Bad loans

Breaking the banks

Print edition : March 16, 2018

.Punjab National Bank’s South Mumbai branch at Brady House in Mumbai. Photo: Shashank Parade /PTI

The government, which has done little to stem the mounting losses arising from bad loans, is now offering a disingenuous solution: sell the banks. Sections of Indian industry that have defaulted heavily on public sector bank loans are now demanding that the banks be privatised.

THE bad loan problem of Indian banks could have been resolved fairly easily. That this was not done was a deliberate policy choice. Now, it is evident that non-performing assets (NPAs) are a mere excuse to privatise public sector banks (PSBs). India’s banking system is facing a crisis of NPAs. At least that is what Prime Minister Narendra Modi conveyed in Parliament recently. He may have got his figures wrong, mistaking gross credit for NPAs. But, according to the Reserve Bank of India (RBI), public sector banks’ total NPAs amounted to Rs.6.5 lakh crore, or 12.5 per cent of their gross advances of Rs.52 lakh crore, at the end of the financial year (March 2017).

Under current accounting norms, a loan becomes an NPA when the debt service (interest + principal) falls overdue beyond 90 days. The financial stability report that was released in December 2017 projected an even more alarming picture, pegging the NPA numbers at Rs.7.2 lakh crore.

The NPA definition for India is modelled on the basis of the proposals of the Switzerland-based Bank for International Settlement (BIS), commonly referred to as Basel recommendations. The Basel norms are, in turn, influenced by Western banking practices where the component of unsecured loans (credit cards, retail loans and student loans) is much bigger than in countries such as India.

It is the exact reverse in India. Loans here, at least most of them, are fully secured. The current lending norms for the banking sector prescribe a physical asset cover ratio of 150 per cent. That means for every Rs.100 lent, the value of the pledged asset needs to be Rs.150. In addition, there is also the provision that along with the asset cover, borrowers are to bring in margin funds, which is why no bank lends 100 per cent of the cost of a project. Besides, loan covenants signed by borrowers provide for lenders to take control of the mortgaged assets in the event of default.

Even in situations where the underlying asset’s value is lower than that estimated by the bank, banks have the option of seeking additional collateralisation or even corporate guarantees. The guarantees sought are seldom unfunded, implying that the guarantees need to be backed by cash deposits made by the guarantors.

Moreover, banks also have internal guidelines that prescribe sector-specific exposure limits to industries and limits for specific corporate groups. In addition, there are cross-default agreements, where a default on loan repayment to one bank is deemed to be a default on repayment to all lenders. These regulatory guidelines are not just strictly observed, but public sector banks are sometimes overzealous in the matter of compliance. This is evident from the fact that banks insist on compliance with credit conditions even in the case of State government-owned entities. In addition to physical asset cover, such entities are expected to provide guarantees from their respective State governments. For instance, term loans to the power generator Karnataka Power Corporation by public sector banks are backed by State government guarantees. These guarantees are fully secured further through the creation of sinking funds in the State budgets.

With such fail-safe measures in place, bad loan occurrences are largely deliberate and only to an extent driven by force majeure events. In the case of Kingfisher Aviation in 2011, the inability of the banking system to enforce loan covenants was deliberate. Instead, the aviation company floated by the liquor baron Vijay Mallya, was given a liberal reprieve. Banks, including State Bank of India (SBI), capitalised on Kingfisher debts amounting to Rs.648 crore in 2011 by converting them into equity at a price of Rs.65 a share. Significantly, Kingfisher, at that time, was actually incurring large-scale losses. This made the conversion price—of debt into equity—extremely suspect. Yet, even after that when the debt service again became overdue, and international lessors repossessed aircraft, banks once again failed to enforce the loan covenants. It was only much later, after the banks were saddled with a Rs.9,000-crore lemon, that the scramble for recovery began through legal recourse. Under the provisions of Chapter III of the Securitisation and Reconstruction of Financial Assets Act (Section 4), lenders have the right to assume ownership of mortgaged assets. The critical question is, why were these provisions not exercised when the statutes provided for execution of loan covenants? It is also to be noted that the RBI, by classifying the airline industry as being part of the infrastructure sector in 2011, actually paved the way for further lending which proved disastrous for banks’ health.

