On defaulters, RBI prioritises public interest

Indian Express June 20, 2023

On June 8, 2023 the Reserve Bank of India set out a framework for bank settlements with defaulters. This circular has triggered widespread criticism because it covers settlements with fraudulent and wilful defaulters implying to some that the RBI is condoning their crimes. This interpretation is not correct. On the contrary, the point of the circular is to establish safeguards so that public interest is protected when banks make such settlements. That said the circular has once again brought to fore two deeper issues in the Indian banking system: government ownership of banks and weaknesses in regulatory governance.

Let's first understand why this issue has even arisen. Why should banks settle with defaulters?

When there is a default, the primary objective of a bank is to recover as much of the loan as possible. Various options might be available to the bank for recovering the loan. The bank decides which strategy would work best, based purely on commercial judgement. For instance, the bank may want to trigger the Insolvency and Bankruptcy Code (IBC, 2016) against the borrower. Alternatively, in some cases, the bank may decide to pursue a “compromise settlement” wherein the bank and the borrower negotiate a settlement amount. It is wrong to think that the RBI has permitted something unusual. One-time settlements are part and parcel of the business of banking. The RBI has simply given a formal regulatory structure to a standard banking practice.

Some of these settlements can indeed be with wilful and fraudulent defaulters. When trying to recover a loan, a bank should not make any distinction between whether the default is wilful, fraudulent or otherwise. Irrespective of the nature of the default, it is upto the bank to decide whether a settlement is a better and quicker option instead of triggering the IBC or pursuing some other strategy. The sole motivation behind such a decision should be to maximize recovery, as speedily as possible. This will help unlock banking capital that is stuck in the wilful default or fraud categories.

What about the crimes that these defaulters may have committed?

The RBI circular makes it clear that banks should feel free to file cases against fraudulent or wilful defaulters. It explicitly states that banks will undertake settlements “without prejudice to the criminal proceeding underway against such debtors.” This separates the criminality of a particular default case from the commercial aspect of it. In other words, no, the circular does not condone any crimes. But the pursuit of a criminal action against a defaulter should not necessitate suspending commercial judgement. This distinction is vital.

That said, there are some valid concerns. One apprehension stems from the government control over the boards of public sector banks. This creates a risk that the settlement process might be misused to favour politically connected defaulters at the cost of the banks’ commercial interests. This concern may not be wholly without merits, and it is therefore incumbent upon the RBI to allow the commercially prudent decisions and prevent the politically motivated ones. Only time will tell whether the requirements and safeguards laid down by the circular will be sufficient for this purpose.

In addition, there are some broader issues that need to be highlighted.

There is ample anecdotal evidence that private sector banks have been settling with wilful defaulters for a while now. So, if banks have already been doing such settlements and various instructions to this effect have already been issued by the RBI to banks over the years, then one might ask: what was the need for this circular?

The answer possibly lies in the fact that two-thirds of the Indian banking system is owned by the government and public sector banks are more likely to come under the scrutiny of investigative agencies for any action they take. The RBI circular gives these banks the regulatory cover for settlement related decisions. In a narrow sense therefore the circular merely levels the playing field. But from a wider perspective, the fact that a circular needed to be issued underscores the distortions that the Indian banking system suffers from owing to the government ownership of banks. In a fully privately-owned banking system there would be no need for such a circular and the ensuing controversy could have been avoided.

The second broad issue concerns regulatory governance. A year ago, the RBI's Regulations Review Authority 2.0 recommended that the RBI place all draft instructions on its website for stakeholder comments and finalise them after considering the feedback. Exceptions should be made only in special circumstances. There do not appear to have been any special circumstances surrounding the June 8 circular. There were no issues related to financial stability, or fiduciary duty, or confidentiality. There does not even appear to have been any pressing urgency. At the same time, the circular is of great public interest since it applies to entities against whom criminal proceedings are underway.

