That the recast of loans totalling Rs 1.2 lakh crore—under the corporate debt restructuring (CDR) —has failed since the cell was setup by RBI in 2001 is testimony to the failure of the scheme. While there has been anecdotal evidence of CDR’s failure, not many studies highlight this problem. But a new study from IGIDR researchers shows that the extent of the problem goes beyond the scheme’s ineffectiveness. The report Bank Financing of Stressed Firms, by Rajeshwari Sengupta and Anjali Sharma, published in Ideas for India states that the failure of CDR was more due to banks’ evergreening of loans to prevent them from being classified as NPAs than the economy being distressed.
Banks lent to financially unhealthy firms that were the least likely to pay the loans back. Lending to financially unsound firms is a well-accepted norm of reviving investment, but in the Indian case, the banks kept on throwing good money at bad firms. To uncover this, the study picks a sample of 114 companies, accounting for rs 62,720 crore in restructured assets, during the period 2008-12—ranking them on the basis of interest coverage ratio (ICR), net cash profit and negative net worth. Firms with ICR less than 1—unable to pay interest—were scored 1, those with ICR of less than one and negative cash profit were scored 2. While the ones with the above conditions and a negative net worth attracted a score of 3. Banks not only lent mostly to firms which scored 2 and 3, they kept doing so even when their quality worsened—80% of the firms that scored 1 slipped to 2 and 3 two years after loan recast, and over 50% of those that had scored 2 slipped to 3 during this period. Instead of alleviating the stress, CDR had the opposite effect.
More important, an analysis shows that average borrowing per firm increased in the two-year horizon. It increased 15% from Rs 5.5 billion in the period in which CDR was initiated to Rs 6.3 billion for the next year, before falling to rs 6.2 billion for the year after. Similarly, bank borrowing, as a share of total borrowing of score 2 and 3 firms, increased 16 percentage points from 64.3% to 80.3% in the first year, coming down to 71.4% in the second. Average leverage, on the other hand, increased from 57.9% to 65.9%, leaving firms more indebted than they were at the start of the CDR mechanism. Besides, if one considers results of another IGIDR study by Sangram Jain, Kanwalpreet Singh and Susan Thomas, they would reach the same conclusion. The Jain et al study further highlights that firms that restructured their loans under CDR performed worse than those that did not. But, where the results differ is that it points to firms getting better in the year immediately after CDR, and thereafter worsening, whereas the Sengupta and Sharma point to ill effects from the first year itself.
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With the Banking Ordinance coming into effect and RBI directing banks to initiate restructuring mechanism, the researchers state, RBI should ensure that banks do not repeat a similar financing strategy. Even if it does go back to CDR formula, which many are demanding post failure of SDR and S4A norms, it would be better to let oversight committee take a call on restructuring and not let regulatory forbearance take effect.