The severity of the NPA crisis

Mint, May 30, 2017 (with Harsh Vardhan)

To understand the extent of the non-performing asset (NPA) problem in the Indian banking sector and come up with solutions, it is important to have a good measure of the problem. While the standard measures have their uses, they do not answer the question that everyone seems interested in: How severe is the NPA crisis? We propose a new measure—the ratio of NPAs to bank capital. This measure shows that the crisis is indeed severe, among the worst in India’s history.

Traditionally, two metrics are used to assess the scale of the problem—the ratio of NPAs (gross or net) to gross domestic product (GDP) and the ratio of NPAs to total loans. The ratio of NPAs to GDP measures the potential losses in relation to the size of the economy. This is especially useful in cross-country comparisons, given that countries are at different levels of GDP. The problem with this measure is that it does not indicate whether banks are able to handle the NPAs with their own resources—their capital.

A more commonly used metric is the NPA to loans ratio. This shows the fraction of bank loans that has turned bad. One shortcoming of this measure is that it suggests the problem can be solved through denominator management—growing the loan books of banks to make the NPA ratio smaller. This growing out of the problem approach is not a reliable one. It depends on the overall economic environment and on the demand for credit. It assumes that the source of the NPA problem is external to the banking system and not in the weaknesses of the lending processes. If the demand for credit is slow it becomes difficult for the banks to grow their loan books. Even if the demand for credit were high, it would be difficult for the NPA-ridden banks to grow. Prolonged NPA episodes erode banks’ capital and constrain their ability to grow their loan books.

In sum, the standard measures do not convey the full picture and can be misleading. A high level of NPAs in the banking sector need not necessarily create a crisis situation, if the banks have the capital needed to provision for the losses. Bank capital is also a key factor in resolving the banking crisis. Hence, banks’ ability to withstand NPAs is best measured in relation to capital.

In the graphs we plot the ratios of gross NPAs (GNPA) and net NPAs (NNPA) to bank loans and to bank capital for the last 20 years. We have also added the amount of restructured loans to GNPAs in both the panels from 2007 onward.

To understand the importance of the NPA to capital ratio, we compare the depth of the NPA problem across two banking crisis episodes in India. The banking sector had witnessed an NPA crisis in the mid to late 1990s. The surge in bank NPAs at that time took place in the aftermath of the introduction of robust income recognition and asset classification norms which exposed two decades of bad loans.

The NPA to loans ratio suggests that the current crisis is considerably less severe than that of the late 1990s. However, when NPAs are measured in relation to bank capital, the current crisis looks just as bad. In particular, the deterioration in the balance sheets of banks post-2010 is much sharper when measured using the NPA to capital ratio.

The drop in the NPA to capital ratios in 2016 looks hopeful but this is partly due to the additional capital received by many public sector banks as part of the government’s Indradhanush programme. Also, in light of the revised disclosures of NPA levels by some large private sector banks in the last few weeks, the 2016 ratios are likely to be much worse.

We also compare the growth rates of NPAs, capital and loans across the two crisis episodes. The average annual growth rates of GNPA and NNPA over the five-year period from 1997-2001 were 8.5% and 9.8%, respectively. During this period, bank capital grew 13.14% and bank loans grew 15.87%. The corresponding numbers for the current crisis are much worse. The average GNPA and NNPA growth rates for the period 2011-2015 were 45.9% and 54.9%, respectively. The average growth rate of bank capital for this period was 16.1%. Bank loans grew at 16.2%.

This shows that during the last NPA crisis, bank capital grew at a higher rate than NPAs. While the NPA to loans ratio was higher then, banks were not undercapitalised. They had better ability to withstand the problem. In the current crisis, however, the growth rate of NPAs has been considerably higher than that of bank capital, further underscoring the severity of the crisis. The growth rates of bank loans on the other hand have been similar across both crisis episodes.

The emphasis on the alternative measure of the NPA problem also highlights the importance of capital in resolving the crisis. If the NPA to capital ratio is to be restored to a level that was prevalent during the high growth years of 2003-2007, the capital base has to roughly quadruple. Even if we assume that roughly 50% of the net NPAs will be recovered by the banking sector, the capital base has to double. This is unlikely to happen through retained profits or sale of real estate or other similar strategies.

An attempt to revive the banking sector must include a credible commitment of capital for it to be meaningful. In absence of capital and accompanying structural reforms, any solution will be incomplete and the banking sector may remain in the quagmire for a long time to come.

Banking ordinance opens up Pandora’s box

Mint, May 23, 2017 (with Anjali Sharma)

The recently promulgated Banking Regulation (Amendment) Ordinance is aimed at resolving the non-performing assets (NPA) crisis in the banking sector. It creates an illusion of state action, and does little by way of addressing the real concerns. We highlight some of the problems created by the ordinance.

