Non Performing Assets

• India is facing serious NPA problem .
• Indian Commercial Banks’ NPA reached  ₹12 lakh crores in 2018; and over 10% of total lending .  Although , NPAs are declining after achieving peak in 2019, but they are still very high.
• Majority of this NPA is in Public Sector Banks (Rs 10 lakh crore in 2018) and are on name of Big Business Houses leading to Twin Balance Sheet Problem .

Three Stages through which Indian economy passed

1. Till mid-2000s: Boom period in global economy. Indian Corporates were taking large amount of loans & became overleveraged in the process. 
2. From 2007-08: Due to Subprime Crisis, exports of Indian goods and services  declined. Along with that , due to UPA government’s policy paralysis , Supreme Court’s judicial activism and NGO’s environment activism ,  projects got delayed. Companies started to face difficulties in finishing projects & repaying loans.
3. By 2013: ~1/3rd of the bank loans were owned by “IC 1 companies” i.e. companies   not generating enough revenue even to repay the loan interest.

Thus, balance-sheets of (1) some Large Corporate Companies & (2) Public Sector Banks (PSB) became weak. It is called “Twin balance sheet syndrome (TBS)”

• Generally speaking , NPA is any asset of a bank which is not producing any income.
• On a bank’s balance sheet, loans made to customers are listed as assets. The biggest risk to a bank is when customers who take out loans stop making their payments, causing the value of the loan assets to decline.

Criteria of Deciding NPA

• Loans don’t go bad straightaway.  Customers are allowed certain grace period
  • Commercial Loans : More than 90 days overdue .
  • Agriculture Loans : More than 2 harvest seasons or 2 years whichever lesser .

Categories 

Net NPA

• Above is Gross NPA. Net NPA is obtained by taking into account Provisioning .
• Provisioning means banks are required to set aside some funds to cover the losses done by NPAs.

Net NPA  = Gross NPA – Provisioning

Stressed Assets

• Stressed Assets = NPA + Loans Written Off
• Banks generally write-off loans to reduce their taxable income & corporate tax & also to clean up their balance sheet. But Write-off doesn’t mean Loan Waiver. They still have right to recover their loans . 

NPA has reached to level of ₹12 lakh crore. Main reasons that situation has reached to such level are

• Global and domestic macro-economic instabilities in the recent decade :  Due to this, a slowdown was seen in the economy diluting the capability of the borrowers to service the loans.
• Cost Overruns :  Due to  Project Delays resulting from Policy Paralysis , Judicial Activism and Environmental activism (eg : latest IL&FS case), loan servicing capability of the borrowers was dented in a big way.
• Projects were not able to recover their costs due to Global Financial Crisis.
• Indiscriminate lending by banks during boom period without proper assessment of risks associated with projects .
• Wait & Watch Approach of Banks : Evergreening of loans (i.e. zombie lending or giving the loan to pay back old loan) by banks before the formation of Bankruptcy code .
• Priority Sector Lending turned NPA because they cater economically vulnerable section .
• Frauds and Wilful Defaulters : Like Nirav Modi and Mehul Choksi Scam .
• Instances of corruption in the banking institutions as was seen in Punjab National Bank’s Bombay Branch in Nirav Modi case .

Special Mention Account

• Loans become NPA after 90 days. If we can classify Assets which are approaching toward NPA but haven’t yet become NPA, we can tackle them.
• Hence, RBI came with new category known as Special Mention Accounts (SMA) between Standard Asset  and NPA 

3R Framework for Revitalising Stressed Assets

It consist of three processes – Rectification, Restructuring and Recovery

1 . Rectification

• 2015: RBI ordered the Banks to conduct Asset Quality Review (AQR) and start rectification of bad loans i.e. Bank doesn’t change  loan interest, tenure or terms, but asks client to rectify his irregularity in loan-repayment.  2015: RBI ordered the Banks to conduct Asset Quality Review (AQR) and start rectification of bad loans i.e. Bank doesn’t change  loan interest, tenure or terms, but asks client to rectify his irregularity in loan-repayment. 

