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Cleaning The Bad Loans Mess

Cleaning The Bad Loans Mess

If global history is any indication, it is high time for India to think out of the box or borrow tested global models. Many experts feel that setting up a bad bank will be a bold and radical idea.

Two decades ago, the Malaysian banking system was on the verge of collapse when a currency crisis engulfed several Asian countries. The bad loan situation was alarming, very similar to the situation in India today, and its non performing assets (NPAs) jumped from 2-3 per cent to double digits in a matter of four-five years. Malaysia had experienced a high growth of 9 per cent plus for a decade leading to the currency crisis in 1997. The Malaysian government reacted fast by setting up two asset management companies (AMCs) - one to take over bad loans named Danaharta with special powers and another for infusing capital into the weak banks called 'Danamodal'. About seven years later, both the AMCs shut shop as the mission was accomplished.

More recently, China, which has a largely opaque banking system, has turned creative by starting a massive securitisation drive to sell stressed loans by bundling them as marketable securities. Half a dozen Chinese banks have tested the market by offering such securitised loans at a discount to investors. Globally , there is enough investors appetite for such high risk, high return junk papers. China, which is currently battling its biggest slowdown after recording near double digit growth for two decades , has bad loans crossing $5.5 trillion. Many global experts believe that the mainland has found a new way to deal with its mounting bad debt problem.

There are numerous examples - from the Czech Republic to Hungary, Japan and the US - where the governments or the regulators have used creative ways to deal with mounting bad loans. India's Rs 75 lakh crore banking system is grappling with a similar problem and the situation appears to be spinning out of control. The gross NPAs have jumped from a low of 2.5 per cent in 2011/12 to a high of 10 per cent in 2016/17. Stressed loans, which include gross NPAs plus the restructured loans under various resolution schemes, is estimated to be anywhere between 18-20 per cent. Experts put the stressed loan figure conservatively at around `14 lakh crore. They warn that the countrys bad loan situation could choke its growth because banks are the only major source of funding for private investment.

K. C. CHAKRABARTY Former Deputy Governor, RBI (Photo: Nishikant Gamre)

A. K. KHANDELWAL Member, Banks Board Bureau (Photo: Ramesh Sharma)

K. C. Chakrabarty, former deputy governor at the Reserve Bank of India (RBI) paints a more alarming picture. According to him, stressed loans in the system will not be less than Rs 20 lakh crore. This includes NBFCs, insurance companies, cooperative banks and other non bank institutions. "The system has also written off around Rs 4 lakh crore. Do we count that money ?" asks Chakrabarty. The government, the owner of public sector banks, realises this. In the last two years , the RBI's approach to stressed assets has been of a deep surgery than band aids. The asset quality review of stressed loans in the entire banking sector revealed the real picture of NPAs in the system. During the six quarters ending March 2017, the banks saw a huge dip in profitability and losses in some cases. While the government has set up a bankruptcy code, the RBI has moved away from corporate debt restructuring (CDR) to schemes like Strategic Debt Restruturing (SDR) where lending banks can even throw the promoters out.

Indeed, the government and the RBI are working in tandem to issue the next set of measures to speed up resolution. There are talks of making a more flexible joint lenders' forum (JLF), by reducing the requirement of approval from at least 75 per cent of the lenders - in value terms - to take a decision to a much lower 51 per cent. This will result in faster decisions on restructuring.

In order to make haircuts easier for banks, there is already a provision of an oversight committee of independent professionals under S4A to take a decision. But there is no such provision for other restructuring mechanisms like SDR, 5/25, etc. The government is now considering setting up a panel headed by the cabinet secretary for taking 'haircut' decision in large cases or more oversight committees for SDR or 5/25.

The government is also considering an institutional mechanism by making changes in the Prevention of Corruption Act (PCA), a big hurdle today as bank employees come under it. There is a fear of future investigation by agencies under the Act for any professional decision gone wrong. Recently, the top officials of IDBI Bank including its former chairman were arrested for allegedly favouring Vijay Mallya's now defunct Kingfisher Airlines. The PCA today doesn't make any distinction between a flawed and a corrupt decision. There is a move to amend the Act to protect employees when decisions are taken in a professional capacity.

