Stress in the Banking Sector: Need for New Approaches

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The lull in the Indian banking sector in the wake of the government’s demonetization move appears to be on its way out. And with that, the focus has shifted back again on that pressing issue plaguing lenders across the nation: non-performing assets (NPAs). The newly appointed deputy governor general of the Reserve Bank of India (RBI), Mr. Viral Acharya, has brought the NPA situation back into attention with his recent analysis of the pain points of the banking sector. Mr. Acharya stressed on the urgency to decisively resolve Indian banks’ stressed assets. A day after his speech, the Chief Economic Advisor, Mr. Arvind Subramanian re-emphasised the same in his own speech.

Stressed assets (loans given to businesses which have defaulted or are now on the brink of default) now make up nearly 17% of all loans in India, worst among the world’s major economies. Bank credit growth hit its lowest point in nearly two decades in January. If not addressed on priority, this issue might spiral downward to a stagnant economy, like what happened in Japan. The situation on the ground is that banks are hesitant to lend more and debt-burdened businesses are hesitant to borrow more.

Commercial lenders were pressured into lending to businesses with political manoeuvring when the economy looked on its way up some 10 years ago. It is now those same connections that are creating impediments to resolving the situation. Big businesses have enough muscle to resist foreclosure or resist harsh repayment demands. In this climate, banks are obviously on the back foot with letting borrowers off too easy, lest they be accused of dishonesty.

Most stressed businesses have loans with various state banks, concentrating and resolving them would be more effective once they are clubbed together under one roof.

Measures implemented by the RBI like the corporate debt restructuring scheme (CDR), strategic debt restructuring scheme (SDR) and the scheme for sustainable structuring of stressed assets (S4A) have been duds. The bankruptcy code passed last year is yet to have much of an impact, given the time required to prop up the supporting infrastructure for it – a faster judicial resolution process and insolvency experts. These unsuccessful efforts have prompted policymakers to explore new ideas to resolve the crisis. One such idea is the creation of a “bad bank” to take these loans off the books of public sector banks.

Mr. Acharya in his recent speech gave us the metrics of this idea: 1) setting up a private asset management company (AMC) with a medium level of debt-forgiveness, and 2) a government AMC with a low level of debt-forgiveness. An AMC is a company that invests its clients’ pooled funds into securities that match declared financial objectives. The premise of this proposal rests on the thought that the only effective mode to eliminate stress off banks’ books is to effect a recovery and resolution in the stressed companies.

A private AMC to handle the creation, selection and implementation of a feasible resolution plan for a quick turnaround, two credit rating agencies to rate the companies as opposed to the loans taken by them, and keeping a check on promoters who may deploy dilatory tactics to retain control, make up for a sound resolution strategy. Most stressed businesses have loans with various state banks, concentrating and resolving them would be more effective once they are clubbed together under one roof.

Mr. Acharya has also proposed a longer-term solution for companies in which a turnaround is not likely or beneficial: creating a national asset management company with a minority government stake, to raise debt and manage asset reconstruction companies (ARCs) and capitalists who would turn such companies around. These new steps aim to tackle the failure-points of previous schemes head-on while giving lenders the power to take critical business calls without the fear of being unduly questioned by investigative agencies.

However, not everyone is equally enthused about this new policy proposal. Notably, the Union Finance Minister, Mr. Arun Jaitley stated after this year’s budget that bad banks were a potential solution but it could not be supported by the government alone. He also said that he would not be able to comment on what solution will eventually emerge as regards the crisis in the banking sector. This difference in the enthusiasm toward bad banks as a viable solution may partly be answered by the state of India’s political economy.

Couple of things: macroeconomic stability and government’s reputation. Let’s talk about the impact of bad bank funding on macroeconomic stability first. Mr. Jaitley has committed to a fiscally balanced budget with a fiscal deficit target of 3.2% for 2017-18, government debt-to-GDP target of 60% by 2023 and net-market borrowing target of Rs. 3.5 trillion in 2017-18. Separate fund allocation for bad banks has not been factored in these commitments. The Economic Survey[1] has suggested the use of government debt and RBI’s equity capital for funding a public asset rehabilitation agency. The survey argues that the burden is already on taxpayers since most of the Rs. 6 trillion stressed assets are in public sector banks. Bad banks would put a further strain on government finances in the short term. Even a 20% fund by the government on stressed assets in the banking system would exceed the net market borrowing target in 2017-18 by more than 30%. Achieving committed targets for fiscal deficit and government debt-to-GDP also becomes difficult for Mr. Jaitley.

Secondly, public perception and damage to the government’s image is an issue. At a time when most quarters believe that the rise in NPAs is due to fraud or diversion of funds to unrelated businesses and general distrust floating about in the economy, doubts are bound to arise as regards the governance practices of public sector banks and investigation into and steps taken against defaulting borrowers.

Here is where a government ruling would come into play. Mr. Acharya has suggested that the haircuts taken by banks under a feasible plan should be required by government ruling as being acceptable to the vigilance authorities. If the government is seen protecting bankers from vigilance, it risks damaging its reputation. Mr. Modi would not want to be seen as helping crony capitalists and corrupt bankers. Further, since most of stressed assets are in large borrowers (public/ listed companies), opposition parties may be quick to paint such moves as “scams” and raise suspicions on the broader policy move to create bad banks.

Alternatively, the government can gain brownie points by ensuring bankers and defaulting borrowers be brought to book. The “Swachh Banking Abhiyan” can be an extension of the Prime Minister’s clean campaigns against black money. Simultaneously, stressed assets can be priced in a transparent manner based on the projects’ cash flows. It thus becomes critical to differentiate between vigilance inquiries for fraud from the pricing of stressed assets.

Aside from the obvious political implications, the government also needs to protect the reputation of the government from an economic point of view. One of the primary reasons why India has witnessed a massive inflow of foreign capital is the clean reputation of the current government, as opposed to the previous government(s). If this reputation taken even so much as a dent, it might significantly reduce future foreign capital inflows and affect India’s macroeconomic stability. This complicates the issue of funding bad banks further. Bankers will be reluctant to sell stressed assets to the bad bank at a substantial haircut for fear of inviting undue vigilance inquiries, which would lead to bad bank paying more to acquire assets and consequently, increasing the funding burden on the government.

Nonetheless, it is a positive sign of things to come that efforts are being made and solutions are being sought to ease the stress in the banking system, which among other things, is holding back the flow of credit.


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Kushan is a corporate lawyer based out of New Delhi. He is the lead on law and policy for The Dialogue and is a commentator on matters relating to corporate and constitutional law.