Bank Frauds: A Chronic Malaise
It does not sound alarm bells any more when someone brings up the Non-Performing Assets (NPAs) problem plaguing our economy. The news of bad loans, willful defaulters, re-capitalization of banks has become a routine occurrence. One would think that this problem is fairly recent, starting a couple years back, with Raghuram Rajan, erstwhile Governor of the RBI, bringing in sweeping changes in the way banks disclose and recognize bad loans. However, that just brought the problem to the surface. What would surprise most people is how far back these issues actually go.
As far as written records serve us, financial institutions and frauds have always gone hand-in-hand. Be it Hegastratos, a 2nd century BC Greek scamster looking to commit insurance fraud, or the 2011 scam, involving executives of Bank of Maharashtra, Oriental Bank of Commerce and IDBI Bank who created fake bank accounts and forwarded loans worth Rs. 1500 crores to these accounts, the history of financial institutions is riddled with such instances of an amalgamation of genius and malice.
In this article we review the causative factors of the NPA crisis and the initiatives implemented to resolve the crisis. Further we discuss the challenges associated with these solutions.
The Dream Run and Its Aftermath
Prior to the global economic crisis, from 2003-2008, India enjoyed its “dream run”; a period of high economic growth averaging 9% per annum. During this period, many corporations worked on projects in capital intensive sectors, raising loans from financial institutions. Banks followed the adaptive expectation model and formulated lending policies accordingly; economic inertia was at play. They gave out loans indiscriminately, regardless of risk and return. However, after the economic downturn of 2008, many companies struggled with the loans, and quite a few had to shut down operations. Although the crisis contributed to the rising NPAs in the system, it was aggravated by the inexperience of commercial banks to deal with long term loans after they were thrust into the role due to the shutting down of development banks, dampened investor sentiment following the Coal and 2G scams as well as wilful defaulters refusing to honour loan agreements. In fact, a sizeable chunk of the NPAs is a result of wilful defaulters. Out of Rs. 10 trillion of NPA as on December 31st 2017, the wilful defaulters’ share is around Rs. 1.1 trillion; this is after Rs. 2.3 trillion had been written off since 2011.
Impact of NPA
Due to NPAs, a lot of precious capital was locked in stressed assets. Consequently, there was less money available for lending. Furthermore, in order to tackle the growing credit risk, the banks started charging higher interest rates. This discouraged borrowing by the MSME’s (Micro Small and Medium Enterprises) and also affected growth. The MSMEs were caught in a crossfire between the banks and the major defaulters. In addition to this, the practice of evergreening of loans made it difficult to evaluate the health of the banking sector and contributed to the prevalent problem of asymmetric information.
Raghuram Rajan, when he started as RBI governor, had focused on gradual reduction of inflation (WPI was upwards of 7% during his swearing in), coupled with steady growth as opposed to the uncertainty associated with the post crisis global economy. In working towards these goals, it was imperative to address the problem of NPAs. The RBI had knowledge of the practice of evergreening of the books and tackling this was of utmost importance. The RBI decided to conduct an Asset Quality Review (AQR) and identified accounts that were to be classified as NPAs. Power, steel, mining, road infrastructure and textile sectors were the biggest loan defaulters of state owned banks.
Even though the NPAs were identified, the resolution process was time consuming. A World Bank study showed that it took 4.3 years on average for the resolution of insolvency cases and the recovery rate was 26 cents to the dollar. The provisions of the Insolvency and Bankruptcy Code (IBC), which came into force in August 2016, helped to expedite the process. The IBC stipulates that the decision regarding insolvency or restructuring be taken by the Council of Creditors within 180 days of filing for bankruptcy; there is a provision for a one-time extension of 90 days. Insolvency and Bankruptcy Code allows the creditors, both operational and financial, to initiate the bankruptcy proceedings against the debtor. IBC contains a critical non-obstante clause in Section 238 which allows it to override other legal provisions which may be deemed as contrary to the IBC’s ruling. This is evident after the Supreme Court’s landmark judgment in Innoventive Industries Limited v ICICI Bank Limited case. The court ruled in favour of ICICI thus indicating that the IBC overrides state laws and gave other banks the reassurance to begin bankruptcy proceedings against their debtors.
Under the IBC, Resolution Professionals (RPs) are required to handle the affairs of the company during the resolution. The ability of the RP to perform this task effectively is one of the most important constraints of the new bankruptcy system. The RP, as mandated by the Code, must be either a Chartered Accountant, Cost Accountant or a lawyer with a minimum of 10 years’ experience. Managerial experience is not necessary, and this proves to be a problem for a company in financial distress, since they could benefit from management expertise. An in-depth knowledge of the industry as a whole, as well as of the niche issues that are characteristic of individual firms is absolutely necessary. The RP is encouraged to approach people with said expertise, but this recommendation is not binding.
