The Banking Ordinance is no magic pill for ailing banks

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Recently, the government promulgated the Banking Regulation(Amendment) Ordinance, 2017, to tackle the huge amount of bad loans that have accumulated in the Indian banking system in general and the government owned public sector banks in particular. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

This Ordinance is now being looked at the magic pill which will cure the problems of Indian banks. Will it?

The Ordinance essentially gives power to the Reserve Bank of India(RBI) to give directions to banks for the resolutions of bad loans from time to time. It also allows the Indian central bank to appoint committees or authorities to advise banks on resolution of stressed assets.

The basic assumption that the Ordinance seems to make is that the RBI knows more about banking than the banks themselves. This doesn’t make much sense for the simple reason that if the RBI was better at banking than the banks themselves, it would have been able to identify the start of the bad loans problem as far back as 2011, which it didn’t.

Over and above this, this is not the first time that Indian banks have landed in trouble because of bad loans. They had landed up in a similar situation in the early 1980s and the early 2000s as well, and the RBI hadn’t been able to do much about it.

In fact, at the level of banks, many banks have been more interested in postponing the recognition of the problem of bad loans. This basically means they haven’t been recognising bad loans as bad loans. One way of doing this is by restructuring the loan and allowing the borrower a moratorium during which he does not have to repay the principal amount of the loan. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased. In many cases this simply means just pushing the can down the road by not recognising a bad loan as a bad loan.

Why have banks been doing this? The Economic Survey gives us multiple reasons for the same. Large debtors have borrowed from many banks and these banks need to coordinate among themselves, and that hasn’t happened. At public sector banks recognising a bad loan as a bad loan and writing it off, can attract the attention of the investigative agencies.

Also, no public sector banker in his right mind would want to negotiate a settlement with the borrower who may not be able to repay the entire loan, but he may be in a position to repay a part of the loan. As the Economic Survey points out: “If PSU banks grant large debt reductions, this could attract the attention of the investigative agencies”. What makes this even more difficult is the fact that some of defaulters have been regular defaulters over the decades, and who are close to politicians across parties.

Hence, bankers have just been happy restructuring a loan and pushing the can down the road.

Over and above this, writing off bad loans once they haven’t been repaid for a while, leads to the banks needing more capital to continue to be in business. In case of public sector banks this means the government having to allocate more money towards recapitalisation of banks. There is a limit to that as well.

Also, a bigger problem which the Economic Survey does not talk about is the fact that the rate of recovery of bad loans has gone down dramatically over the years. In 2013-2014, the rate of recovery was at 18.8 per cent. By 2015-2016, this had fallen to 10.3 per cent. Hence, banks were only recovering around Rs 10 out of the every Rs 100 of bad loans defaulted on by borrowers. This is clear reflection of the weak institutional mechanisms in India, which cannot change overnight.

Also, many of the companies that have taken on large loans are no longer in a position to repay. As the Economic Survey points out: “Cash flows in the large stressed companies have been deteriorating over the past few years, to the point where debt reductions of more than 50 percent will often be needed to restore viability. The only alternative would be to convert debt to equity, take over the companies, and then sell them at a loss.”

The first problem here will be that many businessmen are very close to politicians.
Hence taking over companies won’t be easy. Over and above this, it will require the government and the public sector banks, working with the mindset of a profit motive, like a private equity or a venture capital fund. And that is easier said than done.

The column originally appeared in the Daily News and Analysis on May 22, 2017.

The Clean Up of Public Sector Banks is On, but the Basic Problem Still Remains

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Earlier this week, the Reserve Bank of India(RBI) released the biannual Financial Stability Report. And this is how the most important paragraph of the report reads: “The gross non-performing advances (GNPAs) of SCBs sharply increased to 7.6 per cent of gross advances from 5.1 per cent between September 2015 and March 2016 after the asset quality review (AQR). A simultaneous sharp reduction in restructured standard advances ratio from 6.2 per cent to 3.9 per cent during the same period resulted in the overall stressed advances ratio rising marginally to 11.5 per cent from 11.3 per cent during the period. PSBs continued to hold the highest level of stressed advances ratio at 14.5 per cent, whereas, both private sector banks (PVBs) and foreign banks (FBs), recorded stressed advances ratio at 4.5 per cent.”