Resolution of NPAs is a two-stage process. The first stage involves assessing the viability of the debtor’s business. The second stage involves deciding whether the debtor’s company should be restructured or liquidated. Any such resolution, be it restructuring or liquidation, imposes losses on the banks that had lent money to the corporate debtor. The larger the losses, the higher the amount of capital needed by the banks to meet the Reserve Bank of India’s (RBI) guidelines on provisioning requirements. While the government has promulgated the ordinance, it has not made any commitment of additional capital to support the resolution efforts. Capital allocated for the banking sector in the 2017-18 Union budget, or as part of the mid-term capital infusion plan, falls short of what the banks collectively need.

In absence of additional capital, the RBI’s directions to the banks under the ordinance may impede the resolution process. The RBI may have no option but to direct the banks to extend lifelines to unviable companies to defer the problem to a future date. This can happen as part of the new Insolvency and Bankruptcy Code (IBC) or otherwise. As pointed out in the Economic Survey 2016-17, over the last few years, cash flows of the large stressed companies have been declining. Restoring their viability necessitates loan write-offs. For the banks, resolving these cases requires the most capital. Given the lack of capital, banks could be given the regulatory cover under the ordinance to refinance these large corporate debtors. We have already seen this happen under the RBI’s corporate debt restructuring (CDR) mechanism. The ordinance does not change the status quo where good money is thrown after bad and no real resolution of NPAs takes place.

Second, resolving a bank’s NPAs requires resolving the entity to which money has been lent. The ordinance may instead create perverse outcomes. Under IBC, banks as members of the creditors’ committee are required to vote on a resolution plan. If the RBI directs a bank to initiate IBC action against a corporate debtor, it may also have to direct the bank on the decisions in the creditors’ committee. By empowering the RBI to act, the government has taken away any incentive of the banks to act on their own. In India today, different banks are at different levels of capital adequacy. An IBC resolution plan that works for one bank may be inimical to the interests of another. As the banking regulator, RBI is responsible for the health of all banks. So it is possible that the resolution plan that finally gets approved by the banks under RBI’s directions will focus more on the health of the banks as opposed to addressing the insolvency of the corporate debtor. This defeats the purpose of an IBC resolution.

Third, RBI giving directions on the resolution of banks’ NPAs may undermine the IBC process in other ways too. It may thwart the incentives of third parties which would have otherwise been willing to offer their bids or resolution plans in a market-driven process.

Fourth, with the ordinance in place, all eyes are now on the RBI to resolve the NPAs of the banking sector. This could be problematic because the range of actions that the banks can take to address the problem is limited by the shortage of capital. The tools available to RBI are limited. If the RBI intervenes on a case-by-case basis, questions about conflict of interest, regulatory capacity and capability will arise. If RBI intervenes through general rules and conditions, this will be no different from the corporate debt restructuring (CDR) mechanism, the strategic debt restructuring (SDR) scheme, and the scheme for sustainable structuring of stressed assets (S4A) that have failed in the past to resolve the problem. Either way, the ordinance puts RBI’s credibility and reputation as a micro-prudential regulator at stake.

Fifth, non-commercial factors may also be at play when it comes to resolving the large NPA cases. In the absence of clarity on the rationale behind the ordinance, we conjecture that one reason banks have not been initiating resolution proceedings against the large stressed companies is because of pressure from politically connected promoters. The ordinance gives banks the regulatory cover to take resolution-related decisions but it is not clear whether it also gives the required political cover. If the RBI is to now get directly involved in these loan restructuring decisions, or indirectly through committees reporting to it, this would put it in a difficult spot.

Finally, public and private sector banks have non-government shareholders, and non-bank creditors. So do companies that may get referred to the IBC following RBI’s directions to the banks. Any action under the ordinance that adversely affects the interests of these parties may be litigated in court. In a litigation if courts take cognizance of the rights of private shareholders and rule in their favour, this can further weaken the IBC process. Also private parties, domestic and foreign, may view this as state interference in market processes. This may affect their future investment decisions.

The ordinance was presumably brought about because banks on their own could not trigger IBC proceedings against the stressed companies for fear of investigation and prosecution, or due to lack of capital or because of challenges in negotiating with politically connected promoters. The ordinance gives banks the regulatory cover to take resolution decisions, but it is, by design, limited in its capacity to resolve the crisis. It opens up a pandora’s box of new problems. Most importantly it puts the RBI in a difficult spot and makes the IBC vulnerable to potential abuse. It also creates the problem of misaligning creditors’ and debtors’ incentives farther away from an effective resolution.

Understanding the recent Banking Regulation (Amendment) Ordinance, 2017

Understanding the recent Banking Regulation (Amendment) Ordinance, 2017 The Leap Blog, May 8, 2017 (with Pratik Datta).