Sashakt
Project Sashakt Plan/Project is the latest of many developments that have taken place in the Indian scenario to tackle the NPA problem. It mandates the creation of a high-powered committee, comprised of industry veterans, to take charge of an Asset Management Company (AMC) which would manage the distressed assets. The idea is to resolve the NPA problem through the market mechanism, with the AMC being the market maker and setting floor prices after conducting due diligence. However, many commentators see this Plan as a way for the banks to buy more time before referring their stressed assets to the NCLT for the insolvency procedure.
Sashakt could be seen as emerging out of the disagreements between the government (and its banks) and the RBI since late last year. In July 2017, the RBI nudged the PSBs to refer 25 large accounts, having exposure of over Rs. 2 lakh crores, to the NCLT. However, the push turned to a shove as the RBI, vide a circular dated February 12, 2018, directed the banks to proceed to the NCLT even if the borrower was late by a single day. This became a bone of contention between the banks and their regulator.
As NPA levels surged due to the RBI directive, the banks witnessed a sharp fall in profits during Q1 2018. To tackle the RBI’s move, the heads of three of the biggest PSBs, State Bank of India (Rajnish Kumar), Punjab National Bank (Sunil Mehta) and Bank of Baroda (P.S. Jayakumar) came together and proposed Project Sashakt.
The Project has different strategies to deal with stressed assets of different magnitudes. For loans under Rs. 50 crores, a resolution plan has to be arrived at within 90 days of detection of the stressed asset. For assets between Rs. 50 crores and Rs. 500 crores, the Project mandates the lead bank to take charge and formulate a resolution plan within 180 days. For assets over Rs. 500 crores, an AMC will be created. The AMC will conduct due diligence on stressed accounts, recommend a floor price and will raise money through an Alternate Investment Fund (AIF), which will ensure participation from foreign players and domestic private players. The AIF will furnish 15% of the value upfront in cash, and invite bids from other ARCs, AMCs and stressed asset funds. If any party pays more than the floor price, these extra funds will be used to repay the banks and to the AIF for its 15% share. In case no bids are received, the AMC will continue to hold the stressed asset. Private involvement in the entire process is integral to the functioning of Project Sashakt, with a minimum share of 50%.
Another issue the Project looks to address is the lack of a legal and regulated communication channel between the consortium of banks, with the number of members rising as high as 40. Too many participants make it difficult to coordinate and come up with a decision regarding the asset. The Project, as a corrective measure, charges the lead bank with the responsibility to come up with a resolution for the stressed asset. With Sashakt focusing on resolution rather than liquidation, it will work towards the turnaround of the stressed asset by managing the asset itself or engaging an external party.
One challenge identified with respect to the Plan is the investors’ willingness to employ their resources in the AIF. The AMC must deal with lack of financial depth and the pricing of assets currently plaguing the resolution process. Banks want to set a high price to recover as much debt as possible, but the ARC are aware of the financial health of these assets and want to maximize their return on investment. This duality of intent has prevented the market for bad loans from reaching an equilibrium. Thus, banks are left holding assets which are burning holes in their balance sheets. Furthermore, banks are touted to be one of the investors who will contribute to the AIF in the resolution of distressed assets. This is akin to a bank spending its own money to resolve the situation of a bad asset. This will just exacerbate the issue.
In the IBC, this gap has been bridged by companies with large appetite and deep pockets (read Tata and Vedanta). However, this is the exception, not the trend. Of the initial 12 companies put up for insolvency proceedings, the majority still languish in the coffers of the NCLT. A similar situation under Sashakt will serve no purpose at all, with the AMC continuing to hold the stressed assets with no resolution in sight. This could result in the company being referred to the IBC for insolvency proceedings, making the entire concept of the Sashakt Project redundant.
Until and unless the AIF can tap into the market and raise adequate funds, this entire process will end up being an exercise in futility. Failing this, the Sashakt Fund will exceedingly start looking like a bad bank, where all the bad loans are transferred to free up the books of the commercial banks. Bad loans, whether spread across the banking sector, or concentrated in one bad bank, are as bad as the other. It is not the location of these assets, but their resolution that matters.
In Conclusion
The IBC started operations as recently as August 2016. It needs to be modified to ensure greater compliance of the companies, and address issues which lead to deadline extensions due to poor infrastructure. In close to these two years, the IBC has produced two resolutions. The Code is still taking shape, it is still in its nascent stages. The resolution professionals and the corporates are just beginning to get a feel of the entire process.
IBC and Sashakt could be the key to handling the NPA crisis. Resolution professionals with managerial experience, coupled with better infrastructure for redressal could make the IBC an effective tool in tackling bank NPAs. The key to the success of Sashakt lies in the AMC’s ability to conduct successful sales of distressed assets to financially cushioned corporates. If this could be merged with the functioning of the IBC, the result would be the key to unlocking the full potential of these stressed assets and ensure a steady flow of capital to the economy, something which is necessary to register double-digit growth.