By Ashish Pandey, Quadrature Capital LLC

Indian public sector banks have once again delivered quarterly financial results that will hardly cheer anybody. A deep-dive analysis of statistical data released by Reserve Bank of India on December 23, 2015 shows that India is currently staring at a crisis of unprecedented magnitude. Non-Performing Assets (“NPAs”) in the banking system stood at INR 2.6 trillion, or 5.4% of total advances as of March 31, 2015. In addition, loans totaling another INR 3 trillion, or approximately 6.2% of total advances, belong to restructured category. It is a well-known fact in the Indian banking circles that a significant percentage of restructured assets will eventually become doubtful assets since the financial viability of restructuring wasn’t rigorously validated. Banks wanted their year-end balance sheets to appear healthier than they really were, and unsound restructuring efforts were merely an attempt at pushing the can down the road. Stressed assets, i.e., a combination of NPAs and restructured assets, still do not tell the full story. There is another hidden pocket of non–preforming assets on bank balance sheets that go often unnoticed. When banks sell NPAs to Asset Reconstruction Companies (“ARCs”), they typically retain 85-95% of exposure to eventual loan recovery in the form of Security Receipts. Banks have sold assets with a book value of INR 1.9 trillion until 2015, and considering the abysmal recovery ratio of ARCs till date, it is more than likely that a significant percentage of the face value of security receipt’s will eventually be written off.

The current Governor of the Reserve Bank of India, the Indian equivalent of the Federal Reserve’s Chairperson, is Mr. Raghuram Rajan, a well-meaning and an erudite economist who was the Chief Economist at the International Monetary Fund (IMF) from October 2003 to December 2006. He has been at the forefront trying to tackle this impending crisis that he inherited but, unfortunately, is dogged by the exceptional scale of the problem. Public sector banks, where the Indian government holds the majority shareholding, are worst hit by the crisis. Their share of non-performing and restructured loans as a percentage of total advances is more than double those of private sector banks. Concentration risk for public sector banks is at an all-time high level. The top 10 borrowers account for 13% of the entire bank loans and a whopping 98% of the net worth of the banking system. Stressed assets as a percentage of total net worth exceed 100% for many banks, rendering them insolvent by fiduciary standards though not by accounting standards. Growing NPAs have effectively stymied the transmission of RBI’s repo rate reductions to bank’s lending rate. Banks need a higher net interest margin to manage their capital ratios that are impacted by growing NPAs and subsequent provisioning requirements. This has led to a virtual stoppage of credit growth and has raised theoretical concerns regarding the lemons problem.  India needs to tackle the NPA problem aggressively rather than pussyfooting as it has been doing over the last two years. The magnitude of the crisis is already significant and any delay will only lead to a worsening of the situation to a deep crisis. There are three options available to the Indian government and RBI. It is unlikely that one of them in isolation will be enough to prevent the crisis but a determined multipronged approach may well work.

The first initiative necessary to tackle the NPA problem is a recapitalization of public sector banks by the government so that they can start lending in a prudent fashion. New loans, when underwritten properly, will reduce the magnitude of the problem by a sheer denominator effect. Most of the public sector banks are trading below their theoretical book value, and considering the opacity of their balance sheets, there is a limited demand in secondary markets to participate in a follow-up subscription. The price discovery mechanism for a forced secondary offering of shares of public sector banks is likely to be vicious, and the subsequent dilution of the government’s holding may not be palatable from either a financial or behavioral perspective. The government’s announced plans of INR 700 billion over the next 4 years falls way short of the required amount. Fitch estimates  that banks need a capital infusion of  INR 9 trillion over the next four years to comply with Basel III requirements. This is a huge amount for a cash-constrained government. My own estimate is that the government needs to infuse at least INR 2.5 trillion of capital over the next two years to get the ratio of NPAs to total advances within 0.5. This will bring credibility back into the banking system and remove the impediment in the immediate growth of credit book. A larger, diversified and better quality credit book will improve the profitability of banks, increase equity valuation and position them to tap capital markets rather than relying on government support. An investment by government in public sector banks is actually the most logical initiative as, in the absence of such initiative, the notional value of government’s shareholding will only decline further whereas investment will lead to a higher valuation at a future date. Capital infusion by the government in public sector banks will not be a desperate gambler’s ‘double-down’ decision but a well thought strategic investment.

The second initiative necessary to tackle the NPA problem is a complete overhaul of the ARC sector in India. This will involve changing the sale mechanism adopted by banks currently, liberalizing the FDI regime for the sector and streamlining the legal recovery process. Today, banks sell their assets to the highest price bidder irrespective of their past recovery performance or operational wherewithal to effective manage the distressed assets. Prior to August 2014, ARCs were allowed to only invest 5% of the sale price while they were paid close to 1.5% annually as a management fee. Since it takes a long time to resolve distressed assets (often more than five years), ARCs were able to recoup their entire investment even in a zero recovery scenario and had no ‘skin in the game’. Since August, the 5% requirement has been enhanced to 15% but the pari-passu nature of investment still leads to a perverse incentive. Banks need to adopt a mechanism where ARCs recoup their investment only after banks have received the face value of the security receipt. ARCs can be incentivized by offering them a disproportionate share of recoveries in excess of face value. This mechanism will weed out nonefficient players and will incentivize players that make serious recovery efforts and are technically proficient in managing distressed assets. In addition, the investment restrictions in ARCs need to be removed. The current capitalization of 15 ARCs is approximately INR 30 billion. Given a 15% capital requirement, they cannot buy new assets in excess of INR 200 billion over a period of time. INR 200 billion of investment capital is pittance considering INR 5.5 trillion of distressed assets. Current guidelines impose a restriction on the maximum equity that a foreign player can own in an ARC. Large global buyers of distressed assets and special situations asset management firms have therefore shied away from entry into the Indian market. The government needs to allow the unfettered entry of foreign capital into the ARC sector to bring required capital and the missing expertise required in managing distressed assets. Though the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act in 2002 (the “Sarfaesi Act”) was a noble attempt to resolve legal bottlenecks and expedite the recovery process, there are still some lacunas and procedural bottlenecks that impede the recovery process. Amendments necessary to streamline the process will be a welcome step and should act as confidence building measure for the infusion of fresh capital into ARCs.

The final initiative necessary to tackle the NPA problem is the creation of a ‘bad bank’ that will act as super ARC by the government. The capital flow to the ARC sector will happen over a period of time, and existing ARCs will have a very limited financial ability to participate in the government’s clean-up exercise. Further, there will always be certain assets where a difference in the perception of value exists between the buyer and seller. The existence of a state-owned entity tasked exclusively with tackling NPAs on a one-time basis will facilitate the expedited clean-up of the banking system without sacrificing the intrinsic recovery value of the transferred asset.

None of these initiatives will lead to long term success until systemic and administrative reforms are implemented in the public sector banks. Otherwise, the problem will recur at a later date. To that avail, RBI needs to propose, implement and rigorously monitor guidelines that promote prudent lending and reduce concentration risk significantly from the current levels. In addition, the government needs to appoint more professionals on the boards of directors of banks rather than using state appointees. Skills should be a determining factor instead of political patronage as has been the case. Tighter accountability and adequate incentive mechanisms need to be put in place for bank employees that will stimulate profitable lending in the future.

One thought on “Ticking Time Bomb –The Indian Banking System

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