Hence, the draft circular could and should have been placed on the RBI’s website for public consultation along with a discussion paper clearly explaining its rationale. Concerned stakeholders could have expressed their concerns and the RBI would have had the opportunity to assuage their misgivings by making suitable clarifications to the draft circular before notifying it. That would have saved much trouble for both the central bank and the government.

Banks are commercial enterprises and should be allowed to operate accordingly. In principle, separating a commercial decision such as loan recovery from criminal proceedings against wilful defaulters is a step in the right direction. However the situation in India is unduly complicated because of government ownership of commercial enterprises and gaps in regulatory governance. Future public discourse should focus on these fundamental problems, and not on how banks or RBI could play the role of moral police.

Is the good run of the Indian banking sector over?

Is the good run of the Indian banking sector over?, MoneyControl, June 6, 2023.

The post-pandemic credit landscape in India

The post-pandemic credit landscape in India, Ideas for India, May 8, 2023.

Playing it safe

Indian Express, August 5, 2022

The RBI's latest Financial Stability Report (FSR) has given the banking system a reasonably clean bill of health. It's a significant achievement, considering the stress of the previous decade, the shock of the pandemic and the associated slowdown of the economy. However, the improvement in banks' financials presents a glass half-full picture. It is still unclear whether the banking system is healthy enough to provide the sustained credit growth needed for a strong economic recovery.

Two key indicators demonstrate the banking system’s progress. Successive waves of recapitalization have given banks enough resources to write off most of their bad loans. As a result, they have been able to bring down their gross NPAs from 11 percent of total advances in 2017-18 to 5.9 percent in 2021-22. NPAs for industrial credit have been reduced even more dramatically, from 23 percent to 8.4 percent. Even after these large write-offs, most banks retain comfortable levels of capital.

This financial turnaround has given banks the space to resume their business of extending credit. During the decade when banks were under stress, non-food bank credit growth had been declining, reaching just 6 percent in 2020, its lowest point in six decades. Since then, credit growth has nearly doubled.

These are the visible signs of a healthier banking system. However, the broad aggregates conceal a worrisome picture, raising questions about the role bank credit will play in supporting GDP growth. The problem is that very little of this credit is going to large-scale industry or for financing investment.

Consider first the sectoral distribution of credit. Over the last decade, banks have increasingly shifted away from providing credit to industry, favouring instead lending to consumers. Consequently, the share of industry in total banking credit has declined from 43 percent in 2010 to 30 percent in 2020, while that of consumer loans has increased from 19 percent to 29 percent. This trend is continuing: in the year ending March 2022, consumer loans grew at 13 percent, whereas loans to industry grew at just 8 percent.

Bulk of the industry loans has been extended to the smaller firms (MSMEs), which benefitted from the credit guarantee scheme offered by the government in the wake of the pandemic. Loan growth for MSMEs went up from 3 percent in 2020 to 31 percent in 2022. In contrast, lending to large industries has been stagnant in nominal terms during the last two years, implying that it has declined sharply in real terms.

A related problem is that there has been little lending for private sector investment. Over the last one year, bank lending to infrastructure has grown by 9 percent, up from 3 percent in 2020, but this was fuelled mainly by public sector capital expenditure. Meanwhile, much of the lending to private industry has been in the form of working capital loans, necessitated by the increase in commodity prices, which has led to a sharp rise in the cost of holding inventories.

Why is there so little lending for investment by large firms? Both demand and supply side factors seem to be at work. On the demand side, private sector investment has been sluggish for nearly a decade. The boom-and-bust of the mid-2000s had saddled firms with excess capacity, giving them little reason to expand their production facilities. In addition, the Global Financial Crisis had shown the dangers of ambitious expansion supported by excessive borrowing, leading firms to conclude that it would be prudent to scale back their plans and instead focus on reducing their debts.

