:

Neither a borrower nor a lender be| -

() (Rs.6 lakh crore as on 2016)
8% ,
|

|

NPA and Its Effects

Essentially, NPAs are loans and advances given by banks, on which the borrower
has ceased to pay interest and principal repayments. The advances given by banks
are called assets, which generate income via interests and instalments. If the
instalment is not paid until the due date, it is called a bad loan. If it extends beyond
90 days, it is termed NPA. The ratio of NPAs to total advances given by a bank is a
commonly used indicator reflecting the health of the banking system.

, ,

,
, 90
, |

As of June 2016, the total amount of Gross Non-Performing Assets (NPAs) for
public and private sector banks is around Rs. 6 lakh crore. Nearly 80% of the NPAs
are concentrated with Public Sector Banks (PSBs). 13 PSBs own 40% of the severely
stressed loans. The amount of top twenty Non Performing Assets (NPA) accounts of
Public Sector Banks stands at Rs. 1.54 lakh crores Indias NPAs are higher as
compared to other emerging markets.

2016 , .
6 80%
() 13 40%
 | .
1.54 |

If bank data is looked more closely, Indian Overseas Bank fares worst, having the
highest ratio of NPA to total advances 20.26 per cent. UCO Bank (18.66 per cent)
and Bank of India (16.01 per cent) follow. In absolute terms, State Bank of India has
the highest value of Gross NPA around Rs. 93,000 crores. Punjab National Bank
(Rs. 55,000 crores) and Bank of India (Rs. 44,000 crores) come next. Table 1
represents top 10 banks in terms NPA ratio and table 2 represent top 10 banks in
terms of Gross NPA of all the public and private sector banks. Clearly public sector
banks are leading the pack in both the tables highlighting the fact that problem of
NPA has more severely affected the PSB as compare to their private counterparts.

, 20.26
(18.66 ) (16.01 ) ,
9 3,000
(55,000 ) (44,000 )
1 10 2
10

,

S No. Bank Total Advances Gross NPA NPA Ratio (%)

(Rs. in crore) (Rs. in crore)
1 Indian Overseas Bank 149,217 30,239 20.26
2 UCO Bank 115,166 21,495 18.66
3 Bank of India 274,391 43,935 16.01
4 Punjab National Bank 356,958 55,003 15.41
5 United Bank of India 70,781 10,104 14.28
6 Central Bank of India 185,719 25,107 13.52
7 State Bank of Patiala 85,239 11,365 13.33
8 Bank of Baroda 269,115 35,604 13.23
9 Allahabad Bank 145,328 18,769 12.92
10 Bank of Maharashtra 103,148 13,040 12.64
 S Bank Total Advances Gross NPA NPA Ratio
No. (Rs. in crore) (Rs. in crore) (%)
1 State Bank of India 1,193,325 93,137 7.80
2 Punjab National Bank 356,958 55,003 15.41
3 Bank of India 274,391 43,935 16.01
4 Bank of Baroda 269,115 35,604 13.23
5 Canara Bank 311,615 30,480 9.78
6 Indian Overseas Bank 149,217 30,239 20.26
7 Union Bank of India 242,935 25,560 10.52
8 Central Bank of India 185,719 25,107 13.52
9 IDBI Bank Limited 202,304 21,724 10.74
10 UCO Bank 115,166 21,495 18.66

Increased NPA has following effects-

a. Essentially, NPA gives raise to Twin Balance sheet (TBS) problem. Twin
Balance Sheet problem is about overleveraged and distressed companies who are
unable to pay interest payments from loans and in turn lending Banks are not able
to do more lending. It leads to holding up of private investment in the country
and therefore, growth in all sorts of sectors. It essentially adversely affect the
credit market in the country.

It is important to note that Public sector banks has been affected more by this
than private sector banks evident from their falling credit growth in non-food
credit relative to credit growth from the new private sector banks (Axis, HDFC,
ICICI, and IndusInd) since early 2014. Further shrinkage of public sector lending
hasnt been across-the-board rather only in certain areas of high credit exposure,
specifically in loans to industry and to small enterprises because of mounting
distress on their past loans.

Now this is alarming because small enterprises are heavily dependent on credit
from Public sector banks and if PSBs are not ready to lend its going to affect the
growth of msme sector which also happens to provide most number of jobs.

