NPAs :Early warning system

Govind Sankaranarayanan Financial express 1 Mar 2014

RBI’s proposed framework can be a game-changer for banks.

Recently, the United Bank of India (UBI) reported a large loss in the third 
quarter of fiscal 2014, an outcome of a five-fold increase in provisioning 
for delinquent loans. UBI’s financial woes were only the most acute 
representation of the deep risk of non-performing assets (NPAs) that
 pervades the banking system.

Reacting to the growing NPA challenge that it has observed, RBI, on

 January 30, published its guidelines towards “Early Recognition of 

Stressed Assets” to help bring under control the NPAs within the Indian 

banking system. This report came in the shadow of RBI’s own Financial

 Stability Report, which projected gross NPAs of the banking system to 

reach 4.6% by September 2014. That matters had reached such a pass, 

required, as per RBI, a deeper recognition that it was not sufficient to manage

 credit through lag indicators, such as gross NPA levels, but that there was a

 need to identify stress well before it results in delinquencies. This circular

 gives regulatory sanction (by means of incentives and penalties) to the need

 for continuous monitoring of accounts to ensure that borrowers attempt in

 good faith to achieve projections that they would have given bankers at the 

time they borrowed.

To understand why this paper is being released now, one would need to 

delve into the background of how the problem was created in the first place. 

As pointed out by yet another illuminating working paper of RBI on 

“Re-emerging Stress in Banks” published earlier in February 2014, periods

 of high credit growth are generally followed by periods of significant delinquencies. 

Growth above a certain rate might be possible for an individual bank is unlikely 

to be safe of the system as a whole. Based on the same paper, one could conclude

 that a system-wide growth in lending rates of more than 24% per annum for a 

sustained period increases the likelihood that loans move into the danger zone. 

Growth in lending rates exceeding 30% per year, a phenomenon that was seen 

at a certain period in the past decade, make it likely that delinquencies will be high.

The period of low interest rates immediately after the financial crisis coincided

 with an unreasonable rush to grow balance sheets. Debt, which was close to 

R1 trillion across a sample of large business houses, rose to R7 trillion over 

the past six years. As per reports by Credit Suisse, across large parts of the 

organised sector, debt is now at six times before earnings before interest tax 

and depreciation and interest are just above 1.4 times annual profits.

 When juxtaposed with the slowing growth in the economy, persistently

 high inflation and consequently high interest rates, it is tough to believe 

that all these loans will get repaid. It is for this reason that the current level 

of NPAs has started to exercise the regulator so much.

The very nature of lending means that there is a huge economic asymmetry 

already baked into the profitability equation. Since most banks make a margin 

of about 3% on their assets, they need to get well over 97% of their loan guesses 

correct to be profitable. This is a fairly high bar to set for what is frequently a

 geographically-dispersed judgement-based decision-making process. 

In order to get this perfectly right, it is necessary to be good and not just

 when you are underwriting a loan but also get the monitoring of the loan

 correct through its life.

The new “early recognition” guidelines finesse this problem by asking lender

s to identify certain accounts as special mention accounts and report these 

to a central repository. In the event a loan is 60 days overdue, joint lender

 groups may need to be formed, with incentives to find early solutions to the

 company’s problems. This is in contrast to the earlier situation wherein 

lenders addressed these issues only when loans were 6-9 months

 late in payments.

Through this, what the regulator has done is to place an onus on

 lenders to look at triggers, which suggests that companies are

 headed towards trouble and then disclose these to other lenders 

as well. To those outside the banking space, this will seem like a 

straightforward and common sense solution which ought always to

 have been followed. However, the nature of incentives within the 

system have tended to distort behaviour. There is a strong and 

seemingly impelling force across lending consortia to delay 

recognition of difficulties until denial become simply impossible. 

There also remains the natural tendency among lenders to rope in 

new lenders and thereby achieve some dilution of their share of the

 risks of a troubled asset.

Banks are penalised for an inability to predict early distress, by 

requiring to hold higher provisions. Additional provisioning norms

 will be imposed on companies whose directors sit on the boards 

of wilful defaulters or uncooperative companies (a euphemism for

 firms that refuse to share accounts, respond to queries and the like).

 Auditors of companies who turned a blind eye to the falsification of 

stock certificates or permitted dodgy book-keeping will need to be 

reported to the Institute of Chartered Accountants of India. Similar 

pressure may be brought on valuers of assets, lawyers, etc, who 

may have assisted a creditor in evading repayments.

RBI has provided several carrots to ensure that lenders do not

 face too great a burden because of new rules. These include the

 ability to spread the loss on sale of certain assets over a two-year

 period, allowing take-out financing to be treated as restructuring and

 permitting banks to reverse the excess provision on the sale of an

 NPA to an asset restructuring company under some circumstances.

Several of these recommendations are prudent, but will need an 

institutional culture within banks to make them work. It could be difficult

, even with the best intentions, for regulators to monitor whethe

r banks could truly have predicted early distress. To a large extent,

 boards of these companies need to keep asking tough questions 

to their managements, especially when they see any red flags.

The practice of re-examining why individual accounts that turned

 sour were deemed creditworthy in the first place can very easily

 turn to finger-pointing and is, therefore, generally discouraged in

 most companies. This difficult task will now need to be a part of

 the judgemental exercise banks will need to undertake. By asking 

themselves whether they could have done things better, as required 

under the new dispensation, lenders will frequently have to face the 

unpleasant truth that they had enough facts available to avoid delinquency,

 and in many cases chose to overlook those facts. This will need a degree

 of management maturity and moral courage.

While some will argue that the gross NPA levels of the Indian banking 

system were as high as 10% towards the end of the 1990s, and now 

they stands at only about 3.5%, the statistics do not reveal everything. 

Close to 5% of assets are restructured now and only by the application 

of a particularly elastic version of optimism would one believe that more

 than 50% of this would be collected in the long run. When one considers

 this fact, that the true NPA position of the banking system is above 6%,

 on a base of loans which is now three times as large as what was the 

case in the 1990s, one can begin to see why this would cause systemic 

concern.

In a capital-starved economy, the price of irresponsible lending falls more 

harshly on the small business, the young entrepreneur or the less

 well-connected. Unless the level of NPAs are reduced, the natural

 response is for lending to dry up for good projects, something which

 India can ill-afford. It is always impossible to quantify whether the 

several lakh crores lost out to NPAs deprived funding to a potential

 Indian Google or Microsoft or to even count the number of jobs that

 might have otherwise been created. To the extent that these changes 

will bring about a gradual but important cultural change in the way banks 

lend, it must count among those circulars that have great import for the long term.

The author is CFO & COO, Corporate Affairs, Tata Capital Financial Services

Govind Sankaranarayanan