Let's find a new way to deal with bad loans

The Supreme Court ruling on the February 2018 RBI directive creates an opportunity to take a fresh look at India's bad asset resolution process

The Reserve Bank of India (RBI) will issue a revised circular on stressed assets resolution in the wake of the nation’s apex court striking down the contentious February 12, 2018, directive to clean up the bad loan mess in Asia’s third largest economy.

The regulator had issued the directive, armed with the Section 35AA of India’s Banking Act. The new Section empowered the Union government to authorise the RBI to direct banks to resolve specific stressed assets by initiating the insolvency resolution process. The court has not questioned the validity of this Section introduced in May 2017 through an amendment, but is not happy with the way it is used. Simply put, the new Section of the Act gives RBI the power of “discretion” to direct banks on bad loan resolution but it can’t be seen as a “rule”. 

The judgment will delay the clean-up process but not derail it. Even before the Act gave power to the government to direct the RBI for letting the banks loose over the defaulters for recovery, the banking regulator on its own could interfere in banks’ policies related to advances and inspect their books of accounts under Section 35 and 21 of the Act.

What was the need for the amendment? Probably, the government wanted to play a proactive role in cleaning up the bad loan mess and teaching the corporate defaulters a lesson. Or maybe the idea was to demonstrate to the corporate world that the RBI is not alone in waging a war against bad loans; it has the backing of the government. Since both are joining hands in this mission, the “crony capitalists” who have been taking the banking system for a ride should not try to arbitrage between the regulator and the government.
 

In some sense, the directive re-positioned RBI the regulator as a micro manager. The transformation can be defended, saying extraordinary times demand extraordinary action, but now that the directive has been set aside, the RBI could use this as an opportunity to take a fresh look at the bad asset resolution process. Its job is to protect the depositors’ interest and not chase the loan defaulters — something which should be left to the bankers. If they don’t do their job well, shouldn’t heads roll?

In the business of giving loans, a few can turn sour for external events such as the collapse of the export market, sudden depreciation of the local currency, inordinate delay in regulatory clearances and supply of raw material or even wrong business model. Then, of course, there are a few corrupt promoters who take bank loans not to pay back, and corrupt bankers who lend knowing well that the money will not flow back.

In the mid-1990s, the RBI pulled down the dividing wall between project finance institutions and commercial banks; the concept of universal banking emerged — a one-stop shop for all types of loans. As their expertise had been for only working capital loans, the commercial banks burnt their fingers in the new terrain of project financing, signalling the beginning of the bad loan saga.

Between 2006 and 2008, in the golden era of the Indian economy, characterised by low inflation and high growth, bank credit grew three times the nation’s GDP. After the collapse of the iconic US investment bank, Lehman Brothers Holdings Inc, that led to a global financial crisis, an ultra-loose monetary policy encouraged banks to lend more and prop up consumption demand. 

No wonder that soon, cracks started surfacing on the citadel of their loan portfolios but the banks kept on patching them up with rubbish. Bankers —  mostly in the government-owned banks that have almost 70 per cent of the assets in the industry — started devising ways to postpone the inevitable, using available restructuring schemes even as the pile of bad loans kept on rising. By the time India got its insolvency law, it was too late. 

The bankers were in a denial mode as it suited them. When bad loans rise, banks need to provide for such loans on which they do not earn any interest. It’s a double whammy that hits their balance sheets. Who wants to declare loss? Besides, higher provisions also erode the capital. Where will the capital come from?

So, the bankers have found an easy way out. To make good of the loss of interest income from bad loans and provision, they charge higher interest rates to good borrowers and pay lower interest to depositors. This is a typical Indian jugaad solution to the serious problem of bad loans, thanks to an innovative banking system. 

Why should the good borrowers and depositors be penalised for the banks’ inability to manage risks, monitor loan accounts and external vagaries? Once a borrower stops paying, a bank needs to classify the account as bad and set aside money for it. In the process, if its capital gets eroded, the owner should infuse fresh capital. If a bank is not doing its job properly, both in terms of managing risks, monitoring as well as recognising bad assets, the RBI should show its management the door. 

A couple of unique Indian concepts also complicate bad loan management — “wilful defaulter” and “technical write off”. A wilful defaulter is one who has not used the bank fund for the purpose it has been borrowed or siphoned off money. As money is fungible, is it easy to detect diversion of funds? And, the technical write-off is an accounting practice where a loan is written off and removed from the balance sheet of a bank but is parked at some branches. As and when the money is recovered, it adds to a bank’s profitability. There is no uniform norm for such technical write-offs. Done at the management’s discretion, such write-offs — trillions of rupees in the past decade — help banks create an illusion of lower bad loans.

Going by the December financial stability report of the RBI, a biannual health check-up for the banking system, the pile of bad assets under which quite a few banks have almost got buried, has started showing signs of erosion. As a percentage of the overall loan book of the Indian banking industry, bad loans in September 2018 (10.8 per cent) declined from the March level (11.5 per cent). The RBI expects it to come down further in March 2019 (10.3 per cent).

This is good news but in their over-enthusiasm to clean up the system, both the banks and the regulator should not forget that the key to the insolvency law is revival of companies — recovery of bank dues is an offshoot of that.

The columnist, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd. Twitter: @TamalBandyo