From fault to fracture: India's NPA Crisis

Insurmountable mountains of NPAs, Non-Performing Assets, have become a huge hurdle in the growth of India’s economy. There is no one single factor that can be put to blame. In fact, there are multiple aspects to this issue, from the stand-points of Promoters, Bankers and the RBI.

India was in a growth boom during the years 2004-2008 before the world underwent a severe recession. GDP growth rates during this time period were high, clearly indicating a smooth ride for the economy.

Telecom sector was an accelerator in India’s growth story at the time. Facing its own problems now, it had registered a 43.6% CAGR growth of subscriber base during 2004-08. The share of the IT industry in the GDP increased from 3.6% to 5.9% during this time, thereby increasing employment contribution of the services sector significantly. Government was roping in acts like the Special Economic Zones Act to promote corporate setup in the country. Real Estate was on the rise and home loan interests were at their lowest. Prosperity was widespread and it was the perfect time for making mistakes that would come down to haunt, later in the coming decades.

As we look at success in the context of a failure today, we need to realize that in the first decade of the 21st century, the problem was not growth, but the lack of order and balance.

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Prosperity, at any time, does not come without a cost. In 2008, 2.26% of all loans accounted for NPAs, amounting to more than Rs. 500 billion. However, forecasts were being projected on the rates achieved in the previous years, a fear of an impending recession was absent and everyone was riding high on optimism. With successful odds at hand, bankers at the time had led funding rounds without adequate due diligence. Eventually, revenues generated after a massive hit in 2008 had fallen short of the unrealistic forecasts. A now truly globalized India was as much a victim of the blow as any other country.

With small chances of recovery, promoters leading unprofitable business entities had lost interest in working towards their revival. Their inability to repay loans simply resulted in an extension of the loan period. Bankers did not think of writing the loans off as a solution, and rightly so. However, bankers wanted to insulate themselves from a dent on image and loss in regular profits, leading them to only extend the bad loans in hopes of eventual recovery and not actually classifying them as bad loans. Finally, fraud and malpractices at the ends of all parties involved was the icing on the cake creating a robust system which was structured to bleed money off banks, right from its inception.

Fast forwarding to 2018, NPAs accounted for 11.2% of all loans with a staggering amount of more than Rs 10 trillion.

With ILFS triggering banks to finally classify bad loans as NPAs, the NBFC crises has spiralled into a credit crunch

It is important to note here that it is not suddenly that we landed in a situation which was beyond control. It was inadequacies over the years which had compounded to become a problem as huge. It is incorrect to comment that it was almost sudden or that there was a surge in the amount of NPAs. NPAs existed earlier as well, probably in numbers higher than what were reported at the time, and it was failure or ignorance to classify them as NPAs that caused the surge.

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The RBI was prudent towards an impending disaster and started focusing on instruments that would help with bad loans across the value chain.

Recognition → Revival → Resolution

Recognition

Starting from the problem of realizing an NPA, they introduced CRILC - Central Repository of Information on Large Credits. It was essentially a database of loans above the principal amount 5 crore rupees. It was for banks to see whether a loan was already an NPA or leading to one.

Revival

They came up with the JLF – Joint Lenders’ Forum, which was one to come up with a revival plan. It brought in the banker’s and promoters’ say in planning a charter for resolution and revival of the business entity. Incentives were also introduced for banks which expedited decision making.

Resolution

Finally, came in the SDR – Strategic Debt Restructuring, which gave banks the ability to restructure the debt and convert it into equity. RBI did not, however, want the banks to become perpetual owners of those debts, but to be able to bring in new promoters in the hope of recovering their lost money.

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Tools were in place for the banks and promoters to take effective action. However, RBI was to intervene itself. As a policing body, Asset Quality Review was then set up to evaluate loans that had been provided by the banks. The review was completed by October 2015.

Already existing tribunals were over-burdened that led to the setting up of the Insolvency and Bankruptcy Code in 2016. Under IBC, the NCLT - National Corporate Law Tribunal was created and primarily tasked with helping creditors recover maximum value out of non-profitable companies reeling under debts classified as NPAs by means of either setting up new managing boards to revive the copmany or straightaway auctioning it.