On the supply side, banks have learned similar lessons. During the period 2004-2009, rapid GDP growth in the Indian economy was fuelled by an unprecedented lending boom. Credit doubled within the span of a few years, primarily on the back of lending to large infrastructure projects. Subsequently, many of those loans turned bad, leading to high levels of NPAs on bank balance sheets. As a result of these financial problems, banks for a decade were unable to extend much in the way of credit. Even when their health improved, they remained wary of lending to large-scale industrial projects, preferring instead to shift to smaller-scale and less risky consumer lending. This situation of risk aversion on the part of firms and banks has not changed perceptibly during the post pandemic recovery.

On the positive side, firms seem to have finally used up much of their spare capacity. But on the negative side, the fundamental problems that led to the difficulties of the past decade still have not been resolved. There is still no framework that will reduce the risk of private sector investment in infrastructure, certainly not in the critical and highly troubled power sector. Nor is there any reassurance for the banks that if problems do develop, they can be resolved expeditiously, since the Insolvency and Bankruptcy Code (IBC) has been plagued by delays and other problems. Now, heightened global macroeconomic uncertainty, growing geopolitical tensions and uncertain recovery prospects of the domestic economy are likely to make matters worse.

In other words, a healthy balance sheet of the banking sector is a necessary but not a sufficient condition for economic growth. The important question is whether banks and firms will once again be willing to take on the risk of investment in industry and infrastructure. And this seems unlikely unless there are deep structural reforms – to the infrastructure framework, the resolution process, and indeed in the risk management processes at the banks themselves. In the event that these reforms do not materialise, there may continue to be shortfalls in credit, investment, and ultimately in economic recovery and growth.

‘Consumerisation’ of banking in India: Cyclical or structural?

‘Consumerisation’ of banking in India: Cyclical or structural?, Ideas for India, July 23, 2021.

India's banking sector: a liability for monetary policy effectiveness?

India’s banking sector: a liability for monetary policy effectiveness?, East Asia Forum, October 16, 2020.

Modi government and RBI can learn from mistakes made during 2008 crisis, but time’s running out,

The Print, August 19, 2020

Five months into the lockdown, the Covid-19 pandemic is nowhere near its end, while the economy continues to steadily deteriorate. The pandemic is unprecedented in modern India, but its economic impact is familiar: a toxic mix of poor growth, high inflation, and numerous bad loans, similar to the period after the 2008 Global Financial Crisis. This means we can look to the 2008 crisis for lessons that can help us avoid policy mistakes, especially with respect to inflation and bad loans.

Inflation pressure

Let’s first consider inflation. In the aftermath of the Global Financial Crisis (GFC), the Reserve Bank of India (RBI) responded aggressively, lowering the policy rate by more than 4 percentage points in just four months, to 4.75 per cent in December 2009. At the time, the RBI felt it was safe to relax its monetary policy stance, since the wholesale price index (WPI) inflation had collapsed. But the respite in inflation proved temporary, and soon the WPI was rising at a double-digit pace, causing inflation expectations to soar. Bringing this situation under control proved to be difficult. It was not until 2013, when policy rates had been increased to painful levels, that inflation finally began to subside.

In retrospect, the RBI made two mistakes. First, it focused on the WPI, even as more comprehensive indices were signalling towards growing inflationary pressures. The erstwhile CPI (Consumer Price Index)-industrial workers series exceeded 12 per cent, as early as 2009-10. Second, and more critical, even after the WPI itself began to rise the RBI was slow to respond, since it always had reasons to hope that the increases would be temporary.

When the current Narendra Modi-led government came to power in 2014, it seemed determined to not let such a harrowing episode be repeated. Accordingly, it introduced into law a new monetary policy regime, committing the RBI to keeping inflation within a 4-6 percent range, as measured by the CPI — not the WPI. If inflation did exceed 6 per cent for three consecutive quarters, the RBI was required to explain in a report to the government, in a report, what it was doing to bring inflation back to target levels.

