part of the stressed assets using budgetary resources. The price of the assets can be determined by an independent panel, to be accepted by all parties. The role of the government should be to facilitate, and purchase, the stressed assets at an independently determined price.

While the above suggested measure may initially appear to be drastic, at least going by the theory of incentives, there is actually no practical alternative without the major involvement of the government. Had there been one, the same would have already been adopted by the private parties.

In terms of the benefits from adopting this approach, the corporate investments will get an immediate kick-off leading to demand and job creation. This, in itself should be a huge kicker for the economy. The government can also, in all likelihood, benefit from the improved valuations of the bought out loans in due course.

The proposed solution is not without precedence. It has similarities to the SUUTI framework implemented earlier. The details of the solution can be further worked out through time-bound consultations by the Government with the RBI, lenders, borrowers, and other relevant stakeholders and independent experts.

It is imperative that the government acts fast and decisively on the issue. The political dimension of any approach to resolution that involves government capital is likely to be also an important factor. However, with the right framework of communication and implementation, it would indeed be in the interest of the government to move forward and realise the benefits of a corporate and banking sector revival.

 

 

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Comments

Thank you sir, for sharing your views on one of the biggest issues that is plaguing our economy currently. Enormity of bad debt problem in banks can be gauged by the fact it is estimated that there are 6.97 lakh crores of NPAs lying in the books of banks and out of this around 6 lakh crores NPAs belong to public sector banks. An institutional mechanism along with enabling legal framework is very much need of the hour to resolve this issue. However I feel a National Asset Reconstruction Company (ARC) solution suggested will not resolve the issue on long-term and sustainable basis. ARCs are supposed to work on resolution and revival model. With the government’s entry in this sector again typical issues and inefficiencies related to government’s functioning in business domain will resurface, which in fact may aggravate the problem in long run. In fact, root cause of many NPA cases are believed to be political interference in bank lending rather than hardcore business consideration. In this crisis there is an opportunity to develop whole new industry around distressed assets and develop specialized skill set of industrial revival experts. An enabling policy and legal framework will help in evolution of ARCs in a big way and provide sustainable solution for this problem. Till now Indian experience with ARCs has been a mixed bag but little helping hand from authorities can surely improve the situation. Biggest issues that is being faced by ARCs is promoters interference after debts being referred to ARCs and inability of banks acting as a group in case there are multiple lenders to the project. Curtailment of promoter’s rights, conversion of debt into equity and consortium approach on part of banks can help ARCs smoothly taking over the NPAs and effectively turnaround businesses rather than being vehicle for book transfer of NPAs from banks to ARCs. Currently ARCs role is limited to financial restructuring, which may not work in many cases. So there is need for widening ARCs scope of work so that more turnaround stories can emerge for cases transferred to ARCs.
hemant.manuj_1770's picture

Thank you for your comments. You are quite right that ARCs should be encouraged for the resolution of bad debts. While that is a long term solution, in the short term, they are neither adequately capitalised nor have the requisite skills. Since most of the bad debts have a linkage to government policies, the govt should have a role in their faster resolution too.

I broadly agree with the author that bad loans problem is one of the biggest issue facing the economy, however this may not be the single largest economic issue. I would say broad economic reforms are also holding back the economy which include inter-alia labour reforms and effective implementation of the insolvency and bankruptcy code. Besides various government and regulatory hurdles which push back the ease of doing business in the country. As on date the stressed assets are close to Rs 10 lakh crore which is about 7% of our GDP. Most of the investments that have gone sour are in the iron & steel, construction and power industry. The reasons could be some corporates stretching too far and public sector banks lending to their projects without a rigorous due diligence process. Further, it cannot be ruled out PSBs lending to corporates under political or other pressures. This is also evident form the graph that NPAs of private sector banks are much less as compared to PSBs. Indeed, the bad loan problem needs a quick solution so that banks balance sheets are credible and healthy. However, the solution may not lie entirely by setting up a National asset reconstruction company and transferring all bad loans to it. It would amount the government taking over all the bad loans and an easy exit route for PSBs. Further, as government has earmarked only Rs 10,000 cr in the budget this year for capitalization of banks, it is not clear from where the money will come. Further, there is no guarantee that future loans of PSBs will not turn sour. Instead it may be advisable that lead banks of each lending consortium restructure the bad loans in consultation with the loan recipient in presence of reputed third party sector specialist and government representative. The assets which are beyond recovery should be outright sold. Also as some of our existing PSBs are quite small, these should be merged with some big banks so that the combined NPAs of larger entities are within reasonable limits.

Hi Hemant, Thanks for coming up with this great article which is absolutely relevant today, more so after the Kingfisher fiasco. It’s long since corporates have abused the loose laws around loan recovery and turning bad loans as NPA (nonperforming assets). Bad loans have adversely affected the state exchequer and non-recovery of the same has resulted serious implication on interest rates. Recently the Narendra Modi govt. has passed the ‘Bad Loans Ordinance’ bill which has given more power to the RBI and in-turn the banks. As a result biggest corporate houses such as Reliance, Adani, Essar, Jaypee, GMR, GVK etc. selling off their assets to repay their bad loans. It looks like with continued perseverance and stricter implementation of the ordinance, the govt. will be able to tackle the bad loans problem to a great extent.