1. Reason of NPA-
The truth is, even sensible lending will entail default. In fact a banker who lends
with the intent of never experiencing a default is probably over-conservative and
will lend to too few projects, thus hurting growth. Therefore it is important that
all reasons which lead to NPA formation is thoroughly understood.

a. Market Driven- The increase in NPAs may be due to slow growth in

domestic and international market and drop in prices of commodities in the
global markets.

b. Governance Driven- a variety of governance problems like slowed down

bureaucratic decision making, difficulty in getting various clearances etc. lead
to project cost overruns and make it increasingly difficult to service debt.

c. Willful Defaulters-Willful default refers to a situation where a borrower

defaults on the repayment of a loan, despite having adequate resources. As of
December 2015, the public sector banks had 7,686 willful defaulters, which
accounted for Rs 66,000 crore of outstanding loans. The Standing Committee
of Finance, in February 2016, observed that 21% of the total NPAs of banks
were from willful defaulters.

d. Fundamentals of the borrower The economic cycle is the natural

fluctuation of the economy between periods of expansion (growth) and
contraction (recession). It is the period of expansion where lending decision
are spawned by irrational exuberance and not by business acumen. Instead of
basing lending on the fundamentals of the borrowers and of market bankers
tend to merely extrapolate their past growth and performance to the future. In
so far as, sometimes, banks lend based on project reports by the promoters
investment bank. Evident from the fact that a number of NPAs of public sector
banks are from loans made in 2007-2008 when economy was expanding and
growth was taken to be obvious. But then economic cycle was hit by
contraction due to global financial crisis of 2008 and strong demand
projections for various projects became increasingly unrealistic leading to
creating NPAs.

e. Poor Monitoring and Collection- Even if lending lacked careful assessment

up front of project prospects, same can be somewhat compensated for by-
 i. Careful post-lending monitoring,
ii. Careful documentation and perfection of collateral
iii. Ensuring assets backing promoter guarantees are registered and
tracked.
Unfortunately, projects are left weakly monitored by banks; especially by
PSBs. When a project went into distress, private banks secured their positions
with more agility than PSBs by attaching additional collateral from the
promoter, or getting repaid, even while PSBs continued supporting projects
with fresh loans. Promoters on the other hand astutely stopped infusing equity,
and sometimes even stopped putting in effort, knowing the project was
unlikely to repay given the debt overhang.

f. Ability of the lender to collect being weak-

Loan recovery system in India is protracted and costly especially against well-
connected promoters despite laws like SARFAESI which was enacted with
the intention to speed up secured debt collection. Inefficiency of the system is
exploited in following ways by the promoters-

i. Promoters encourage banks to double-up by expanding the scale of

the project, even though the initial scale was unable to service debt
giving hope that scaling up will make the project viable and ensuing
debt serviceable. And then unscrupulous among the promoters divert
money from the expanded lending further aggravating the problem.

ii. Promoters play one lender off against another by threatening to divert
payments to the favored bank, they refuse to pay unless the lender
brings in more money, especially if the lender fears the loan becoming
a NPA.

iii. Sometimes promoters offer miserly one-time settlements (OTS)

knowing that the system will ensure the banks can collect even secured
loans only after years.
 All these, effectively, makes loans implicit equity, with a tough promoter
enjoying the upside in good times, and forcing banks to absorb losses in bad
times, even while he holds on to his equity.

The process of recovering outstanding loans is time consuming. This includes

time taken to resolve insolvency, which is a situation where a borrower is
unable to repay his outstanding debt. The inability to resolve insolvency is
one of the factors that impacts NPAs, the credit market, and affects the flow
of money in the country. As of 2015, it took over four years to resolve
insolvency in India. This was higher than other countries such as the UK (1
year) and USA (1.5 years).

g. Bank Moral Hazard The absence of sound and well documented loan
evaluation and monitoring practices in PSBs exposes them to certain moral
hazards. In economics moral hazard is the lack of any incentive to guard
against a risk when you are protected against it. On one hand the short tenure
of managers meant they will be unwilling to recognize losses immediately,
and more willing to postpone them into the future for their successors to deal
with it leading to over lending to or ever-greening unviable projects. On the
other hand the taint of NPA immediately makes managers reluctant to lend to
a project even if it is viable. So excessive lending to bad projects and too little
lending to viable ones can coexist due to distorted incentives built in the built
into the public sector banking system.