The RBI now finds itself in precisely the situation that the law meant to safeguard against? CPI inflation has exceeded 6 per cent for the past 10 months. But the reaction of the RBI has been the same as it was after the GFC. The central bank has been reluctant to increase interest rates, on the grounds that high inflation triggered by supply side constraints is temporary. Without doubt, prices have been pushed up by supply disruptions during the lockdown period, and these will eventually disappear. But the process of restoring supply chains might easily take a year, by which time high inflation expectations could become firmly entrenched. Hence, there is a risk that despite all the efforts to ensure post-GFC mistakes never happen again, they are about to be repeated.

Covid's bad loan crisis

So much for inflation. What about bad loans? After the GFC, slower growth and higher interest rates rendered unviable many of the investment projects initiated during the 2004-08 boom. , making This made it impossible for many firms to repay their bank loans. The RBI responded with a series of restructuring schemes, which failed to resolve the problem. Instead, the schemes facilitated an ‘extend and pretend’ policy which enabled the banking sector to hide the bad loans for years.

The delay in resolution of the stressed assets triggered a prolonged phase of low investment-low growth in the economy, and high risk aversion in the banking sector, from which the economy still hadn’t recovered when it was hit by the Covid-19 pandemic. As these consequences became apparent, the Modi government brought in the Insolvency and Bankruptcy Code (IBC), mandating that bankrupt firms be resolved expeditiously, and in a transparent manner, essentially by auctioning them off to new, financially stronger, owners.

For a time, the IBC was indeed able to whittle down the stock of bad loans. But the Covid-19 shock generated a new wave of stressed assets, which according to the RBI’s latest Financial Stability Reports is likely to propel nonperforming assets (NPAs) to a new peak of 12.5 per cent by March 2021, even under a favourable scenario.

Going forward

It is unclear how the authorities plan to deal with this problem. So far, the government has suspended the initiation of fresh insolvency proceedings for a year, while the RBI has appointed a committee to recommend new restructuring guidelines.

If the new restructuring guidelines follow the same ‘extend and pretend’ strategy chosen after the GFC, the outcome will be the same as before. Or possibly worse, given that in 2008 the corporate and banking sectors were comparatively stronger, whereas even before the virus hit in 2020, they both had been substantially weakened by years of balance-sheet stress. Hence, the effects of delaying resolution this time might be more serious. If the banking sector gets paralysed, unlike the post-2008 period, borrowers will no longer be able to turn to the non-banking finance companies (NBFCs), since the NBFCs are also in a weak condition now.

India, thus, stands at a crossroads now. Soon, the Modi government and the RBI will need to decide whether to deal quickly and decisively with the economic problems that Covid-19 has created, or wait and watch in the hope that they will disappear over time. The stakes in this decision are high, since it will determine the course of India’s economy for the next decade.

Looking back, the GFC episode makes it clear that the decisive strategy is superior. What is unclear is whether this lesson has truly been learned. And we all recall American philosopher George Santayana’s admonition: if we do not learn from history, we are doomed to repeat it.

RBI vs. Covid-19: Understanding the announcements of March 27

RBI vs. Covid-19: Understanding the announcements of March 27, Ideas for India, April 7, 2020.

Policymaking at a time of high risk-aversion

Policymaking at a time of high risk-aversion, Ideas for India, April 6, 2020.

Banking crisis impedes India’s economy

Banking crisis impedes India’s economy (with Harsh Vardhan), East Asia Forum, October 3, 2019.

The Indian bankruptcy reform: old defaults vs. recent ones

The Indian bankruptcy reform: old defaults vs. recent ones, The Leap Blog, April 11, 2019.

PSU bank privatization is not a panacea for the ills of the banking sector

Mint, March 22, 2018 (with Shubho Roy)

The PNB fraud has rekindled the debate on bank privatization, often considered a solution for the poor management in public sector banks (). While government ownership of businesses is a bad idea and leads to poor economic outcomes, we should not pin all hopes on privatization as a solution. It is not a panacea for the ills of the banking sector unless accompanied by reforms in banking regulation.