Although the mechanisms in place appear fail-safe, borrowers have applied disingenuous methods to subvert the loan covenants and escape the statutes. In the case of the media group Deccan Chronicle, which also failed to repay banks, its fixed assets were pledged with multiple lenders. Multiple mortgages left bankers fighting legal battles among themselves to enforce the loan covenants. The total dues to the banking system from the media group are over Rs.6,000 crore. Each of these lenders sought first charge on the assets for enforcing lenders’ legal obligations. In both Kingfisher and Deccan Chronicle situations, what was significant was the role of some of the leading private sector banks. They broke ranks with other banks (read PSBs) in the lending consortium by delaying legal action against the delinquent borrowers.

It was only in July 2017 that the National Company Law Tribunal appointed an insolvency resolution professional under Section 7 of the Insolvency and Bankruptcy Code, five years after the mess erupted. Section 7 of the code allows creditors to initiate insolvency proceedings against borrowers, including liquidation of assets for the recovery of dues. Enforcement of the code allowed banks to recover dues, mitigating or even recovering capital losses. This case made it amply clear that it was not the inadequacies in the statutes but the lack of moral wherewithal to enforce the legal provisions that were available that forced the banks to suffer losses. But there are other sectors where NPAs are in the incipient stage. Some were beyond the control of lenders but reflected a failure of lenders to undertake due diligence. These include sectors such as telecommunications, real estate, highways, ports, power and airports. Telecommunications remains a problem area. The Anil Ambani-owned Reliance Communications (RCom) defaulted on payments amounting to Rs.7,500 crore to China Development Bank (CDB) in November 2017, which were mostly dollar-denominated. The group had refinanced rupee borrowings with CDB-funded foreign currency bonds in 2011 to take advantage of low global interest rates but failed to foresee the drop in tariffs and exchange rate depreciation.

RCom currently has a debt of Rs.45,000 crore. Another telecom company, Aircel, has also caused grief to banks. Aircel was originally promoted by Sivasankaran but later sold to the Malaysian telecom company Maxis. The Malaysian company has declared bankruptcy but Indian banks’ exposure to Aircel is Rs.15,500 crore. However, in both these high-profile telecom cases, domestic loans are backed by asset covers and corporate guarantees. Given the past conduct of lenders, it is too much to expect that they will enforce the loan covenants on these powerful oligarchs. Domestic banks exposure to the telecom sector, however, is less than 2 per cent of the gross credit. In reality, the major exposures are by foreign lenders that in the past took out rupee borrowings from Indian banks as in the case of RCom.

As for the transport infrastructure sector, banks’ credit risk appears even higher. This is because the lenders security is only the project cash flows from vehicle movements, air traffic flows or movements of ships/cargo. The only option, therefore, for the banking sector in the event of loan delinquency is to enforce loan covenants of capitalising the debt and extinguishing promoter equity. Lenders’ exposure is barely 3.5 per cent of gross credit. So far, few of the covenants have been enforced, though legally banks have the option to do so. However, there is the involvement of the National Highways Authority of India, the Airports Authority of India and the Port Trusts which provide implicit support to lenders. The risk in these cases comes from elsewhere: the lenient policy framework that in the name of promoting opaque public-private partnerships actually encourages cost-padding. This, in turn, renders them unviable for end users, which undermines the very viability of the project in the medium to long term.

In the power sector, however, the risks are lower. Lenders already have a first charge on payments from the state-owned distribution companies. Consequently, the credit risks are effectively on the state-owned entities that make payments for power purchases, unless the distribution companies default on payments. That has allowed banks to keep the lending exposure levels at a high of 10.22 per cent. But the high figure is also largely because of credits to public sector entities such as the National Thermal Power Corporation and the National Hydropower Corporation.

In the case of the realty sector, banks have a charge on the underlying fixed assets. But unlike other sectors, the risk in real estate stems from the value of the underlying assets. Loans in the sector are advanced on the basis of the value of the assets. In the event of asset values dropping, lenders face capital losses even if they repossess the assets. This is the real NPA sector where even recovery as a last resort does not eliminate the risk of losses arising from defaults by borrowers. In some cities this has already started occurring, as evident from Unitech’s inability to refund dues to home buyers in the National Capital Territory of Delhi. The risk of asset depreciation is even more severe in automotive loans, which most banks have been trying to push. In automobile loans, asset value translates into capital losses for lenders in the event of default. The reason is that despite repossession and resale, banks are unlikely to realise the full value of the loan, particularly in high-value automobiles. The rapid depreciation of automobile assets also adds to the risk for lenders.

