The new guidelines for recognition and resolution of bad loans, issued by the Reserve Bank of India on Monday, should be taken as a clear message to borrowers: pay your dues on time or face insolvency proceedings. At the same time, these rules – which will come into effect from March-end – are a warning to bankers to clean up their balance sheets.

From the point of view of earnings, the central bank’s move may increase the non-performing assets ratios of banks in general and government-owned banks in particular. A non-performing asset is a loan for which the principal or interest payment has not been paid for 90 days or more. On the other hand, the move will ensure discipline among borrowers and banks, and may improve the operational efficiency of the latter.

The biggest advantage of the proposed framework is that it will keep banks on their toes. Even if a loan is overdue by just 30 days, banks will have to identify it as a special mention account, report it to the Central Repository of Information on Large Credits – a database maintained by the Reserve Bank – and start working on a resolution plan.

According to a Credit Suisse estimate, cited by BloombergQuint in a report on Thursday, the new rules could place another Rs 1.5 lakh crores worth of loans before the National Company Law Tribunal. Banks have already moved the tribunal for the recovery of loans amounting to Rs 3.5 lakh crores as part of the Insolvency and Bankruptcy Code mandate issued by the Reserve Bank in 2016.

Rating agency Crisil said the central bank’s move would strengthen the banking system in the long run. “The revised framework for the resolution of large stressed assets has the potential to herald a big change in the approach of banks to monitoring of exposures and resolution of non-performing assets, and thereby strengthen the banking system,” it said in a note.

The bad loan problem

Indian banks are sitting on a mountain of bad loans. As of September 2017, the total non-performing assets of banks was estimated at Rs 8.4 lakh crores. Crisil estimates that this amount will touch Rs 9.5 lakh crores by March. Simply put, banks are currently unable to recover Rs 10 of every Rs 100 they lend.

A high prevalence of non-performing assets limits the ability of banks to lend. In addition, banks have to set aside money for loans that it expects to go bad. This is called provisioning. Higher provisioning results in lower profitability, and thereby the need for increased capital.

According to a Care Ratings study with a sample of 30 banks, total provisioning for banks in India increased by 69% to Rs 61,200 crores in the quarter ended December 2017. The data also showed that the banks reported a net loss of Rs 154 crores in that quarter compared to a net profit of Rs 10,237 crores in the corresponding quarter in 2016.

Slow recovery

The Reserve Bank, the government and banks have been trying to fix the problem of bad loans since 2015. In recent years, several measures such as Corporate Debt Restructuring, the Strategic Debt Restructuring Scheme, and the Scheme for Sustainable Structuring of Stressed Assets have been taken in this direction but have met with limited success.

The progress on recovery has been tepid. As per a written reply in the Lok Sabha, public sector banks had recovered Rs 39.6 crores till November after filing cases with the National Company Law Tribunal. There are over 2,400 cases pending before the tribunal for recovery of dues. These include some two dozen cases of large borrowers identified by the Reserve Bank as accounting for more than a quarter of the country’s total bad loans.

Recovery through the various Debt Recovery Tribunals has also been slow. Of a total of Rs 67,200 crores in 2016-2017, banks could recover only Rs 16,400 crores (or 24%).

The present system has a major flaw. All banks have to disclose discrepancies in the amount of their non-performing assets if the difference between their reported numbers and the Reserve Bank’s risk assessment report findings exceeds 15%. Private sector banks HDFC Bank, Yes Bank and ICICI Bank have reported such discrepancies in the past. On Friday, the State Bank of India – which controls 20% of the country’s banking assets – also reported a similar, and large, discrepancy.

Such divergence in risk assessment and reported numbers translates into a failure to paint a true picture of India’s banking sector.

The new framework

Bad loans, whether cases of wilful default or commercially unviable projects, have three dimensions – identification, resolution and recovery – that impact the working of all concerned. For recovery, the Insolvency and Bankruptcy Code is in place with a mandate to take decisions in a time-bound manner. However, multiple and overlapping schemes limit the scope of the identification and resolution process.

The new framework has addressed the problem of a generic and time-bound guideline for identification of a stressed asset.

Scrapping all the old schemes, it proposes that banks start insolvency proceedings against accounts with a total default amount of Rs 2,000 crores or more if a resolution plan is not implemented within 180 days of the initial occurrence of default. The Reserve Bank has also warned banks of a penalty if they fail to comply with the new rules.

The rules around resolution plans have also been tightened. Processes involving restructuring or change in ownership for large accounts with loans of Rs 100 crores or more will require an independent credit evaluation by credit rating agencies authorised by the Reserve Bank.

In addition, the rules make it mandatory for banks to submit details of all identified bad loans on a monthly basis to the central bank, a move aimed at bringing about greater transparency.

Bhavesh Shah is a business journalist and financial analyst.