VINAYAK BAHUGUNA CEO, ARCIL Ltd (Photo: Rachit Goswami)

Undoubtedly, there is a huge accumulation of stressed loans in a very short period of time. "When you have such a massive build up, there is no option but to sell. In the current set-up, there are issues of skill, bandwidth and ability to preserve present value," believes Vinayak Bahuguna , MD & CEO of the countrys first asset reconstruction company (ARC) ARCIL Ltd. The situation is indeed grim. Two stalwarts of the financial world also spoke their mind recently. K. V. Kamath, who now heads the BRIC Bank, has warned that time is fast running out while Deepak Parekh, Chairman of HDFC Group, has talked about biting the bullet.

Is Bad Bank The Answer?

If global history is any indication, it is high time for India to think out of the box or borrow tested global models. Many experts feel that setting up a bad bank will be a bold and radical idea. But then there are also fiscal constraints in supporting such an initiative. In the past, the government has struggled to recapitalise banks.

Some PSB bankers cite Uttar Pradesh government's move to waive farm loans of Rs 36,500 crore by way of Kisan Rahat Bonds as an example, asserting that "when there is a will, there is a way". Undoubtedly, the current BJP-led NDA government has acted decisively on some fronts. It has formed a professional body, Banks Board Bureau (BBB) for appointment of CEOs of PSBs, initiated privatisation of IDBI Bank and merger of five associate banks of SBI. Early last year, the finance ministry itself floated the idea of a stressed assets fund. A year later , the economic survey suggested a bad bank in the form of Public Sector Asset Rehabilitation Agency (PARA). More recently, Viral Acharya, the new Deputy Governor of RBI , echoed the sentiments of chief economic advisor Arvind Subramanian and suggested two asset management companies.

Acharya has suggested a Private Asset Management Company (PAMC) for stressed sectors such as metals, infrastructure and textiles, where the assets are likely to have economic value in the short run. He has also proposed a National Asset Management Company (NAMC) where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short to medium term. He cited power companies as fit for NAMC because the projects are under utilised due to raw material shortages and lack of power purchase agreements.

A. K. Khandelwal, a member of BBB, says that while global models can be a good guide, in a country like India these resolution models cannot be aped per se. " The idea of bad bank deserves informed deliberations among all stakeholders. However, one has to take into consideration the moral hazards in creating a bad bank," says Khandelwal. Ashwin Bishnoi, Partner at Khaitan & Company, a leading law firm, also cautions that any form of bad bank would need to ensure returns for tax payer money being deployed, incentivise banks to sell their NPAs besides grappling with issues of moral hazard.

New ARC Model: A Right Fit

If funding is a big issue for a bad bank or an AMC model, the existing ARC structure is ideal for helping in resolution. The ARC model of part cash and part security receipts also works well for banks which are hugely under-capitalised to take haircuts. Some cite the UDAY power bond as a precedent where a banks loan to state electricity boards were converted into investments in its books. Many may argue that the ARCs, with a decade-long presence, haven't been successful in resolution. But Siby Antony, who heads Edelweiss ARC, the largest ARC in the country, says many constraints for them have been removed only recently. Last week, the RBI has increased the net owned fund requirement from `2 crore to `100 crore in order to weed out smaller players. The government has also permitted 100 per cent FDI in the ARC model. Foreign players are already trooping into India. For instance, US-based private equity firm JC Flowers & Co. has joined hands with the Ambit Group to acquire stressed assets in India. US-based KKR, which also has a private equity business in India, too is interested in the ARC model.

ASHWIN BISHNOI Partner , Khaitan & Company

The minimum upfront requirement for sale of bad loans has also been increased from 5 to 15 per cent to encourage banks to hand over assets to these specialised agencies. "The legal framework of a Bankruptcy Code is also in place especially for ARCs because they are the ones who aggregate the debt," says Antony. In any case, ARCs would help in taking only part of the burden. "In instances where the debt is less than Rs 10,000 crore, an ARC structure may be best suited to handle it. Where the debt is very high, say Rs 30,000 crore or Rs 40,000 crore, ARCs may not be ready today," says Antony.

