The Five R's of Indian Banking NPA

The following article appeared on CNBCTV18.com and in Financial Chronicle on 02Jul18

https://www.cnbctv18.com/finance/the-five-rs-central-to-indian-bank-npas-230231.htm

The Five R’s of Indian banking NPAs

Let’s consider five aspects relating to bank non-performing assets (NPAs) – NPA recognition, bank recapitalization, NPA resolution, reforms going forward, and finally, the realpolitik surrounding this.

Recognition of NPAs

Since the RBI launched the Asset Quality Review (AQR) in 2015, Indian banks have had to progressively reveal the true extent of their NPAs. These went up from 4.6% of advances in fiscal year 2015 (FY15), to 7.8% in FY16, 9.6% in FY17, and 11.6% in FY18.

The much-debated February 2018 RBI circular on resolution of stressed assets increased FY18 disclosures, and should help achieve full recognition in FY19.

Some have sought dilution of the circular, arguing that the tight timelines in the new insolvency process could force even viable businesses into liquidation.

That may be a reason to review the resolution process, but not an excuse to delay recognition. Institutional investors, analysts and markets have anyway known of skeletons in our banking closet for a while now. Only small investors could be misled by any accounting or disclosure forbearance.

RBI is right to insist that we restore credibility with full NPA disclosures. Criticizing RBI for ensuring disclosures is akin to the emperor blaming his new clothes on the mirror.

Recapitalization of banks

PSBs will likely need another round of recapitalization to credibly stay within Basel III guidelines.

For one, per the June 2018 RBI financial stability report, the FY18 Capital Risk Asset Ratio (CRAR) of PSBs under RBI’s Prompt Corrective Action (PCA) is at 10.8%, below the eventual Basel 3 minimum of 11.5. Worryingly, the same report projects the FY19 baseline CRAR of PSBs to drop further - PCA banks to 6.5%, and non-PCA to 10.6% - both well below 11.5%.  

Secondly, the loan loss provisions of Indian banks likely need to be enhanced.

FY18 PSB loan loss provisions were at 42% of stressed assets, across gross NPA and restructured assets. These may not be conservative or credible enough.

RBI’s December 2017 report on trend and progress of banking in India shows that during 2015-17, PSBs managed a recovery rate of only 25% on their NPAs.

This is visibly improving with the insolvency and bankruptcy code (IBC), with the first few steel sector resolutions coming through.

But there are many other cases facing delay, and questions around sectors such as power and telecom. PSBs will need a further INR1.65T just to raise the loan loss provision from 42% of stressed assets to 60%.

In summary, while the INR2.11T recapitalization plan of October 2017 was a welcome acknowledgment of a festering problem, PSBs need more capital. Whatever our views about Basel 3, we may have little choice but to make sure our financial ecosystem is seen as adequately capitalized.

Of course, this additional capital should not be obtained without progress on banking reform.

Resolution of NPAs

The IBC process is a welcome development. The resolution of Bhushan Steels and Electrosteel Steels are particularly heartening, and should allow banks to write back some provisions in Q1 FY19.

However, there is a backlog of cases building up at the National Company Law Tribunal (NCLT). Credit Suisse’s June 2018 India corporate health tracker points out that while 2,200 cases have been referred to NCLT, the tribunal has only admitted 700 cases. The 270-day deadline for resolution has been breached for many large cases. The IBC/ NCLT process is likely a bottleneck for now.

Which brings us to the question of a bad bank. Hopefully, the newly appointed committee under Sunil Mehta will take a call on this idea that’s repeatedly brought up, trashed, and resurrected.

Personally, I think a bad bank makes sense. For one, while the IBC/ NCLT process will work on a steady state basis, we need a one-time framework for the existing long list of cases. Second, resolution of distressed assets of this scale requires skills and flexibility that any disparate collection of commercial banks will struggle to demonstrate.

While no two countries are comparable, the experience of Malaysia’s distressed debt AMC (Danaharta) post the Asian crisis bears studying. Danaharta offered to buy distressed loans at a discounted purchase price. Banks could either take up the offer, or take steep loan loss provisions. In return for the sale, the banks would get back 80% of the excess recoveries made by Danaharta over the purchase price. Aided by state muscle, resolution plans, reforms, consolidation, and recapitalization bonds, this experiment worked reasonably well.

Reforming our PSBs

Neither recapitalization nor a one-time resolution of stressed assets guarantee that these cycles of lend and write-off will stop. We need serious banking reforms, and the recommendations of the P J Nayak committee report fit the bill.

The committee recommended the formation of a Bank Investment Company (BIC) to hold government’s PSB stakes. The government would then distance itself from managing banks, repeal the Bank Nationalization and State Bank of India acts, and put all PSBs and the BIC under Companies Act.

This would in turn allow the BIC to operate as a professional manager of PSBs. It would allow PSBs to develop market-linked human resource policies including pay, promotion and performance accountability, in line with other professionally managed companies. It would also bring all of banking regulation under RBI, rather than the dual government/ RBI framework for PSBs today.

Eventually, the BIC would downstream governance fully to individual bank boards, including the responsibility for selecting CEOs, business strategy, financials, risk and human resources.

The government could then consider bringing the stake of the BIC to below 50% in each bank. That would also allow PSBs to be outside the ambit of CVC/ CAG/ RTI, brining them on par with private sector banks.

Interestingly, the P J Nayak committee also makes this observation – “in loan and expenditure cases, deviations from procedure should not constitute the sole basis for initiating criminal action (against bankers)”!

Realpolitik

The steps recommended therefore are (i) fully recognize and disclose banking NPA (ii) provide adequately for loan losses and future business needs, alongside another round of PSB recapitalization (iii) set up a bad bank for a one-time resolution of the growing list of IBC/ NCLT cases and (iv) implement the P J Nayak committee report, as an enduring reform of Indian banking.

It’s easy to list all this, but politically, very challenging to implement. Each stage has ramifications that cannot be ignored.

Full disclosure of NPA, provisioning, and recapitalization will be portrayed as a reflection on the current government performance – never mind that the seeds were sown many, many years ago.

A big political issue around the bad bank would be the transfer of loans at a haircut. This will be portrayed as waivers to big borrowers; many of who are also suspected of malpractice, while ordinary retail borrowers are given no such respite.

Lastly, imagine Babus and Netas implementing the P J Nayak committee recommendations, which will end up disempowering them from Indian banking. Also, while economists and experts will largely applaud the steps, there will be popular protests – including from bank unions - portraying this as backdoor bank privatization.

Each of these objections can be countered by logical arguments, consultations and reassurances. But political discourse is not dictated by rational logic alone.

We need a government that is both convinced on the way forward, and is confident it has the political capital and savvy to shape the narrative. Or is patriotic enough to do the right thing, even if it means paying the supreme political price!