Two kinds of stories dominate finance news regularly. The first is about the Sensex and Nifty hitting new all-time highs and the second is the problem of rising non-performing assets in India’s public sector banks. Thus, while investors are positive about Indian economy’s prospects, they have also learned to live with the problems of bad loans in the country, hoping that someone will do something someday to solve the problem.
That day may not be too far.
On Friday, President Pranab Mukherjee approved an ordinance to amend the Banking Regulation Act, 1949 to give more powers to the Reserve Bank of India to take action against defaulters to solve the NPA crisis. The ordinance gives the RBI powers to:
- Issue directions to any bank to initiate insolvency resolution process in case of default,
- Issue directions to the banking companies for resolution of stressed assets and,
- Specify one or more authority or committee that will advise banks on how to resolve their stressed assets.
The ordinance begins ominously by accepting that “the stressed assets in the banking system have reached unacceptably high levels,” and adds that “urgent measures are required for their resolution.” But how did we get here?
How do loans go bad?
Banks take deposits from customers and give them out to companies or individuals as loans. Thus, a deposit is a liability (since it has to be paid back to the customer) and a loan is an asset (since it generates income in the form of interest for the bank).
A non-performing asset is a loan on which the borrower has stopped paying interest and/or principal. It is up to the banks to provide for the loss of the asset (if the principal is not paid). Thus, provisioning for NPAs hits the profits and losses (because of the interest income on loans that go bad) and balance sheets of banks.
Bad loans are a part of life for the banking sector and follow the overall trend of the economy. So, in the 2003-’04 and 2007-’08 financial year, as the economy boomed, NPAs fell from 7% to around 2% of total advances of loans made by banks. However, 2008-’09 onwards, NPAs have risen steadily. For the first half of the 2016-’17 financial year, bad loans constituted more than 9% of total advances. The problem is most acute in public sector banks, where NPAs were nearly 12% of total advances for the first half of the just-concluded financial year. India’s public sector banks had about Rs 6 lakh crores in non-performing assets as of December.
A brief history of bad loans
What was the origin of the current NPA crisis? It was in the credit-fueled infrastructure boom of the late 2000s. Between the 2004-’05 and 2008-’09 financial years, non-food bank credit (lending to sectors other than food procurement) doubled and investment to GDP ratio surged, led mainly by the private sector.
From power to steel to telecom, every infrastructure-related sector was taking loans to expand businesses and banks were more than happy to oblige. However, this party came to an end with India’s infamous “policy paralysis” in 2012, when no major reforms were taking place. With several projects delayed and stalled over policy limbo, industrial growth came to a near standstill. The infrastructure sector was the worst hit.
This is where the crisis began. After staying at a manageable 2.3% to 2.5% of the total advances from 2007 to 2011, in the financial year ending 2012, bad loans rose to 3.1% and never looked back.
As the Economic Survey 2017 released by the Ministry of Finance in January, which looks at the year gone by and growth projections for the year ahead, put it:
“Higher costs, lower revenues, greater financing costs – all squeezed corporate cash flow, quickly leading to debt servicing problems. By 2013, nearly one-third of corporate debt was owed by companies with an interest coverage ratio less than 1, many of them in the infrastructure (especially power generation) and metals sectors. By 2015, the share of IC1 companies [whose earnings are not enough to cover their interests] reached nearly 40%, as slowing growth in China caused international steel prices to collapse, causing nearly every Indian steel company to record large losses.”
The first response to the rise in NPAs was simple: banks gave borrowers more time to repay and hoped that a recovering economy would strengthen their borrowers’ ability to service their loans. Fresh loans were also given to tide over the tough times.
The RBI also made many attempts to resolve the NPA crisis: from flexible refinancing of long-period infrastructure loans to changing the fee structure of asset reconstruction companies and strategic debt restructuring. But none of them worked.
The RBI’s Asset Quality Review conducted in 2015 revealed an ugly picture. As the Economic Survey said:
“In February 2016, financial markets in India were rocked by bad news from the banking system. One by one, public sector banks revealed their financial results for the December quarter. And the numbers were stunning. Banks reported that nonperforming assets had soared, to such an extent that provisioning had overwhelmed operating earnings. As a result, net income had plunged deeply into the red.”
In its Financial Stability Report released last June, the RBI said that the gross non-performing advances ratio of banks increased sharply to 7.6% from 5.1% between September 2015 and March 2016.
Last February, the government set up an autonomous Banks Board Bureau headed by former Comptroller and Auditor General Vinod Rai. The Bureau was formed “with a view to improve the Governance of Public Sector Banks” – in an admission of the severe NPA issues facing public sector banks.
The government has finally recognised that stressed assets “have reached unacceptably high levels”. And with the current ordinance, the RBI is in a stronger position to find a permanent solution to India’s NPA crisis.
The solution will not be easy. It will involve losses and pain for the banks as well as for borrowers. But this is a bitter pill that the ailing banking sector needs to swallow. It is time for a cure.
Anupam Gupta is a chartered accountant and has worked in equity research since 1999, first as an analyst and now as a consultant. His Twitter handle is @b50.