NPAs, bad loans and festering twin-balance sheet problem
A loan given by a bank is an asset for the bank, as it earns money for the bank in the form of interest.
NPAs or non-performing assets are those loans which default- i.e. don’t pay their interest on time or simply don’t pay their debt at all. There are various stages in an NPA. Let it be clear by an example.
Suppose a person XYZ buys a car by taking a loan of a certain amount, say 5 lakhs. He has to pay a certain interest amount against that loan in a period of 30 days. His loan account is called a special mention account (SMA) of category zero.
If for any reason, his interest payment becomes overdue for more than 30 days, it becomes SMA of category one. It remains SMA – 1 from 30 to 60 days.
If the payment is still due then the account becomes SMA – 2 from 30 days to 90 days.
If the interest is still not paid then the asset turns into an NPA. Now, the NPA has been classified into three categories:
- Substandard Assets: Assets which has remained NPA for a period less than or equal to 12 months.
- Doubtful Assets: An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months. It remains in doubtful category for a period of three years in general.
- Loss Assets: After a certain time the asset is declared as loss asset. There are different rules for this declaration for a different account. After declaring an asset as loss asset, it no longer remains an asset, since now it is not making money for the bank. In that case, they have to remove that loan from the asset section of their balance sheet. As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”
Setting aside of money from Profits to compensate a probable loss caused on lending a loan is called Provisioning. Provisioning is done to cover the risk. When a loan is not getting repaid, this provisioning amount is used to reconstitute the money.
In February 2016, financial markets in India were shocked by the bad news from the banking system. One by one, public sector banks revealed their financial results for the December quarter. And the numbers were stunning. Banks reported that nonperforming assets had soared, to such an extent that provisioning had overwhelmed operating earnings. As a result, net income had plunged deeply into the red.
Bad loans — or NPAs — were about 9 per cent of total loans of all Indian banks in September 2016. At public sector banks, bad loans were 12 per cent of all advances while another 3 per cent of loans in the aggregate have been restructured.
Meanwhile, on the corporate side, Credit Suisse reported that around 40 percent of the corporate debt it monitored was owed by companies which had an interest coverage ratio less than 1, meaning they did not earn enough to pay the interest obligations on their loans.
Here came the picture of twin-balance-sheet-problem, where both the banking and corporate sectors are under stress. Not just a small amount of stress, but one of the highest degrees of stress in the world. The increasing numbers of NPAs are damaging the balance sheets of banks and at the same time, corporate sectors are not earning enough to repay their loans, as their balance sheets are also getting damaged.
The highest nos. of NPAs are in power and steel sectors.
But this is not the end. The story has a new turn. A fresh wave of potential NPAs is looming on the horizon.
Agriculture, power and auto pressure are adding to clouds of bad loans, as the recent survey suggests.
Banks, led by the Indian Banks Association, are in the process of petitioning the Centre over the increasing trend of power distribution companies (DISCOMS) in states, such as Rajasthan and Tamil Nadu, reportedly curtailing solar and wind-power generation. Discoms in Tamil Nadu, Madhya Pradesh, Maharashtra, and Rajasthan are also reported to be delaying payments to generators of the wind and solar power by 6-12 months, putting the cash flows of most of the smaller renewable firms under severe stress. Adding to their woes is the fact that states such as Tamil Nadu, Uttar Pradesh, Andhra Pradesh, Rajasthan and Madhya Pradesh are moving to renegotiate power purchase agreements of both renewable and thermal units.
In the case of just renewable projects, at stake is over Rs 1.10 lakh crore lent by around 23 public sectors and seven private sector banks and six Non-Banking Financing Companies (NBFCs) that have cumulatively committed financing of green projects worth 30,984 MW capacity, as on March 31, 2016.
Alongside this, the collateral impact of the agri-bank loan waivers could play out in the coming quarters, which could see more stress emanating that could further strain the loan books of banks.
HDFC Bank Ltd, which has so far done well on the bad loans problem as compared to competitors, reported a sharp surge in the gross non-performing assets (NPAs) ratio during the June quarter to touch the highest in seven years on account of farm loan waivers announced by states.
The RBI has already red-flagged the disastrous potential impact of the spate of loan waivers. As per the directions of RBI on priority sector lending, a target of 18 per cent of adjusted net bank credit or credit equivalent of off-balance sheet exposure has been prescribed to all Scheduled Commercial Banks (excluding regional rural banks) for agriculture.
