What I understood from ‘Note to Parliamentary Estimates Committee on Bank NPAs’ by Prof. Raghuram Rajan

Q 1: Why did NPA occur?

1. Over-optimism by banks in lending to higher leverage projects, without own due diligence (during 2006-08)

2. Global growth slowdown, which extended to India, thereby not meeting unrealistic demand projections.

3. Fear of investigation slowed down govt decision making, causing high cost overrun for stalled projects, making debt servicing difficult.

4. Deceptive Accounting - Additional loans provided to enable promoter to pay interest, to showcase the asset as 'performing'

5. Lack of due Diligence, outsourcing of analysis and corruption - further loans were made to well-connected promoters with history of default.

6. Fraud - System ineffective to bring high profile fraudster to book, fraud not discouraged. Banks are slow in reporting the fraud to avoid harassment by investigative agencies. No progress update on list of high-profile cases sent to PMO.

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Q 2: Why did RBI set up various schemes to restructure debt and how effective were they?

Reason for Setting Up-

1. Slow recovery (only 13%) under existing laws (DRT)

2. Growing Backlogs & delays in cases

3. Promoters started 'gaming' the inefficient loan recovery system by offering 'One Time Settlements' to banks, knowing banks could collect even secured loans only after years.

Steps by RBI:

1. Set up loan database (CRILC) for loans >5 Cr, which was shared with all banks. It allowed banks to identify early signs of distress in a borrower.

2. Joint Lender's Forum (JLF) - decides the approach for resolution, promoted quick action by banks

3. End of forbearance (Apr 2015) - Banks can't restructure loans without recognising them as NPA, except long term projects (roads) with T&C.

4. Strategic Debt Restructuring (SDR) scheme introduced with SEBI - Banks can displace weak promoters by converting debt to equity. Time-line provided for finding new promoters.

Q 3: Why recognise bad loans?

There are 2 approaches to 'loan stress':

1. Band-aids (Evergreening of loans)

2. Deep Surgery (Write down loans & fresh equity by promoter)

To do a deep surgery, it is important to recognise that bank has a problem, hence classify the asset as a Non-Performing Asset (NPA). Loan Classification reflects true value of loan, accompanied by provisioning i.e. buffer set aside to absorb losses.

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Q 4: Did RBI create NPAs?

Regulator can't substitute for banker's commercial decisions or micromanage them. It can at best warn about poor lending practices and demand adequate risk buffers. RBI nominees on bank Board have no commercial lending experience and can only try make sure that processes are followed.

The important duty of regulator is to force timely recognition and disclosure of NPAs which is done through RBI's regular supervision.

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Q 5: Why did RBI initiate the Asset Quality Review (AQR)?

Banks were not recognising bad loans, not following uniform procedures and not even making adequate provisions. They had also slowed credit growth.

Steps by RBI:

2015 - Ensure in bank inspection that every bank follows same norms on stressed loans

Dedicated team of supervisors to ensure AQR was fair and done without favour.

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Q 6: Did NPA recognition slow credit growth, and hence economic growth?

1. Public sector banks non-food credit growth was falling relative to credit growth from new private sector banks (Axis HDFC, ICICI & IndusInd)

2. Public Sector Banks slowed lending where they were seeing large NPAs (Agriculture, Micro & Small Enterprises) but not in sectors where NPAs were low. (Personal Loan, Housing)

3. Bank credit slowdown to industry dates from early 2014 suggesting that bank clean-up (which started in second half of 2015) was not the cause.

4. Private banks didn't suffer as much from such problems. Remedy was to clean the balance sheets of public sector banks.

Clean-up was a part of the solution, not the problem.

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Q 7: Why do NPAs continue mounting even after the AQR is over?

1. As NPAs age, they require more provisioning. Projects that have not been revived simply add to the stock of gross NPAs.

2. Risk averse bankers seeing arrests of their colleagues are not willing to take right downs and conclude restructuring without blessings of the court, which delays the process endlessly.

3. Before Bankruptcy Code, promoters were under no threat of losing their firms. Even now, some are playing the process, hoping to regain control through proxy bidder, at a much lower price.

4. Govt has dragged its feet on project revival - continuous problems in power sector are just one example. Recapitalisation is not likely to useful without governance reform.

5. Continuous and sometimes frivolous appeals slow down bankruptcy resolution. Promoters should have chance of concluding a deal before firm goes to auction, but not after.

We need concentrated attention by high level empowered and responsible group set up by government on cleaning up the banks.

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Q 8: What could the regulator have done better?

1. RBI should have raised more flags about quality of lending in early days of banking exuberance.

2. In hindsight, Forbearance was not a right decision at the time.

3. Bankruptcy Code & AQR should have been enacted and started earlier.

4. RBI should have been more decisive in enforcing penalties on non-compliant banks

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Q 9: How should we prevent recurrence?

1. Improve governance of Public Sector Banks and distance them from the government

- Govt decides board appointment with the inevitable politicization. PJ Naik Committee report to be followed more carefully.

- Prepare in advance for succession as date of retirement of CEOs is well known.

- Outside talent in top management of Public Sector Banks and rethinking of their compensation structures.

- Risk Management Process needs substantial improvement and cyber risk needs greater attention.

2. Improve process of project evaluation and monitoring to lower the risk of project NPAs

- More in-house expertise including demand projections, competition, promoter's expertise and reliability

- Real risks mitigation requires ensuring key permissions are in place and agreements made for key inputs and customers. Where risk can't be mitigated, they should be shared contractually between promoters and financiers.

- Flexible capital structure related to residual risks of the project, i.e. more equity, if the risk is high

- Financiers do a real-time monitoring of costs, so that suspicious transactions suggesting over-invoicing are quickly flagged.

- Incentive structure for bankers, a senior banker puts her name on proposal. Bankers be rewarded when the projects work out, based on performance records of loans recommended by individual banker.

3. Strengthen the recovery process further

- Both out of court restructuring process and bankruptcy process needs to be strengthened and made speedy.

4. Government should refrain from setting ambitious credit targets or waiving loans

- Targets are sometimes achieved by abandoning appropriate Due Diligence processes, creating environment for future NPAs

- Loan waivers stress budgets of waiving state/central government and eventually reduce flow of credit.

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Additional Points by the Author:

Several irregularities are pointed out by RBI during their inspections of banks, however these issues and recommendations stay buried only in the RBI Report and are not incorporated in the Financial Statements published by the banks. The banks should be mandated to provide a disclosure of the points put forth in the RBI Recommendation report and their response on each point. Further, where possible these changes should be incorporated in the Financials, thereby reflected a ‘true and fair view’.

A direct intervention of the government is urgently required in order to clean-up the banking mess. Banks being the backbone of the industry and commerce, let’s hope this action is taken on a priority basis.

Author Note:

Thanks to Sunil Singhania for sharing the Note in his post – What We Are Reading

The above article is my understanding and brief summary of what Prof. Raghuram Rajan has stated in his note. I found the original note to be an interesting read, and would recommend checking it out, if time permits.

You can read about Prof. Raghuram Rajan here