Thanks for writing this blog and enlightening us with insights of persisting bad loan and probable efforts to be made by the stakeholders to bring NPA level down. I can’t agree more with you about how the burgeoning bad loan malaise is creating ripple effect in the economy. For last few years, the government and RBI is up in arms about NPA by taking certain prescriptive actions such as declaring restructured accounts as NPA from the date of restructuring, introducing fast-tracking bankruptcy law, proposing Bad bank, creating of Banks board bureau and recently empowering RBI to tackle with bad loan. The only question here is how much time will these efforts take to show the result? Undoubtedly, the worsened situation of NPA in India especially with the PSU banks cannot be resolved overnight. It is a humongous task to eradicate this persistent problem. Yet even after couple of years of introducing these measures, NPA level stands high and in fact is growing year on year. With the approval of ordinance to amend Banking Regulation Act, a new ray of hope has emerged. Banks are empowered by relaxing JLF norms i.e. approval by minimum of 60% creditors by value and 50% by number in the forum to restructure loans. I presume that with newly promulgated ordinance to empower RBI and introduce corrective action plans coupled with expected growth in economy, overall NPA level of banking industry should recede quickly and significantly. All these improvements will not only lead to reduction in NPA but also will drastically improve the balance sheet as well as valuation of stocks of banks. With the support of government to recapitalise banks and series of reform actions, we can truly see a silver linings for the banking industry.

A very well structured blog makes it an interesting read. This blog describes a topic which many may find a bit difficult to understand but the use of framework which the author uses makes it very easy to understand the issue in hand. The use of graph makes it even easier to understand. Author also details some of the limitations of the solutions he is proposing. The bad loans are truly an issue that should be dealt with by the government on high priority. Thank you, sir, for helping us understand a bit more about the topic.

A very well written and informative article sir. You rightly got out the systemic problems that banks face in recovering the bad loans. An other major problem I want to highlight is banks are not willing to take any haircuts to have a speedy resolution, out of the fear of investigations from vigilance authorities. A very recent example is the arrest of the IDBI bank officials for the Kingfisher loan default case. Along with a host of other measures that the government of India should take, they should also get bankers out of this fear from investigation agencies by removing bankers out of Prevention of Corruption Act. This change will motivate the bankers to deal with the problem more swiftly. The government has recently made a few policy changes. One of these changes being, giving extra power to RBI to tackle the NPA problem of a bank if it is not able to handle it in a given period. While we will have to wait to know how this works out, if we have a look at the NPAs as a whole the majority of them (around 75%) are from the steel and the power sector. I think rather than being reactive, the government should be proactive in looking at sectors periodically to analyse if the players in any sector are more likely to face problems. This give heads up to banks about the probable NPA’s that they might be staring at and act more quickly.

Prof Manuj has effectively pointed out the core issues of the piling up bad debts problem in India and also suggested some possible practical solutions to tackle this problem. It is not surprising that the recent announcements by the government to empower RBI to take measures to curb NPA problem is of the same tune with that of the author. The issue of bad debts is a massive economic issue troubling the government since long. This severe problem is kept unattended most of the time due to lack of power to RBI and banks. The sudden growth in some industries proved to be like cancer to the banks. On top of that, government regulations to fund SME and mid-corporate, Agricultural credit waiver, lack of security in small tickets added to the NPA problem. Along with that, poor credit risk assessment methodology, rush to achieve targets, incentives to achieve numbers, political pressure, lack of knowledge of credit officials, ignorance of early warning signals and lack of follow-ups with bad debts were responsible in the unacceptable growth of bad debts. As a breath of fresh air, the banks have finally found a road map to drive out of the NPA jam. The cabinet has cleared the NPA Resolution Package that includes a presidential ordinance amending the Banking Regulation Act. It gives RBI the necessary power to more effectively deal with stressed assets. Hopefully, the banks will now grab this opportunity and jump to clean up their balance sheets burdened with bad assets. We need to wait and watch how the actual implementation turns out to be.

The issue of NPAs isn’t a stranger to the Indian economy which had its traces in the early 2002-03 but the closure of FY 2015 for the banking system sent jitters down the stock markets that portrayed NPAs as high as over 8% of their advances where the banks were compelled to make provisions for the NPA plummeting their profits. Why is it very significant in the present scenario? What made the government and the regulators to react now ? In the early 2002-03,when the credit fuelled economic expansion marked its beginning and private companies especially in the power and infrastructure domain unleashed their spree of expansion at the expense of the credit from the banking system. But the NPAs reduced from 7% in 2002-03 to 2% in 2004-05 due to the boom in the economy and positive response of the global and domestic markets. The scenario of NPAs in 2011-12 was completely different as rightly portrayed by the author as to the lack of the investor support that leveraged the exuberant growth post the global financial crisis. Also I would like to add to the systemic reasons of the author that lack of transparency, soaring crude oil prices fuelling inflation and unstable political scenario delayed or almost stalled the projects which led to the growth of NPA from 2.3% of advances in 2007 to 3.1% in 2012 and then never looked back. As the author rightly pointed out it was too late for our banking system to react enacting swift and strong policies to curb the NPAs. Though I would accept with the author’s framework of that creating a strong Asset reconstruction Company (ARC) and seeking the intervention of the government to facilitate the repurchase of the NPAs I would like to remind that the government’s prudent fiscal management FY 2017-18 to curtail the fiscal deficit at 3.2% with net borrowings restricted to Rs.3.48 Lakh crore leaves it a very little room to spear head this solution. We are in a very dismal situation of cleansing the balance sheets of the public as well as private sectors. I would suggest a different perspective which can act as both cure by resolving the current NPAs and also a prevention in shielding the banking system from recourse in the future. The government should tap the potential of the dormant corporate bond markets in reviving the situation. The ARC should be an effective company alike the Berkshire Hathaway but with a board of economists, regulators and industrialists headed by an able Warren Buffet who would strengthen the banks with the credit from the corporate bond market and then recover the bad loans. Also policy measures of credit restructuring emphasising the exploration of the bond markets would ensure risk diversification, off-loading the banking system. It is indeed a herculean task for the government of India and the RBI but I would say all it needs is a Warren Buffet of India to wave his magic wand and cast the spell to recovery.

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