The Impending Post-Covid Bad Loan Crisis

With the latest Indian Express Report quoting anonymous Senior Private Sector Bankers stating that the present year's NPAs could go as high as 13-15% this year, from a nominal 8% in 2020, and the RBI FSR Report for Jan 2021 also quoting similar figures, it seems all but likely that the Banking Sector, particularly the Scheduled Commercial Banks are set for rough times ahead.

Let us first have a look at the various banking terminologies involved, the respite available to the investors, and how the Government can help mitigate the impending crisis.

NPA:

A non-performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days.

Banks are required to classify NPAs further into Substandard, Doubtful, and Loss assets.

1. Substandard assets:?Assets which has remained NPA for a period less than or equal to 12 months.
2. Doubtful assets:?An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
3. Loss assets:?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.”

GNPA: GNPA stands for gross non-performing assets. GNPA is an absolute amount. It tells you the total value of gross non-performing assets for the bank in a particular quarter or financial year as the case may be.

CAR:

The capital adequacy ratio (CAR) is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures. The capital adequacy ratio, also known as the capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured:?tier-1 capital, which can absorb losses without a bank being required to cease trading, and?tier-2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets.?

CAR= (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets

        

MFI:

Microfinance institutions (MFIs) are financial companies that provide small loans to people who do not have any access to banking facilities. In India, all loans that are below Rs.1 lakh can be considered microloans.

NBFC:

Nonbank financial companies (NBFCs), also known as nonbank financial institutions (NBFIs) are?financial institutions?that offer various banking services but do not have a banking license

AUM:

Assets under management (AUM) is the total?market value?of the investments that a person or entity manages on behalf of clients. Assets under management definitions and formulas vary by company.

SARFAESI Act:

The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest?Act,?2002?(also known as the?SARFAESI Act) is an Indian?law. It allows banks and other financial institutions to auction residential or commercial properties (of Defaulter) to recover loans.

IBC:

As a continuation of the SARFAESI Act, Insolvency and Bankruptcy Code (IBC) 2016, is a one-stop solution for resolving insolvencies, which previously was a long process that did not offer an economically viable arrangement. The code aims to protect the interests of small investors and make the process of doing business less cumbersome. The IBC has 255 sections and 11 Schedules.

AMC:

An asset management company (AMC) invests pooled funds from clients into a variety of securities and assets. AMCs span a wide range in terms of their size and operations, from personal money managers that handle high-net-worth (HNW) individual accounts and have a few hundred million dollars in AUM, to giant investment companies that offer ETFs and mutual funds and have trillions in AUM.

SR:

Security Receipt means a receipt or other security, issued by an ARC to any Qualified Buyers (QBs) pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title, or interest in the financial asset involved in securitization.

QB:

“Qualified buyer” means a financial institution, insurance company, bank, state financial corporation, state industrial development corporation, trustee or another asset reconstruction company that has been granted a certificate of registration under the?SARFAESI?Act, 2002

Now that we have a basic understanding of the terminologies involved, let us discuss what the RBI FSI 2021 report has to say about the status of SCBs.

As per the report, several steps have been taken on the domestic front for easing the financial burdens. A brief summary that I have collated are as follows

Repo Rate?– RBI announced that it?was cutting the repo rate by 75 bps, or 0.75% to 4.4. The Repo Rate was earlier 5.15; last being cut in October 2019.

Reverse Repo?– The regulator also announced that it would cut the Reverse Repo rate by 90 bps, or 0.90%. On a daily average,?banks?had been parking Rs 3 lakh crore with the RBI. The current reverse repo rate was 4%.

Loan Moratorium?– In a massive relief for the middle class, the?RBI Governor also announced that lenders could give a moratorium of 3 months on term loans, outstanding as of 1 March 2020. This is applicable to All Commercial Banks including Regional, Rural, Small Finance, Co-Op banks,?All India Financial Institutions?and NBFCs including Housing Finance and Microfinance.

CRR?– The RBI also announced that the Cash Reserve Ratio (CRR) would be reduced by 100 bps, or 1%, to 3%. This would be applicable from March 28 and would inject Rs. 1,37,000 crore.

LTRO?– The RBI will also undertake Long Term Repo Operations (LTRO); allowing further liquidity with the banks. The banks however are specified that this liquidity will be deployed in commercial papers, investment-grade corporate bonds, and non-convertible debentures.

