The recent attention to bankruptcy reform in India (see my last column; http://goo.gl/QM7Gfm) reminds us that distressed firms have been contributing to distress for Indian banks. A firm may face financial distress for various reasons, including negative shocks to its market or the whole economy, as well as poor or inappropriate management. Many firms rely on debt—short-term, long-term or both—to function, and when this debt includes bank borrowing, firms’ problems become banks’ problems. Non-performing assets (NPA) is simply a bland technical term for bank loans gone bad. Bankruptcy reform will help to clean up existing and future messes, but examining how and why bank lending runs into difficulties can reduce the extent of future calls on the bankruptcy process.
In September of this year, Rama Subramaniam Gandhi, a deputy governor of RBI, gave a speech on “Asset reconstruction and NPA management in India.” Much of the speech deals with what to do when problems arise, but there are also pointers to how to reduce the likelihood of NPA problems. The approach comes under the general rubric of “management of credit risk,” which includes measurement, quantification and pricing of risk as advance actions, as well as loan reviews and portfolio management as ongoing actions. In 2014, RBI itself created a central database on large loans, but deputy governor Gandhi noted the need for banks to improve their own structuring of loans to be better tailored to the idiosyncratic nature of many large projects. A theme that receives repeated mention is the lack of adequate credit appraisal expertise both within the banking sector, and among the usual outside consultants. But, overall, the issue of efficiency of bank operations is treated somewhat delicately here.
A report from a consulting firm (FTI Consulting) is more blunt. It was asked to help a multinational bank in recovering a large unsecured loan made to a listed Indian company, and reveals that “Through the course of our investigation … it became apparent that the borrower had been involved in arranging bribes for state government contracts in India while certain principals of the company were also found to be heavily politically exposed. Furthermore, our team was able to obtain credible intelligence to reflect how certain individuals in the company, along with rogue traders, had manipulated the share price of the company to artificially inflate its net worth.” More generally, the report notes that Indian banks have to deal with “poor credit appraisal procedures, inadequate monitoring, lending under political pressure as well as high exposure to government lending schemes.”
A simple survey of 60 branch managers of public sector banks, in a recent study by Seema Mahlawat, is even more revealing. The percentages agreeing or strongly agreeing with a range of possible internal factors contributing to bad loans were as follows: Appraisal (80%); Managers have poor skills in credit scoring (82%); Managers are not fully competent in appraising the value of collateral (80%); and Target completion (80%). These were not the only internal factors, and several others received high percentages of agreement. The external factors in the survey are less informative, since they include “Economic downturns” and “Business failure,” but several indicators of political interference also featured prominently.
Political interference in loan-making is a pernicious and difficult problem, but giving bank employees better skills and better analytical tools can even help in that respect, since trained managers using risk management models will have less scope for non-transparent, politically-influenced lending decisions. Indeed, in an October speech, RBI Governor Raghuram Rajan noted that banks are deficient in their use of IT systems for managing operations, “IT and IT usage has not penetrated into the banks as fully and as properly as we would like. The entire banks are not fully integrated in terms of IT usage such that on a daily basis it can spin out what the details of the loans are, what the performance is.” Of course, IT systems cover much more than tools for assessment and management of credit risk, but clearly the latter are at the heart of the banking business—if banks cannot bring specific expertise to the process of making loans, then they should not be in operation at all.
We know from recent experience that assessing credit risk is not an easy task. Even advanced country financial institutions have made serious mistakes in the past. However, the conceptual frameworks and modelling tools keep improving, and enhancing the capacity of banks to perform this core function is an obvious area for immediate policy attention. If dealing with corporate bankruptcy is like trying to revive a patient who is already seriously ill, credit risk management by banks that make loans to these companies is like a preventive health programme. The difference is that credit risk management tools enable professionals to do their job better in specific settings, whereas individual wellness programmes can require multifaceted lifestyle changes. Prevention is better than cure, and in this case seems to be simpler and cheaper.
The author is professor of economics, University of California, Santa Cruz