The problem with bad loans

The health of the banking sector is deteriorating. India needs robust insolvency laws

Sunil B.S.   First Published: Thu, Aug 23 2012. 07 30 PM IST

pdated: Thu, Aug 23 2012. 07 36 PM IST

The sharp economic downturn has once again brought the problem of bad loans to the forefront.

In its annual report released on Thursday, the Reserve Bank of India (RBI) pointed out that the health of the banking system is linked to the credit cycle. “Financial institutions tend to overstretch their lending portfolio during economic booms and tend to retrench the same during economic downturns,” it said.

The market is often abuzz with speculation about the inability of some overleveraged business groups to service their bank loans. India has traditionally had a system that tries to help companies in financial distress, making it easy for them to restructure loans. Even RBI has pointed out that the ability of Indian banks to maintain asset quality is “partly on account of the policy of loans restructuring”.

While bad assets of Indian banks have grown 46% in the fiscal year ended March 2012, the growth pace of credit has been at 17%. On 31 March, gross non-performing assets (NPAs) of the banking system amounted to Rs.1.37 trillion and restructured assets Rs.218 trillion.

To reduce the adverse effects of economic downturns on companies and lenders, corporate debt restructuring (CDR) was introduced by RBI in 2001. Despite success in helping companies emerge out of financial troubles, there are several shortcomings in this mechanism. India continues to miss strong insolvency laws.

Restructuring often involves extension of maturities, lower interest rates, debt forgiveness, among others, in case a firm is unable to repay its debt. Further, loans may or may not get classified as NPAs after they are restructured. A working group set up by RBI to review existing guidelines on loan restructuring has recommended increasing the provisions for accounts which get the asset classification benefit on restructuring. Hence, such restructuring places huge stress on the resources of banks

Such restructuring has also attracted criticism about being partial towards big companies. RBI deputy governor K.C. Chakravarty, in a recent speech, raised an important question: Are small and marginal borrowers discriminated against by the banks? An economic downturn is likely to affect smaller companies more adversely than larger ones, so smaller borrowers should be having a greater share in restructured accounts. The data with RBI does not show this.

The soft corner which Indian banks have for large companies is also highlighted by a recent report by Credit Suisse Group AG, which pointed out that the exposure to 10 large industrial groups constitutes 13% of the entire Indian banking system’s loan assets.

In the absence of effective laws on insolvency, many firms who can’t repay their debts for reasons beyond their control remain orphans, and banks are forced to restructure their loss-making assets at a cost. The Sick Industrial Companies Act (SICA), 1985, enabled sick firms to approach the Board for Industrial and Financial Reconstruction (BIFR) to help them revive.

Under the SICA provisions, a company is classified as sick if it has a track record of erosion of net worth over five years. But what is required is a law, which can detect that a company is going through financial difficulty in earlier, and then attempt to revive it. The lack of infrastructure has resulted in bankruptcy procedures under BIFR to take a long time, something which needs to be addressed. Also, steps should be taken to prevent misuse of BIFR provisions by companies that, under section 22 of SICA, seek immunity from creditors after cooking their accounts; this has plagued efficiency at BIFR for long.

Also asset reconstruction companies (ARCs), which were established by the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, to acquire, manage and recover illiquid loans or NPAs from banks have failed to take off in a big way. The appetite of Indian investors for securities issued by ARCs is weak, and remains limited to short-tenor papers and those with high ratings. A major hindrance in the way of development of securitization in the country has been high stamp duties. Moreover, the Indian credit markets are closely regulated and loans typically don’t trade on a secondary market, unlike developed countries.

These laws are also tilted in favour of creditors whose major goal remains short term, which is to recover their debts. What is needed are sound insolvency laws in our country along the lines of chapter 11 in the US, which can protect firms and help them adopt a suitable strategy to emerge out of financial difficulties.

http://www.livemint.com/Opinion/FF0FFDxOooUbUDEcAWDHmI/The-problem-with-bad-loans.html

http://foreclosureindia.com/

Asset reconstruction firms expect boost in business

According to a Bill passed on Monday, these firms can convert part of their debt into shares of defaulting companies.
Dinesh Unnikrishnan 

Updated: Wed, Dec 12 2012. 12 42 AM IST

Mumbai: Asset reconstruction companies (ARCs) that purchase bad loans given to sick units from commercial banks are likely to see a revival in their business, once the Enforcement of Security Interest and Recovery of Debts Laws (Amendment) Bill 2011 comes into effect.