Ease of Working Capital financing?– Lenders were allowed lending to recalculate drawing power by reducing margins and/or by reassessing the working capital cycle for the borrowers. The RBI also specified that such a move would not result in an asset classification downgrade.

Working Capital Interest?– A Three-month interest moratorium shall also be permitted to all lending institutions.

Deferment of NSFR- The?Net Stable Funding Ratio?(NSFR), which reduces funding risk by requiring banks to fund their activities with sufficiently stable sources of funding was postponed to October 1, 2020. The NSFR was earlier supposed to be implemented by April 1, 2020.

MSF?– Marginal Standing Facility (MSF) has also been increased to 3% of SLR, available till June 30, 2020. “This measure should provide comfort to the banking system by allowing it to avail an additional ` 1,37,000 crore of liquidity under the LAF window in times of stress at the reduced,” said the RBI.

Fresh Liquidity?– The impact of all the announcements today shall inject almost 3.2% of GDP, the Governor said in his brief today. The RBI also added that since February 2020 it had injected Rs 2.8 lakh crore of liquidity, equivalent to 1.4 percent of GDP.

Bank credit growth (Y-o-Y), which had declined to 5.7 percent in 2019-20, remains sluggish; on the other hand, deposit growth has remained robust in the double digits, reflecting precautionary saving in the face of high uncertainty.?

Return on assets (RoA) and return on equity (RoE) for SCBs have improved across all bank groups and capital to risk-weighted assets ratios (CRARs) improved by 110 bps over March 2020 levels to 15.8 percent in September 2020. Gross non-performing assets (GNPA) and net NPA (NNPA) ratios, which were edging down from September 2019 levels, fell further to 7.5 percent and 2.1 percent, respectively, by September 2020.

However the major points of concern get highlighted below in the report, wherein,

Macro-stress tests for credit risk show that SCBs’ GNPA ratio may increase from 7.5 percent in September 2020 to 13.5 percent by September 2021 under the baseline scenario. If the macroeconomic environment deteriorates, the ratio may escalate to 14.8 percent under the severe stress scenario. These projections are indicative of the possible economic impairment latent in banks’ portfolios.

A sector-wise analysis for credit highlights how the different sectors have been impacted in the pandemic.

Industries have high capital and running costs, and the financial leverage has been impacted the most in this sector compared to other sectors. A closer analysis of the sub-industries reveals their GNPAs as follows.

Given the high GNPAs, it was no wonder when the Realty Sector got the worst hit from the pandemic.

However given the relaxations offered by the RBI in the past year, there is a high probability of many of these NPAs not returning any meaningful value to the Banks. The banking industry was already hit with poor returns on their credits since FY 2016. The present situation will only serve to worsen an impending crisis.

It was in this context that the IBA had made a proposal for the creation of a bad bank for swift resolution of non-performing assets (NPAs). The government accepted the proposal and decided to go for the asset reconstruction company (ARC) and asset management company (AMC) model for this. The IBA was appointed nodal agency to constitute the Asset Reconstruction and Asset Management Companies designated as NARCL and India Debt Management Company Ltd (IDMCL) respectively.

Already, the IBA has formed a core committee headed by its chairman (Union Bank of India?managing director Rajkiran Rai) for setting up NARCL and the Indian Asset Management Company. The committee also comprises IBA chief executive Sunil Mehta,?State Bank of India?MD J Swaminathan,?IDBI Bank?MD and CEO Rakesh Sharma and?ICICI Bank?executive director Sandeep Batra.

ARCs are not a new phenomenon, in fact after the passing of the establishment of the Asset Reconstruction Company India Ltd (ARCIL) in 2003, the RBI said. have been constituted to take care of Bad Loans, however, the trouble has been in securing appropriate funding and recovery mechanisms. While the Centre has announced an asset reconstruction (ARC) and asset management company backed by a government guarantee to address the problem of NPAs with public sector banks, the existing ARC industry has registered a lackluster performance so far. Of the total AUM, about 62 percent and 76 percent were held by the top-three and top-five ARCs in March 2020, respectively.

