Early warning system

Updated: Mar 2 2014, 04:55am hrs
Recently, the United Bank of India (UBI) reported a large loss in the third quarter of fiscal 2014, an outcome of a five-fold increase in provisioning for delinquent loans. UBIs financial woes were only the most acute representation of the deep risk of non-performing assets (NPAs) that pervades the banking system.

Reacting to the growing NPA challenge that it has observed, RBI, on January 30, published its guidelines towards Early Recognition of Stressed Assets to help bring under control the NPAs within the Indian banking system. This report came in the shadow of RBIs own Financial Stability Report, which projected gross NPAs of the banking system to reach 4.6% by September 2014. That matters had reached such a pass, required, as per RBI, a deeper recognition that it was not sufficient to manage credit through lag indicators, such as gross NPA levels, but that there was a need to identify stress well before it results in delinquencies. This circular gives regulatory sanction (by means of incentives and penalties) to the need for continuous monitoring of accounts to ensure that borrowers attempt in good faith to achieve projections that they would have given bankers at the time they borrowed.

To understand why this paper is being released now, one would need to delve into the background of how the problem was created in the first place. As pointed out by yet another illuminating working paper of RBI on Re-emerging Stress in Banks published earlier in February 2014, periods of high credit growth are generally followed by periods of significant delinquencies. Growth above a certain rate might be possible for an individual bank is unlikely to be safe of the system as a whole. Based on the same paper, one could conclude that a system-wide growth in lending rates of more than 24% per annum for a sustained period increases the likelihood that loans move into the danger zone. Growth in lending rates exceeding 30% per year, a phenomenon that was seen at a certain period in the past decade, make it likely that delinquencies will be high.

The period of low interest rates immediately after the financial crisis coincided with an unreasonable rush to grow balance sheets. Debt, which was close to R1 trillion across a sample of large business houses, rose to R7 trillion over the past six years. As per reports by Credit Suisse, across large parts of the organised sector, debt is now at six times before earnings before interest tax and depreciation and interest are just above 1.4 times annual profits. When juxtaposed with the slowing growth in the economy, persistently high inflation and consequently high interest rates, it is tough to believe that all these loans will get repaid. It is for this reason that the current level of NPAs has started to exercise the regulator so much.

The very nature of lending means that there is a huge economic asymmetry already baked into the profitability equation. Since most banks make a margin of about 3% on their assets, they need to get well over 97% of their loan guesses correct to be profitable. This is a fairly high bar to set for what is frequently a geographically-dispersed judgement-based decision-making process. In order to get this perfectly right, it is necessary to be good and not just when you are underwriting a loan but also get the monitoring of the loan correct through its life.

The new early recognition guidelines finesse this problem by asking lenders to identify certain accounts as special mention accounts and report these to a central repository. In the event a loan is 60 days overdue, joint lender groups may need to be formed, with incentives to find early solutions to the companys problems. This is in contrast to the earlier situation wherein lenders addressed these issues only when loans were 6-9 months late in payments.

Through this, what the regulator has done is to place an onus on lenders to look at triggers, which suggests that companies are headed towards trouble and then disclose these to other lenders as well. To those outside the banking space, this will seem like a straightforward and common sense solution which ought always to have been followed. However, the nature of incentives within the system have tended to distort behaviour. There is a strong and seemingly impelling force across lending consortia to delay recognition of difficulties until denial become simply impossible. There also remains the natural tendency among lenders to rope in new lenders and thereby achieve some dilution of their share of the risks of a troubled asset.

Banks are penalised for an inability to predict early distress, by requiring to hold higher provisions. Additional provisioning norms will be imposed on companies whose directors sit on the boards of wilful defaulters or uncooperative companies (a euphemism for firms that refuse to share accounts, respond to queries and the like). Auditors of companies who turned a blind eye to the falsification of stock certificates or permitted dodgy book-keeping will need to be reported to the Institute of Chartered Accountants of India. Similar pressure may be brought on valuers of assets, lawyers, etc, who may have assisted a creditor in evading repayments.

RBI has provided several carrots to ensure that lenders do not face too great a burden because of new rules. These include the ability to spread the loss on sale of certain assets over a two-year period, allowing take-out financing to be treated as restructuring and permitting banks to reverse the excess provision on the sale of an NPA to an asset restructuring company under some circumstances.

Several of these recommendations are prudent, but will need an institutional culture within banks to make them work. It could be difficult, even with the best intentions, for regulators to monitor whether banks could truly have predicted early distress. To a large extent, boards of these companies need to keep asking tough questions to their managements, especially when they see any red flags.

The practice of re-examining why individual accounts that turned sour were deemed creditworthy in the first place can very easily turn to finger-pointing and is, therefore, generally discouraged in most companies. This difficult task will now need to be a part of the judgemental exercise banks will need to undertake. By asking themselves whether they could have done things better, as required under the new dispensation, lenders will frequently have to face the unpleasant truth that they had enough facts available to avoid delinquency, and in many cases chose to overlook those facts. This will need a degree of management maturity and moral courage.

While some will argue that the gross NPA levels of the Indian banking system were as high as 10% towards the end of the 1990s, and now they stands at only about 3.5%, the statistics do not reveal everything. Close to 5% of assets are restructured now and only by the application of a particularly elastic version of optimism would one believe that more than 50% of this would be collected in the long run. When one considers this fact, that the true NPA position of the banking system is above 6%, on a base of loans which is now three times as large as what was the case in the 1990s, one can begin to see why this would cause systemic concern.

In a capital-starved economy, the price of irresponsible lending falls more harshly on the small business, the young entrepreneur or the less well-connected. Unless the level of NPAs are reduced, the natural response is for lending to dry up for good projects, something which India can ill-afford. It is always impossible to quantify whether the several lakh crores lost out to NPAs deprived funding to a potential Indian Google or Microsoft or to even count the number of jobs that might have otherwise been created. To the extent that these changes will bring about a gradual but important cultural change in the way banks lend, it must count among those circulars that have great import for the long term.

The author is CFO & COO, Corporate Affairs, Tata Capital Financial Services

Govind Sankaranarayanan