Below is a summary from former RBI Governor Raghuram Rajan ‘s letter to India’s Parliamentary Estimates Committee. In the note, Raghuram Rajan discusses about the source of the current NPA mess that Indian banks are going through, and probable solutions for the same.
There is just no reason for media to sensationalize the letter. Mr. Rajan has put the hard facts out there & helps us to understand the extent of rot in the PSU banking system.
Why did the NPAs occur?
- Over-optimism :
- A larger number of bad loans were originated in the period 2006-2008 when economic growth was strong. It is at such times that banks make mistakes. They extrapolate past growth and performance to the future. So they are willing to accept higher leverage in projects without doing enough due diligence. One promoter told about how he was pursued then by banks waving checkbooks, asking him to name the amount he wanted.
- Slow Growth :
- Unfortunately, growth does not always take place as expected. Strong demand projections for various projects were shown to be increasingly unrealistic as domestic demand slowed down.
- Government Permissions and Foot-Dragging :
- A variety of governance problems such as the suspect allocation of coal mines coupled with the fear of investigation slowed down government decision making in Delhi, both in the UPA and the subsequent NDA governments. This also lead to project cost overruns.
- Loss of Promoter and Banker Interest :
- Once projects got delayed enough that the promoter had little equity left in the project, he lost interest. Writing down the debt was then simply a gift to promoters, and no banker wanted to take the risk of doing so and inviting the attention of the investigative agencies. Stalled projects continued as “zombie” projects, neither dead nor alive.
- It was in everyone’s interest to extend the loan by making additional loans to enable the promoter to pay interest and pretend it was performing. In reality though, because the loan was actually non-performing, bank profitability was illusory, and the size of losses on its balance sheet were ballooning because no interest was actually coming in. This was deceptive accounting.
- Malfeasance :
- Clearly, bankers were overconfident and probably did too little due diligence for some of these loans. Many did no independent analysis, and placed excessive reliance on SBI Caps and IDBI to do the necessary due diligence.
- Unscrupulous promoters who inflated the cost of capital equipment through over-invoicing were rarely checked. Too many bankers put yet more money for additional “balancing” equipment, even though the initial project was heavily underwater, and the promoter’s intent suspect. Public sector bankers continued financing promoters even while private sector banks were getting out.
Why did the RBI set up various schemes to restructure debt and how effective were they?
- The amount recovered from cases decided in 2013-14 under DRTs (Debts Recovery Tribunals) was Rs. 30590 crores while the outstanding value of debt sought to be recovered was a huge Rs 2,36,600 crores, i.e. 13% recovery.
- The inefficient loan recovery system gave promoters tremendous power over lenders. Not only could they play one lender off against another by threatening to divert payments to the favored bank, they could also refuse to pay unless the lender brought in more money, especially if the lender feared the loan becoming an NPA.
- Effectively, bank loans in such a system become equity, with a tough promoter enjoying the upside in good times, and forcing banks to absorb losses in bad times, even while he holds on to his equity.
- To empower the banks and improve the CDR system, it was needed to make sure banks had information on who had lent to a borrower. So large loan database (CRILC) was created that included all loans over Rs. 5 crore. This helped in giving early warning signs of distress.
- Then Joint Lenders’ Forum (JLF) was tasked with deciding on an approach for resolution. Incentives were given to banks for reaching quick decisions. Then ‘forbearance’ (the ability of banks to restructure projects without calling them NPA) was ended in April 2015.
- Because promoters were often unable to bring in new funds, and because the judicial system often protected those with equity ownership, together with SEBI we introduced the Strategic Debt Restructuring (SDR) scheme so as to enable banks to displace weak promoters by converting debt to equity within a set timeline.
Why Recognize Bad Loans?
- There are two polar approaches to loan stress. One is to apply band aids to keep the loan current, and hope that time and growth will set the project back on track.
- An alternative approach is to try to put the stressed project back on track rather than simply applying band aids. This may require deep surgery. If loans are written down, the promoter brings in more equity, and other stakeholders like the tariff authorities or the local government chip in, the project may have a strong chance of revival, and the promoter will be incentivized to try his utmost to put it back on track.
- But to do deep surgery such as restructuring or writing down loans banks first need to classify asset as NPA. It is like an anesthetic that allows the bank to perform extensive necessary surgery.
- Loan classification is merely good accounting – it reflects what the true value of the loan might be. It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely losses. If the losses do not materialize, the bank can write back provisioning to profits
Why did RBI initiate the Asset Quality Review?
- Banks were simply not recognizing bad loans. They were not following uniform procedures – a loan that was non-performing in one bank was shown as performing in others. They were not making adequate provisions for loans that had stayed NPA for a long time. Equally problematic, they were doing little to put projects back on track. They had also slowed credit growth.