2. Restructuring

• If Rectification doesn’t work (but client is not wilful defaulter) , second solution is Restructuring .
• In this , either bank can go for
  1. Change in tenure (eg change tenure from 10 to 15 years) or interest rate (reduce interest rate) so that they can service their loans
  2. Strategic Debt Restructuring (ie change debt into equity) : Bank’s debt  is converted to Equity (shares with voting rights) & bank sell this equity  to the highest bidder .But scheme remained unsuccessful as floating shares with voting rights require the approval of existing shareholders.
  3. 5/25 for Infra loans: RBI allowed Banks to extend loan tenure to 25 years, and even reduce loan interest rate for the client so that tenure of the loans matches the long gestation period in the sectors. But, such Interest rate was to be reviewed each 5 years .
  4. Scheme for Sustainable Structuring of Stressed Assets (S4A):  In this , only unsustainable portion of the Debt is converted to equity (Preferential Shares without voting rights) . No permission is required for floating such shares as it doesn’t affect the voting powers of existing shareholders and was more successful than Strategic Debt Restructuring. 
  5. JLF- Joint lenders forum : Consortium of the lenders, who had to work out aforementioned restructuring methods. But, this proved unsuccessful because PSB Officials did not vote positively due to the fear of Media & 4C  [Courts, CBI, CAG and CVC].

RBI stopped above schemes from 31 March 2018. Now banks can restructure loans only under the provisions of Insolvency and Bankruptcy Code (IBC) 2016.

3. Recovery

• If both Rectification and Restructuring don’t work, bank  liquidates defaulter’s assets under either of the following acts:
  1. SARFAESI Act 2002 OR
  2. Insolvency and Bankruptcy Code 2016

• Earlier, Banks weren’t able to recover their loans because clients used to obtain stay orders from ordinary courts . Hence, Narsimham Committee recommended formation of Debt Recovery Tribunal (DRT) . DRT was formed in 1993 , so that  ordinary courts couldn’t interfere in loan recovery cases  .
• To further empower Banks,  Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest(SARFAESI) Act was enacted in 2002 under which 
  1. Banks and Housing Finance Companies (NBFCs) can attach the mortgaged assets when loan is not repaid. They can also change the  board of directors in such companies, can auction such assets and can also sell such assets to Asset Reconstruction Companies (ARC).
  2. SARFAESI is not applicable on farm loans.
  3. If loan-defaulter wants to obtain a stay order against decision of Bank , he can’t go to ordinary courts. He will have to approach DRT.  Decision of DRT can be challenged in  Debt Recovery Appellate Tribunal (DRAT), but DRAT will require him to deposit minimum 50% of the loan dues (to discourage frivolous appeals) . Appeal against decision of DRAT can be made in High Court.

Limitations of SARFAESI Act

• DRTs & DRATs are understaffed. As a result, 1 lakh cases are pending (as of 2016).
• In some businesses, auction or liquidation may not yield the best return for the banks (e.g. hotel resort in remote area, where no other hoteliers are keen to invest). In such cases, if the loans were restructured, banks could salvage more value. But, SARFAESI act doesn’t facilitate arbitration .

To deal with such issues, Insolvency and Bankruptcy Code was enacted.

Dealt in Separate Article (Click here).

Now, just Insolvency and Bankruptcy Code will be used to settle all the cases involving NPAs. All other schemes have been scrapped.

• Till now, Officers of the Banks were not able to take decisions to resolve NPAs in fear of persecution by CVC, CBI,CAG etc.  because it require giving haircuts and restructuring loans .
• To solve these problems, Government first amended Banking Regulation Act.

• It has following provisions
  • Government can order RBI to initiate Insolvency & Bankruptcy proceedings against defaulters.
  • It empowers Central Bank to  identify specific stressed assets and also initiate Insolvency and Bankruptcy proceedings against them .
  • To address issue of fear of bank officials of persecution by CBI, CVC etc, their decisions will be ratified by Oversight Committees appointed by the RBI which will ensure that due process was followed to reach at particular decision.
  • There was also problem of non-compliance. Oversight Committee will ensure that everybody is compliant after decision has been taken.

