Credit provisions to spike for banks as cases gets referred to insolvency process

Karthik Srinivasan

Over the last few years, the Indian banking sector has been plagued by asset quality pains and the various measures taken in this regard have not yielded the desired results.

This war against bad loans has gained significant traction lately, in the last quarter, with the Reserve Bank of India (RBI) issuing directives to banks to refer the identified 12 large defaulters to National Company Law Tribunal (NCLT), under Insolvency and Bankruptcy Code (IBC). Further RBI has also asked banks to arrive at an amicable solution for most of the large stressed assets by December 2017 else those accounts may also be needed to be referred to NCLT.

While in the medium term the impact should be positive as the domestic debt market matures, in the near term, the higher provision requirement for banks on the cases under IBC would be a painful pill to digest given their already low profitability and weak capitalization levels.

The earlier provisioning norms on non-performing loans required the banks to make only 40 percent provision on the loan amount over a period of three years and 100 percent in the fourth year. However, with accelerated provisioning on the loans for cases referred to NCLT under IBC, banks will now be required to make an immediate provision of 50 percent on the secured exposures and 100 percent on the unsecured exposures.

Additionally, if the liquidation of the defaulter is ordered by NCLT, the banks will be required to make 100 percent provision even on the secured portion of the loan. For the existing 12 cases, RBI has directed banks to stagger the provision over three quarters, i.e. during Q2 through Q4 FY2018, which could increase the credit costs for many banks during FY2018.

It is estimated that the banks are currently maintaining provisions of ~40-42 percent of the loan amount on these exposures at a system level and accordingly, the incremental credit provisions on these loans could be around Rs 16,000-20,000 crore during FY2018.

Accordingly, for FY2018, the credit provision for banks is likely to increase by 14-15 bps to 1.2-1.4 percent of average total assets (ATA) for the banking sector (1.4  - 1.8 percent for public sector banks and 0.65-0.80 percent for private banks). The actual impact, however, may vary across banks depending on the provisions held by them on the respective accounts.

With higher credit costs and hence lower profits (or higher losses), the capital requirements for the banks will also increase and will create additional challenges for public sector banks given the fact that they are already struggling for capital with an estimated required Tier-I capital of Rs 1.2-1.3 lakh crore during FY2018 and FY2019.

With this new resolution tool, the borrowers and the lenders are likely to sail the unchartered territories, that too in a time-bound manner. A time bound resolution or liquidation of defaulter as the only scenarios under IBC, a reference under IBC may commence a reverse countdown for liquidation of the defaulter. Promoters, banks and other stakeholders are expected to make coordinated efforts to arrive at a resolution plan and prevent a liquidation of the defaulter – a scenario in which possible losses to all stakeholders can be higher. This may also improve the financial discipline among the borrowers by not leveraging excessively as they may fear losing management control of their companies.

Banks may not be eager to initiate IBC against defaulting borrowers on account of the higher provisioning requirement upon reference to NCLT, hence they may want to build up adequate provisions before taking recourse under IBC despite the imminent risk of the assets losing economic value over time.

However, they would need to take into account that operational creditors can initiate actions against the borrower under IBC. In such scenario, banks would have no choice but to make higher provisions and consequently greater clarity on provisioning norms; for banks upon such references by operational creditors may reduce the ambiguity among the stakeholders in the borrowers and lenders.

With help from the Government and the regulators, the lenders have tools to recover bad debts but they need to improve their underwriting norms and account monitoring, as it is not a just an issue of the existing stock of bad loans.

(The author is a Senior Vice President & Group Head - Financial Sector Ratings, ICRA Ltd. - Ratings agency)