The bailout charade

Instead of urging banks to enforce the available legal covenants in order to recover dues from borrowers, the government has embarked on a recapitalisation programme. In October 2017, Finance Minister Arun Jaitley announced a recapitalisation package of Rs.2.11 lakh crore, of which, Rs.1.35 lakh crore would be provided by the government in the form of recapitalisation bonds and the remaining would have to be raised through other sources, including capital from financial markets. The recapitalisation exercise is not fiscally neutral, but it also did not involve a cash outflow from the exchequer.

The portrayal of this entire exercise as a “bailout” is utterly farcical. The reality is that “bailouts”, as practised in India, are actually “bail-ins”. Bailouts generally refer to an external infusion of funds through equity or long-term/preference/perpetual bonds by a government agency or through another corporate entity. A bail-in, on the other hand, is an internal infusion, by conversion of bank borrowings (existing bank bonds or subordinated debts) and deposits into equity. The bailout definition as applied in India is questionable because banks already maintain a statutory liquidity ratio (SLR). The SLR mandates that 19.5 per cent of bank deposits need to be parked in government securities. That would mean that at least Rs.20 lakh crore is taken out of the banking system by way of government borrowings. Jaitley’s bank capitalisation is in fact a small component of the SLR that returns as capital to banks. In effect, it is nothing but the circular flow of depositor funds.

Interestingly, those who swear by the logic of the market but cite the high NPAs of public sector banks as a mark of their inefficiency ignore the fundamental ironies. If indeed interest rates reflect the price of credit, then the sharp increase in NPAs in the last few years ought to have taken interest rates even higher. But the RBI’s policy rates, as reflected by the repurchase rate—an overnight cash support window for banks—is at 6 per cent now, down from 7.75 per cent in 2015. It is only logical to expect that lending rates or the cost of credit should have increased under the heft of the bad loans. After all, is that not the way bond markets react—yields rising in response to a suspected fiscal slippage? International credit markets have also reacted the same way in the event of sovereign defaults by countries in South America, West Asia and East Asia. Yet, in the Indian credit markets, lending rates have not increased but have moved in the reverse direction. SBI’s benchmark prime lending rate was 14.45 per cent in 2013 when the NPA ratio was 3.8 per cent. But when the NPA ratio is now in double digits, the lending rates are down to 13.4 per cent! While there is an element of scaremongering about NPAs, it is also true that the exaggeration of the NPA problem has made public sector banks credit-shy. Public sector banks’ credit growth in 2017 was just a little over 1 per cent, down from 13 per cent in the final year of the United Progressive Alliance government.

That is not all. If more bailout (bail-ins, actually) were required to support NPAs, more SLR funds would need to be provided for bank capitalisation. This is because the SLR has been a key instrument in providing capital to public sector banks. Yet, in reality, the RBI has actually been reducing the SLR over a period of time, which could choke capital availability to public sector banks and drive them to seek capital from the private sector. Even a novice would understand what “seeking capital” from the private sector means: selling a stake in the bank. Simply stated, this means privatisation. After all, the present public sector banks with the exception of SBI were once mostly privately owned by the Tata group, the Birlas and even the extended family of former Finance Minister P. Chidambaram. Repeated utterances by the government give away the nature of the agenda. Chidambaram as Finance Minister had conveyed that the government intended to bring down its stake in the banking sector to 33 per cent. The National Democratic Alliance, it appears, prepares to proceed hastily along that path.

So, why are NPAs such a big deal? Is it that the real agenda lies elsewhere, in the self-serving agenda of privatising public sector banks? Is it not ironic that sections of the government—its Chief Economic Adviser, for instance—have advocated privatisation in the wake of the PNB scandal? In effect, the government, the very owner of these banks, which has been proved to have been sleeping at the wheel in the latest bank fiasco and which has done little to stem the mounting losses arising from bad loans, is now providing the disingenuous solution: sell the banks. The chorus has got louder from industry lobbies such as Assocham. There is much irony in this. Sections of Indian industry that have defaulted heavily to the publicly owned banks are now calling these banks inefficient, slothful and inept and demanding that they be privatised. The sheer duplicity of this approach is staggering. That the government and industry are speaking the same language says much about the times we live in.

C. Shiv Kumar is a Nilgiris-based journalist.