India’s loan conundrum points to a huge miscalculation on both sides of the transaction

The failure of a loan usually represents miscalculation on both sides of the transaction or distortion in the lending process itself, and India’s miscalculations and distortion in dealing with lending risks is a work in progress. The new focus on fundamentals and first principles like balancing risks with processes and technology, data and enhanced oversight along with greater accountability of borrowers could help reduce the imperfections.

loan, economy, transactions
Illustration: Rohnit Phore

By Kaushik Dutta and Rishika Malik

India faced a banking shock in 2015, when the then Reserve Bank of India (RBI) Governor Raghuram Rajan undertook an Asset Quality Review of major commercial banks. It was discovered that banks were delaying the recognition of the inevitable—neither recording the non-performing assets (NPAs), nor accounting for lending losses. They used creative accounting like evergreening loans, i.e. lending to the borrower more loans to enable him to return the outstanding loan, extending payment schedules, or even changing the milestones so that the loan appears as good. The NPA juggernaut did not suddenly emerge in 2016 due to any policy or fiscal intervention, but the accumulated toxic loans simply got recognised by banks due to stringent review standards of RBI.

Most public sector banks ended up reporting losses in 2016 as they stepped up provisioning for the newly-declared bad loans. In 2015-16, NPAs shot up by 99%, and bank profits reduced by 62%. Although RBI has scaled down its baseline estimate of gross NPAs for FY18 to 10.3%, it is still high. According to the World Bank, the average gross NPA ratio across countries was 6.7% in 2017, and it recorded India’s gross NPA as 10% during the year, higher than the average. Researchers expect that, up to 2020, public sector banks will continue to have NPAs at 5% of their loan portfolio.

Money drives all engines of economic growth, and in case of India this is driven significantly by public money from government-owned banks and institutions, as the corporate debt market is still not deep. The total lending in economies varied roughly 1 times of GDP for countries like Brazil, Russia and the US, to 2-6 times of GDP for South Korea, China and euro area countries.

Economic growth gives rise to exuberant lending, but credit losses precipitate once growth slows down and then emerges disbelief over ignorance of simple fundamentals. The source of the NPA crisis, as enunciated by Rajan in his reply to the Estimates Committee of Parliament in September 2018, can be traced to 2006-08, when economic growth was strong and the success of previous infrastructure projects led banks to assume that the good times would continue. So, they extrapolated past growth to the future and lent generously, not demanding enough promoter equity in the projects. After 2009, growth suddenly slowed, and so did projects, due to either government slowing down permissions or dragging their feet. Costs escalated, and promoters who anyway had very little equity in the projects walked away. Another factor that increased lending risks was the level of corruption that lowered the barriers for giving loans, making our lending edifice vulnerable.

Subsequently, RBI tightened the screws on banks through the Prompt Corrective Action (PCA) framework. Three main ratios evaluated under it are capital to risk weighted assets (CRAR), net NPAs and Return on Assets (RoA). Once CRAR falls below 9%, or net NPAs cross 10% or RoA falls below 0.25%, it starts to face penalties like limits on branch expansion, dividend payments, change in ownership and eventual liquidation. Currently, there are 10 banks in PCA and the government is trying hard to bring six banks out of the quarantine through infusing fresh capital.

In the midst of such tight regulation, banks started lending to non-banking financial companies (NBFCs), and they grew rapidly—such that their latest balance sheet size is a whopping `26 trillion, according to the December 2018 Financial Stability Report of RBI. The collapse of IL&FS shows that the NPA problem was only being outsourced to NBFCs, and not addressed.

Banks are now riddled with toxic NPA assets, new lending has been crowded out, and they are spending inordinate resources in recouping lent capital. Companies’ debts have ballooned, but their loan servicing capacities are stagnant, which has led to the infamous twin balance sheet problem—a situation where banks’ balance sheets are not robust and borrowers, i.e. companies, don’t have adequate income to pay for the interest and loans. According to the Economic Survey 2016-17, it was reported that around 40% of the corporate debt it monitored was owed by companies that had an interest coverage ratio less than 1. This condition then snowballs into high government bond yields and, ultimately, sovereign ratings barely two notches above junk status.

A curtailment of lending, which is the first reaction to toxic assets, cannot be a solution to the NPA problem. As of March 2017, the total assets of the Indian scheduled commercial banks (SCBs) were `141.6 trillion, according to the RBI Data Warehouse, or $2.2 trillion at the prevailing exchange rate, roughly equal to India’s GDP. In contrast, assets of China’s banks totalled $37.1 trillion in Q3 2017, the highest in the world, roughly three times China’s GDP. It is safe to infer that the Indian banking industry’s asset size is not a problem and, in fact, we have space to lend more, if we go by China’s lending strategy to support growth, employment and building of infrastructure.

One of the key lending paradigms in India is reflected in the fact that 40% of the large borrowers contribute to 70% of NPAs, which, in turn, questions the basic rationale and robustness of evaluation of lending in India. In the case of IL&FS, a bank’s ability to safeguard its lending when the loans flow through a group that has over 200 associates and subsidiaries can rarely be done effectively. In other cases, such as the Bank of Baroda’s `6,000 crore scam in early 2018, funds get round-tripped from the same branch of the bank, undetected for months, and loans or letters of comfort are given on non-existing collaterals and receivables in collusion with bank employees, like in Nirav Modi’s case.

Public sector banks, whose NPAs were triple that of private sector banks in FY18, need to invest more in due diligence of projects, which comprises evaluating business plans of companies, their expected earnings, and realisable cash flows. The focus on realisable cash flows and on the real strength of a balance sheet has been somewhat lost, and that needs to be refocused. Further, regulators and gatekeepers like auditors, rating agencies and boards must work with the government to make banks Basel-III-compliant, which requires strengthening the quantity and quality of capital, stronger supervision, stringent risk management, and disclosure standards.

The Insolvency and Bankruptcy Code (IBC) is a meaningful step to increase promoter liability, as for the first time the risk of losing one’s enterprise is real, but it is only useful once the borrower has defaulted. When the State Bank of India (SBI) and its associates accepted an intangible asset, the Kingfisher brand, as collateral for granting loans to companies of Vijay Mallya, based on the company’s own evaluation of the brand, they were asking for trouble! According to the Bank for International Settlements, once a loan becomes an NPA, ‘the single biggest driver of the required level of provisions is the value assigned to collateral’.

Experts say “that the failure of a loan usually represents miscalculation on both sides of the transaction or distortion in the lending process itself,” and India’s miscalculations and distortion in dealing with lending risks is a work in progress. The new focus on fundamentals and first principles like balancing risks with processes and technology, data and enhanced oversight along with greater accountability of the borrowers could help reduce the imperfections, and we hope that these measures will contain the NPA floodgates at acceptable norms that public money can afford.

The authors work for Thought Arbitrage Research Institute, a not-for-profit think tank on public policy, governance and economics

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First published on: 17-01-2019 at 03:08 IST