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
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