• 2002: RBI Governor Bimal Jalan designed it.
• 2017: Urjit Patel toughened PCA norms further.

What exactly is PCA?

• PCA = Prompt Corrective Action
• In this system, Banks are categorized in category 1, 2 or 3 based on levels of NPA in that bank.  (Category 1= 6 to 9% NPA, Category 2 = 9 to 12 % NPA and Category 3 = more than 12% NPA)
• Then, accordingly, RBI will take corrective actions against weaker banks with high NPA like :
  1. Restricting raise in salaries of bank directors  .
  2. Stopping bank to give dividend  to its investors.
  3. Restricting  branch expansion .
  4. Restricting lending operations  of weak banks.
  5. Forcing merger and shutdown of  weak bank .
• If bank wants to come out of restrictions, it will have to reduce its NPA  .
• As of Dec-2018: 11 out of 21 Public Sector Banks were in PCA list creating great uproar.

This created Government vs RBI situation

• In those Banks, Government is the biggest shareholder => as a result ,Government was not getting back adequate Dividend .
• Government argues that this impacts the growth of nation as Banks in PCA can’t lend to MSMEs, Entrepreneurs etc . 

• If a company is blacklisted by Indian banks, it could apply for loans overseas, and those foreign bankers may not be aware of company’s history. So, there should be a global number for companies, and they must be forced to quote that number during every financial transaction.
• This is the concept behind legal entity identifier (LEI). It is a 20 digit alphanumeric code for the companies.
• After sub-prime crisis and global financial crisis (GFC), G20 and Financial Stability Board (FSB) came up with this idea of LEI.

RBI’s directives about LEI:

• Companies who have taken loans above Rs.1,000 crore from Indian banks have to obtain this number by 31/8/2018, then gradually smaller companies have to obtain LEI-number in a phase-wise manner.

• A Wilful Defaulter is one who
  • is financially capable to repay and yet does not do so OR
  • diverts the funds for purposes other than what the fund was availed for OR
  • has sold or disposed the property that was used as a security to obtain the loan.
• If an entity’s or individual’s name figures in the list of wilful defaulters, he is barred from availing any banking facility and access financial institutions for five years . The lenders can initiate the process of recovery with full vigour and can even initiate criminal proceedings, if required.

• The higher is the amount of non-performing assets (NPAs), the weaker will be the banking systems health. Nonperforming loans will imperil a bank’s health.
• There is  scarcity of funds in the Indian market . Hence, businesses cant get loans to expand .
• Provisioning amount increases – Despite having funds , they cant give loans because all money will be used in provisioning .
• Fall in value of shares of Banks: Return on Assets (ROA) of Indian banks has become lower than international norm of  1.5% . Hence, Investors are not willing to invest in shares of Banks .
• Total NPAs have touched figures close to the size of UP budget. Imagine if all the NPA was recovered, how well it can augur for the Indian economy.

1. Recover NPA

Simplest approach to cut down NPA  is to recover debt by

• Making Bad Bank/ PARA (explained below).
• Amending Bankruptcy Act to make it friendly for creditors to recover their money .

2. Using tools of Information Technology

Economic Survey (2020) has suggested to used AI and ML to fight the menace of NPAs. This can be used in following ways

1 . Using Artificial Intelligence and Machine Learning : AI can be used to monitor transactions of Wilful defaulters so that they can be stopped from transferring assets of company to other accounts before applying for insolvency .

2 . Geo-tagging the assets of company  (using GPS technology) so that defaulters cant pledge same assets to take different loans as well as to move assets from the property before undergoing bankruptcy.

3. Using Blockchain Technology to check the authenticity of data provided by the creditors .

4 . Tracking Social Media accounts and travel history of the defaulters using AI and ML to know about the real financial position of defaulter and prove  he is Wilful defaulter in court of law.