What does this mean? As on March 31, 2016, the gross non-performing advances (or bad loans) of banks stood at 7.6% of the loans that they have given out. This figure had stood at 5.1% as on September 30, 2016. It had stood at 4.6% as on March 31, 2015.

This basically means that between March last year and March this year, the bad loans of banks have gone up by 300 basis points. One basis point is one hundredth of a percentage. Between September 2015 and March 2016, the bad loans of banks have gone by 250 basis points.

Nevertheless, this is good news. But how can bad loans of banks going up be good news?  It is good news because the banks (particularly public sector banks) are finally getting around to recognising bad loans as bad loans. Up until now, they were basically postponing the recognition of bad loans as bad loans by passing them as restructured loans.

A restructured loan essentially implies that the borrower has been given a moratorium during which he does not have to repay the principal amount. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased.

This is how banks had been helping many borrowers who were no longer in a position to repay the loans they had taken on. In many cases, restructuring was just an exercise to postpone the recognition of bad loans. Even after the loans were restructured many borrowers, were not in a position to repay their loans.

This becomes clear from looking at the stressed advances ratio of the banks. The stressed advances figure is obtained by adding the total bad loans to the restructured assets. Over the last few years, the stressed advances ratio of banks has gone up at a rapid rate, as banks restructured loans at a rapid pace.

This has now stopped. The restructured asset of banks as on March 31, 2016, fell to 3.9% of loans. In September 2015, it had stood at 6.2% of total advances. This basically means that the strategy of banks to postpone recognition of bank loans by passing them off as restructured assets has come to an end. Given this, the overall stressed assets ratio of banks as on March 31, 2016, stood at 11.5%, against 11.3% as on September 30, 2015.

A stressed asset ratio of 11.5% was basically obtained by adding bad loans of 7.6% to restructured assets of 3.9%. In September 2015, the restructured assets had stood at 6.2% whereas the bad loans had stood at 5.1%, leading to a stressed assets ratio of 11.3%.

What this tells us is that between September 2015 and March 2016, the stressed assets ratio has gone up by just 20 basis points from 11.3% to 11.5%. Indeed, this is good news for the simple reason that banks are now being forced to recognise bad loans as bad loans and not pass them of as restructured assets like they were doing earlier.

This is a huge feather in the cap of both the Reserve Bank of India as well as the Narendra Modi government. The basic problem is with public sector banks which gave out loans in the past primarily to many crony capitalists, which these borrowers are now not in a position to repay.

The stressed asset ratio of public sector banks as on March 31, 2016, stood at 14.5%. As on September 30, 2015, the ratio had stood at 14.1%. The stressed asset ratio of public sector banks is now going up at a slower rate than it was in the past, as can be seen from the accompanying table.

 

DateRatio
March 31, 201614.50%
September 30, 201514.10%
March 31, 201513.50%
September 30, 201412.90%
March 31, 201411.70%
September 30, 201312.30%
March 31, 201310.90%
  

 

What this means is that public sector banks are cleaning up their act by recognising more and more bad loans. This wasn’t happening in the past. Now it is important that they go after the borrowers (especially the larger ones) and recover as much of the loans as they can. The more the loans they can recover, the lesser will be the capital that the government will have to put into these banks, to get them up and running again.

Also, it is important to point out that this cleaning up has been possible because of the asset quality review initiated by the Rajan led RBI. The RBI asset quality review covered 36 banks (including all public sector banks). This review accounted for 93% of the total lending carried out by the scheduled commercial banks.

As the RBI Financial Stability Report points out: “The exercise sought to validate objective compliance of banks with applicable income recognition, asset classification and provisioning (IRACP) norms and exceptions were reported by the supervisors as divergences in asset classification / provisioning.” This basically means that RBI was checking for whether banks are recognising bad loans as bad loans.

