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

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

In 2016, banks will continue to kick the bad loans can down the road

In June 2015, the Reserve Bank of India(RBI) came with the strategic debt restructuring(SDR) scheme. This scheme allows the banks to convert a part of the debt owed to them by corporates into equity and is actively being used to kick the bad loans can down the road.

As the RBI notification on the SDR scheme pointed out: It has been observed that in many cases of restructuring of accounts, borrower companies are not able to come out of stress due to operational/ managerial inefficiencies despite substantial sacrifices made by the lending banks. In such cases, change of ownership will be a preferred option.”

Under the corporate debt restructuring scheme banks restructured loans by lowering the interest rate charged to the borrower or the borrower was given more time to repay the loan i.e. the tenure of the loan was increased, among other things.
But the restructuring did not help with a good portion of the restructured loans between 2011 and 2014, turning into bad loans. Crisil Research puts the number at 40%.

Further, as Parag Jariwala and Vikesh Mehta of Religaire Institutional Research write in a research note titled SDR: A band-aid for a bullet wound: “Indian banks went on a massive restructuring spree over 2012-2013 and 2013-2014. The corporate debt restructuring (CDR) cell received 530 cases till March 2015 from banks looking to restructure debt aggregating to Rs 4 lakh crore without classifying these accounts as NPAs.”

But this did not work. As Jariwala and Mehta point out: “On the whole, the success of CDR packages in rehabilitating stressed assets remains in question – the failure rate for the above restructured cases has increased to ~36% in September 2015 from 24% in September 2013. Out of the 530 cases received, close to 190 cases aggregating to Rs 70,000 crore have exited CDR due to repayment failures.” Most of these failures have been with regard to loans where banks had entered into a moratorium of two years with corporates, for repayment of principal amount of the loan.

One of the reasons for the failure of CDR has been the lack of interest and cooperation from the promoters who had taken on bank loans. Their intention has been to default on the bank loans they have taken on. SDR has been initiated to address this problem.  As Ashish Gupta, Prashant Kumar and Kush Shah of Credit Suisse write in a research note titled Failed CDR now SDR: “SDR allows banks to convert part of their debt to equity to take controlling stake (at least 51%) in the stressed company and thereby, banks can effect change in ownership wherever existing management is not performing. This gives banks significant power while dealing with non-performing or non-cooperating promoters.”

The idea with SDR is to convert the weak bank debt into equity and then sell the equity to a new promoter, and recover the money owed to the banks by the corporate. As the RBI Annual Report for 2014-2015 points out: “RBI and SEBI have together allowed banks to write in clauses that allow banks to convert loans to equity in case the project gets stressed again. Not only will such Strategic Debt Restructuring give creditors some upside, in return for reducing the project’s debt, it can also give them the control needed to redeploy the asset (say with a more effective promoter).”

SDR allows banks to postpone asset classification of a loan for a period of 18 months. This means that if a loan is in the process of turning into a bad loan and the bank has converted that into equity, it does not need to categorise that as a bad loan.

Also, the equity shares post conversion are exempt from following the “mark to market” rule. This means if the share price of the company falls below the price at which the debt was converted into equity, the bank does not need to book the difference as a loss during the 18-month period.

SDR essentially gives a bank (actually to the consortium of banks to whom the money is owed by the corporate, and which is referred to as joint lenders’ forum) a period of 18 months to look for a buyer for the company which they have taken over.

The question is will it allow banks to recover the loans that they have given to corporates and which are now in a risky territory? As the Credit Suisse analysts point out: “There has been a significant pick-up in activities under the SDR route over the past few months, with the banks invoking SDR in case of nine accounts with debt of ~Rs57,000 crore (~1% of system loans,). Majority of these accounts have been restructured earlier and have failed to achieve the targets set during the restructuring. Also, with their restructuring moratoriums now ending many would have been on the verge of turning non-performing assets.”

What does this mean? It means banks have tried rescuing the loans they had given to corporates by restructuring them in the past. And they have failed at it. Now these restructured loans are being put through strategic debt restructuring and being converted into equity. If the option of strategic debt restructuring wasn’t available to banks, they would have had to possibly recognise these loans as bad loans.

The Religaire analysts estimate that banks will “end up refinancing 30-40 ailing accounts under the scheme in the next one year, thus postponing non-performing assets [bad loans] recognition of Rs 1.5 lakh crore.”

The other option before banks is to sell these loans to asset restructuring companies for a loss, and then account for that loss over a period of two years. But given that they have the option of postponing any losses through the SDR route, they are more likely to take that route.

What is also interesting is that banks need to keep the companies in which they have converted their debt into equity through the SDR route, running, until they are able to find buyers for them. This means that the lending to these companies can’t completely stop.

Hence, banks will have to provide working capital finance to these companies as well as  fresh loans, so that these companies can continue to pay interest on their remaining debt.

As the Religaire analysts write: “It is important for lenders to keep companies under SDR running until they find new buyers. Banks are thus likely to continue funding interest costs and working capital during the 18-month SDR window. This includes meeting guarantees invoked by state governments or developers for delayed project completion. We assume that debt levels (including interest) will rise ~20% during this period.”

To conclude, as I keep saying things are not looking good for Indian banks.

The column originally appeared on the Vivek Kaul’s Diary on January 7, 2016