PIYUSH SINGH MD, Accenture Financial Services Group in India

Size, Sector Matter

Speed in resolution is of essence since assets deteriorate very fast. Today, large loans are actually the problem area. They are concentrated in select sectors such as steel, power and infrastructure. Bhushan Steel, for instance, with over Rs 40,000 crore of debt is awaiting restructuring under S4A for a long time.

The steel major is making losses and has been severely impacted by the global glut in steel and dumping by Chinese players. This Delhi based company was also impacted by the coal block cancellation by the Supreme Court. There is already news of Vedanta and JSW Steel being in talks with lenders for a buy out, but the company has denied such reports. Similarly, many other large steel projects are facing similar sector specific issues and need immediate injection of capital.

In fact, RBI Deputy Governor Acharya's NAMC model resonates well with a sectoral approach. Experts argue that a bad bank or AMCs won't work in the current scenario. "We need a surgical strike by identifying and narrowing down the problem assets," suggest a senior foreign banker. "Unlike other countries, we have significantly high level of NPAs in few sectors.

These sectors have also suffered from non-financial reasons such as Supreme Court decisions. So while a bad bank solution would help, we also need a policy stimulus for these sectors," suggests Ashwin Bishnoi, Partner, Khaitan & Company, a leading law firm. In the past, the government has taken steps like anti dumping duties on steel imported from China and South Korea, providing some relief to steel companies. The banks expect the government to take similar steps in the power sector such as guiding State Electricity Boards (SEBs) to sign long term power purchase agreements (PPAs). Currently, SEBs are staying away from PPAs because of availability of cheap power over the power exchanges.

ABIZER DIWANJI Partner and National Leader, EY

Along with the sector specific approach, the government is also focusing on resolving the problems of large companies. In fact, bulk of the NPAs are from few large corporates. "It is not that hundreds and thousands of businesses have created this problem. The problem of big NPAs is confined to essentially 30-50 companies. Therefore , those 30-50 accounts need to be resolved," Finance Minister Arun Jaitley had said recently. There are some who are not comfortable with a sector or size specific approach. "Only big people are given oxygen. That's not fair. This can also snowball into a political slugfest," warns a consultant. The approach should then be to look at deserving candidates.

"The first filter has to be the size (of loan). The other criterion should be operational projects or projects that can be made operational in a short period of time. We should also have another filter to look at projects where additional money is required to complete the project," advises Bahuguna.

There are other issues as well. "Pricing is a big issue. The problem with the power sector is actually low tariffs. In case of infrastructure, the pricing is wrong. We want world class infrastructure at zero cost," says Chakrabarty. Some say there are many broken pieces in the system like cancelled telecom and coal licenses, which cannot be fixed.

Another radical idea, often discussed in banking circles, is allowing large public sector units such as SAIL and NTPC to buy some of the large assets. But experts say, given the current challenging environment, it is not the right time to burden the PSUs. Steel major SAIL has been making losses in the past 18 months. Khandelwal says this can be experimented selectively by PSUs who have strong balance sheets and have past track record of transformational turnaround of their own enterprises. But some experts believe that such a merger will also have integration challenges in terms of work culture, policies, compensation, etc.

Existing Resolution Tools

Some expert suggest there are enough tools available currently like SDR, S4A, 5/25 and CDR. There is a need to plug the gaps like having more oversight committees to decide the haircut, a leaner joint lenders forum (JLF) for faster decision making etc. The bankers, however, complain that there is no one size that fits all. The various resolution mechanisms haven't been successful. The SDR has been a complete failure while S4A requires conversion of debt into equity without changing the management.

There is also a move to strengthen the wilful default mechanism. Legal experts say the guidelines are adequate but they are not effectively used by the banks. The banks have been using them as arm twisting tactics. They invoke wilful default guidelines even in cases where long term funds are used for short term and vice-a-versa. In many instances, the courts have rejected the banks case for a wilful default. In fact, there is also no coordination among banks when declaring a promoter or director a wilful defaulter. "The banks have to beef up their anti-fraud systems and also forensic skills to make a full proof case against defaulters," says a lawyer. Khandelwal says the guidelines are adequate and sufficient enough. " Failures experienced by banks in court cases are primarily due to lapses on the part of the banks in following the due process of declaring any company or directors as wilful defaulters," says Khandelwal.

