Why NPAs pile up

As a veteran in the global banking and capital markets space, I despair at the ongoing saga of NPAs and their ensuing impact on capital adequacy and balance sheet strength and, of course, the latest ordinance. I see various experts’ suggestions, including from the Ministry of Finance and from the Chief Economic Advisor, on matters ranging from strict operating guidelines for banks’ management, to creation of a “bad” bank entity that would absorb all the NPAs, thereby lowering the capital requirements of the public sector banks. Further, the RBI too has come out with guidelines on how it would evaluate bank performance — this list goes on.

The main issue is that banks are just one part of a larger ecosystem characterised by the lack of a bond market, inadequate credit risk assessment tools and high interest rates for domestic borrowers. Let me elaborate with some simple examples. Sometime ago, our US-based firm received enquiries for overseas loans; in at least three instances our initial analysis and stress-tests suggested they were non-viable even at lower coupon rates. These three companies subsequently informed us that they had been able to get domestic banks to underwrite loans, a matter that surprised us. About two or three years later, all of them are in default status.

The reason why the overall banking system underwrites and pumps more questionable loans is simple; very poor underwriting standards coupled with a lack of execution experience and poor governance standards. Public sector banks work off standard underwriting guidelines for lending, with land, equipment and other personal assets of borrowers as typical collateral. What banks lack is the depth of knowledge and assessment tools that, say, a rating agency that does corporate bond analysis has — reviewing companies’ operating capabilities and performance, not merely the debt servicing cover.

Further, the inability to convert the debt into some form of equity, with voting rights hinders banks’ ability to achieve a financial turnaround of the companies they lend to.

In the absence of a sophisticated bond market, ventures across all industries and credit applications go through the same screening process. And when loans approach NPA status, the first mode of action is to restructure the loan — all that this accomplishes is to postpone the problem at hand. To make matters worse, very few companies hire investment bankers for their expertise in optimising the capital structure of a firm and in seeking the right sources of capital. Instead, companies and promoters see themselves as self-experts in corporate finance and reduce investment bankers to the role of funding brokers.

In the US, we have seen first-hand or handled portfolio turnarounds where profitability has increased 15-20 fold, where bank balance sheet risks have been optimised through a combination of financial risk and credit risk frameworks and rigorous balancing with growth targets established by bank CEOs. In India, the first step would be to scale down lending, rigorously analyse and segment the borrower portfolio with actionable steps, cure the current pipeline and then template from historical performance all future lending activity. A larger objective for the finance ministry would be to bring this same rigour to other channels of capital and funding that are being created through specialised funds.

The writer is a US-based banking and capital markets expert

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