The Bill, passed by the Lok Sabha on Monday, allows ARCs to convert part of the debt into the shares of the defaulting companies and purchase the sticky assets of multi-state cooperative banks, among other things.

The actual implementation of the new rules may not take place immediately as the Bill is yet to be cleared by the Rajya Sabha, the upper house of Parliament, following which the Reserve Bank of India (RBI) will announce detailed guidelines.

Chiefs of leading asset reconstruction companies are optimistic that the provision to convert debt in distressed companies to equity will make such purchases more attractive as equity ownership will give more control to them in the operations of companies besides yielding higher returns once the companies turn profitable.

For companies too, conversion of debt into equity will be beneficial as their interest payment burden will come down.

“It’s indeed a big positive for ARCs,” said P. Rudran, managing director and chief executive officer of Arcil, India’s largest ARC. “This will enable us to do actual reconstruction of businesses for the eligible firms. ARCs will be able to take equity ownership in such companies and exit at a later stage by earning an upside on the equity, when the unit turns profitable.”

Another key provision of the debt recovery Bill allows banks to accept immovable property of defaulting companies to realize claims.

ARCs are currently not allowed to directly pick up stakes in stressed units whose loans they buy from commercial banks or other financial institutions. Instead, they typically facilitate the bringing in of long-term capital to these firms.

According to Rudran of Arcil, the provision to allow banks and financial institutions to file caveats and to be heard in debt recovery tribunals before any stay is granted will ensure that the process of law is not misused by unscrupulous borrowers to delay settlements and payment of dues.

“When you are reviving a running company, you are investing in a sick unit. ARCs always wanted to have equity relationships in companies which have a potential to revive but it was not allowed,” said P.H. Ravikumar, managing director and chief executive officer of Invent Assets Securitisation and Reconstruction Pvt. Ltd. “The new provisions will help ARCs to focus more on reviving the units rather than just buying out the bad assets.”

Ravikumar is optimistic that the provisions in the new law will help Indian ARCs buy more assets and enhance their ability to revive sick units in a slowing economy. Birendra Kumar, chief executive officer of International Asset Reconstruction Co. Pvt. Ltd, said more clarity will come only after the Reserve Bank announces the norms.

Slowing global exports, high inflation and high interest rates have hit the earnings of most industrial units, especially small and medium enterprises, in Asia’s third largest economy. This has impacted the ability of many companies to repay loans to commercial banks.

However, despite the rise in non-performing assets (NPAs), the business of ARCs is not swelling. Even Arcil, the largest among the ARCs, added just Rs.200 crore to its books this fiscal. For the other two ARCs, there have been hardly any deals in the current fiscal. Arcil has assets under management worth Rs.6,200 crore, Invent has bought assets worth Rs.2,500 crore, while International has principal outstanding assets of Rs.4,000-Rs.4,500 crore. Analysts said the business prospects of ARCs look bright in India, given the stress in the economy and the rise of bad loans and restructured assets. Gross NPAs of 40 listed banks rose by 47% to Rs.1.6 trillion in September from Rs.1.1 trillion in the year-ago period, with state-run banks leading the pack.

Analysts expect at least 25-30% of the restructured assets to turn bad in the absence of a major pick up in the economy, which grew at 5.3% in September quarter. Total restructured assets under the so-called corporate debt restructuring mechanism touched Rs.1.9 trillion on a cumulative basis till September. “It is boom time for ARCs, given the rise in bad loans in the banking system,” said Abhishek Kothari, research analyst at Violet Arch Securities Ltd.

