A resolution of this complex situation requires a comprehensive approach to address the multiple behavioural, technical, economic, legal and social dimensions of the problem.
We have been hearing about the NPA mess and the stressed asset situation for quite some time now. Although there have been several attempts to resolve the situation, starting with RBI’s Asset Quality Reviews, strategic debt restructuring and S4A—nothing seems to work and the bad loans continue to fester and widen with no resolution in sight. The stressed asset situation is a serious problem. Our distressed loans stand close to $200 billion, which is almost 10% of our GDP. As stressed companies reduce investments to conserve cash-flows, while the stressed banks with impaired balance sheets are unable to assume new lending risks to extend credit, investments start contracting and the nation’s growth of capital stock starts waning affecting economic growth negatively.
A resolution of this complex situation requires a comprehensive approach to address the multiple behavioural, technical, economic, legal and social dimensions of the problem. It is not only about designing a mechanism for debt restructuring, but equally—if not more importantly—about the ability to address the conflicting incentives of all stakeholders—bankers to promoters to the government and to the Indian tax-payer, alike.
The origins of the problem date back to 2003-2004, when the Indian economy went on a growth overdrive for the next seven years. In a developing country, such growth attracts large investments and typically through debt financing in infrastructure sectors like steel, power, cement, aviation and construction. Aided by easy industrial credit many promoters and industrialists undertook exuberant expansionary strategies, which resulted in a mix of industrial investments, which were neither rational nor prudent from long-term profitability and return on capital perspective. These foundational shortcomings not only created intrinsic barriers to the competitiveness and sustainable profitable operations of these firms, but also left them unprepared to withstand any downturns. Capitally intensive projects like steel and power had amassed large debts, and in many of these firms over 85% of the capital investment was debt-financed.
Unfortunately, much of these debts were inflated, in the sense that they were much above what a commensurate productive capital investment could support. When the market situation changed, the limited resilience of the debt heavy companies, resulted in profitability dropping by more than 50% with many of the firms were unable to withstand the shock. This, combined with the evergreening of loans by the banks, led to the NPA mess we see today. Leading to 20% of the debts of banks turning into non-performing assets.
While one can certainly try to blame the banks with crony capitalism, lack of sufficient due diligence and risk-taking as to why the loans were extended in the first place—that in my opinion should not be the primary premise to focus on. What is crucial, now, is for the banks to recover from the situation by recognising bad loans at the earliest, and quickly and surgically writing down the toxic loans. Unfortunately, write-downs is anathema to PSU banks, both from a decision-making and incentive perspective. The bankers are scared to take decisions on write-downs as they can be blamed for wrong-doing by the government investigative agencies who can make their life miserable through suspensions, freezing of pensions and sending them to jail. Their decision making ability on write-downs is also hampered by the culture of ever greening and consensus-seeking behaviour of the bank consortiums. The bankers, therefore, rather than resolving the bad loans, procrastinate and let these loans fester for years in the hope that things will eventually turn around.
Many of the loans that were taken by passionate promoters from enthusiastic bankers overwilling to extend credit, had the best of intentions. It was just that a combination of circumstances, some of which were beyond their control landed them in the situation that we see today. Some had to do with relative inexperience and expertise of promoters and others were extraneous factors, like deallocation of coal blocks and iron ore mines which busted the basic premise of their operating model. Certainly, the global commodity cycle bust, over-capacities and infrastructure project delays had a role to play in the price deflation and the ensuing losses. And, yes there is certainly a category of promoters, where anecdotal evidence suggests that malfeasance and leakages resulted in loans being misappropriated. We certainly have to go after the wilful defaulters, but that is a second priority.
Resolution of the situation requires that we separate the productive from the non-productive assets and operationally turn them around, so that they become profitable. However, to do that the promoters need to relinquish control to a turnaround team, and the banks need to take haircuts so that an appropriate amount of debt can be supported through a rationalised operation. Under the prevailing circumstances and legal system, it is unlikely that the promoters could be forced to relinquish control. Solutions should, thus, be designed to use options for incentivising debt write-downs and transfer of control.
Raghuram Rajan, the former RBI Governor introduced the bank-based work-out mechanisms named the strategic debt restructuring (SDR) and later, the Scheme for Sustainable Structuring of Stressed Assets (S4A). Their success, however, has been limited and only two cases of SDR, and one case under S4A has been concluded as of December 2016.
In underdeveloped capital markets like India, where equity is marked to market and debt is marked to face with no write-downs, an SDR-like instrument will disproportionately dilute a distressed companies equity with minimal debt conversion, while the promoter cedes majority control. So, neither does the debt get reduced, nor does the promoter have any incentive to give up control as there is no upside. Secondly, the banks are required to take over operational control under SDR and they are not chartered or equipped to run and turnaround companies, and that too with an unwilling promoter. Third, any SDR company will likely only draw distressed investors in a down cycle, who would offer pennies to the dollar for an asset. The banks, therefore, will hardly recover anything from the equity sale when they sell their stake, if at all, on exit. Similarly, in the S4A scheme it is unlikely that a distressed asset would be able to honour the high payout rates on the quasi debt-equity instruments and also be able to generate the cash flows for sustainable debt requirement of S4A.
We have to understand that the more we delay and the more we try to go after the wrongdoers first—the worse our NPA becomes, the more our citizens and the economy suffer, the more unstable and under-capitalised our banks become and more is the taxpayer bill to the average Indian for eventual resolution of the NPAs.
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The first step is to understand the size, extent and depth of the NPAs through continuing AQRs and the real value of the assets through sector and company specific techno-economic assessments. This will enable us to price the debts and determine the extent of write-downs the PSU banks will have to take and how the company specific restructuring needs to be implemented. Write-downs of this magnitude—in the steel sector alone a conservative estimate would be around $15 billion—will necessarily require recapitalisation of the banks. Given the aversion of the banks to write-downs and the indecisiveness in consortiums like JLF (Joint Lenders Forum), it probably makes sense to aggregate and transfer these impaired assets at face value of debt to a set of quasi-government funded sector specific institutions. They will be independently chartered and empowered to take control of these assets for markdowns, turnaround, divestment or liquidation.
With credible and sector focused plans, substantial part of the funding of these institutions could be done through private capital over time. Underwriting by the government with some form of partial sovereign guarantees will make this more attractive for private investors. The design, constitution and empowerment of the sector-specific asset reconstruction institutions is crucial to the success of such an NPA resolution blueprint. These institutions will take control of the distressed companies from the promoters based on win-win incentive options and will improve the value of these assets by operating and optimising them in the interim. They will eventually extract maximum value by selling to the right buyer at the right time, rather than using value destructive auctions in a down cycle or conservatorship under a PSU company, till all the assets are disposed.
Can we slay the NPA dragon? If we focus on the right priorities and work in a decisive, cohesive and purposeful manner across the government, banks and the industries—with resolve, intelligence and courage—Yes, we can.
– Atanu Mukherjee
The author is president, MN Dastur & Co (P) Ltd. Views are personal