Bank loans in deep waters

NS Vageesh BL 17 March 14

From debt recovery tribunals to waivers to asset reconstruction companies to debt restructuring, practically every solution in the book has been tried to tame bad loans. And yet they continue to rise. NS Vageesh looks at the genesis of the problem and the way forward.

Bad debts are the harsh new reality of banking. For the first time in over 200 years of its existence, State Bank of India is really serious about stemming the rot — its non-performing assets (NPAs) have swelled to ₹67,799 crore.

On Monday, the country's top lender announced that it intended to sell around ₹5,000 crore of its dud assets to asset reconstruction companies (ARCs) before the end of this month (this financial year). In the quarter ended December 2013, India’s largest lender had candidly reported that 5.73 per cent of its loans had gone bad.

Twenty-five years ago, nobody but an exclusive set would have known this state of affairs at SBI — banks simply did not reveal bad debts in their income statements. The prevailing wisdom at the time was that if the number was known, there would be a run on banks by panicky customers.

Only the net income (after making allowances for bad debts) was shown, and only the top management of the bank knew the actual level of bad debts. The rest (depositors, a few investors, borrowers et al) didn’t know and perhaps didn’t really care — since the government owned most of the banking sector and depositor protection was therefore implicit.

That changed in the 1990s when prudential norms for income recognition and asset classification were introduced along with economic reforms. It started with the recognition of overdues of four quarters (a year) as NPAs. This was moved to a 90-day (one quarter) norm in the course of a decade.

Public-sector banks were exposed to a fresh wave of competition from private banks and were asked to get listed on the bourses — both to access capital and introduce a culture of transparency. Thus began the practice of bank NPAs being tracked every quarter. This parameter dominates the discourse because it indicates the health of the entire economy.

For banks, the transition to the new norms has not been easy — from not knowing what the problem was, to being in a state of denial, to reluctant acknowledgment and finally setting up some systems to mitigate the problem.

During this period, the scale of the problem has ballooned as gross NPAs, which were at about ₹60,000 crore at the beginning of 2000, have grown to over ₹2,00,000 crore today.

Yet, thanks to the parallel growth in the economy, the demand for bank credit, and a rather fortuitous drop in interest rates, the dimensions of the problem have been manageable, at least until recently.

Why it happens

NPAs occur because lending is risky and there is no guarantee a borrower will repay in full and on time. Banks minimise risks by ‘knowing the customer’ and doing a credit appraisal — whether you are an individual or a company — by looking at track records on borrowings and repayments, income and potential for growth, assets possessed and available as collateral, and, more recently, credit scores. Of course, the external environment — changes in policies, impact of competition, regulatory and administrative hurdles — also need to be factored in.

When banks fail to do this, problems arise. As KC Chakrabarty, a Deputy Governor of the RBI, said at the last bankers’ conference, in Mumbai: “The failure of banks to collect and analyse granular data on credit risk is one of the major reasons banks failed to foresee impending problems.”

NPAs have risen as promoters over-leveraged themselves. When you combine that with other challenges — corruption, policy delays, swings in interest rates and currencies — it is not surprising banks are confronted with these issues.

A menu of solutions

During the past two decades, banks, the RBI and the government have tried a variety of solutions to address the problems, with mixed success. Old laws have been amended. New laws have been framed. New institutions and mechanisms have been invented.

From debt recovery tribunals to one-time settlements to lok adalats to loan waivers to asset reconstruction companies to debt restructuring, practically every solution in the book has been explored. Each solution looks promising for a while only to hit roadblocks or lose effectiveness.

New NPAs enter the system even as banks reduce old dues by writing them off or recovering them. In what appears to have been a Sisyphean task, banks reduced NPAs of about ₹5 lakh crore in a little over a decade and added ₹6 lakh crore of new NPAs in that time.

Interestingly, it is public sector banks that have borne the brunt (85 per cent) of this problem while private banks have managed their record smartly — reflected most clearly in the price-earnings multiples that their stocks command.

Information flow and systems need to be tightened and accountability enforced in state-owned banks. Lawmakers and courts will have to frame and enforce laws so that the big fish are caught and punished for defaults. This will do more to restore financial discipline than any other step. Defaulting on loans has to be a matter of shame, not a badge of honour.

Not doomsday

Gross NPAs today are at about 4.5 per cent of total advances, after going as low as 2.4 per cent four years ago. And if you add restructured assets (where lenders give borrowers extra time or concessions on interest rates), the total level of stressed assets in the system is around 10 per cent.

There may be more pain in the next two quarters before any improvement. This is a cause for concern but perhaps not for alarm. We have seen worse: in 1994, the average gross NPA ratio of Indian banks was a mindboggling 19 per cent. Even that was considered an understatement by many.

All it needs is a change in sentiment, a revival in growth, some quick decisions… And then the NPA mountain may start looking like a molehill.