The Reserve Bank of India (RBI) has often cited government ownership as an explanation for management failures in PSU banks. The RBI committee to look into the governance of PSU banks in 2014 stated: “If the Government stake in these banks were to reduce to less than 50 per cent, together with certain other executive measures taken, all these external constraints would disappear.” There are incentive conflicts when government owns banks, and this affects the efficiency of capital allocation. However, this does not explain why the RBI cannot hold the PSU banks accountable for issues such as capital adequacy, fraud control or appropriate reporting of financial statements.

RBI’s powers over PSU banks

It is true that the RBI does not have all the powers over PSU banks that it has over private sector banks, such as the power to revoke a banking licence, merge a bank, shut down a bank, or penalize the board of directors. However, Section 51 of the Banking Regulation Act, 1949 enables the RBI to exercise some powers over PSU banks, which apply notwithstanding any special provision governing PSU banks in other laws.

The RBI can control the lending policy of PSU banks, including determining maximum exposure, and the purpose of lending (Section 21). The RBI approves the auditor for PSU banks and has the power to issue special audits on PSU banks (section 30). RBI can lay down the returns that a PSU bank has to file (Section 31). RBI can inspect PSU banks just like private sector banks (Section 35), and give directions, including directions on management (Section 35A). It can appoint RBI officers to attend board meetings of PSU banks and speak in them, collect all communications of a PSU bank’s board, and require PSU banks to make changes in management (except board) (Section 36). RBI can ask PSU banks to maintain records as per rules made by RBI (Section 45Y), impose penalties on PSU banks through the courts (section 46) or directly under RBI systems (Section 47A). RBI cannot impose penalties on PSU bank directors appointed by it or the government. But this protection does not extend to other employees of the banks.

The lack of some powers of RBI over PSU banks is balanced, to some extent, by the right of RBI to appoint a director on the board of a PSU bank (bank nationalisation laws and the law governing State Bank of India). Unlike private sector banks, this director must have expertise and experience in regulation and supervision of banks, a skill available only with RBI. This allows the RBI to keep a PSU bank under constant supervision.

Regulation of private sector banks by RBI

Had government ownership been a constraint for effective banking regulation, we should have seen better oversight of private sector banks. That has not always been the case. For instance, in recent times, we have come to know about the divergence between the non-performing assets (NPAs) stated by major private sector banks in their regulatory disclosures and the amounts that the RBI uncovered during its inspections. RBI found that Yes Bank’s NPAs were 558% more than reported. Similar divergences have been found in Axis Bank and ICICI Bank. Although the bulk of the NPAs are in PSU banks, the private sector banks are not fine either.

We know from media reports that RBI fined Yes Bank and Axis Bank for these divergences. However, the information on penalties is not publicly available on RBI’s website. We do not know whether due process was followed before imposing sanctions on these banks, whether the fines were backed by a show cause notice, and a reasoned order. We also do not know whether any other bank reporting NPA divergences has been fined. The lack of transparency in the manner in which banking regulation is enforced applies to all banks irrespective of the ownership structure.

Private and public sector banks are driven by different incentives which may help explain the difference in the violations seen in these two categories of banks. In the private sector, the shareholders’ effective control over banks may explain the absence of large-scale frauds such as the PNB episode. However, the interests of shareholders may not be aligned with those of the regulator.

In banking, shareholders bring only Rs12 of every Rs100 of the capital required to do business. The rest is brought in by depositors. Shareholders are interested in trying to get their return as quickly as possible and hide the bad news. When banks fail, shareholders have already recouped their investments and depositors are left high and dry. Prudential regulations, such as NPA norms, are designed to prevent this.

NPA regulations require banks to keep money stowed away to repay depositors. This is done by reducing the income of the bank by the amount of NPAs. Lower NPAs mean there is more profit to be distributed as dividends to shareholders. So, the shareholders and the management of private sector banks have interest in showing lower NPAs. It is the job of the banking regulator to prevent this from happening. When a bank understates its NPAs, it is a failure of banking regulation.

