Stressed assets in the banking system are dragging India’s growth by 1 to 1.5%. Non-performing loans mean severe capital shortages for many public sector banks and as a result restricting private investment, one of the main drivers of growth in India. India has the worst non-performing loan ratio among the world’s major economies with gross non-performing advances nearly 10% of the total assets.
Although the recently released data by RBI showed some signs of recovery with overall credit growth rising by 14.30% as on Oct 2018 (highest in four years) and credit to industry by 4% ( y-o-y) in November 2018 (highest in three years), we are miles away from resolving the crisis in entirety. The investment picture looks particularly grim. According to CMIE, new investments in the December 2018 quarter fell to a 14 year low. Uncertainty ahead of polls may be one reason for low investment rate, but the other most obvious and worrying reason is the Twin balance sheet problem.
The twin balance sheet challenge deals with two problems in the economy; over-leveraged corporates (companies with high debts and unpaid interests of the loans taken) and bank’s bad assets (non-repayment of the principal loan and interest to banks well past the due date). The origins of the crisis can be traced back to the early 2000s when the Indian economy experienced relatively high growth rates. During this financial cycle, Indian banks indulged in excess lending to companies without due diligence.
Corporates went on a borrowing spree looking to expand their businesses in boom years. Investment to GDP ratio was at an all-time high of 38% in 2007. Once the economy slowed down in late 2008 due to the global financial crisis, profit margins declined rapidly and companies started defaulting loan payments and the Non-Performing Assets kept increasing. Corporates diverting funds for dubious activities and high-interest rates have compounded the problem.
The central bank and the government failed to identify the scale of the problem in the initial stages. The logical understanding of this negligence is that usually when Non-Performing Assets rise, there will be a substantial decline in growth rates and probably destabilization of the entire banking system. Although the TBS problem slowed down growth in India, the impact was not substantial enough to warrant immediate measures. India was still one of the fastest growing major economies in the world during that period.
The situation was allowed to deteriorate further as banks followed the process of ever-greening loans (lending money to already debt-ridden companies) and under-reported non-performing loans. In 2015, Raghuram Rajan in his capacity as the RBI governor conducted Asset Quality Review (AQR), an additional inspection of the balance sheets of banks apart from the routine Annual Financial Inspection. The AQR by the RBI revealed higher deteriorating asset quality. The stressed assets ballooned up by about 7.2 lakh crore between March 2015 and Sept 2018.
The RBI and the government initially assumed that, as the economy grows faster, stalled sectors would grow as a matter of course and generate revenues. The hypothesis that economic growth and sufficient time will enable the corporates to service their debts has gone wrong and stressed assets started taking the toll on the economy. The first serious step undertaken to tackle the problem has been the creation of Asset Restructuring Companies (ARC). ARCs purchase bad loans from the banks and help to clean up balance sheets.
Once the balance sheets are clean, banks can concentrate on their normal activities rather than going after defaulters. However, only 5 to 7 per cent of the total loans are recovered using ARCs. Strategic Debt Restructuring (restructuring or delaying loan repayments) and Sustainable Structuring of Stressed Assets (S4A) are some of the measures implemented to exit the twin balance sheet problem without significant results. One of the main reasons for the failure of the above schemes is the reluctance of banks to take haircuts due to the fear of harassment from investigative agencies.
Insolvency and Bankruptcy Code (IBC) was a big ticket reform rolled out in 2016 to tackle NPAs. Bringing debtors to books via myriad laws before the implementation of IBC was tedious. The insolvency code subsumed all the existing laws, established a resolution mechanism process for speedy identification and recovery of assets within a stipulated time period of 180 days. Some of the largest and complex cases in the banking system were resolved under the new bankruptcy code.
Debt-ridden Bhushan steel acquired by Tata Steel, Binani cement’s resolution and Anil Ambani’s Rcom filing for bankruptcy are some of the successes of IBC. According to the RBI, the recovery rate of NPAs is 49.6% under the new mechanism. However, the insolvency code has a long way to go in solving the problems faced by the banking sector. For example, resolving power sector loans via insolvency is quite laborious as it is difficult to find bidders to buy heavily debt-laden non-operational power plants. There is also an imminent risk of overload as more and more companies file bankruptcy.
The economic survey of 2016-17 mooted the idea of a ‘bad bank’ or PARA ( Public sector Asset Rehabilitation Agency), a method adopted by East Asian countries during their crisis to successfully resolve the TBS challenge. A bad bank is a centralized agency (may be under the government but independent from their influence) with statutory backing that purchases bad loans by converting them into equity and then goes on to recover them within a time frame. Once the loans are off the balance sheet, banks can start their normal lending process.
The banks have to incur some losses in the process, but that should not be a reason to oppose the idea as some haircuts are inevitable in the future. The funding of a bad bank can be done through government securities and capital markets. If the exit has to be thorough and complete, a case can be made for some structural reforms like privatising few public sector banks. This is not a panacea but will result in better risk assessment while lending and solve governance problems.
The government can go ahead with the bank recapitalization provided the necessary precondition of initiating regulatory reforms. The central bank also has to step up as the regulator and strengthen the vigilance over banks. How soon or how later these reforms are introduced and implemented will determine whether we exit the twin balance sheet conundrum or get stuck in the quicksand that has the potential to collapse entire banking system and the economy in the future.