A healthier system

IFR India Special Report 2013
11 min read

With Basel III capital requirements looming, Indian banks are finally being forced to deal with stressed assets on their books. A full clean-up, however, is some way off.

“It is like the critically ill patient in hospital. You never give up hope until the last minute,” said KR Kamath, chairman and managing director of Punjab National Bank, in referring to efforts to prevent stressed loans from becoming non-performing assets, a hot-button topic for India’s capital-constrained banking sector.

“Revival of an asset is always desirable,” he said. Yet, Kamath, as head of one of India’s largest lenders, knows banks cannot afford to wait forever to recover their investments.

Stressed banking assets are now one of India’s biggest macroeconomic challenges, with the potential to threaten government finances and weigh on already fragile economic growth.

Over the last few years, as India’s growth has faltered from high single digits to around 5%, stressed assets on the balance sheets of Indian banks have risen sharply, partly due to the weak economic environment, but also due to systemic issues. Policy logjams, the cancellation of 2G licences and coal-mining concessions explain some of the blots on the banks’ books.

“It was a perfect storm for us, where payments from several state-owned companies were stuck for a long time and the overall macroeconomic environment was bleak. Nobody wants to be labelled as sick. Yet, when there is a sickness the best thing is to go to hospital.”

That, however, is only part of the picture. Among other reasons are high corporate leverage, especially in asset-heavy industries, and questionable risk judgements of many Indian banks.

As a proportion of assets, the deterioration in asset quality has been largely confined to the state-owned banks, and the true picture may be even more dire. The recent high-level panel on bank reforms headed by former Axis Bank chief PJ Nayak was bald in its assessment: “The financial position of public sector banks is fragile, partly masked by regulatory forbearance.”

The same panel pointed out that nearly 79% of total bank provisions are held by public sector banks. As of December 2013 Indian banks collectively held loan provisions for Rs985.93bn (US$16.03bn), with the SBI group alone holding nearly a third.

Unfortunately, that is not the only bias in the stressed-asset story. The credit profile of banks is skewed towards riskier sectors that yield the highest amount of impaired assets.

“While the CAGR of credit between 2009 and 2012 for the banking sector was 19%, segments like iron and steel, infrastructure, power and telecom witnessed much higher credit growth, despite the impaired assets ratio for these segments being significantly higher,” said former RBI Deputy Governor KC Chakrabarty in an analysis of Indian banks’ credit management last year.

RBI’s half-yearly Financial Stability Report in December 2013 also acknowledged the problem: five sectors, namely infrastructure, iron and steel, textiles, aviation and mining, together accounted for 24% of commercial bank advances, but 53% of their stressed assets.


Banks’ credit appraisal and market analysis skills are under the spotlight. Most Indian banks only started collecting granular data on asset-quality metrics, such as segmental NPAs, write-offs and recoveries, in 2009, in response to regulatory requirements, and, for years, have preferred to kick the can down the road through the refinancing of stressed assets in a practice known as “evergreening”.

Governance issues exacerbate these credit-risk challenges. Undeserving and unviable businesses may still be able to access credit due to collusion between bankers, politicians, businessmen and middlemen. A couple of months ago, the head of state-owned Syndicate Bank was arrested in a bribe-for-credit scam. In February, United Bank of India’s chief was forced to resign after bad debts reached more than twice the paid-up capital of the Kolkata-based lender.

The asset qualities of Indian banks need more careful scrutiny.

“A clear picture of asset quality across the banking sector can emerge only if restructured accounts and write-offs are taken into account,” said Chakrabarty.

The businessman-banker-politician nexus may contribute to the unhelpful practices of evergreening. However, a perverse incentive is also attributable to the banking regulator itself, which relaxed asset classification standards for restructured loans in the wake of the global financial crisis in 2008-09. In fact, the central bank acknowledged “the possibility of the relaxations not being used judiciously by banks commensurate with the viability of projects.”

Another challenge is the use of write-offs to manage the NPA levels. Introduced as a means to manage taxes on impaired assets, write-offs emerged in the post-crisis period as an effective way to cut down on NPAs without serious efforts at recovery. Over Rs4trn had been written off as of the end of 2013.