3. Make PSBN (using PSBN)

• Economic Survey (2020) has recommended to create Public Sector Bank Network (PSBN) .
• PSBN will act as  a Financial Technology Hub that will connect all the banks to single server containing data with all the Public Sector Banks from past 50 years, Financial data from Corporate Affair Ministry, SEBI , Income Tax Department etc.
• Mechanism for PSBN: Whenever customer approaches the Public Sector Bank for loan , Bank will transfer this information to PSBN. PSBN completes the KYC process and generates a credit profile of the customer. Based on this profile the PSB takes the decision on the amount and rate of loan to be given.

4. Employee Stock Option Plans (ESOPs)

• ESOP is a type of benefit plan wherein employees are given some shares of the company apart from regular salary (companies like Facebook, Google and many other startups already use ESOPs) .
• Existing salary-based compensation mechanism encourages employees to prefer safety and conservatism over risk-taking and innovation. But giving them some shares via ESOP may encourage risk-taking and possible change of mindset from that of an employee to that of an owner.

5. Conservatism

• Banks need to be more conservative in granting loans to sectors that have traditionally found to be contributors in NPAs. Infrastructure sector is one such example. 

6. Deregulate economy

• Government should promote Corporate Bond market so that Corporate houses and entrepreneurs can directly raise debt from the market instead of approaching the banks.

7. Merger and Privatization

• Government should recapitalise only profit making banks while loss making PSBs with high levels of NPAs should either be merged with some anchor bank (United Bank having 24% NPA merged with Punjab National Bank) or privatised (like IDBI bank having NPA of 28%)

Once the Twin Balance Sheet problem is resolved, there could be significant moral hazards . Newly cleaned up balance sheets may simply encourage bank managers to lend freely, ignoring the lessons of the past. Structural reform aimed at preventing this can take many forms but serious consideration must also be given to the issue of government majority ownership in the public sector banks. This leads to Governance Reforms in Banking sector .

This came to scene as issue of Bank failures became a reality due to large NPAs . There are some issues in DICGCI which needs to be corrected .

DICGCI

• Deposit Insurance & Credit Guarantee Corporation of India.
• It is a 100% RBI owned company.
• All Banks have to buy insurance from DICGCI on their deposit . Max 5 lakh (changed in Budget 2020 – earlier it was Rs 1 lakh) of each depositor is insured in case of Bank shutdown .

Problem

• If a customer had deposited more than ₹5 lakh  in a single commercial  bank, then he gets only ₹5 lakh from DICGCI.  For remaining amount he must wait till RBI liquidates the bank.
• DICGCI doesn’t cover NBFCs.  Eg : UTI Mutual Fund Case of 2002 .

• Former Chief Economic Advisor (CEA) Arvind Surbamanian in Economic Survey 2016-17 had proposed a bad bank named “Public Sector Asset Rehabilitation Agency” .
• To solve NPA problem, PARA/ Bad Bank will buy bad loans (loans which have turned NPA) from PSBs and try to salvage the maximum value from loan by either restructuring loan OR  liquidation , auctioning or changing ownership of the company and absorbing the losses. 
• Arvind suggested RBI to give additional dividend to Government to start this bad bank & finance its losses. 

Why Bad Bank can be good idea ?

1. This approach has been successfully used by East Asian Economies to solve the mess created during South Asian Currency Crisis of mid 1990s  (successful example).
2. Decentralised Decision making isn’t working because there are coordination problems, since large debtors have many creditors. Bad Bank can solve this issue.
3. Stressed debt is heavily concentrated in large companies. Such big debts can be solved by professional organisation like PARA or Bad Bank.
4. ARCs (Asset Reconstruction Companies) haven’t proved any more successful than banks in resolving bad debts. But international experience shows that a professionally run central agency with government backing can provide the solution in this regard.

Use in mains?  in recommendations to solve NPA , can give this as one recommendation