Preventing the pile up of NPAs — I

Much has been written and said about resolving and recovering mounting NPAs that banking system is saddled with. The purpose of this article is different.

It is addressed on how to prevent the accumulation of non-performing assets. Otherwise, we will be faced with the problem of resolving NPAs every few years.

Current Status of NPAs

Gross NPAs which piled up as high as 11.2 per cent in FY 2018 had come down to 7.5 per cent by March 2021. However, RBI’s latest Financial Stability Report (FSR) warns that NPA levels are likely to get worse again. NPA levels may see a spike from 7.5 per cent in 2021 to 11.2 per cent in March 2022 under severe stress scenario. This high level was seen in 2018. However this projection is much less than the prognosis in the previous (January 2021) FSR at over 14.8 per cent under severe stress and even less than Baseline projection of 13.5 per cent.

Large advances contributed to over 77.9 per cent of these bad loans. This article focuses on this segment. However it may be noted that according to latest FSR, MSME are showing signs of severe stress even after special restructuring packages of about ₹58,000 crore. The impact of ferocious Covid second wave on businesses particularly MSME is a matter of concern.

Fix legal ecosystem

In the most recent case resolved under IBC, lenders suffered a 95 per cent haircut. Debt of over ₹45,000 crore is settled for a paltry 5 per cent and down payment of a measly ₹300 crore and the rest to be repaid after several years. Huge haircuts of over 60-70 per cent are seen in many large NPA accounts leading to write offs of over ₹4 lakh crore during the last 4-5 years. This is largely a reflection of weak and dilatory legal ecosystem even after introduction of IBC.

If this is left unchecked, it may demotivate genuine borrowers and create a wrong climate. Government and RBI need to strengthen the entire legal ecosystem including the institution of Resolution Professionals.

Contributory factors: Credit growth

As several reports bear it out, excessive lending, lax credit standards, poor monitoring, diversion or siphoning off funds besides malfeasance and frauds have contributed to the high level of NPAs. This is not to dismiss genuine business failures.

It is said time and again that all bad loans are given in good times or hey days when animal spirits run high. This time too, it is no different. Some of the salient features of the credit scenario in this context are noted below.

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As can be seen from Table-1, during the 5-year period ending FY2013, the banking system credit grew by 137.7 per cent only to crash to 48.9 per cent in the next five-year period ending 2018. During the same period credit of PSU banks grew by 148.3 per cent only to plummet in the next five-year period to 27.5 per cent and to decelerate further.

The credit bubble is too evident as seen from Table-2, bank credit to Infrastructure grew by over 246.2 per cent during 2008-13 and that of power sector spurted by a whopping 355.6 per cent.

These bouts of credit excesses, followed by credit declines have only harmed both lenders as well as the development of these sectors. Such excessive credit growth needs to be avoided and requires the primary attention of regulators, bank boards and credit dispersing functionaries.

Credit growth rate beyond a level must come to the immediate attention of regulators and Bank boards. There is a heavy concentration in terms of borrowers’ group as well. In many banks, default of just three groups was sufficient to impair Tier One Capital. The regulator’s role is particularly important in cautioning the government about excessive lending even to infrastructure sector. Terms like ‘lazy banking’ should be used rarely.

The ‘3 C’ Framework

As evident from the huge pile up of NPAs and several audit and investigation reports, banks need to significantly improve credit appraisal techniques and processes and also strengthen monitoring system.

To begin with, a sound credit appraisal essentially involves assessment of Character, Capacity, and Capital of the prospective borrower. The most difficult to evaluate is Character and Intent of the borrower and this may be gauged from the fact that banks classified a whopping ₹4 lakh crore (approx) as frauds and wilful defaults during the last 3-4 years. This is a manifestation of Conduct risk which appears to overwhelm all other risks in causing damage.

Secondly the Capacity of the borrower to successfully operate frequent expansions and run diverse businesses is overestimated. Many a time ambitions and dreams of entrepreneurs are not backed up by adequate capacity to operate businesses in this VUCA (Volatile, Uncertain, Complex and Ambiguous) world. This is not captured in typical Excel projections. In real world, capacity to successfully run business and repay is a moving target. The lenders need to track these developments in near real time.

Thirdly the forensic audit reports now reveal that in many cases of bad loans, borrowers have not brought in adequate capital and they only circulated debt from one bank as equity in another project through a web of affiliates.

Some of these errant borrowers have dozens of these affiliates and even hundreds of bank accounts. This makes tracking movement of funds in real time difficult, if not impossible. This remains still a challenge and needs to be addressed both by banks and regulators or government.

These 3Cs need to be evaluated not only at the entry level but at regular intervals. Banks may co source external experts. This framework looks blindingly obvious but has a lot of subtle nuances which requires a lot of expertise.

A well designed framework is an aid and not a hindrance to fund disciplined risk taking by entrepreneurs.

Monitoring: Connect the Dots

The information flow from the borrower is often delayed, scanty and many a time unreliable. Banks deploy over 20 monitoring tools right from the humble stock movement statement to analysts’ reports. There are over 20 parameters like basic sales reports, end use of funds to evolving market dynamics, competitive position of the borrowers etc. Lenders need to connect the dots to effectively strengthen monitoring tools and enforce remedial measures. (To be continued)

Rangarajan is former Chairman of the Economic Advisory Council to the Prime Minister and former Governor, RBI, and Sambamurthy is former Director and CEO, IDRBT.

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