Harking back to the period of irrational exuberance in 2007-08 when bankers lent without asking too many questions, Reserve Bank of India Governor Raghuram Rajan on Tuesday hoped that this time it will be different. His comments come in the context of the asset quality challenges banks are facing.

Speaking at the FICCI-IBA Annual Global Banking Conference, Rajan observed that India will have enormous project financing needs in the days ahead.

“Even though bankers are very risk averse today, and few projects are coming up for financing, this will change soon. What is in the pipeline is truly enormous — airports, railway lines, power plants, roads, manufacturing plants, etc.

“Bankers will remember the period of irrational exuberance in 2007-08 when they lent without asking too many questions. I am hopeful that this time will be different,” said Rajan.

Fitch Ratings, in a recent report, cautioned that the outlook for the banking sector’s asset quality will remain challenging over the next 12-18 months, given exposure to stressed sectors and the difficult resolution process for stressed assets in the near term.

Stressed assets (gross non-performing loans plus performing restructured loans) of private banks and public sector banks stood at 4.5 per cent and 14.5 per cent of total loans, respectively, as at March-end 2016.

Tackling stressed assets

With the asset quality review, initiated by RBI in early 2015-16, improving recognition of non-performing loans (NPLs) and provisioning in banks enormously, the Governor felt that now the focus should move more to improving operational efficiency of stressed assets, and creating the right capital structure so that all stakeholders can benefit.

He sought action from banks on two fronts — where necessary, new project management teams have to be brought in, sometimes as owners, and where this is not possible, as managers; and equally important, the capital structure should be tailored to what is reasonable, given the project’s situation.

Industry knowledge

“Here are ways it (lending) can be different and risks lowered. First, significantly more in-house expertise can be brought to project evaluation, including understanding demand projections for the project’s output, likely competition, and the expertise and reliability of the promoter. Bankers will have to develop industry knowledge in key areas since consultants can be biased,” suggested Rajan.

Second, real risks have to be mitigated where possible, and shared. Real risk mitigation requires ensuring that key permissions for land acquisition and construction are in place upfront, while key inputs and customers are tied up through purchase agreements. “Where these risks cannot be mitigated, they should be shared contractually between the promoter and financiers, or a transparent arbitration system agreed upon. So, for instance, if demand falls below projections, perhaps an agreement among promoters and financier can indicate when new equity will be brought in and by whom,” explained the Governor.

Third, the capital structure (of the project), according to Rajan, has to be related to residual risks of the project. The more the risks, the more the equity component should be (genuine promoter equity, not fake borrowed equity, of course), and greater the flexibility in the debt structure. Promoters should be incentivised to deliver, with significant rewards for on-time execution and debt repayment.

“Where possible, corporate debt markets, either through direct issues or securitised project loan portfolios, should be used to absorb some of the initial project risk. More such arm’s length debt should typically refinance bank debt when construction is over.

“Hopefully, some of the measures taken to strengthen corporate debt markets, including the new bankruptcy code, should make all this possible,” he said.

Fourth, financiers should put in a robust system of project monitoring and appraisal, including where possible, careful real-time monitoring of costs. For example, can project input costs be monitored and compared with comparable inputs elsewhere using IT, so that suspicious transactions suggesting over-invoicing are flagged?

And, finally, Rajan said the incentive structure for bankers should be worked out so that they evaluate, design, and monitor projects carefully, and get significant rewards if these work out.

“This means that even while committees may take the final loan decision, some senior banker ought to put her name on the proposal, taking responsibility for recommending the loan. IT systems within banks should be able to pull up overall performance records of loans recommended by individual bankers easily, and this should be an input into their promotion,” he said.

Not futuristic

The Governor observed that none of his suggestions were futuristic, but they require a much stronger marriage between information technology and financial engineering, with an important role for practical industry knowledge and incentive design.

There are also inputs to making profitable project loans — such as the availability of low-cost CASA (current and savings account) deposits — that will accrue to the banks that build out their IT to access and serve the broader saver cheaply and effectively. He felt that few banks have the in-house talent to do all this now, but preparation is imperative.

“An area of more intensive use of IT and analysis is customer loans, which is my second example. It seems today that, having abandoned project loans, every bank is targeting the retail customer.

“Clearly, the risks in this herding will mount over time, as banks compete for less and less creditworthy customers. But some of this risk can be mitigated if they do sufficient due diligence,” said Rajan.

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