“Post the new regulations, there is a likelihood of more bad loans being sold to ARCs as they will be keen to take equity relationships, which will reward them at a later stage, when valuations go up.”

http://www.livemint.com/Politics/xtLcRxhvhTqpwySmiABmYM/Asset-reconstruction-firms-expect-boost-in-business.html

Save the rod ... and create a Frankenstein

Like all morals and most hazards, moral hazard is man-made. Only man can reduce it.
Dipankar Choudhury - LiveMint

A close friend, who works for an asset reconstruction company, recently told me after a few drinks: “I suggest that you do a project report and take a Rs.100-200 crore loan. The bank, RBI, government –will all treat you like a king if you default. Don’t borrow just 5 or 10 crore, then you will be in trouble.”

He went on: “If my son wants me to find a match for him, I will look for the daughter of a defaulter. Then his life will be made”. Yes, some entrepreneurs regularly dream of graduating from facing a problem to becoming a problem for the system.

Nearly 20 years ago, Michael Fay, an American student in Singapore, was sentenced to six cane lashes for vandalism, which due to hectic American lobbying was reduced to four and he was let off with that. His partners in crime got more severe punishment. Four years later, Fay was held in the US for possessing drugs.

Wikipedia defines moral hazard as a tendency to take undue risks because the costs are not borne by the party taking the risk. The bothersome part is that it is rife even in developed and developing countries which hold the rule of law in high esteem. Just the perspective differs: in the West, public discourse sees moral hazard largely as excessive risk-taking by overpaid bankers, in India it is repeated defaults encouraged by mollycoddling lenders.

Where genuine accommodation ends and mollycoddling begins is extremely tough to ascertain ex-ante. There have been cases of remarkable borrower resuscitation after one lifeline, and even two. And then there are the perpetual delusions. Most banks do not have this data, or choose not to compile it.

But one thumb rule will always work. Indulgence by a lender makes sense only if the underlying fundamentals of the borrower’s business are sound and he happens to be facing a cyclical problem (this of course is a judgment call but not too difficult to make, e.g. it takes some imagination to contend that airlines are facing a temporary problem and their fundamentals are sound). Else it is mala fide and a potential source of moral hazard.

It is a difficult and unpleasant subject as a result of which not much literature is available. However, in a noteworthy paper titled “Financial Intermediation in India: A Case of Aggravated Moral Hazard?” dated July 2002, Saugata Bhattacharya and Urjit Patel made an attempt to look at this issue very early in the lending growth cycle in India. Many points presented there are still relevant.

The authors identify three reasons for the malaise: large and increasing government role in the financial sector, high regulatory forbearance and absence of efficient bankruptcy procedures. They premise that the resultant moral hazard inhibits effective co-financing and capital formation in the economy.

On the first point, it is important to note that the authors identify government participation in the financial sector and not just government ownership that leads to increasing moral hazard. It includes provision of government guarantees to projects, priority sector lending, mandating write-offs of loans, and so on. In good times, there is little incentive for the government to change the status quo, and in bad times, it feels the need to increase its involvement, at which point prudence takes a back seat.

Regulatory forbearance ensures lenders, especially banks, do not close down. At least for banks there is this argument, though shallow, that faith in them should not erode. Why wholesale lenders like IFCI have to remain in perpetual life support is less understandable. If a lender will most likely never be allowed to fail, depositors will not care to monitor lender performance, managers will be less vigilant and the borrower incentivized to take advantage of the system.

Developments on the bankruptcy procedures front have however been encouraging. The SARFAESI Act (which is India’s foreclosure law) has been quite effective but there is still a long way to go.

Ironically, bankers suggest that it has been used largely as a stick to beat the borrowers with and bring them to the negotiating table, and not for seizing and selling off security, the ostensible purpose for which the law was enacted. Thus the effectiveness is at best sub-optimal. Judicial and quasi-judicial proceedings for debt recovery are still tortuous.

To conclude, I particularly like one sentence which the authors use: “This process of increasingly aggravated moral hazard driving…riskiness of the asset portfolios…is analogous to riding a bicycle without brakes – once on it, if you stop pedaling, you will fall off.” Very similar to what Ramalinga Raju remarked along with his confession of having cooked the books of Satyam for years. Let’s not carry on the comparison further; it looks scary.