No more easy days

A number of positive measures are under way, however, as India drags its lumbering financial system into the Basel III era. Bad loans can no longer be pushed under the carpet.

The Nayak Committee found that, without regulatory forbearance on restructured assets and assuming a 70% provision cover, Tier 1 capital adequacy of public sector banks would shrink to 3.8% – a big shortfall relative to the regulatory requirement for end-March 2014.

No surprise then that the elephant in the room is being acknowledged. A new and energetic political dispensation in Delhi is only hastening the changes. Saurabh Tripathi, who heads the financial services practice at Boston Consulting Group, takes heart from the policy pronouncements of the RBI and the new government.

“There are administrative changes. Some test cases will help plug loopholes in the legal and regulatory regime. I am very hopeful,” he said.

In the past year, the RBI has moved to streamline lending procedures through the inception of the joint lenders’ forum (JLF) and has instituted tougher and swifter loan classifications via accurate management information systems. It has also put a sunset clause on the forbearance of restructured loans. The Central Repository of Information on Large Credits (CRILC) is now tasked with collecting from banks credit information, including classifications beyond specified thresholds.

Foreign asset-reconstruction specialists are gaining greater access, and an imminent change in bankruptcy laws will help create a market for distressed companies. On October 20, the government instituted a Bankruptcy Reforms Committee, which is expected to file its report come February 2015.

Longer term

Under the right legal framework, the market for distressed assets should thrive, and the arrival of specialised distressed-debt managers or special situations private-equity funds will offer an alternative beyond the banking sector.

Haresh Chawla, a partner with India Value Fund, believes these firms are better equipped than banks to handle such situations, though any related venture will need “a protective cocoon around the business and support from the banking system to operate the business and not spend all its time fighting battles in courts.”

Any new framework, he says, “needs to ensure that parties can take swift and meaningful action the moment a company is in distress – and attend to the patient at the golden hour, as they say.”

A cultural acceptance of commercial distress is also needed if the changes are to have any meaningful impact. Although there are some positive examples of restructurings, companies still struggle with the stigma attached.

Praveen Sood, group CFO at Hindustan Construction Company, builder of Mumbai landmark Bandra-Worli Sealink recounts his firm’s journey towards a corporate restructuring.

“It was a perfect storm for us, where payments from several state-owned companies were stuck for a long time and the overall macroeconomic environment was bleak.”

HCC sought a restructuring package in early 2012, but Sood points out it took the company management around four months to agree on the move.

“Nobody wants to be labelled as sick. Yet, when there is a sickness the best thing is to go to hospital.”

To speed up that transition, legislators are at pains to distinguish between honest borrowers with genuine business problems and companies that have either colluded with banks or siphoned off money.

“Societal change has to happen. Restructuring is a legitimate financial tool. The borrower is not always the culprit,” said Chakrabarty.

Where guilt is established, punishment will be quick and severe, but the high-profile test case of liquor baron and politician Vijay Mallya is hardly encouraging.

Mallya’s Kingfisher Airlines was grounded in 2012 owing over Rs75bn to a consortium of banks, and Mallya was declared a wilful defaulter – someone who has the ability to pay, but deliberately chooses not to – after his name figured at the top in a list of over 400 large defaulters released by a bank employees association.

So far, lenders have recovered around Rs20bn through the sale of pledged shares, and the wilful defaulter label is designed to put further pressure on Mallya to remedy the situation as soon as possible by closing off other fundraising avenues. Mallya, however, is fighting the move in the courts, and has won a temporary reprieve. Rather than an accelerated resolution, banks look set for another long haul.

Those hoping that India’s banking reforms will have an immediate impact on economic growth will also have to be patient. BCG’s Tripathi alludes to the nature of the Indian economy, which combines emerging-market characteristics with democracy.

“It is not a traditional economic growth cycle. Economic progress here will be volatile. We have unearthed many issues and we are learning good lessons.”

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A healthier system