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Last Updated : Sep 11, 2018 10:19 PM IST | Source:

Podcast | Pick of the day - Highlights from Raghuram Rajan’s note on non-performing assets

Rajan answered several big questions in his note, as well expressed his views on the depreciation of the rupee, emerging market scenarios, and global trade war concerns will be the prime focus in the Story of the Day.

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Raghuram Rajan – IIT-IIM graduate, MIT PhD, youngest ever Chief Economist at the IMF, every mother’s dream, and subject of Shobhaa De’s wishful thinking involving towels and their dropping – is back in the news.

Rajan, RBI Governor between 2013 and 2016, and currently Professor of Finance at the University of Chicago Booth School of Business, was requested by the Parliament Estimates Committee, headed by Murli  Manohar Joshi, to present a note on the NPA situation dogging the Indian banking system, after former Chief Economic Advisor (CEA) Arvind Subramanian praised him for identifying the NPA crisis and trying to resolve it.

Why did NPAs occur? Why did the RBI set up various schemes to restructure debt and how effective were they? Why recognize bad loans? Did the RBI create the NPAs? Why did RBI initiate the Asset Quality Review (AQR)? Did NPA recognition slow credit growth, and hence economic growth? Why do NPAs continue mounting even after the AQR is over? What could the regulator have done better? How should we prevent recurrence?

These were the big questions that Rajan answered in his note, and those answers, in addition to his views on the depreciation of the rupee, emerging market scenarios, and global trade war concerns will be the prime focus of our Story of the Day. My name is Rakesh, and you are listening to Moneycontrol.

Over-optimistic bankers, a slowdown in the government’s decision-making process and the moderation in economic growth mainly contributed to the mounting bad loans, said former RBI Governor Raghuram Rajan in a note to a Parliamentary panel.

In the note, Rajan said, "A variety of governance problems such as the suspect allocation of coal mines, coupled with the fear of investigation, slowed down government decision making in Delhi, both in the UPA and the subsequent NDA governments". Project cost overruns escalated for stalled projects and they became increasingly unable to service debt, he said, adding the continuing travails of the stranded power plants, even though India is short of power, suggests government decision making has not picked up sufficient pace to date.

He said a larger number of bad loans were originated in the period 2006 to 2008 when economic growth was strong, and previous infrastructure projects such as power plants had been completed on time and within budget.

"It is at such times that banks make mistakes. They extrapolate past growth and performance to the future. So, they are willing to accept higher leverage in projects and less promoter equity. Indeed, sometimes banks signed up to lend based on project reports by the promoter's investment bank, without doing their own due diligence," he said. Citing an example, he said, "One promoter told me about how he was pursued then by banks waving chequebooks, asking him to name the amount he wanted".

This is the historic phenomenon of irrational exuberance, common across countries at such a phase in the cycle, he said.

Unfortunately, he said, growth does not always take place as expected and the years of strong global growth before the global financial crisis was followed by a slowdown, which extended even to India, showing how much more integrated the country had become with the world.

Strong demand projections for various projects were shown to be increasingly unrealistic as domestic demand slowed down, he said.

He also pointed to a loss of promoter and banker interest for rising NPAs.

Over malfeasance and corruption in the NPA problem, he said, "Undoubtedly, there was some, but it is hard to tell banker exuberance, incompetence, and corruption apart".

"Clearly, bankers were overconfident and probably did too little due diligence for some of these loans. Many did no independent analysis and placed excessive reliance on SBI Caps and IDBI to do the necessary due diligence. Such outsourcing of analysis is a weakness in the system, and multiplies the possibilities for undue influence," the note said. Rajan was stern in his reproach, saying, “the bankruptcy process is being tested by the large promoters with continuous and sometimes frivolous appeals.” He went on to add, “Banks and promoters have to strike deals outside of bankruptcy or if promoters prove uncooperative bankers should have the ability to proceed without them.”

On steps required to prevent recurrence of rising non-performing assets (NPAs), Rajan suggested that there is a need for improving governance of public sector banks and process of project evaluation and monitoring to lower the risk of project NPAs.

Besides, he also made a case for strengthening the recovery process and distance public sector banks from the government.

“How can we prevent recurrence?”

Rajan also spoke about the Reserve Bank of India's role, admitting that the central bank could have done more and that a "culture of leniency" present at the bank has started changing.

Rajan said RBI could "probably have raised more flags about the quality of lending in the early days of banking exuberance". He added the RBI could have started the asset quality review (AQR) process earlier than it did and that it could have been "more decisive in enforcing penalties on non-compliant banks". This, however, is changing, Rajan said. "This culture of leniency [at the RBI] has been changing in recent years."

Claiming that public sector banks are still not adequately professionalised, he emphasised the need to distance PSBs from the government. PSB board appointments are still made by the government rather than an independent body, and this brings in inevitable politicisation, he said. He also pointed to the deficit in internal talent in PSBs to take top managerial spots, and encouraged the idea of external hires, with appropriate compensation. On the idea of external hires, he said, “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, he pointed out.

In terms of project evaluation, including understanding demand projections for the project’s output, likely competition, and the expertise and reliability of the promoter, Rajan said, more in-house expertise needs to be brought in, as consultants may be biased in their input.

