Reforming India

In December last year the Reserve Bank of India, under the auspices of the still relatively new Governor Raghuram Rajan, put out a discussion paper on ‘Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalising Distressed Assets in the Economy’. In short: ‘How to get Indian banks to finally tackle nonperforming assets (NPAs)’.

The suggested changes can be placed in the following three categories: recognizing NPAs quicker; encouraging creditors to create resolution strategies; and making it easier for banks to sell NPAs.

A particularly notable incentive is allowing a bank selling an NPA to recognise the loss as a writedown to P&L over two years. On the other hand a notable penalty is a requirement to double the capital set aside to cover certain NPAs if measures for recovery are not taken.

In addition the RBI will collect information from the banks on loans with principal balances over INR 50 million each (approx $800,000) to form a centralised database (the ‘Central Repository of Information on Large Credit’ or ‘CRILC’) to then share signs of distress or default with other lenders. There is also a long overdue move to punish willful defaulters.

Three new categories for ‘special mention accounts’ will be created. An SMA-0 asset is if principal or interest payment is overdue by less than 30 days. SMA-1 applies to overdue payments between 31-60 days and SMA-2 for 61-90 days. This is more in line with international norms for early recognition of problem accounts. A SMA-1 loan will require lenders to form a joint committee to look at restructuring, while SMA-2 loans are encouraged to be sold to the specialized asset recovery vehicles, known as ‘Asset Reconstruction Companies’ (ARCs).

The banks are meant to comply with the new rules by beginning of April 2014.

Why is there a need for Indian banks to start aggressively changing their attitude toward problem assets?

NPAs in the Indian banking system have grown at more than 20 perform CAGR over the last five years and stand ‘officially’ at somewhere around 10 percent of total Indian banking assets. This also includes restructured loans often with no hope of returning to performing status. However if you talk to some senior bankers, they will tell you the true figure for NPAs is rapidly heading towards 15 percent or $150 billion.

In addition you have problems emerging at specific banks. Recently the RBI appointed Deloitte to conduct a forensic audit of United Bank of India. This came after UBI announced NPAs at 10.89 percent of total assets, which was a threefold increase on its previous NPA figure. The bank has now been tasked by the central bank with focusing on debt recovery and not pursuing [new] business. Early indications from the Deloitte audit suggest systematic and deliberate lapses in credit appraisal and automated NPA recognition.

Also the number of cases exiting the Corporate Debt Restructuring (CDR) system where the obligor company could not be turned around are now twice the number exiting because of a successful revival. This suggests a deteriorating quality in NPAs being referred to CDR and is based on a report from Macquarie Bank covering April to October 2013. Sectors with particularly high default rates include construction, hospitality, steel, textiles and infrastructure.

Yet if you look at the level of asset disposals to ARCs over the last few years, the figures are relatively low, totally approximately $6.5 billion of assets in book value in the last five years. Why is this?

ARCs are basically cash poor because the ability of investors to fund acquisitions has up to now been massively restricted due to convoluted rules on economic ownership, especially for foreign investors. Up to know most bad asset purchases by ARCs have consisted of 5 percent as cash and the remainder as ‘security receipts’ issued by the ARC trust created to hold those assets.

The effective exclusion of foreign investment led to other issues at the CDR and ARC level, including corruption. This situation has improved to some degree with new rules for ARC ownership issued in August last year. Combined with implementation of the RBI norms maybe India will now finally develop a properly functioning market for domestic distressed debt.