Bad debts - is India heading towards a banking crisis?

India, the world’s fastest growing large economy is facing a double whammy of ‘high and yet rising non-performing loans’, and ‘slowing demand for credit’ especially from private sector that is likely to affect investment, and has have the potential to derail India’s growth story going forward.

Bad debts or non-performing assets (NPAs) of the Indian banking sector rose to 9.1% in September from 7.6% in March 2016. The overall stressed assets that also include restructured loans rose to 12.3% in September 2016. The condition of state owned banks is worse which saw their stressed loans climbing up to 15.8%. And just 24 Indian companies account for two-third of dodgy debts. On the other hand, bank credit grew at a historically low rate of 5.1% – the lowest in decades.

A non-performing asset ceases to generate interest income to a bank. Besides, the bank also has to make provisions for the NPA. That blocks liquidity (and hence its ability and willingness to lend) and may lead to downgrading of its rating. Worse, the banks may be forced to write off bad debts.

Between 2013 and 2015, 29 state owned banks in the country wrote off 1.14 trillion rupees of bad debts. In 2016, State Bank of India, India’s largest state owned bank wrote off 70.1 billion rupees owed by 63 willful defaulters including Mr. Vijay Mallya.

Thus, the high and rising bad debts along with subdued credit demand will adversely affect the sales and profitability of Indian banks. To add to that investment as measured by gross fixed capital formation fell by 1.9%, 3.1% and 5.6% respectively in the last three quarters. Slowing credit demand means that decline in investment is likely to continue for some more time and if that happens, India may have to embrace lower economic growth going forward.

Genesis of the problem

Demand slowdown, and delay in regulatory approvals in particular environmental clearances for projects have led to cost overruns and lower profitability than initially estimated or projected. That ruined the financials of many large borrowers and led to a surge in non-performing assets of their bankers.

Just five sectors (infrastructure and realty, steel, textile, power and telecom) account for three-fifth of all the stressed loans. Strangely these are the sectors which are the most dependent upon government. Most of these sectors such as infrastructure and steel are still not out of woods and are likely to add to the bank NPAs.

That’s not all though. Banks themselves are responsible for many bad moves that might have turned many of their assets into liabilities. For instance, competition among banks to lure the big corporate borrowers which are prone to payment default but are easier to service in terms of time or cost and bring high bonuses for bank employees. The shares of large borrowers (with a loan size of Rs. 50 million and above) in both banks’ overall loan portfolio and bad loans have shot of to 56.5% and 88.4% respectively in Sept 2016.

Bank staffs often lack the necessary skills to assess complex projects for their technical and financial viability. That along with laxity in credit risk appraisals and loan monitoring often leads to sub-prime lending and add to the bad loans. Many a times, third party agencies - which are often relied upon by banks to assess projects or the values of collaterals - are influenced by unscrupulous borrowers to get more loans than they should get.

Though borrowers often blame economic slowdown for the failure to repay bank loans, underbidding for projects to outbid competitors, diversion of funds for non-sanctioned purposes and willful defaults on part of unscrupulous borrowers can explain the high rates of NPAs. 

The way forward

Demonetization did provide a temporary cushion in form of low-cost deposits to the banks troubled by bad loans. However, slowing demand for credit will neutralize most of the benefits of increase in the low cost bank deposits. Worse, banks may have to shell out 3 to 4% interest on those mostly short term deposits and yet can’t really use them for lending.

Given the magnitude of the bad debt problem, New Delhi has taken a series of measures to deal with bad debts. The most important measure is the enactment of Bankruptcy and Insolvency Code which is expected to ensure quicker resolution of the bad loans, and discourage diversion of funds and loan frauds.

Government, the major shareholder in state owned banks may consider recapitalization. However, recapitalization alone will not be enough. It’s at best, a short term measure to deal with the problem of liquidity crunch caused by the rising tide of non-performing assets. Yet it may not work when demand for new loans is not there. That calls for measures to address concerns on demand for goods and services that make businesses go slow on capacity expansions or ease of doing business that may keep the no. of entrepreneurs seeking bank loans low.

There’s a limit to how much the government can address the concerns on demand either in domestic or overseas market especially in the short term. Modi government is committed to improve India’s global ranking on ease of doing business, but it has not met with much success. Thus slowing credit demand is expected to persist for some more time.

Many experts have floated the idea of setting up a specialized bad bank which will take over all bad debts from banks and help clean up their balance sheets. That in turn will reduce their provisioning requirements and unblock capital thereof. But it has a major problem: given the size of India’s bad loans ($100 billion of public sector banks alone), acquiring them will require huge capital resources, financing of which will be challenging even for the government. That may explain government’s hesitation on the issue even though the idea is worth considering.

RBI has also devised measures to help banks deal with bad debt problem with less pain. It allows troubled banks to explore the option of Scheme for Sustainable Structuring of Stressed Assets or S4A. Under this, liabilities of a borrower company are bifurcated into sustainable and unsustainable debt, and the latter is converted into equity. The equity stake is then sold to a new owner who has the advantage of running the company with a lower and more manageable debt. This way banks can clean up a large portion of their loan books. However, this may involve taking a haircut (up to 50%) as market value of the unsustainable portion of stressed debt may be lower than its book value.

A somewhat similar scheme is the strategic debt restructuring (SDR) under which a lender bank converts its stressed debt into equity, acquire a majority stake and takes management control by dislodging the promoters. However, this has two limitations: even bigger haircut than S4A and inexperience of the Indian banks in running businesses. As a result, SDR has not taken off in the country.

Dealing effectively with bad debts also calls for internal actions by banks themselves. One measure could be to give more loans to small borrowers for reducing reliance on large borrowers which are more prone to repayment default. However, unless Indian banks become cost efficient, giving more loans to small borrowers will reduce their operating margins and in turn profitability. Yet banks need to swallow this bitter pill if they are serious about curbing NPAs.

Besides, it’s important to realize that unless the system of credit sanctioning and post-credit monitoring improves, the problem of bad loans will continue to persist. Loan should be given purely on commercial consideration. Government shouldn’t have any influence on who should get a bank loan, and it should let the assessment of loan proposals independently be done by banks on merit. Monitoring of lent money i.e. how the lent money is being spent must improve substantially to check diversion of funds that often turns a good loan into a bad one.

Moreover, RBI or government should disclose the names of willful defaulters to deter potential defaulters. RBI should also undertake to study and analyze which sectors are contributing to NPAs and if there are any systemic reasons for that and suggest what actions would help. That will help in effectively dealing with the growing menace of bad loans before they turn into a serious crisis.

Since next Indian Budget is expected on Wednesday, you may like to check my post: 5 simple tests to judge upcoming India Budget 2017

********************

Related readings

Banks yet to file cases against 1080 willful loan defaulters despite RBI's instruction

Please share your thoughts and ideas about how to deal with the growing menace of India's bad debt. You can also tweet your suggestions or comments tagging me @RiteshEconomist . If we're not connected, it's time to get to know each other. 

A modified version of this post catering to International readership has been published in Nikkei Asian Review from Nikkei-Financial Times Group: India must face up to bad debt menace