Unraveling India's Bad Loan Riddle

Despite having the highest Gross Non-Performing Assets (NPAs) among Public sector banks, they began writing off bad loans from 2018. The reasons for bad loans included the a2008 Global Financial Crisis, delays in infrastructure projects, evergreening practices, loans to "Too big to fail" entities, and poor recovery rates. The enactment of the Insolvency & Bankruptcy Code and the RBI's Asset Quality Review prompted this action, addressing the bad loan crisis more proactively.

Non-Performing Assets (NPAs) are loans or advances that borrowers have failed to repay for a specified period, typically 90 days. These assets pose a significant challenge for banks and financial institutions, as they reduce profitability, erode capital, and hamper the smooth functioning of the banking system. Managing and resolving NPAs is crucial for maintaining a healthy and stable financial sector.

Despite having the highest Gross Non-Performing Assets (NPAs) among Public sector banks, these banks began the process of writing off these bad loans from 2018. Here are some of the pressing questions around the subject.

1. Why did NPAs occur?

Several factors contributed to the occurrence of Non-Performing Assets (NPAs) in Indian banks:

• Over-optimism during the period of strong economic growth led to excessive lending with high leverage and less promoter equity.

• Slow economic growth after the 2008 Global Financial Crisis made projected demand for projects unrealistic.

• Government decision-making delays in granting permissions for infrastructure projects caused cost overruns and loan defaults.

• Banks avoided recognizing bad loans to avoid scrutiny and engaged in evergreening, prolonging the problem.

• Banks continued lending to entities considered "Too big to fail," increasing risk exposure.

• Poor monitoring of loans and lack of action against defaulting promoters contributed to the crisis.

2. Why did the RBI set up various schemes to restructure debt and how effective were they?

The RBI implemented various schemes to help banks recover from NPAs and restructure debt. These included the Joint Lenders' Forum (JLF), Strategic Debt Restructuring (SDR), and the 5/25 scheme for long-term projects. The effectiveness of these schemes varied, and while they facilitated some resolution and recovery, the results fell short of expectations due to various reasons, including risk-averse bankers and uncooperative promoters.

3. Why recognize bad loans?

Recognizing bad loans and classifying them as NPAs is essential for proper accounting and risk assessment in banks. It allows for timely provisioning, ensuring that the bank sets aside a buffer to absorb potential losses. By classifying NPAs, banks can take necessary actions to revive distressed projects and undertake restructuring or write-downs, promoting a healthier banking system.

4. Did the RBI create the NPAs?

The NPAs were primarily a result of decisions made by bankers, promoters, and the economic environment. While the RBI could have raised more caution during the period of exuberant lending, it cannot substitute for commercial decisions made by banks. The regulator's role is to enforce timely recognition of NPAs and ensure adequate bank capitalization.

5. Why did the RBI initiate the Asset Quality Review?

The Asset Quality Review (AQR) was initiated to address evergreening and concealment of bad loans by banks. The RBI aimed to force banks to recognize and disclose NPAs accurately. The AQR process was essential for assessing the true health of banks and identifying the scale of the bad loan problem.

6. Did NPA recognition slow credit growth, and hence economic growth?

NPA recognition by the RBI did not significantly slow overall credit growth or economic growth. Public sector banks witnessed a slowdown in credit to certain sectors, but private sector banks continued to maintain credit growth. The credit slowdown in public sector banks was more likely due to their balance sheet problems and risk aversion rather than NPA recognition.

7. Why do NPAs continue mounting even after the AQR is over?

NPAs continue to increase due to several reasons, including aging NPAs that require more provisioning. The resolution process has been slower than expected, partly due to risk-averse bankers and uncooperative promoters. Government support for project revival, strengthening recovery processes, and timely bankruptcy resolution are crucial to address the ongoing NPA problem effectively.

8. What could the regulator have done better?

The RBI could have raised more caution during the period of exuberant lending and initiated the new tools earlier. Rapid enactment of the Bankruptcy Code and more decisive enforcement of penalties on non-compliant banks would have been beneficial. The regulator must maintain discipline and transparency in the banking system and ensure timely recognition of NPAs.

9. How should we prevent recurrence?

Preventing recurrence requires improving governance in public sector banks, distancing them from the government, and professionalizing bank boards. Strengthening the project evaluation and monitoring process, along with flexible capital structures, is essential. The recovery process needs enhancement through out-of-court restructuring and efficient bankruptcy resolution. The government should avoid setting ambitious credit targets or waiving loans and focus on addressing potential sources of future crises.

The enactment of the Insolvency & Bankruptcy Code and the initiation of the Asset Quality Review by the Reserve Bank of India played a significant role in prompting Public sector banks to start writing off bad loans. These measures compelled banks to address the issue more proactively and take necessary steps to clean up their balance sheets.

Source: https://thewire.in/banking/raghuram-rajan-npa-parliamentary-committee-modi-government