There is anecdotal evidence that banks
in India have been financing distressed firms to delay the recognition of bad loans.
Extending credit to firms that face temporary financial stress
may be critical for keeping them operational and reviving them. However, lending to firms that are highly distressed and have little or no ability to repay these loans is tantamount to throwing good money after bad. This reduces the supply of bank credit to healthy, more productive firms; hides the true extent of balance sheet impairment; and delays resolution of firms’ distress. Such delays may increase the eventual losses faced by banks.
We find preliminary evidence that banks
have indeed been lending to highly distressed firms, a large fraction of which may have been economically unviable.
Unlike developed countries, corporate distress in India is not identifiable from market mechanisms. To identify distress, we look at firms that were referred to the Corporate Debt Restructuring (CDR) mechanism. Initiated in 2001 by the Reserve Bank of India (RBI), the CDR
scheme was aimed at alleviating distress in economically viable firms, and through this, control the rising non-performing assets (NPA) on banks’ balance sheets. In the wake of the 2008 global financial crisis, the RBI
provided regulatory forbearance to the scheme, permitting banks
to hold lower provisions against loans given to CDR
firms. Using a sample of 114 firms referred to the CDR
forum during 2008-2012, we analyse the financial health of firms and the evolution of their bank-borrowing patterns before and after they received CDR.
We study each firm for a five-year period, two years before and two years after the CDR
reference year, and the reference year itself. We assign scores to firms based on their distress levels. Firms with interest coverage ratio (ICR) less than 1 are assigned a score of 1. These firms do not have the capacity to repay their interest, which is an incipient sign of distress. Firms with ICR less than 1 and negative cash profit are assigned a score of 2. These are loss-making firms, which are clearly distressed. Finally, firms with ICR less than 1, negative cash profit and negative net worth are assigned a score of 3. The liabilities of these firms exceed their assets and they are highly distressed. All other firms are considered financially healthy and assigned a score of 0.
In our analysis we find four main results. First, firms’ distress levels did not get alleviated in the post-CDR
period, in fact they worsened. Of the firms that had a score of 0 or 1 in the CDR
reference years, more than 80 per cent worsened to score 2 and score 3 categories two years post CDR.
More than 50 per cent of the firms that had a score of 2 worsened to score 3. Among the largest bank borrowers, 16 firms were highly distressed in the CDR
reference years. Only three of these showed an improvement in their score post CDR.
We get the same result when we look at three years post-CDR.
Second, despite more firms becoming financially distressed in the post-CDR
continued to lend to them. More than 70 per cent of bank borrowing in the post-CDR
period was accounted for by highly distressed (scores 2 and 3) firms. Banks
extended a higher amount of financing to distressed firms than to relatively less distressed ones (scores 0 and 1).
Third, while these firms continued to receive bank financing, their distress levels did not go down. This evidence points to the fact that the nature of financial distress in these CDR
firms was not temporary and many of them might have been economically unviable.
Finally, we find that the leverage of these firms increased in the post-CDR
period and the proportion of bank borrowing to total borrowing of these firms also remained high. In other words, these financially distressed firms did not de-lever, and their leverage increase came primarily from additional bank borrowing.
Our results point to the fact that banks, incentivised by the RBI’s regulatory forbearance, were using the CDR
mechanism to prevent loans to distressed firms from becoming NPAs. Ideally, banks
should have followed an “adjustment strategy”, fully providing for NPAs coming from highly distressed firms. This might have reduced banks’ profits early on, but would have subsequently led to higher recoveries, with firms getting restructured. Instead, banks
chose the “financing strategy”. This further increased the leverage of distressed firms, aggravated the stress in corporate and bank balance sheets, and created the twin balance sheet crisis we are witnessing today.
The finding that banks
have been throwing good money after bad is particularly important against the backdrop of the recent Banking Regulation (Amendment) Ordinance, 2017. The Ordinance empowers the RBI
to direct banks
to initiate restructuring mechanisms against defaulting firms. In doing so, it is critical that the “financing strategy” does not get repeated.
An effective restructuring mechanism has three components. First, there needs to be an independent assessment of firm viability prior to restructuring. This failed in CDR
where banks, which were affected by CDR
outcomes, were also the decision-makers. Second, regulatory forbearance vitiates the incentive for viability assessment, which is a commercial decision, and should not be granted. Third, the presence of a formal insolvency process imposes discipline on informal restructuring mechanisms. Lenders informally restructure only those firms where they are likely to recover more than in the formal process, and borrowers cooperate with lenders or face liquidation as part of formal bankruptcy. In India today, one out of these three elements is in place in the form of the Insolvency and Bankruptcy Code, 2016. To ensure the effectiveness of any restructuring mechanism that banks
may now be directed by the RBI
to pursue, the other two elements are crucial.
Sengupta is assistant professor of economics, IGIDR; Sharma is consultant, Finance
Research Group, IGIDR
Published with permission from Ideas For India (www.ideasforindia.in
), an economics and policy portal. A version of this appeared on I4I.