2. Existing Tools to address the menace of NPA-

Given, however, that public sector banks are much bigger than private sector
banks, private sector banks cannot substitute fully for the slowdown in public
sector bank credit. We absolutely need to get public sector banks back into
lending to industry and infrastructure, else credit and growth will suffer as the
economy picks up.

a. Legislative mechanisms
(i) Recovery of Debt Due to Banks and Financial Institutions Act, 1993
(DRT Act) - The Debt Recovery Tribunals established under DRT Act
allow banks to recover outstanding loans.
 (ii) Securitization and Reconstruction of Financial Assets and Security
Interest Act, 2002 (SARFAESI Act) - The SARFAESI Act allows a
secured creditor to enforce his security interest without the intervention
of courts or tribunals.
- ARCs purchase stressed assets from banks, and try to recover them.
The ARCs buy NPAs from banks at a discount and try to recover
the money. The Standing Committee observed that the prolonged
slowdown in the economy had made it difficult for ARCs to absorb
NPAs. Encouraging private Asset reconstruction companies (ARC)
introduced under SARAFAESI Act. This lets bank focus on its core
activities and ARC solving debt problems. But ARCs have only
been able to buy 5% of the total NPAs over 2014-2015. They have
found it difficult to recover from the debtors.

b. Voluntary mechanisms These mechanisms allow banks to collectively

restructure debt of borrowers (which includes changing repayment schedule
of loans) and take over the management of a company.
i. Corporate Debt Restructuring Corporate debt restructuring is the
reorganization of a company's outstanding obligations, often achieved
by reducing the burden of the debts on the company by decreasing the
rates paid and increasing the time the company has to pay the obligation
back. Initially RBI came tired rescheduling amortizations with 5/25
scheme. It was for infrastructure sector and eight core industry sectors.
It extended loan periods by 25 years and adjusted interest rates every 5
years so as to match the funding period with the long gestation and
productive life of these projects.
ii. Strategic Debt Restructuring - Under this the banks can take over
firms and sell them to new owner.
iii. Sustainable Structuring of Stressed Assets - An independent agency
hired by banks decides how much unsustainable debt can be converted
to equity. Unlike SDR it does not have change of companys ownership.

3. Recommendations for reform

Even while we make it easier for committed promoters to restructure when they
experience bad luck or unforeseen problems, we should reduce the ability of the
fraudster or the willful defaulter, who can pay but simply is disinclined to do so,
or the fraudster, to get away.

Some economist believe that this NPA problem is self-healing. They argue one
of the two scenarios are possible -
a. Phoenix scenario - Economy grows with improvement in cash flows to
stressed companies so that they can service debts.
b. Containment scenario NPAs are limited to a small proportion of the GDP
and GDP growth is increased. In this way problem is not solved but fades in
importance.

However both the scenarios appear to fail. Economy is not able to grow in the
first place because of low investments and low bank lending. Banks NPAs are
also increasing because of higher interests on more loans they gave to debtors.

Further, Specific measures have been taken for sectors where the incidence of
NPA is high by the government. To improve the resolution or recovery of bank
loans, IBC (Insolvency and Bankruptcy Code) has been enacted and SARFAESI
(Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest) Act and RDDBFI (Recovery of Debts due to Banks and
Financial Institutions) have been amended, the response said. Further, six new
Debt Recovery Tribunals (DRTs) have been established for improving recovery.
The SARFAESI Act allows banks and other financial institutions to auction
residential and commercial properties when borrowers default on their payments.
This helps the banks to reduce their NPA by recovery and reconstruction. Under
this Act, 64,519 properties were seized or taken possession off by the banks in
2015-16. In the current financial year, as of June, the number stands at 33,928.

A. Economic Survey 2016 indicates that 4Rs are required to address the problem:
a. Reform: Here, the least amount of progress has occurred. Recurrence of
NPA problem highlights the need for structural reforms. Serious
consideration must also be given to issue of government majority
ownership in the public sector banks (PSBs). The first is to improve the
governance of public sector banks so that we are not faced with this
situation again. The Government, through the Indradhanush initiative, has
sent a clear signal that it wants to make sure that public sector banks, once
healthy, stay healthy. Breaking up the post of Chairman and Managing
 Director, strengthening Board and management appointments through the
Banks Board Bureau, decentralizing more decisions to the professional
board, finding ways to incentivize management, all these will help improve
loan evaluation, monitoring and repayment.

b. Recognition: It is the area where there has been the most progress.
Following the RBIs AQR, banks have recognized a growing number of
loans as non-performing.