Apart from the agriculture loans, the scare on the auto loan front is growing amid rising defaults by those working with ride-hailing companies, such as Ola and Uber, prompting lenders to cut back on car loans and modify underwriting norms.
The economy regulator RBI has been trying since a long time to tackle this hazard. Following are the actions taken by RBI time to time to handle this big issue:
- The 5/25 refinancing of Infrastructure Scheme: This scheme offered a larger window for the revival of stressed assets in the infrastructure sectors and eight core industry sectors. Under this scheme, lenders were allowed to extend amortization periods to 25 years with interest rates adjusted every 5 years, so as to match the funding period with the long gestation and productive life of these projects.
- Private Asset Reconstruction Companies (ARCs): ARCs were introduced to India under the SARFAESI Act (2002), with the notion that as specialists in the task of resolving problem loans, they could relieve banks of this burden. However, ARCs have found it difficult to resolve the assets they have purchased, so they are only willing to purchase loans at low prices.
- Strategic Debt Restructuring (SDR): The RBI came up with the SDR scheme in June 2015 to provide an opportunity to banks to convert debt of companies (whose stressed assets were restructured but which could not finally fulfil the conditions attached to such restructuring) to 51 percent equity and sell them to the highest bidders, subject to authorization by existing shareholders. An 18-month period was envisaged for these transactions, during which the loans could be classified as performing. But as of end-December 2016, only two sales had materialized, in part because many firms remained financially unviable since only a small portion of their debt had been converted to equity.
- Asset Quality Review (AQR): Resolution of the problem of bad assets requires sound recognition of such assets. Therefore, the RBI emphasized AQR, to verify that banks were assessing loans in line with RBI loan classification rules. Any deviations from such rules were to be rectified by March 2016.
- Sustainable Structuring of Stressed Assets (S4A): Under this arrangement, introduced in June 2016, an independent agency hired by the banks will decide on how much of the stressed debt of a company is ‘sustainable’. The rest (‘unsustainable’) will be converted into equity and preference shares. Unlike the SDR arrangement, this involves no change in the ownership of the company.
- And the most recent is Insolvency and bankruptcy code (IBC). Under this code, the IBBI (Insolvency and Bankruptcy Board of India) has been established to deal with debt defaulter firms. When a firm default on its debt, control shifts from promoter/shareholder to a committee of creditors, who have 180 days to evaluate proposals from various players about resuscitating the company or taking it into liquidation. The most advantageous feature of this code is that it puts a time bound to solve a case. This code has four pillars;
- Pillar I – insolvency professionals regulated by insolvency professional agencies to handle the commercial aspects of insolvency resolution process.
- Pillar II – informational utilities which would store facts in the form of an electronic database so that any information related to the firm or individual can be obtained from a single place, hence avoiding unnecessary delay to gather the required facts.
- Pillar III – Adjudication of insolvency cases, for which two tribunals to be formed:
- Debt Recovery Tribunal (DRT) along with Debt Recovery Appellate Tribunal (DRAT), to deal with Individual insolvency cases
- National Company Law Tribunal (NCLT) along with its appellate tribunal (NCLAT) to hear firm insolvency cases.
- And the fourth pillar is IBBI itself, to keep a regulatory oversight over insolvency professionals, insolvency professional agencies and informational utilities.
To work with largest and most complex cases, a Public Asset Rehabilitation Agency (PARA) is proposed to be constructed, also known as ‘bad bank’ as it collects all the bad loans. It would purchase specified loans (for example, those belonging to large, over-indebted infrastructure and steel firms) from banks and then work them out, either by converting debt to equity and selling the stakes in auctions or by granting debt reduction, depending on professional assessments of the value-maximizing strategy.
Once the loans are off the books of the public sector banks, the government would recapitalise them, thereby restoring them to financial health and allowing them to shift their resources – financial and human – back toward the critical task of making new loans. Similarly, once the financial viability of the over-indebted enterprises is restored, they will be able to focus on their operations, rather than their finances. And they will finally be able to consider new investments.
Besides, revised PCA framework has been launched by RBI to tighten the jibes on defaulting companies and non performing banks (We will discuss PCA framework in some other article as this requires a lot of new concepts, so including it here will make this article very lengthy).
Still, RBI’s new policies are yet to show their effects. Hence we have to have patience and make these policies work to bring our economy back on track. Only time will tell..
- Economic survey of India pg 82 -104