He also called for an incentive structure for bankers which should be worked out so that bankers evaluate, design, and monitor projects carefully, and get significant rewards if these worked out. “This means that even while committees may take the final loan decision, some senior banker ought to put her name on the proposal, taking responsibility for recommending the loan. IT systems within banks should be able to pull up overall performance records of loans recommended by individual bankers easily, and this should be an input into their promotion and pay.”

Credit targets are sometimes achieved by abandoning appropriate due diligence, creating the environment for future NPAs. Both MUDRA loans as well as the Kisan Credit Card, while popular, have to be examined more closely for potential credit risk, he went on to say. The Credit Guarantee Scheme for MSME (CGTMSE) run by SIDBI is a growing contingent liability and needs to be examined with urgency. (NB. Launched in 2000, the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), now known as UDAAN, has recorded cumulative guarantee approvals of over 25 lakh with an aggregate loan amount of over Rs 125,000 crore in FY 2016-17.)

On the subject of loan waivers, he reiterated his stance that they 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. Agriculture needs serious attention, but not through loan waivers. An all-party agreement to this effect would be in the nation’s interest, especially given the impending elections.”

The Rajan list

Among the many takeaways from his note that are being highlighted in the media was the list of NPAs that he had flagged off. Addressing the growing number of frauds that are coming to light in the wake of Nirav Modi-Mehul Choksi (and others), he said:

“The size of frauds in the public sector banking system has been increasing, though still small relative to the overall volume of NPAs. Frauds are different from normal NPAs in that the loss is because of a patently illegal action, by either the borrower or the banker. Unfortunately, the system has been singularly ineffective in bringing even a single high profile fraudster to book. As a result, fraud is not discouraged.”

“The investigative agencies blame the banks for labelling frauds much after the fraud has actually taken place; the bankers are slow because they know that once they call a transaction a fraud, they will be subject to harassment by the investigative agencies, without substantial progress in catching the crooks. The RBI set up a fraud monitoring cell when I was Governor to coordinate the early reporting of fraud cases to the investigative agencies. I also sent a list of high profile cases to the PMO urging that we coordinate action to bring at least one or two to book. I am not aware of progress on this front. This is a matter that should be addressed with urgency.”

Sources have confirmed that the PMO and Ministry of Finance did indeed receive Rajan’s list, but no action was taken. This is among the questions that the Modi government needs to answer, given the growing public disenchantment with public sector banks and the government’s inability thus far to either curb the frauds or extradite the alleged scamsters.

Sources also say that the parliamentary committee will now ask the principal secretary to the prime minister, Nripendra Mishra, and finance secretary Hasmukh Adhia to depose before it on why no action was taken on Rajan’s fraud list, as reported by The Wire. Adhia has already deposed before the committee once. Current RBI governor Urjit Patel has also been asked to testify before the Committee.

Rajan’s views on the state of the Rupee

Raghuram Rajan said in an interview with CNBC-TV18 yesterday that he expects the rupee to not go in for a free fall as the central bank is appropriately raising the interest rate to control inflation.

The rupee crashed below the 72-mark to end at a life-low of 72.45 against the US dollar on growing fears of contagion from an emerging-market rout and escalation of a global trade war. Heavy speculative dollar demand along with panic among importers sent the domestic currency tumbling by a sharp 94 paise to hit a historic low of 72.67 in mid-morning trade, triggering the central bank intervention to defend the currency.

"It is very important that RBI continues to signal as it has done so far on its concern about keeping inflation on track, about raising interest rate whenever appropriate, to fulfil its inflation objective ... that gives investors confidence that rupee is not going to go in for free fall because ultimately inflation will be in control ...," he said.

On suggestions of NRI bonds to check rupee depreciation against the US dollar, Rajan remained non-committal, but said they are "weapons you have in the armoury".

On the issue of the growing CAD, Rajan also said India has to pay attention to the aggregate fiscal deficit, as state governments have increased their fiscal deficits. "The fact that India is growing quite strongly gives some positive but in general we have to pay attention," he said. Rajan also stressed that India cannot "afford an election year budget" going forward given the kind of turmoil is there in the financial market.

"It has to be a responsible one," he added.

Emerging markets crisis

On the subject of the crisis in the emerging markets, in the face of a strong dollar and higher Fed rates as well as the brewing trade war, Rajan said, these issues make emerging markets more vulnerable. “I think this is a big source of uncertainty because many countries export to China and via China to the US, and this includes Latin America and much of East Asia. Of course, India is different because it's more of a self-contained economy. But these are sources of vulnerability and unfortunately, there is very little confidence that the US administration fully recognises all these interlinkages, and that it actually worries about the feedback effects as the emerging markets slow. Now, the reality is much of world growth now is driven by the emerging markets, so the industrial world cannot be decoupled from growth in the emerging markets. We need both to grow if the industrial countries have to do well. We have a temporary illusion that the industrial countries are growing and growing strongly and it doesn’t depend on the growth in emerging markets. That is an illusion that will crack if in fact, the emerging markets slow considerably.”
First Published on Sep 11, 2018 10:19 pm
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