- We proceeded to ensure in our bank inspections in 2015 that every bank followed the same norms on every stressed loan. A dedicated team of supervisors ensured that the Asset Quality Review (AQR), completed in October 2015 and subsequently shared with banks, was fair and conducted without favor.
Did NPA recognition slow credit growth, and hence economic growth?
- The reality is that public sector banks slowed lending to the sectors where they were seeing large NPAs but not in sectors where NPAs were low.
- The slowdown is best attributed to over-burdened public sector bank balance sheets and growing risk aversion in public sector bankers. Their aversion to increasing their activity can be seen in the rapid slowdown of their deposit growth also. After all, why would public sector banks raise deposits aggressively if they are unwilling to lend?
Why do NPAs continue mounting even after the AQR is over?
- The AQR was meant to stop the ever-greening and concealment of bad loans, and force banks to revive stalled projects. Unfortunately, this process has not played out as well.
- Why have projects not been revived? Blame probably lies on all sides here.
- Risk-averse bankers, seeing the arrests of some of their colleagues, are simply not willing to take the write-downs and push a restructuring to conclusion, without the process being blessed by the courts or eminent individuals.
- Until the Bankruptcy Code was enacted, promoters never believed they were under serious threat of losing their firms. Even after it was enacted, some still are playing the process, hoping to regain control though a proxy bidder, at a much lower price.
- The government has dragged its feet on project revival – the continuing problems in the power sector are just one example.
- The Bankruptcy Code is being tested by the large promoters, with continuous and sometimes frivolous appeals. Higher courts must resist the temptation to intervene routinely in these cases, and appeals must be limited once points of law are settled.
- That said, the judicial process is simply not equipped to handle every NPA through a bankruptcy process. Banks and promoters have to strike deals outside of bankruptcy, or if promoters prove uncooperative, bankers should have the ability to proceed without them.
What could the regulator have done better?
- The RBI should probably have raised more flags about the quality of lending in the early days of banking exuberance.
- With the benefit of hindsight, we should probably not have agreed to forbearance, though without the tools to clean up, it is not clear what the banks would have done.
- Also, we should have initiated the new tools earlier, and pushed for a more rapid enactment of the Bankruptcy Code. If so, we could have started the AQR process earlier.
- Finally, the RBI could have been more decisive in enforcing penalties on non-compliant banks. Fortunately, this culture of leniency has been changing in recent years.
How should we prevent recurrence?
- Improve governance of public sector banks and distance them from the government.
- Public sector bank boards are still not adequately professionalized, and the government rather than a more independent body still decides board appointments, with the inevitable politicization. The government could follow the PJ Naik Committee report more carefully.
- Pending the change above, there is absolutely no excuse for banks to be left leaderless for long periods of time as has been the case in recent years.
- Outside talent has been brought in very limited ways into top management in Public Sector Banks. Compensation structures in PSBs also need rethinking, especially for high level outside hires.
- Risk management processes still need substantial improvement in PSBs. Compliance is still not adequate, and cyber risk needs greater attention.
- Improve the process of project evaluation and monitoring to lower the risk of project NPAs.
- Significantly more in-house expertise can be brought to project evaluation. Bankers will have to develop industry knowledge in key areas since consultants can be biased.
- Real risks have to be mitigated where possible, and shared (between the promoter and financiers) where not.
- An appropriately flexible capital structure should be in place. The capital structure has to be related to residual risks of the project. Promoters should be incentivized to deliver, with significant rewards for on-time execution and debt repayment.
- Financiers should put in a robust system of project monitoring and appraisal, including where possible, careful real-time monitoring of costs. Projects that are going off track should be restructured quickly, before they become unviable.
- And finally, the incentive structure for bankers should be worked out so that they evaluate, design, and monitor projects carefully, and get significant rewards if these work out.
- Strengthen the recovery process further.
- Both the out of court restructuring process and the bankruptcy process need to be strengthened and made speedy.
- Government should focus on sources of the next crisis, not just the last one. In particular, government should refrain from setting ambitious credit targets or waiving loans.
- Credit targets are sometimes achieved by abandoning appropriate due diligence, creating the environment for future NPAs. Both MUDRA loans as well as the Kisan Credit Card, while popular, have to be examined more closely for potential credit risk. The Credit Guarantee Scheme for MSME (CGTMSE) run by SIDBI is a growing contingent liability and needs to be examined with urgency.
- Loan waivers, as RBI has repeatedly argued, vitiate the credit culture, and stress the budgets of the waiving state or central government. Agriculture needs serious attention, but not through loan waivers. An all-party agreement to this effect would be in the nation’s interest, especially given the impending elections.