It’s already beginning to show. Late last month, Suryoday Small Finance Bank (SFB) posted an 89% decline in its net profit to about ?12 crores for FY 2020-21, said a PTI report

Public sector Punjab National Bank (PNB) recently identified “major challenges” arising from “eroding cash flows and extended working capital cycles”

NBFC Bajaj Finance expects higher levels of NPAs in the first and second quarters of this fiscal — caused by the local lockdowns across the country — to impact asset quality. “The second wave has caused a marginal increase in EMI bounce rates in Q1 FY22 over Q4 FY21.

However, with the recent passing of the CIRP in the IBC, there finally seems to be good news for the sector with good recoveries made on some of the assets involved. The IBC process has changed the debtor-creditor relationship. A number of major cases have been resolved in two years, while some others are in advanced stages of resolution. It provides for a time-bound process to resolve insolvency. When a default in repayment occurs, creditors gain control over the debtor’s assets and must make decisions to resolve insolvency. Under IBC, debtor, and creditor both can start 'recovery' proceedings against each other.

?Companies have to complete the entire insolvency exercise within 180 days under IBC. The deadline may be extended if the creditors do not raise objections on the extension. For smaller companies, including startups with an annual turnover of Rs 1 crore, the whole exercise of insolvency must be completed in 90 days and the deadline can be extended by 45 days. If debt resolution doesn't happen the company goes for liquidation. A case in point is the recent deal for Piramal Group to take over Dewan Housing Finance Ltd (DHFL). While it will save DHFL from extinction, the CIRP is going to result in a 65% haircut for the lenders, which means they will recoup just a third of what they had lent the housing finance firm.

It has been revealed that in fiscal 2020-21, Indian banks altogether wrote off about ?1.53 lakh-crore of debt to pare down their own non-performing asset (NPA) levels.

During 2019-20, asset sales by banks to ARCs declined, which could probably be due to banks opting for other resolution channels such as IBC and SARFAESI. The acquisition cost of ARCs as a proportion to the book value of assets declined, suggesting a lower realizable value of the assets.

According to an?Indian Express?report, several large banks, non-banking finance companies (NBFCs), and microfinance institutions (MFIs) are set to see a substantial increase in NPAs due to disruptions caused by the second wave of COVID.

In the light of all these constraints, the National Asset Reconstruction Company will benefit from larger pools of funding available from the SCBs, apart from the SRs that will be backed by the government.

Canara Bank has been invited to be the lead lender for this bank with a 12% stake. The Initial phase of the NARC will have ? 80,000 Crore to be transferred in the initial phase. The IBA is to be appointed nodal agency to constitute the Asset Reconstruction and Asset Management Companies designated as NARCL and India Debt Management Company Ltd (IDMCL) respectively.

Some eight years ago, the RBI had revised the 5:95 structure of sale of assets by banks to ARCs to 15:85 structure. This meant the ARCs' investment limit in security receipt was hiked to 15 percent as against 5 percent earlier.?The plan seems to be to provide immediate cash returns to the banks for the NPA to the tune of 15% with the remaining 85% provided as Government-backed Security Receipts (SRs) that will have to be paid back within 5 years to the investors.

The Pros and Cons of such a move could be

NARCL will need to make a decision as to the route to be taken for recovery from the bad loan. Some potential routes could be:?

1. Initiating corporate insolvency process on the Company
2. Engaging an investment banker to pursue mergers and acquisitions transactions for the said asset.
3. Undertake a compromise or settlement u/s 230 of Companies Act.

Besides the above processes defined, a second concern has been that each of the loans has to be above 500 Crores to become eligible for this process. Banks that have classified a Loan as a Fraud are not eligible to partake in this process. Those undergoing the liquidation process are also not under its ambit.

Conclusion:

As per the World Bank and the Financial Stability Institute, the AMC experiments — including the ones discussed earlier — that succeeded in fulfilling their original mandate had: a narrow mandate (such as resolving NPAs) with clearly defined goals; a sunset clause defining their lifespan; supportive legal infrastructure involving bankruptcy and private property laws; backing of a strong political will to recognize problem loans; a commercial focus of the AMC including governance, transparency, and disclosure requirements, the RBI said. India will also have to be mindful of the ARC experiment and its success and failures abroad. For example, there have been reports about the Chinese NARC,?China Huarong Asset Management Co. suffering from a bad liability to equity ratio owing to the slowdowns in the pandemic. Hence the RBI and the Government will need to carefully monitor the NPA recovery process and ensure adequate safeguards are implemented.

-BasuDeo Dubey