NCLT gave flourishing businesses of the time with the likes of Reliance Industries, Arcelor Mittal, Tata Steel, Aditya Birla – UltraTech, Vedanta to submit bids and acquire companies ridden with debts. It was a safe landing for defaulters and a brilliant opportunity to diversify profiles and reduce competition for acquiring companies. Some of the landmark cases for the tribunal during 2018 and 2019, included that of Bhushan Steel, Binani Cement, Videocon Group, Jaypee Infratech and Essar Steel.

In 2018 alone, close to Rs. 80,000 Crore (~USD 11 billion at the time) was acquired from defaulting debtors.

Stringent action tasks in place led many to believe that it was due to these practices by the central bank that our economy was flailing, but in reality it was the losses that these banks were already deep into and their now exercised caution especially on their part that led to a crunch in lending.

This crunch was faced by some of the important sectors for a country’s GDP, raw materials, mining, infrastructure, telecom and everything came down to a halt. It is interesting to note here, that lending was however not much slower in segments that were unlikely to result in an NPA, namely personal and housing loans.

The RBI is taking action to fight the credit crunch and lack of transparency triggered by the ILFS default

The RBI, in trying to bring in more balance, has started exercising caution. Measures that have already been taken over time include reducing concentration of risk levels related to banks’ exposure to loans. At the same time, pumping liquidity in the market has become of focus. Bankers have become more risk averse and infusing cash flow is of importance to push lending and eventually demand. It is clear that the central bank does not shy away from taking unconventional steps to boost growth. Interest rate cuts have become a regular affair.

RBI has also been unconventional with some of their measures which include Operation Twist and Dollar – Rupee swaps to ingest liquidity into Forex markets. Such measures have been further extended during the ongoing Covid-19 crisis. Steep rate cut accompanied with temporary EMI repayment relief are examples of the same.

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Unfortunately, what India saw with NPAs was not the last of its economy’s financial woes. There was more in store in the coming years. The most structured and trusted functionaries in the financial infrastructure, banks, were out wide on the frontlines. The core was shaking and it was inevitable that what stemmed out of them were looking at an eventual collapse.

To take the next punch were one of the key beneficiaries of the financial infrastructure, the NBFCs - Non-banking Financial Companies.

NBFCs in their essence are lending institutions which lend to people and collectives to whom banks are skeptical about lending because of either prevalent higher default rates in the industry/region or high risk in the particular venture otherwise. NBFCs generate liquidity for themselves by heavy borrowing from banks, foreign investments, selling debt against equity and bonds. They can sometimes be linked to manufacturing companies, or be subsidiaries of promoter companies.

There are around 11,000 NBFCs in the country, lending in sectors like Infrastructure and Real Estate, Automobiles, personal loans and such. Of these, most of them are Retail Asset financing companies contributing to product financing like ACs and other white goods and agricultural tools. Gold Financing companies and Infrastructure financing NBFCs are those of the most risky nature.

It is important to note that a major role NBFCs play in an economy is that of creating demand.

To say that ILFS is id deep waters would be an understatement given the events since its default on repayments

The problem started when loans disbursed to the commercial sector reduced by 1/3rd in 2018-19. Cash based lending had already been affected with demonetization. The issue was furthered when the IL&FS (Infrastructure Leasing and Financing Services), an Infrastructure NBFC operating in India started to default on loans to the tunes of their Rs. 1 lac crore after mid-2018.

NBFCs acquire money to lend in the form of short term loans for themselves and in turn lend the acquired money for longer periods of time. It is more commonly termed as a way of Asset – Liability Management (or ALM). The system works until the investments or borrowing entities are able to provide regular returns, make repayments and their regular operations are unhurt by any financial instability.

The problem here crops up when defaulting on repayments becomes regular, thereby hurting NBFCs’ contracts of repayments on their acquired money.

Initial assumptions were that IL&FS defaulted as an effect of the ALM and that there was a liquidity problem. However, diving deeper it was realized that there was more to the story. The institute employed ever-greening, indefinite extension of loans, inability and ignorance to identify NPAs and inefficient governance with their borrowers. The problem now had a new outlook along with default, that of malfeasance and corrupt practices. ALM, here, stood for Astounding Levels of Mismanagement.

As the crisis emerged, financial institutions started plugging their lending to NBFCs. Interestingly, as overall funding decreased, NBFCs started relying heavily on loans borrowed by banks. These loans were expensive and in most cases least preferred.

The overall real estate sector was stuck and in effect, not just IL&FS, but all NBFCs related to financing these sectors met the crisis with their funding also being curbed.

