Rajan is right, the window dressing of bad loans by banks should end


The Reserve Bank of India (RBI) Raghuram Rajan was speaking at a function to inaugurate the Meghanand Desai Academy of Economics in Mumbai, yesterday (July 28, 2015). Normally, whenever the RBI governor makes a speech, a copy of the speech is made available on the RBI website.

But as I write this on the afternoon of July 29, 2015, the speech is yet to be uploaded on the RBI website. Media reports suggest that the PR agency handling the event sent out a press release yesterday. A report in The Economic Times quotes the press release and points out that one of the things that Rajan had said during the course of the speech: “Declaring an NPA (non-performing asset) is primarily an issue of cleaning up accounting…The market fully understands what is truly non-performing. Moreover, it gives the wrong incentives, as by avoiding NPAs it merely postpones the problem. There is confused understanding of this problem.”

After sending out the press release, the PR agency withdrew the release and sent out another release in which the above statement attributed to Rajan in the first release was missing. The event was closed to the media.

Irrespective of whether Rajan said it or not, the fact that banks need to recognise their non-performing assets i.e. loans which have gone bad, on time, is a very important point. What makes this point even more important is the fact that the lending carried out by public sector banks over the last few years, particularly to the infrastructure sector, will continue to go bad in the days to come.

In a research report titled Current Worries Crisil Ratings estimates that “around 46,000 mw of power generation projects (36,000 mw coal-based and 10,000 mw gas-based) are in distress today. Loans to these projects are around Rs 2.1 lakh crore, with about two-thirds lent by public sector banks.”
Of these loans “as much as Rs 75,000 crore of loans – or nearly 15% of aggregated debt to power generation companies — are at risk of becoming delinquent in the medium term.”

“Further, close to Rs 1.9 lakh crore of loans to six weak discoms, wherein the moratorium under the financial restructuring package (FRP) is ending in the next 18 months, are also at risk if timely support is not extended by the central or state governments,” Crisil points out.

The rating agency feels that the risk is highest in 16,000 mw of projects. “These projects don’t have strong sponsor company support and are not expected to turn viable in the long run even if they are structured under the 5/25 scheme. The exposure of banks and FIs to them was about Rs 75,000 crore as on March 31, 2015. CRISIL believes accretion of non-performing assets (NPAs) from these accounts could be high in medium term.”

This is a worrying sign given that loans to the power sector form 8.3% of the total advances made by scheduled commercial banks. In case of the public sector banks the number is higher at 10.1%. Further, advances to the power sector form 16.1% of the total stressed advances. In case of public sector banks, the number is even higher at 17.3%.

The stressed asset ratio is the sum of gross non performing assets (or bad loans) plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate, which entails a loss for the bank.

Hence, if the stressed advances of public sector banks to the power sector are at 17.3%, it means that of every Rs 100 of loan given to the power sector by the banks, Rs 17.3 has either gone bad or has been restructured.

The power sector in India has been facing many problems. As the RBI Financial Stability Report released in June 2015 points out: “The power sector in India…has been facing significant problems in terms of fuel availability / linkages, project clearances, social activism and aggressive bidding in coal block auctions by power producers resulting in lower plant load factors (PLF). Dependence on imported coal, which is three to four times more expensive, impinges on the bottom lines of companies.”

All these reasons have led to power companies not being able to pay the loans that they had taken on. And this is likely to continue in the days to come, meaning more trouble for banks in general and public sector banks in particular.

It is important that as and when these loans turn bad, they are recognised as bad loans. But that is not something that Indian banks have done over the past few years. Their tendency has been to not recognise the problem and kick the can down the road.

In a research note titled A Growing Need for Indian TARP, Anil Agarwal, Sumeet Kariwala and Subramanian Iyer, analysts at Morgan Stanley point out: “The current managements’ policy of “extend and pretend” is causing banks to move further into problems.”

What do they mean by this? Crisil Research estimates that 40% of the loans restructured during 2011-2014 have become bad loans.

A loan is said to have been restructured where the borrower is allowed to repay the loan over a longer period of time than was originally scheduled. Or the rate of interest on the loan is decreased. If 40% of the loans that were restructured have gone bad over the years, what it clearly shows is that banks have used the restructuring route to essentially kick the can down the road and not recognise the bad loan problem upfront.

The Morgan Stanley analysts quoted earlier expect nearly 65% of restructured loans to turn into bad loans. This is what Rajan was supposedly worried about in his speech in Mumbai yesterday. As Crisil Research points out in a research note titled Modified Expectations: “Reported gross non performing assets[bad loans] will still remain at elevated levels as some of the assets restructured in the previous 2-3 years, especially in the infrastructure, construction, and textiles sectors, degenerate into non-performing assets again.”

Another sector where the banks have been busy window dressing their bad loans is the steel sector. The sector is in a mess with too much debt and is earning too little money to be able to repay it. As Neelkanth Mishra India Equity Strategist, Credit Suisse points out in a recent column in The Indian Express: “At the end of the last financial year, the total debt outstanding to Indian steel companies was nearly $50 billion. This was nearly ten times the industry’s ebitda (profits before interest, taxes and depreciation are deducted), a good proxy for cash profits.” What this clearly tells us is that the steel industry has borrowed way too much and is really not in a position to repay.

The industry continues to be in a mess due to various reasons. As the RBI Financial Stability Report points out: “the industry is beset with many problems: inadequate capital investments, shortage of iron ore, low paced mechanisation of mines, lower level of capacity utilisation of coal washeries, dependence on imported coking coal (the quality of most of the domestic coking coal is not considered good for steel production)…land acquisitions and environmental clearances issues…deceleration in domestic demand.”

In fact, the industry is even finding it difficult to pay the interest on the debt that they have taken on from banks. As Mishra writes: “Companies are borrowing from banks to pay their interest—as underscored by the many “refinancing” deals recently for broke steel companies, where an additional R5,000-8,000 crore were lent by banks.”

Guess, Rajan if he said what he did, was merely stating the obvious.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on July 29, 2015