For a long time, banks had access to restructuring schemes (such as corporate debt restructuring, strategic debt restructuring and schemes for sustainable structuring of stressed assets,) initiated by RBI. Both private and public sector banks used these schemes to delay the recognition of bad loans. While in a welcome move, the RBI has now withdrawn these schemes, the fact remains that they played a big role in worsening the current NPA crisis.

Income and loss recognition continues to involve discretion from the regulator. PNB has asked RBI to spread out loss provisioning from the recent fraud over four quarters. This is in spite of RBI regulations requiring fraud to be recognised and provisioned for immediately. PNB has good reasons to expect a special dispensation from RBI, which will allow it to violate RBI’s regulations. Such exceptions are frequently made. For example, in May 2015, the RBI allowed lenders to keep loans to Haldia Petrochemicals as standard assets, even though they had been restructured twice and should have been designated as NPAs.

Regulation of private sector banks: Misselling

Failure in regulation is not limited to prudential regulation. On several occasions, RBI has not been able to protect the interests of consumers and the problem may be systemic. Monika Halan (consulting editor, Mint) and Renuka Sane show in an academic paper, "Misled And Mis-sold:Financial Misbehaviour In Retail Banks" that there is widespread misselling in both private and public sector banks. Banks rarely disclose the features of their products and frequently provide incomplete or inaccurate information. The situation became so bad in Rajasthan in a misselling episode involving ICICI Bank that the police had to step in.

While the underlying financial products in such misselling may be regulated by the Securities and Exchange Board of India or Insurance Regulatory and Development Authority of India, the act of misselling takes place in banks, which are regulated by RBI. All financial regulations are for (1) consumer protection (2) micro-prudential oversight (3) resolution and (4) systemic risk reduction. When bank officers cheat consumers, this violates consumer protection and falls within the purview of banking regulation. The fact that misselling is rampant in private sector banks goes to show that there are problems in these banks too.

Banks can earn more fees and make higher profits by selling financial products with high commissions, as opposed to the appropriate financial products, to consumers. If the management of a private sector bank is incentivised to increase income, they will try to sell insurance products (which may carry commissions equalling the entire premium for one year) rather than fixed deposits (the Rajasthan episode).

The objective of banking regulation is to make the management of banks, both private and public, take decisions which they would not normally take to protect depositors and consumers. Since the incentive structures of the management of private and public sector banks are different, they will take different types of decisions. But in both cases, the decisions may adversely affect the consumers and the depositors.

Privatization of banks, with the same level of regulatory capacity and the same quality of regulatory oversight, may only trade one type of banking management failure (frauds, poor system controls) with other types of failures (underreporting of NPAs, misselling of financial products). There is no evidence that the RBI is better at regulating private sector banks and no reason to believe that bank privatization will cure the ills of banking regulation.

Doing the right thing for the wrong reasons is dangerous. Privatisation may solve other problems in the economy, free up fiscal resources and may even reduce corruption, but it is not a solution for regulatory weaknesses. If bank privatisation is the only reform that is undertaken in response to the current crisis in the banking system without fixing fundamental problems in banking regulation, the crisis will keep recurring. This will then delegitimise the privatisation move. The consequent backlash may undo many good reforms which have reduced the role of state in commerce and redirected it towards public goods like regulation.

Bank recapitalisation: the allocation challenge

Bank recapitalisation: the allocation challenge, The Leap Blog, January 30, 2018 (with Anjali Sharma).

Commercial wisdom to judicial discretion: NCLT reorients IBC

Commercial wisdom to judicial discretion: NCLT reorients IBC The Leap Blog, December 13, 2017 (with Pratik Datta).

Bank recapitalisation: The myth around growth capital

Bank recapitalisation: The myth around growth capital The Leap Blog, November 21, 2017 (with Anjali Sharma).

NPA Ordinance: The impact of secrecy in ordinance making

NPA Ordinance: The impact of secrecy in ordinance making The Leap Blog, June 30, 2017 (with Pratik Datta).

Bank financing of stressed firms

Bank financing of stressed firms Ideas for India, June 7, 2017 (with Anjali Sharma).

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).