c. Recapitalization: With rising NPAs banks will need to be recapitalized

most of which will need to be funded by government for PSBs. However,
it is not the need of the hour. The second is to infuse bank capital, with
some of the infusion related to stronger performance, so that better banks
have more room to grow. Capital infusion into weak banks should ideally
accompany an improvement in governance, but given the need for
absorbing the losses associated with balance sheet clean up, better that
government capital be infused quickly. Governments are sometimes
reluctant to infuse bank capital because there are so many more pressing
demands for funds. Yet, there are few higher return activities than
capitalizing the public sector banks so that they can support credit growth.
Finally, the Economic Survey has suggested the RBI should capitalize
public sector banks. This seems a non-transparent way of proceeding,
getting the banking regulator once again into the business of owning banks,
with attendant conflicts of interest.

d. Resolution: For speeding up resolution, India can follow the approach of

East Asian Countries by adopting a centralized strategy (post 1990s
economic crisis) instead of decentralized approach currently adopted.
Till now, the solution was based on decentralized approach i.e. banks
resolving NPAs themselves. The economic survey suggests a centralized
approach where Public Sector Asset Rehabilitation Agency (PARA)
should be formed. It would recognize losses, help in coordination and
provide incentives to solve TBS problem. Essentially it will do following

- It will resolve bad debts on sound economic principles.
- Stressed debt is concentrated in larger companies. Bigger cases are
difficult to resolve and needs an independent agency.
- Banks have difficulty in solving these cases due to lack of
coordination, capital etc. Even private ARCs have failed.
 International practice has shown PARA like organization to be
viable to solve TBS problem. E.g. Post East Asian crisis
- Immediate step is needed because delays are increasing the problem.
- It would purchase loans from banks and adopt value maximizing
strategy to solve them. E.g. Converting loan (debt) to equity etc.
Then the government can recapitalize PSBs.
- In this process, losses would have to be paid to the creditors. The
bulk of this burden will fall on government as PSBs are major
creditors. The government can finance this capital by
a. Issuing Government Securities.
b. Capital markets Private sector can take equity floated by PARA.
Government can sell its holdings in PSBs too.
c. RBI is one of the most highly capitalized banks in the world. Therefore,
its excess capital like securities can be transferred to PARA.
PARA is not a panacea. Issues that need to be resolved to make PARA work
are
- There is a need to confront the losses and accept the political
consequences.
- PARA should be highly professional with the sole objective of
maximizing recovery value. It should be an independent agency
staffed by banking experts.
- Although difficult and time consuming, market pricing of the
distressed loans should be done to minimize losses.

B. Action against defaulters: It recommended that the names of top 30 willful

defaulters of every bank be made public. It noted that making such
information publicly available would act as a deterrent for others.

C. Prolonged slowdown in the economy had made it difficult for ARCs to absorb
NPAs. Therefore, it recommended that the RBI should allow banks to absorb
their written-off assets in a staggered manner. This would help them in
gradually restoring their balance sheets to normal health.

D. The Insolvency and Bankruptcy Code seeks to address this situation. The
Code, which was passed by Lok Sabha on May 5, 2016, is currently pending
in Rajya Sabha. It provides a 180-day period to resolve insolvency (which
includes change in repayment schedule of loans to recover outstanding loans.)
If insolvency is not resolved within this time period, the company will go in
 for liquidation of its assets, and the creditors will be repaid from these sale
proceeds.
E. Removing Distress- The world over, there are three cardinal rules when faced
with incipient distress-
a. Viability does not depend on the debt outstanding, but on economic value.
Debt may have to be written down to correspond to what is viable
Because of changed circumstances, demand may be lower and project cash
flows may be significantly lower than projected earlier. The project has
economic value when completed in the sense that operating cash flows are
positive, but much less than the interest on the debt it carries. If the debt is
not written down, the project continues as an NPA, even while the promoter,
knowing it cannot repay, loses interest. If neglected, the project may stop
generating any cash flows and the assets may depreciate rapidly.

b. Complete projects that are viable, even if it requires additional funds

infusion- Stalled projects do not get any better over time. If there are small
investments needed to complete the project, and the promoter has no funds,
it may still make sense to lend to it, even while writing down the overall
debt. Essentially, the new loan makes it possible to generate operating cash
flows to service some debt, even if not all the outstanding debt.

c. Dont throw good money after bad money simply because there is an
unreliable promise that debt will become serviceable- This is the opposite
of (2). If the project is unviable, doubling its size does not make it any more
viable. Promoters that have over-borrowed often propose an increase in
scale so that the banks outstanding debt and new loans will all become
serviceable. Perhaps it would be better for the bank to write down its loans
to the initial project, rather than going deeper into the hole because the
promoter may incur new cost-overruns as he expands. An incompetent or
unreliable promoter will remain so even when scale expands.