Bank stressed assets: As bad loans rise to all time high of Rs 5.8 tn, here is how to solve crisis

Stressed assets in the banking system in India are at an all-time high, with bad loans across the 40 listed banks increasing to R5.8 trillion at the end March 2016 from R4.38 trillion at the end of December 2015. Bankers indicate this number may rise over course of this year. Weighed down by NPAs, banks’ stability as well as their ability to lend is impacted. However, a lot more is at stake. If the assets are not revived, not just bank balance-sheets, India’s overall economic and industrial growth could be challenged.

The loss of jobs and economic activity resulting from a large-scale liquidation of corporate assets, and its likely downstream effect on SMEs which are the lifeline of the economy, is something the country can ill-afford. Flow of credit to vital parts of the economy like infrastructure is already constricted. Jobs would come under risk, and with it the government’s larger vision to lift millions out of poverty. The government and RBI have announced measures to address this. The most recent of the central bank’s initiatives is the Scheme for Sustainable Structuring for Stressed Assets (S4A), aimed at easing the amount of troubled loans on bank balance sheets. The scheme allows banks to convert up to half the loans to corporate borrowers into equity. Other moves include the Bankruptcy code, that will allow time-bound settlement of insolvency and the CRILC (Central Repository of Information on Large Credits), a repository to collect and track data about large credit accounts to lenders.

These measures are enablers to support resolution, yet actions that will nurse corporate assets back to health are yet to be attempted in most instances. The NPA problem requires tackling of industry-level problems as well as bank-level issues.

So far stressed asset resolution has been constrained by several factors. Loan fragmentation is one problem—loans to stressed companies are often disaggregated across more than a dozen financial institutions, with up to 30 lenders in some cases. While the Joint Lender Forum provides a common platform for all debtors, in practice each lending bank has a different posture on a given asset. This inhibits any prompt action, and leads to deterioration in asset values. There is little sectoral co-ordination, with no standard process and pricing for the sale of assets to the Asset Reconstruction Companies (ARCs). Also, most ARCs currently lack the capital and capabilities to take over big-ticket bad loans from banks. Ownership of the asset is often split across multiple banks and ARCs. The absence of a decision maker, leads to significant operational underperformance, making it tougher to chart a viable resolution plan and attract capital from the private sector.

Untangling the knots

Any effective resolution has to be tailored depending on the nature of the asset. Long-term quarantine for assets that are expected to regain value over time, corporate turnaround methods for assets that can be recovered and lastly, liquidation, only in cases where it is too late to try the other two. Liquidation leads to significant value destruction, and should be the last resort in a growing market like India. Delayed resolution often leads to a situation, where it is sadly the only outcome.

Global experience of recent years, shows several approaches being used to deal with distressed assets. The first, and probably most high-profile way, is injecting long-term government capital to support the sector/ company. The US government’s TARP (Troubled Asset Relief Program) in 2008-09, through which GM received $50 billion in federal assistance, is the most discussed example. The US treasury acquired about 60.8% of the shares in the new company, which it offloaded in the markets over the next few years. Creating a national `bad bank’ to clean up bank balance sheets is the second approach, being examined by Indian policy-makers. A prominent global example of this is SAREB, a bad bank created by the Spanish government in 2012, to manage impaired assets that were in trouble after over-exposure to real-estate. SAREB has 15 years to dispose of all assets and maximize profitability.

A third approach, is to create one or more asset management companies (MCs) to nurse stressed companies back to health. All banks with exposure to the asset disaggregate their exposure into `sustainable’ and `unsustainable’ debt. The sustainable portion of the debt continues to be serviced by the borrower. While banks convert the unsustainable debt into equity (or some form of long term bonds) and transfer management control of the asset to a single MC, which will be responsible for asset turnaround.

Multiple MCs exist in this model, each handling a different asset. A governance committee comprising representatives of 3-4 large banks may be set up to oversee the functioning of these MCs. The MC essentially operate like a PE investor, and could have private sector participants as general partners. They can be incentivised to turn the asset around like PE firms are—wherein they receive a fee, linked to the realised upside. The MC facilitates action around five levers—filling gaps in management, bringing in sector and functional expertise, driving performance management, ensuring time-bound decision making and facilitating milestone-linked infusion of capital (including private sources) into individual assets.

The problem of toxic debt is a vexed one and has no silver bullet solutions; most developed countries have struggled to find answers. A longer term solution cannot be found without treating the problem at its genesis. At the individual bank level, a more effective credit process with digitised credit workflow could help, along with improved early warning systems. At the industry level, a better and more consolidated industry structure, with fewer and more capable institutions for corporate lending, can help avoid some of today’s problems.

Improving asset resolution in India requires improvements on all fronts listed here. It will also require some innovative approaches to build a consensus across debtors. The quicker this is done, the better it will be for the economy.

Thomas is a senior partner and Bal is a partner of McKinsey & Company.