Raghuram Rajan’s note to Parliamentary Estimates Committee on bank NPAs

Banks were fine with projects having more debt and less promoter equity. Many banks happily accepted estimates made by promoters, without doing their own due diligence.

Slow Growth

The years of strong global growth before the global financial crisis were followed by a slowdown, which extended even to India. As domestic demand slowed, the strong projections made by companies looked hollow.

Government Permissions and Foot-Dragging

Problems such as the suspect allocation of coal mines, spectrum coupled with the fear of investigation slowed down government decision making in Delhi, both in the UPA and NDA.

Project cost overruns escalated for stalled projects and they became increasingly unable to service debt.

Loss of Promoter and Banker Interest

Once projects got delayed enough that the promoter had little equity left in the project, he lost interest. Ideally, at such time, banks should write down their debt that is uncollectable, and promoters should either bring in more equity or lose their project.

Unfortunately, until the Bankruptcy Code was enacted, bankers could not threaten promoters with loss of their project. Also, no banker wanted to write down their loans and draw the attention of the investigative agencies.

It was in everyone’s interest to extend the loan by making additional loans to enable the promoter to pay interest and pretend it was performing.

The promoter had no need to bring in equity, the banker did not have to restructure and recognise losses or declare the loan NPA and spoil his profitability, the government had no need to infuse capital.

In reality though, because the loan was actually non-performing, bank profitability was illusory, and the size of losses on its balance sheet was ballooning because no interest was actually coming in.

Malfeasance

Undoubtedly, there was some corruption as well, but it is hard to tell banker exuberance, incompetence, and corruption apart.

Many banks did no independent analysis and placed excessive reliance on SBI and IDBI Caps to do the necessary due diligence. Such outsourcing of analysis is a weakness in the system and multiplies the possibilities for undue influence.

Banks did not go after unscrupulous promoters who inflated the cost of capital equipment through fake bills. Public sector bankers continued financing promoters even while private sector banks were getting out, suggesting their monitoring of promoter and project health was inadequate.

Were bankers alone responsible?

Rather than attempting to hold bankers responsible for specific loans, bank boards and investigative agencies must look for a pattern of bad loans that bank CEOs were responsible for – some banks went from healthy to critically undercapitalised under the term of a single CEO. Then they must look for unaccounted assets with that CEO. Only then should there be a presumption that there was corruption.

Frauds

The size of frauds in the public sector banking system has been increasing, though still small relative to the overall volume of NPAs. The system has been singularly ineffective in bringing even one high profile fraudster to book. As a result, fraud is not discouraged.

Bankers are slow because they know once they call a transaction a fraud, they will be subject to harassment by the investigative agencies, without substantial progress in catching the crooks.

Why did the RBI set up various schemes to restructure debt and how effective were they?

In 2013, bankers had very little power to recover from large promoters. There were Debts Recovery Tribunals (DRTs) to help banks and financial institutions recover their dues speedily without being subject to the lengthy procedures of usual civil courts.

The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002 went a step further by enabling banks and some financial institutions to enforce their security interest and recover dues even without approaching the DRTs.

Yet the amount banks recovered from defaulted debt was both meagre and long delayed. The DRTs and SARFAESI were initially successful before they became overburdened as large promoters understood how to game them.

The inefficient loan recovery system gave promoters tremendous power over lenders. Sometimes promoters offered low one-time settlements (OTS) knowing that the system would allow the banks to collect even secured loans only after years.

What the RBI did under Rajan

1. The RBI created a large loan database (CRILC), that included all loans over Rs. 5 crore, which was shared with all the banks. The data showed the status of each loan–whether it was performing, already an NPA or headed there.

2. Lenders were coordinated through a Joint Lenders' Forum (JLF) once such early signals were seen. The JLF was tasked with deciding on an approach for resolution. Incentives were given to banks for reaching quick decisions. Banks who were unconvinced by the joint decision were given the option to exit.

3. To stop ever-greening of projects by banks—giving new loans to repay old--RBI ended forbearance, the ability of banks to restructure projects without calling them NPA, in April 2015.

4. Because promoters were often unable to bring in new funds, and because the judicial system often protected those with equity ownership, RBI together with SEBI introduced the Strategic Debt Restructuring (SDR) scheme to enable banks to displace weak promoters by converting debt to equity. Banks were set a deadline by which they had to find a new promoter.

The schemes were a step forward, and enabled some resolution and recovery, but far less than was thought possible. Incentives to conclude deals were unfortunately too weak.

Why recognise bad loans?

There are two opposite approaches to loan stress. One is to apply band-aids to keep the loan current and hope that time and growth will set the project back on track. Sometimes this works. But most of the time, the low growth that precipitated the stress persists.

An alternative approach is to try to put the stressed project back on track rather than simply applying band-aids. This may require deep surgery. Existing loans may have to be written down somewhat because of the changed circumstances since they were sanctioned.

If loans are written down, the promoter brings in more equity, and other stakeholders like the tariff authorities or the local government chip in, the project may have a strong chance of revival, and the promoter will be incentivised to try his utmost to put it back on track.

To do deep surgery such as restructuring or writing down loans, the bank has to recognise it has a problem – classify the asset as a non-performing asset (NPA).

Loan classification is merely a good accounting – it reflects what the true value of the loan might be.

It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely losses. If the losses do not materialise, the bank can write back provisioning to profits. If the losses do materialise, the bank does not have to suddenly declare a big loss, it can set the losses against the prudential provisions it has made.

Did the RBI create the NPAs?

