Headline : Understanding bad loans
- Former RBI Governor Raghuram Rajan explains the reason behind bad loans.
Highlights of the news
- Gross Non-performing Assets (NPAs) of banks rose to Rs 10.3 lakh crore in FY18, or 11.2% of advances.
- Banks wrote off a record Rs 1.44 lakh crore of bad loans in 2017-18.
About bad loans or Non-performing assets (NPAs)
- A Non-performing asset (NPA) is defined as a credit facility in respect of which the interest and/or installment of principal has remained ‘past due’ for a specified period of time.
- In simple terms, an asset is tagged as non-performing when it ceases to generate income for the lender.
- NPA is used by financial institutions that refer to loans that are in jeopardy of default.
- Once the borrower has failed to make interest or principal payments for 90 days the loan isconsidered a non-performing asset.
- Non-performing assets are problematic for financial institutions since they depend on interest payments for income.
- Troublesome pressure from the economy can lead to a sharp increase in NPLs and often results in massive write-downs.
Reasons for bad loans as explained by Raghuram Rajan
- A larger number of bad loans were originated in the period 2006-2008 when economic growth was strong, and previous infrastructure projects such as power plants had been completed on time and within budget.
- It is at such times that banks extrapolate past growth and performance to the future. They were willing to accept higher leverage in projects, and less promoter equity.
- This was the irrational exuberance.
- Slow Growth
- The years of strong global growth before the global financial crisis were followed by a slowdown, which extended even to India.
- Strong demand projections for various projects were shown to be increasingly unrealistic as domestic demand slowed down.
- Government Permissions and Foot-Dragging
- A variety of governance problems such as the suspect allocation of coal mines coupled with the fear of investigation slowed down government decision making.
- Due to this delay in decision making project cost overruns escalated for stalled projects and they became increasingly unable to service debt.
- Loss of Promoter and Banker Interest
- Once projects got delayed enough that the promoter had little equity left in the project, he lost interest.
- Also unfortunately, until the Bankruptcy Code was enacted, bankers had little ability to threaten promoters, even incompetent or unscrupulous ones, with loss of their project.
- Writing down the debt was then simply a gift to promoters, and no banker wanted to take the risk of doing so and inviting the attention of the investigative agencies.
- Stalled projects continued as “zombie” projects, neither dead nor alive.
- It was in everyone’s interest to extend the loan by making additional loans to enable the promoter to pay interest and pretend it was performing.
- Clearly, bankers were overconfident and probably did too little due diligence for some of these loans.
- Many did no independent analysis, and placed excessive reliance on SBI Caps and IDBI to do the necessary due diligence.
- Such outsourcing of analysis is a weakness in the system, and multiplies the possibilities for undue influence.
- Banker performance after the initial loans were made was also not up to the mark.
- There can be chances of corruption also.
- The size of frauds in the public sector banking system had been increasing, though still small relative to the overall volume of NPAs.
- Unfortunately, the system has been singularly ineffective in bringing even a single high profile fraudster to book. As a result, fraud is not discouraged.
Various schemes and their effectiveness
- The Debts Recovery Tribunals (DRTs) were set up under the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act, 1993 to help banks and financial institutions recover their dues speedily without being subject to the lengthy procedures of usual civil courts.
- The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002 went a step further by enabling banks and some financial institutions to enforce their security interest and recover dues even without approaching the DRTs.
- Yet the amount banks recover from defaulted debt was both meager and long delayed. The recovery was only 13% of the amount at stake.
- The DRTs and SARFAESI were initially successful, before they became overburdened as large promoters understood how to game them.
- The RBI decided to empower the banks and improve on the ineffective CDR system then in place.
- It created a large loan database (CRILC) that included all loans over Rs. 5 crore, which we shared with all the banks.
- That database allowed banks to identify early warning signs of distress in a borrower such as habitual late payments to a segment of lenders.
- The next step was to coordinate the lenders through a Joint Lenders’ Forum (JLF).
- The JLF was tasked with deciding on an approach for resolution, much as a bankruptcy forum does.
- At the same time, a number of long duration projects such as roads had been structured with overly rapid required repayments through the 5/25 scheme.
- With SEBI it introduced the Strategic Debt Restructuring (SDR) scheme so as to enable banks to displace weak promoters by converting debt to equity.
- All these new tools effectively created a resolution system that replicated an out-of-court bankruptcy.
- Banks now had the power to resolve distress, so RBI could push them to exercise these powers by requiring recognition.
- The schemes were a step forward, and enabled some resolution and recovery, but far less than RBI thought was possible.
- Incentives to conclude deals were unfortunately too weak.
- The Assets quality reviews (AQR) were started, which was meant to stop the ever-greening and concealment of bad loans, and force banks to revive stalled projects.
- Bankers, promoters, or their backers in government sometimes turn around and accuse regulators of creating the bad loan problem.
- The truth is bankers, promoters, and circumstances create the bad loan problem.
- The regulator cannot substitute for the banker’s commercial decisions or micromanage them or even investigate them when they are being made.
- The RBI is primarily a referee, not a player in the process of commercial lending.
- The important duty of the regulator is to force timely recognition of NPAs and their disclosure when they happen, followed by requiring adequate bank capitalization.
- This is done through the RBI’s regular supervision of banks.
Reasons for continuance or increase of bad loans despite various schemes
- A fair amount of the increase in NPAs may be due to ageing rather than as a result of a fresh lot of NPAs.
- Projects have not been revived may be due to:
- Risk-averse bankers, seeing the arrests of some of their colleagues, are simply not willing to take the write-downs and push a restructuring to conclusion, without the process being blessed by the courts or eminent individuals.
- Some bankers still are hoping to regain control though a proxy bidder. So many have not engaged seriously with the banks.
- The government has dragged its feet on project revival – the continuing problems in the power sector are just one example.
- The steps on reforming governance of public sector banks, or on protecting bank commercial decisions from second guessing by the investigative agencies, have been limited and ineffective.
- The government has not recapitalized banks with the urgency that the matter needed.
- The Bankruptcy Code is being tested by the large promoters, with continuous and sometimes frivolous appeals.
- The judicial process is simply not equipped to handle every NPA through a bankruptcy process.
- Banks and promoters have to strike deals outside of bankruptcy, or if promoters prove uncooperative, bankers should have the ability to proceed without them.
- Bankruptcy Court should be a final threat, and much loan renegotiation should be done under the shadow of the Bankruptcy Court, not in it.
- This requires fixing the factors mentioned in (a) that make bankers risk averse and in (b) that make promoters uncooperative.
- We need concentrated attention by a high level empowered and responsible group set up by government on cleaning up the banks.
- The new tools should be initiated.
- It is very important that the integrity of the process of identification of bad loans be maintained, and bankruptcy resolution be speedy.
- Given the conditions, the promoter should have every chance of concluding a deal before the firm goes to auction, but not after.
- Higher courts must resist the temptation to intervene routinely in these cases, and appeals must be limited once points of law are settled.