Snowballing bad loans of public sector banks headed for the insolvency and bankruptcy process is widely known. But what is not so readily realised is the precise nature of the challenge that this poses for the country’s economic system. If these banks continue to be run essentially the same way they have been, then they may pose a systemic risk.

Public sector banks and their owner, the government, are ready for huge write-offs — in the vicinity of 60-70 per cent — where a resolution plan is approved by the creditors, and they may lose even more if firms go in for bankruptcy.

This will need huge recapitalisation of the banks, creating a substantial fiscal burden. The bill will eventually have to be paid to enable the banks meet their minimum capital adequacy requirements and remain in business. This is imperative as the pipeline for bank credit cannot be severely restricted. But that will not be the end of the story. After extensive write-offs and recapitalisation, if there is little change in the way the banks are run, then in a few years they will again have generated a substantial pile of fresh bad debts.

The banks have come to such a pass because of several reasons. One is the consequences of lending longer term to large infrastructure projects when their expertise lies in granting short term working capital loans. But the main culprit is the overarching control that senior government officials and their political masters have over banks. This has led to poor choice of the top management for the banks and inadequate governance standards.

Governance reforms

Fully aware of this reality, the current dispensation created the Banks Board Bureau, under the leadership of former CAG Vinod Rai, to bring about a fundamental change for the better in both selection of top management and governance standards. But that has been a futile endeavour.

As the quality of assets has deteriorated, the Reserve Bank of India has since 2014 issued increasingly rigorous directives to the banks to carry out asset quality reviews in order to end window-dressing and recognise non-performing assets (NPAs) for what they are.

Now things have come to a boil with the RBI issuing a directive in February that if creditors are unable to achieve a resolution for large NPAs of over ₹2,000 crore within 180 days, then they will have to be referred under the Insolvency and Bankruptcy Code (IBC).

With this deadline hanging over its head, the government came up with a new scheme in July, Project Sashakt. It outlined an elaborate process for large defaulters (above ₹500 crore), aimed at creating a vibrant market for online trading of stressed assets. Companies whose defaults cannot be resolved in this manner will, as a last resort, be brought under the IBC.

But under the new process, banks will first pass on their large sticky accounts to an asset reconstruction company (ARC) which will restructure the assets, define haircuts and transfer their ownership to one or more asset management companies (AMCs), which will be funded by sector-specific alternative investment funds (AIFs).

At the end of the process banks will get paid for the restructured assets (involving a haircut or discount), the ARC will be cash neutral and the ownership of the assets will pass on to the AMC-AIFs with a minimum 76 per cent of equity holding so that they can exercise ownership control. If this process is not completed in 180 days, a stressed company will go to the National Company Law Tribunal under the IBC process.

While the new process, Project Sashakt, has been welcomed by financial players it is widely agreed that success will depend on the stressed assets being realistically priced.

The inability of existing AMCs to make much progress in the resolution of stressed assets (estimated at ₹3-lakh crore for the above ₹500-crore category) is the reluctance of bank managements to agree to substantial haircuts (discounting of their dues).

Under these circumstances, what is the risk scenario facing the economy? The RBI says in its annual report for 2017-18 that over the medium term growth will depend on, among other things, “resolution of banking and corporate financial stress.” The latest financial stability report (June 2018) puts across the expert view that the risks of asset quality deterioration and additional capital requirement of banks will be “high”.

Future outlook

The report elaborates that around 60 per cent of experts feel that “continuous rise of NPAs and falling governance standards in banks continue to be a cause for concern.”

What the government has done through IBC and Sashakt is to take care of existing bad loans. This takes care of “continues rise in NPAs” mentioned above but not “governance standards”. Under this scenario, what happens beyond the medium term?

As things stand, with no change in governance standards (Vinod Rai exited BBB with little to show in terms of his recommendations being accepted), bad debts will reappear with the government being compelled to recapitalise the banks again. If this becomes a periodic feature, then we see a risk to the future of fiscal stability, maintenance of a pipeline for bank credit and growth. That would amount to a systemic risk.

The writer is a senior journalist.

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