Indeed, the fact that the bad loans ratio has jumped to 7.6%, tells us that many banks were not recognising bad loans as bad loans, and that anomaly has been corrected. The first step in tackling a problem is to recognise that it exists. The Indian banks, in particular, the public sector banks have now started to do that.

The Financial Stability Report suggests that “under the baseline scenario, the gross non-performing assets ratio [bad loans ratio] may rise to 8.5 per cent by March 2017 from 7.6 per cent in March 2016. If the macro scenarios deteriorate in the future, the gross non-performing assets ratio may further increase to 9.3 per cent.” The point is that the worst is still not over for India’s banks.

Also, this basically means that banks need to be aggressive about recovering their loans. Further, it’s time that the government as the owner of public sector banks, starts forcing the defaulting promoters to give up on their equity.

Nevertheless, the bigger problem still remains. The bigger problem is the fact that the public sector banks continue to remain government owned. As Ruchir Sharma writes in The Rise and Fall of Nations—Ten Rules of Change in the Post Crisis World: “Spend a lot of time in field, and it is all too easy to find evidence that the state is not a competent banker.”

The Indian public sector banks have ended up in trouble more than a few times before. One of the reasons for this is the politicians forcing these banks to lend to crony capitalists. And as long as these banks continue to remain government owned, that risk remains, especially given that it is crony capitalists who ultimately finance the electoral ambitions of India’s politicians.

The column was originally published in Vivek Kaul’s Diary on June 30, 2016

Is Your Banker with You or with Corporates?

RBI-Logo_8What is the purpose of a bank? Any bank?

It is to match lenders with borrowers.

It is to take the savings of people (i.e. deposits) by offering a certain rate of interest and then lend it out at a higher rate of interest, and in the process make a reasonable profit.

Is that all there is to it? No.

The bank also has to ensure that the deposits that it lends out are fully repaid. This means carrying out a proper “due diligence” of the borrower, before lending money.
It also means lending only to those people it expects will repay.

It also means not lending to people and companies who are already in trouble.

It ‘basically’ means not putting the depositor’s savings at risk.

These are the basic tenets of banking, which the Indian banks, in particular banks owned and run by the government, have broken over the past few years, and continue to do so.

Take the case of the 5/25 scheme which banks have been using in order to restructure loans which borrowers have had trouble repaying. What is the 5/25 scheme? There are many physical infrastructure projects which have long gestation periods of up to 25 years. The trouble is that companies which have borrowed money to build such projects need to repay the principal amount of the loan in a period of around five years.

And this creates a problem simply because in a short period of five years, physical infrastructure projects like roads do not start to throw up money which can be used to repay the loan that has been taken on.

In this scenario defaults start to happen even though the project continues to remain economically viable. It’s just that a period of five years is too short a time for the project to start throwing up money which the corporate can use to repay the loan that it has taken on. Having said that, such a loan could perhaps be easily repaid over a period of 25 years.

The Reserve Bank of India has allowed banks to restructure such loans by allowing corporates to delay making principal repayments of the loan. In some cases, interest repayments have also been delayed.

As Suresh Ganapathy and Sameer Bhise of Macquarie Research write in a recent research note titled Apocalypse Now: “RBI has allowed that going forward, banks can restructure loans such that they can finance the projects for 5 years and at the time of structuring the contract, stipulate an explicit condition that at the end of 5 years, loans will be rolled forward for the next 20 years and define milestone payments at the end of every subsequent 5-year period.”

A loan restructured under the 5/25 scheme is not treated as a bad loan. Further, only loans of Rs 500 crore or more can be restructured under this scheme.

All this sounds good on paper. The trouble is this rule is being used by banks to postpone the recognition of bad loans. Take the case of Essar Steel. As Ganapathy and Bhise write: “For example, in case of Essar Steel—an account that HDFC Bank already classifies as a non performing loan and on which the bank has already taken 40% provision—other banks have instead refinanced their loan. According to the terms agreed by the consortium of bankers led by State Bank of India, Essar Steel needs to pay just about 9% of the principal loan in the initial 7 years, and the remaining 91% will be due for refinancing at end-2022.”

