BQ - Samudra Manthan of our Financial Sector

 (The following article appeared in BQ on May 14, 2020 - URL below:

https://www.bloombergquint.com/coronavirus-outbreak/covid-19-a-samudra-manthan-of-our-financial-sector )

Making Our Financial Sector Fit for Growth

Delhi, we have a problem

 

Our financial services ecosystem is in trouble.

 

Even before Covid-19, beyond the smokescreens, the true Gross Non-Performing Assets (NPAs) across banks and NBFCs probably stood at 12% of the INR 140 lakh crores of advances. Covid-19 could well push this to 20% of advances. This fear is reflected in the current state of savings, lending and credit markets.

 

Status quo and forbearance can at best keep the ecosystem undead. Instead, we need the ecosystem to be fit enough to fuel our growth aspirations with adequate flow of credit.

 

China’s credit to the non-financial sector is at 259% of GDP. India’s is at 126%. When credit fuels jobs and output, it can trigger the virtuous cycle of supply, consumption, investment and savings that India sorely needs.

 

Of course, this fuel alone is insufficient to ensure sustainable growth. Alongside, we also need a strong real sector to serve as a reliable vehicle, and a healthy investment climate to make the growth path motorable. Prime Minister Modi’s vision of reforms, as articulated yesterday, should help address these aspects.

 

In this note, however, we will focus our attention on the revival of the financial sector.

 

Sizing the Problem & Possible Solution

 

With NPAs perhaps already at INR 17 lakh crores, and maybe heading to INR 28 lakh crores, we must start by acknowledging that a tumor of this scale requires surgery, not Band-Aid.

 

First, the system needs to be unburdened of its NPAs, and recovery has to be expedited. We could start by quarantining at least INR 5 lakh crores – perhaps more - of the larger NPAs away from banks and NBFCs. Their resolution can be dealt with separately.

 

Second, to protect the taxpayer and to restore trust, this quarantining has to be done at fair market valuations, not at book value.  The bright light of truth could expose weaknesses in some financial institutions. They will then need resolution or recapitalization.

 

Third, to pivot towards sustainable lending going forward, we will need accountability and reforms to guard against a repeat of this age-old lend, pretend, and rescue cycle.

 

Quarantine and Recovery – “Neelkanth”

 

The suggestions below draw entirely from Malaysia’s experience with their institutions ‘Danaharta’ and ‘Danamodal’ after the Asian crisis.

 

The government should set up a bad bank (“Neelkanth”) with say INR 2 lakh crores of capital, self-funded by INR 2 lakh crores of GOI recap bonds. The fiscal implications would be no different from the substantial public sector bank recapitalization that has already been undertaken over the past three years.

 

This capital of INR 2 lakh crores would allow Neelkanth to acquire INR 5 lakh crores of gross NPA, paid for in recap bonds, assuming an average fair value of 40% of notional.

 

The sheer size of the fund needed, the need for speed, and the need for flexibility in tweaking rules to aid speedy NPA resolution make the case for a fully government-owned bad bank. Bringing in external funds of reasonable scale on economically and politically acceptable terms may simply take too much time.

 

Notwithstanding government ownership, Neelkanth should be headed by an independent, respected finance professional of unimpeachable integrity. It should be manned by specialized distressed asset professionals, including international and sectoral experts. Recovery management is very different from regular commercial relationship banking.

 

Neelkanth would be given statutory powers to acquire, manage, and dispose of the NPAs. Financial institutions would be allowed to deal with Neelkanth without fear of prosecution.

 

Neelkanth would have a finite lifespan of five years to work with stakeholders and address the NPAs.

 

Neelkanth Operations

 

Let’s illustrate how Neelkanth would work.

 

To start with, it would arrive at a fair value for every large NPA beyond a threshold size of say INR 1,000 crores.

 

In a specific example, assume that it bids INR 400 crores (in GOI recap bonds) as assessed fair value for an INR 1,000 crores loan on an NBFC’s books.

 

The NBFC could reject the bid as being too low. But it would then have to ensure provisions of at least INR 600 crores against the loan, so that the Net NPA on its books would be at or below the bid price of INR 400 crores.

 

Assume the NBFC did sell the asset to Neelkanth. On the upside, if Neelkanth actually recovered INR 700 crores from the asset over time, then 80% of the additional INR 300 crores recovered – INR 240 crores - would be paid back to the NBFC. On the downside, any recovery below INR 400 crores would be the sole liability of Neelkanth.

 

This approach could help address the concerns around asset valuation for both the NBFC and for Neelkanth.

 

The Price of Fair Value

 

Transferring NPAs at an independently assessed fair value would help ensure that taxpayers do not bail out any promoter or financial institution. However, it would severely expose financial institutions with inadequate loan loss provisions.

 

Over time, loan loss provisions for bank NPAs has improved. However, for some financial institutions, even NPA recognition may be incomplete. When they are forced to mark down their large NPAs to fair value, some of them may require capital. Once again, the taxpayer could be eyed.

 

In Malaysia, Danamodal was created precisely to provide equity to such strained financial institutions. Any such taxpayer equity infusion, however, would have pass some litmus tests. First, it must only be considered if rescuing the institution is critical for overall financial stability. Second, such infusion cannot be a bailout for promoters and equity holders – they would first have to take an appropriate hit.

 

In the case of Malaysia, taxpayers did not face a loss from Danaharta and Danamodal. In fact, at 59%, their recovery against NPAs was quite creditable. The bad bank was also wound up in a time-bound manner, as envisaged.

 

Learnings from the Past

 

While the scale and import of the problem argues for putting taxpayer money at risk now, we cannot allow this cycle of extend, pretend and bailout to continue.

 

Any intervention has to be accompanied by long-awaited reforms. Prime Minister Modi’s speech of yesterday is encouraging in this regard.

 

The recommendations of the P J Nayak committee (May 2014) must be implemented, if nothing else, to grant professional autonomy to public sector bankers, and to hold them truly accountable for their performance.

 

There is also the need for governance reform – across risk managers, auditors, boards, rating agencies, supervisors, regulators and the bureaucracy.

 

We need reform of our debt markets, to improve their liquidity, depth and functioning.

 

Finally, as argued earlier, real sector reforms and improvements in the overall investment climate will have to go hand in hand with any financial sector cleanup.

 

Murder on the Mumbai Express

 

There has to be accountability as well. Before casting the first stone however, it is worth reflecting that few classes of stakeholders, if any, come out of this looking good.

 

Across commentators, analysts, investors, bankers, financiers, promoters, fund managers, regulators, rating agencies, auditors, the bureaucracy, politicians, and the government, we have all played our part in this murder on the Mumbai Express.

 

Alongside enforcing specific accountability, we also need a collective truth and reconciliation approach to introspect, learn and correct for the future.

 

The Critical Challenge - Execution

 

Admittedly, the suggested solution set here – a bad bank, recapitalization and extensive reforms – will be anything but easy.

 

There will be no shortage of expert objections on legal, regulatory, moral and other grounds.

 

Perhaps there are alternative routes. But any alternative has to account for the scale of the problem and target the ultimate objective – making our financial services ecosystem fit to support our growth aspirations. Tinkering at the edges is simply not an option.

 

Ultimately, our political leadership will have to direct our legal experts, regulators and bureaucrats to focus less on the objections, and instead find ways to make the chosen solution set work. Execution, as always, will be key.