The RBI is primarily a referee, not a player in the process of commercial lending. Its nominees on bank boards have no commercial lending experience and can only try and make sure that processes are followed.

The important duty of the regulator is to force timely recognition of NPAs and their disclosure when they happen, followed by requiring adequate bank capitalisation.

Why did RBI initiate the asset quality review (AQR)?

Banks were simply not recognising bad loans. They were not following uniform procedures – a loan that was non-performing in one bank was shown as performing in others.

They were not making adequate provisions for loans that had stayed NPA for a long time.

In its bank inspections in 2015, RBI proceeded to ensure every bank followed the same norms on every stressed loan. It especially looked for signs of ever-greening.

Did NPA recognition slow credit growth, and hence economic growth?

No. The trend in non-food credit growth shows that public sector bank non-food credit growth was falling, while new private sector banks (Axis, HDFC, ICICI, and IndusInd) were reporting a growth since early 2014.

In segments like personal loan and housing loans, public sector bank loan growth approaches private sector bank growth. So the reality is that public sector banks slowed lending to the sectors where they were seeing large NPAs but not in sectors where NPAs were low.

Why are NPAs mounting even after the AQR is over?

The AQR was meant to stop the ever-greening and concealment of bad loans, and force banks to revive stalled projects. Unfortunately, this process has not played out as well.

As NPAs age, they require more provisioning, so projects that have not been revived simply add to the stock of gross NPAs. A fair amount of the increase in NPAs may be due to ageing rather than as a result of a fresh lot of NPAs.

Why have projects not been revived?

> Risk-averse bankers, seeing the arrests of some of their colleagues, are simply not willing to take the write-downs and push a restructuring to a conclusion, without the process being blessed by the courts or eminent individuals.

> Even with the Bankruptcy Code in place, some promoters are still gaming the process, hoping to regain control through a proxy bidder, at a much lower price. So many promoters have not engaged seriously with the banks.

> The government has dragged its feet on project revival – the continuing problems in the power sector are just one example. Finally, the government has not recapitalised banks with the urgency that the matter needed (though without governance reform, recapitalisation is also not like to be as useful).

> The Bankruptcy Code is being challenged by the large promoters, with continuous and sometimes frivolous appeals. Higher courts must resist the temptation to intervene routinely in these cases, and appeals must be limited once points of law are settled.

Limitations of the judicial process

The judicial process is simply not equipped to handle every NPA through a bankruptcy process. Banks and promoters have to strike deals outside of bankruptcy. If promoters prove uncooperative, bankers should have the ability to proceed without them.

Bankruptcy Court should be a final threat, and much loan renegotiation should be done under the shadow of the Bankruptcy Court, not in it.

What could the regulator have done better?

The RBI should probably have raised more flags about the quality of lending in the early days of banking exuberance.

With the benefit of hindsight, RBI should probably not have agreed to forbearance, though without the tools to clean up, it is not clear what the banks would have done.

Forbearance was a bet that growth would revive, and projects would come back on track. That it did not work out does not mean that it was not the right decision at the time it was initiated.

Also, RBI should have pushed for a more rapid enactment of the Bankruptcy Code. If so, the AQR process could have been started earlier.

Finally, the RBI could have been more decisive in enforcing penalties on non-compliant banks.

How should we prevent recurrence?

> Improve governance of public sector banks and distance them from the government. Public sector bank boards are still not adequately professionalised, and the government still decides board appointments, with the inevitable politicisation.

> Banks should not be left leaderless for long periods of time. The date of retirement of CEOs is well known and the government should be prepared well in advance. An entity like the Bank Board Bureau should decide appointments.

> Bring more of outside talent. There is already a talent deficit in internal PSB candidates in coming years because of a hiatus in recruitment in the past.

> Compensation structures in PSBs also need rethinking, especially for high level outside hires. There will be internal resistance, but lakhs of crores of national assets cannot be held hostage to the career concerns of a few.

> Risk management processes still need substantial improvement in PSBs. Compliance is still not adequate, and cyber risk needs greater attention.

> Improve the process of project evaluation and monitoring to lower the risk of project NPAs.

> Real risks have to be mitigated where possible and shared where not. Real risk mitigation requires ensuring that key permissions for land acquisition and construction are in place up front, while key inputs and customers are tied up through purchase agreements. Where these risks cannot be mitigated, they should be shared contractually between the promoter and financiers, or a transparent arbitration system agreed upon.

> An appropriately flexible capital structure should be in place. The more the risks, the more the equity component should be and the greater the flexibility in the debt structure.

> Promoters should be incentivised to deliver, with significant rewards for on-time execution and debt repayment.|

> Where possible, corporate debt markets, either through direct issues or securitised project loan portfolios, should be used to absorb some of the initial project risks. More such arm’s length debt should typically refinance bank debt when construction is over.

> Financiers should put in a robust system of project monitoring and appraisal, including where possible, careful real-time monitoring of costs. Projects that are going off track should be restructured quickly before they become unviable.

> Finally, the incentive structure for bankers should be worked out so that they evaluate, design, and monitor projects carefully, and get significant rewards if these work out.

> Strengthen the recovery process further. Both the out of court restructuring process and the bankruptcy process need to be strengthened and made speedy.

> Government should focus on sources of the next crisis, not just the last one. In particular, the government should refrain from setting ambitious credit targets or waiving loans.

> Credit targets are sometimes achieved by abandoning appropriate due diligence, creating the environment for future NPAs. Loan waivers vitiate the credit culture and stress the budgets of the waiving state or central government. They are poorly targeted, and eventually reduce the flow of credit.