The ALM problem was addressed here by the RBI. They introduced norms requiring regular checks and submission of reports related to funding and subsequent results generated by the institutions. Regulation limits were set on the amount of negative mismatch that an NBFC could operate with. Again, as in the case of NPAs, solving liquidity became a prime concern. Government promoted lending to NBFCs by offering capped safety net support to lenders. RBI increased the Single Borrower limit allowing higher exposure to a single institution.

In the middle of fraud, fundamental operational problems and rising regulations, there were less and less opportunities for the NBFCs to earn any profit for themselves. This was a price they had to pay for their past mistakes.

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In all of these scenarios, in some way or the other, it has been the end consumers who have had to absorb the toll. This time around, they faced the repercussions of the whole NBFC debacle in the form of tumbling commercial banks they had made deposits in. Starting with one and then leading on to another in one year has been the worst hit on confidence India’s banking sector has taken.

Co-operative banks, the next hit entity, are public sector banks with the primary aim of making formal banking services available to those who cannot afford the services of a larger public or private sector bank. this is largely due to unaffordability of services or lack of an adequate number of branches in their localities, especially rural areas. Their job is to increase penetration of the banking system to such people.

PMC Bank offers a case study in ethics in banking

Maleficent activities can exist even in the most sacred places and the Punjab and Maharashtra Co-operative Bank was no cleaner. PMC was performing well with a controlled level of NPAs and maintaining liquidity ratios with respect to regulations provided by the RBI. All was working fine, until one day it was brought to the notice of RBI, that ~75% of the official loan exposure of the bank was to HDIL, another infra NBFC to have been caught in the wind and now struggling to make ends meet.

There were two fundamental violations at PMC. First was extremely high lending exposure to a single entity. Second was hiding vital bank information. More financial irregularities were revealed as RBI dug further in the wake of such big violations of regulations.

RBI finally took charge of the bank and put the bank in a moratorium. Essentially, it imposed limits of withdrawal of sums and put on hold, all the lending and retail practices of the bank.

The suspended MD also had a “reason” for not having revealed such information. He said that the bank had enough assets to survive NPAs as high as that and that hiding the information wouldn’t have led the consumers and borrowers to worry about the bank’s future and their money with the bank. We could really get a lesson here on ethical business practices.

Another bank to meet similar fate has been the Yes Bank. Over the last decade, Yes Bank has raised its total loan exposure by 334%, higher than any other commercial bank has. The second bank in the race, which is Kotak Mahindra, is behind by 46%. With such a large increase, NPAs are unavoidable and resultantly, by September 2019, its NPAs had risen to a high 7.4%, again, the highest among private commercial banks.

Despite practically pioneering digital payments in India, Yes Bank finds itself in trouble because of past sins

As a perspective around reckless loan disbursement, amongst its bad loans, was the now defunct airline company, Jet Airways alongside bankrupt NBFCs - IL&FS, HDIL and DHFL. Vodafone Idea ltd. was another one of their beneficiaries. What could have been more wrong at the time than losing money with a telecom player in India on the brink of bankruptcy?

With such exuberant lending, the Credit – Deposit Ratio at Yes Bank was 106% in 2018-19. The bank was lending out more than it was receiving in deposits.

Currently promoters of the bank are under probe. As mandated by the RBI and the central government, SBI led the reconstruction plan to bail Yes Bank out. Amongst all participants in the rescue operation are SBI, ICICI Bank, HDFC, Axis Bank and Kotak Mahindra Bank. Over the moratorium period, withdrawal limits were imposed on customers. With the revival, withdrawal restrictions have now been lifted. The consumers can breathe some relief as no harm has been acceded to their deposits.

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The crisis has been multifold. The central bank has made several interventions. Efforts continue to be made to mitigate losses as much as possible, however, stakeholders of the banking system at all levels have somewhere or the other been found in the grey and the rot in the system is deep. Losses are in numbers so huge that even the boldest of headlines would shy away from mentioning them.

More than anything else, the biggest loss here can undoubtedly be stated, as the loss of trust.

It has become evident that the pillars on which the building has been erected has been made of adulterated cement. The whole banking sector toppling today is a result of a domino effect. This trickling down of mistakes that is crippling the lending ecosystem today has left a gap in the economy with eventual hammers on the consumers’ personal wealth. Rebuilding the faults fundamentally and not fixing cracks with bandages is the only solution that lies ahead.