What does this tell us? HDFC Bank probably the best managed bank in the country has classified Essar Steel as a bad loan. Other banks led by State Bank of India have refinanced the loan. Refinancing essentially means giving a new loan so that the older loan can be repaid, and a new loan can be started on better terms for the borrower.

The question is why are banks refinancing a loan to a company in the steel sector, which is currently in a mess and is unlikely to recover any time soon. The prospects of the sector remain largely subdued over the next five years.

Also, what explains HDFC Bank categorising the loan as a bad loan, and other banks giving Essar Steel a fresh loan? It is not surprising that HDFC Bank as on March 31, 2015, had a net non-performing assets ratio (one representation of bad loans) of 0.20% of its total advances. In case of State Bank of India the number had stood at 2.12%. This is a clear case of what the RBI governor Raghuram Rajan had called “extend and pretend” that all is well.

Now let’s take the case of Bhushan Steel. Loans of the company amounting to Rs 40,000 crore were restructured under the 5:25 scheme in February 2015. As Parag Jariwala and Vikesh Mehta of Religaire Institutional Research write in a research note titled SDR: A band-aid for a bullet wound: “Under 5:25, Bhushan Steel’s loan repayments have been postponed for the first four years and thereafter are to be made in a staggered manner in the next 21 years. Management stated that the company may face small repayments of Rs 500 crore per annum which in all probability will be funded by the current set of banks.”

Between 2015 and 2019, Bhushan Steel need not make principal repayments on the loans worth Rs 40,000 crore. Over and above this, it is not in a position to repay even the small repayments of around Rs 500 crore per year. The banks will give it new loans so that it can pay these dues. Jariwala and Mehta point out that the company can generate only up to Rs 200 crore of free cash flow during the course of this financial year. Hence, it is not in a position to repay Rs 500 crore. The company also has interest dues of close to Rs 4,000 crore during the course of this year.

The question is if a company is not in a position to repay Rs 500 crore currently, will it really get around to being able to repay Rs 40,000 crore over a period of time?

In fact, the loans given to many big business groups are being restructured under the 5:25 scheme. As Ganpathy and Bhise point out: “As the table below shows, several cases are now being considered for 5:25 refinancing, which also explains why some of these large groups are not currently classified as non-performing loans. Close to 1.7% of system loans are under consideration or already being implemented for 5:25 refinancing. Another issue is that banks may have lent fresh loans to these groups to cover interest payments on older loans.”

What does this mean? It means that the banks will be able to further delay recognising bad loans as bad loans for the next few years. As Zariwala and Mehta write: “Banks are likely to restructure such accounts through SDR/5:25, which would delay non-performing assets recognition as well as increase the likely losses due to additional funding.”
To conclude, it is safe to say that the banks are clearly with companies and not with depositors whose hard-earned money they have lent.

The column originally appeared on Vivek Kaul’s Diary on January 22, 2016

 

When It Comes to Bad Loans of Banks, Nothing is as It Seems

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One of the issues that I have been regularly writing about is the bad state of banks in India. The tragedy is that their state continues to get worse as time progresses.

As on September 30, 2015, the bad loans of the banking system amounted to 5.1% of the total loans given by banks. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a short period of just six months. One basis point is one hundredth of a percentage.

The trouble is that even the bad loans number of 5.1% of total loans, may not be the right number. This is primarily because over the years the Indian banks, in particular public sector banks, seem to have mastered the art of not recognising a bad loan as a bad loan. They have turned the practice of kicking the can down the road, to an art form.

Banks have used various methods to delay the recognition of bad loans and this has made balance sheets of banks more opaque. As Suresh Ganapathy and Sameer Bhise of Macquarie Research write in a recent research note titled Apocalypse Now: “The biggest problem that we now have with the Indian banking industry is that various regulatory forbearance techniques like restructuring (for under-construction infra and long term projects), 5:25 refinancing, SDR (strategic debt restructuring), NPL sales to ARCs (asset reconstruction companies) etc., are making the balance sheets of banks more opaque.

