NPAs: A problem that refuses to go away

An extract from Rajrishi Singhal’s book, 'Slip, Stitch and Stumble: The Untold Story of India's Financial Sector Reforms'

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There was general jubilation in the stock markets on 29 February 2016. Then finance minister Arun Jaitley had just finished reading his budget speech for 2016-17 in which he happened to announce a scheme to sort out the messy tangle of bad loans in the banking sector. The equity market’s optimism surprised everybody because NPAs—or non-performing assets, as bad loans are technically referred to in India—have remained an intractable problem for close to three decades, impervious to a steady procession of schemes formulated by both the government and the RBI.

This is what Jaitley said that caused the markets to combust:

A systemic vacuum exists with regard to bankruptcy situations in financial firms. A comprehensive Code on Resolution of Financial Firms will be introduced as a Bill in the Parliament during 2016–17. This Code will provide a specialised resolution mechanism to deal with bankruptcy situations in banks, insurance companies and financial sector entities. This Code, together with the Insolvency and Bankruptcy Code 2015, when enacted, will provide a comprehensive resolution mechanism for our economy.

Truth be told, those looking askance at the stock market buoyancy seemed justified; there was nothing in Jaitley’s statement that was different from what his various predecessors had said on numerous occasions, especially when announcing yet another new scheme for tackling NPAs.

The story of NPAs, thus, needs to be told.

In 1991, the Narasimham Committee-I had recognized that rising NPAs on the balance sheets of Indian banks were a menace which, left unchecked, could engulf the entire banking sector in India, threatening financial stability and bringing the entire economy to a standstill. The committee members saw bulging NPAs tucked away deep in the balance sheets of banks, ominously lurking in the background as a permanent threat to the industry and economy. All and any reforms would be infructuous if bad loans continued to weigh on banks’ balance sheets.

The danger can be understood from the basic business model of a bank: unlike any other business, a bank is a highly leveraged entity. In other words, a bank borrows in multiples of its capital, mostly through the instrument of deposits, making it much more vulnerable to shocks than any other commercial unit. Mounting NPAs in a bank is a source of severe stress, directly eroding the bank’s capital and jeopardizing its existence. As the Indian economy entered the decade of the 1990s, it was clear to policymakers that the gnawing NPA problem could undo all the good work done over the decades.

It was a crisis by any other word. What is unfortunate is that the NPA problem existed at the time of the Narasimham Committee report, and it exists even now, waxing and waning with shifts in the economy. The suite of solutions to fix it has also swung from the absurd to the ineffective, with some half-way legal solutions working hard to wrest half-way solutions from within the politico-industry complex. As with the rest of the financial sector reforms, the sporadic attempts to provide solutions were felt necessary only when matters got out of hand. But whenever the law or rules proved antagonistic to its interests, industry wielded its superior collective bargaining powers, using the cracks in India’s distorted campaign finance structure to press home its advantage and to ease the pressure.

It may therefore be instructive to look at all the attempts made to solve the problem of NPAs and all the solutions brought to the table to see which of those worked and which had to be junked.

There are two kinds of NPAs in India. One is the genuine bad loan, arising from external factors such as a war, a drought, an earthquake or a flood affecting business or farming operations. Often, it is also the result of inefficiency or mismanagement, a business strategy going wrong, or just plain simple business obsolescence. There are also instances of NPAs resulting from banks not conducting due diligence or from haphazard credit appraisals on their part.

The second kind is wilful default, where the borrower does not repay the loan on purpose, either safe in the knowledge that political pressure would be brought upon the banks to write off the loan (such as farm loans on which there are mass waivers before an election) or that the long and winding legal process is typically structured to favour the borrower and not the lender.

The second category is usually monopolized by large- and medium-scale industries and, over time, started contributing to a larger share of the NPAs in the economy. The slow-burn liberalization of the economy in the 1980s, which saw a new breed of entrepreneurs testing the system, collided against what was still a capital-scarce economy in which even banks exercised severe funding restrictions. The RBI would decide which organizations deserved credit, and how much, based on some internal formula, and at a pre-determined high rate to cross-subsidize other concessional loans. This gave rise to what is known as gold-plating, a euphemism for entrepreneurs inflating their project costs, borrowing in excess of the project’s requirements and siphoning off the excess. The money would usually come back in the form of the promoter’s equity contribution to the project or would be diverted to finance another project. Sometimes the siphoning off also occurred to finance the entrepreneur’s lifestyle. There are also well-known examples now of promoters siphoning off the entire loan amount and using illegal channels to transfer the funds overseas. The need for gold-plating seemed to increase after 1991, when the economic reforms programme allowed free competition and existing entrepreneurs realized they needed to inject additional capital into their companies to stay competitive.

It might be appropriate to note here that a study of NPAs by the RBI in its July 1999 monthly bulletin, titled ‘Some Aspects and Issues Relating to NPAs in Commercial Banks’, found diversion of funds by companies as the predominant reason for defaults. Here, companies would take loans for one project but divert them to other projects within their business group that would otherwise not have been found loan-worthy. The RBI study observed:

‘Diversion of funds . . . mostly for expansion/diversification/ modernization, taking up new projects and for helping/ promoting associate concerns, is the single most prominent reason. Besides being so, this factor is also in a significant proportion of cases, combined with other factors like recessionary trends developing during the expansion/ diversification/promotion phase and failure to raise capital/ debt from public issue due to market turning lukewarm.’

Even former RBI governor Urjit Patel has mentioned in his book Overdraft that a nexus between the lender and borrower has stymied the speedy resolution of NPAs:

The broad conclusion that has been universally accepted is that enterprises in India have over and over again received excessive credit during loan growth cycles, which is followed soon after with repayment problems. Rather than resolving stressed credit problems swiftly, banks — either through loan-level fudges or refusal to recognize the true asset quality of the credits — have allowed promoters in charge of enterprises to have a soft landing; this has comprised of even more bank lending so as to keep the accounts artificially in full repayment on past dues, protracted control for promoters over failed assets, and effectively granting them the ability to divert cash and assets, often outside of our jurisdictional reach.

Attempts to find solutions to insolvency and bankruptcy have been made in India since pre-Independence. The real issue is that the NPA problem never went away permanently; it has risen and fallen, abated temporarily when new solutions were thrown at it, and then roared back again when there was either a new economic shock or the stakeholders got acquainted with the nuts and bolts of the new device and could finesse it once again.

(This is an extract from Slip, Stitch and Stumble: The Untold Story of India’s Financial Sector Reforms by Rajrishi Singhal. Reproduced with permission from Penguin Random House India)

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Founding Fuel

Founding Fuel aims to create the new playbook of entrepreneurship. Think of us as a hub for entrepreneurs- the go-to place for ideas, insights, practices and wisdom essential to build the enterprise of tomorrow. It is co-founded by veteran journalists Indrajit Gupta and Charles Assisi, along with CS Swaminathan, the former president of Pearson's online learning venture.

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