Two years ago , the Calcutta High Court had set aside the United Bank of India's decision to declare defunct Kingfisher Airlines and its directors as willful defaulters. The High Court had ruled that the grievance redressal committee was not formed as stated in the guidelines. Chakrabarty has another reservation about the existing guidelines. "Nowhere in the world is there a distinction between wilful and non wilful defaulter," he says.

Twin Balance Sheet Problem Today, banks are operating in a much more transparent environment. In the past, banks have taken a long time to detect loans becoming NPAs - either deliberately or because of their own ignorance - and this has to change. In order to have coordination among banks, the RBI has also created a database of large loans accessible to all banks to take corrective action. "Going forward, the banks will have to play a dual role in corporate banking in terms of being the provider of both capital and sound advice. The banks as lender will likely be heard by the enterprise," says Piyush Singh, Accenture Financial Services India.


Meanwhile, the RBI has already started an exercise to identify weak balance sheets based on higher gross NPAs and restructured loans. Recently, the RBI has put some restrictions on few banks which have very weak balance sheets. The idea is to tackle the bad loan problem from both ends - the company as well as lending institution.

A weak balance sheet issue also makes a case for merger in the PSB space. The RBI has now come out with a new framework for triggering a merger of weak banks. The weak banks would be identified based on falling capital adequacy ratio, higher NPAs, lower profitability and higher leverage.

For example, Chennai-based Indian Overseas Bank has seen its gross NPAs rising to an alarming level of 22 per cent. This loss making bank has a capital adequacy of 10.42 per cent , which is in the danger of absorbing the provisioning shocks. In case there is a substantial deterioration , there could be some severe action from the RBI. There are half a dozen other PSBs mirroring similar trends. There is already talk of creating five-six large banks by merging the 27-odd PSBs. Most of these banks are mirror images of each other when it comes to service culture, product basket, people , etc. The larger bank with management bandwidth will be in a better position to tackle the bad loan problem.

The banks now have a good legal framework, in terms of the Bankruptcy Code, to deal with the problem. The good part about the system is that it is not just dependent on the banks. Currently, an SDR and S4A are available for Indian banks. The Bankruptcy Code is for everyone including foreign lenders. So non-bank lenders can also trigger an SDR or S4A.

"The Bankruptcy Code will encourage faster decision making for all the stakeholders. The banks have to be prepared to decide very quickly (on restructuring). If a non bank player invokes it, the banks will be forced to come to the table," says Bahuguna. Bankruptcy won't work if the debt is not aggregated and you have only six months to get the work done, points out Siby Antony of Edelweiss.

Solution Lies Within

Despite the new models , the basic principles of restructuring cannot change. "There is a need for banks to take deep haircuts. There is a need for a turnaround strategy for every business. The whole culture or mindset of turnaround is not there," says Abizer Diwanji, Partner and National Leader at EY. There is also a cost (attached to bad loans). If one takes gross NPAs of Rs 7.35 lakh crore, the cost of funds to banks (at 5-6 per cent ) alone would be Rs 40,000 crore. The earning loss to banks would be Rs 73 ,500 crore. As against this, the recovery every year is less than Rs 22,000 crore. "The recovery has to keep pace with the cost or earning otherwise the stress would gradually make the system inefficient," says a private banker. Ultimately, the solution to the bad loan problem lies within."In our system , there is no concept of accountability. The banks have to improve governance, build good risk management practices, hire quality people and inculcate the system of accountability. We have to hold people accountable for lapses. How many banks' board have been superseded because of high NPAs?" says Chakrabarty.

Private sector HDFC Bank with the lowest NPAs in the banking system is a good example of sound credit and risk management. The government has taken the first step by setting up BBB which should percolate down . "All possible steps are being taken to improve the leadership bench strength and improve the overall governance standards in the areas of credit and risk management," says Khandelwal.

RBI Deputy Governor N. S. Viswanathan recently gave a good football analogy to explain the basic framework of a robust bank lending system. The loan officers are the first line of defense, the credit risk officer the second and the internal audit is the third. The board and the senior management are like the coach and manager of a team.

That's a winning formula. And at this stage of the bad loan game, time is actually running out for banks.