Forbearance essentially means “holding back”. In the context of banking it means that the bank gives more time/better terms to the borrower to repay the loan, among other things. This could mean extending the term of the loan, lowering the interest or even postponing the repayment of the principal of the loan for a few years. Such loans are also referred to as restructured loans.

These options were supposed to be used sparingly. Nevertheless, banks in general and public sector banks in particular have massively abused these options over the years, in order to postpone the recognition of bad loans.

The bad loans of public sector banks stand at 6.2% of total loans, as on September 30, 2015. The restructured loans on the other hand stand at 7.9% of total loans. For the system as a whole, the number stands at 6%, which is higher than total bad loans, which stand at 5.1% of total loans.

The trouble is that many of the loans which were restructured in the years gone by have been defaulted on. As mentioned earlier one of the popular methods of restructuring a loan is to give the borrower a moratorium of few years on the repayment of the principal amount of the loan. The idea is that in that period the company will manage to set its business right and be in a position to start repaying the loan.

But that hasn’t happened. The restructured loans have been turning into bad loans. Ganpathy and Bhise of Macquarie Research estimate that the failure rate of restructured loans has jumped from 24% to 41%, over the last two years. “Many of these loans have come out of their principal moratorium and started defaulting,” the analysts point out.

What such a large default rate clearly tells us is that many of these loans should not have been restructured in the first place. As a November 2014 editorial in the Mint newspaper points out: “The decision to restructure a loan was supposed to be a technical one, taking into account the viability of the borrower. But in case of government banks, the decision to restructure has often been influenced by political considerations, and has depended on the clout of the concerned promoters.” The restructured loans now being defaulted on would have been restructured before the Narendra Modi government came to power in May 2014.

The situation is likely to get worse given that around half of the restructured loans were restructured over the last two years. Hence, companies have a moratorium on principal repayments for a period of two years. Once they start coming out of this moratorium, the loan defaults will go up.

Over and above this many companies continue to remain highly leveraged, that is they have significantly more debt on their books in comparison to their equity. In fact, as the Financial Stability Report released by the Reserve Bank of India(RBI) in December 2015 points out: “The proportion of companies among the leveraged companies with debt equity ratio of >=3 (termed as ‘highly leveraged’ companies) increased from 13.6 per cent in September 2014 to 15.3 per cent in September 2015, while the share of debt of these companies in the total debt increased from 22.9 to 24.9 per cent.”

This has happened because banks have lent more money to companies which are already in trouble and not in a position to repay their loans. As Parag Jariwala and Vikesh Mehta of Religaire Institutional Research write in a research note titled SDR: A band-aid for a bullet wound: “Bank funding to stressed corporates has gone up in the last 2-3 years and most of it is towards funding additional working capital requirement, loss funding and interest accruals (not paid). This will translate into large and bulky credit cost for banks if these accounts slip into non-performing assets [bad loans].

Also, there is the problem of large borrowers. As Jariwala and Mehta point out: “The RBI’s analysis shows that stressed assets [bad loans + restructured assets] as a proportion of total loans to large corporates have gone up from 13.8% in Mar’15 to 15.5% in Sep’15.”

Further, what is worrying is that banks are still to recognise many of these loans as bad loans. As Ganpathy and Bhise point out: “The issue is that some of these large corporate groups have already been downgraded to default by rating agencies. Since banks have a 90-day window to classify as non-performing loans plus have other regulatory forbearance techniques like restructuring (still can be done for underconstruction projects) and 5:25 refinancing, these assets are not being shown as non-performing loans on the books.”

The analysts estimate that large borrowers form around 11-12% of total bank loans and roughly 15% of these loans are likely to turn into bad loans over the years.

Once these factors are taken into account, Ganpathy and Bhise feel that “potentially 16-18% of the loans will attract higher provisions and/or see write-offs over the next 3-4 years.” This means nearly one-sixth of bank loans can still go bad. And that is a huge number.

Hence, when it comes to bank loans, nothing is as it seems.

Stay tuned!

The column originally appeared in the Vivek Kaul Diary on January 21, 2016