The paper published by Raghuram Rajan and Viral Acharya addresses how the PSBs face the systematic risk of inadequate loan disbursing standards and ineffective resolution processes
By: Tavaga Research
With the world economies eyeing the fag end of the pandemic, a need to introduce well-structured reforms is key in ensuring systemic stability. Raghuram Rajan, ex-RBI Chairman, and Viral Acharya, ex-RBI Deputy Governor have attempted to propose the said reforms for the banking sector of India. The paper, in addition to the management of public sector banks (PSBs) and bad loans, also touched upon strengthening risk management at banks.
Credit growth is considered an important function of growth in the gross domestic product (GDP). As for ideal emerging market trends, India is operating at a low credit to GDP ratio of less than 60 percent. The reason for such a trend is that banks in India stick to high-quality borrowers and there is an entire section of the economy waiting to be tapped. However, low credit penetration is not consistent with a high proportion of non-performing assets (NPAs) in India. As cited in the paper, Gross NPA to total assets ratio stood at 8.5 percent for the banking sector as a whole, and 11.3 percent for PSBs. Ironically, high-quality borrowers have contributed significantly to asset downgrades whereas default rates on loans provided by micro-credit institutions have been lower. The non-banking finance, in the form of housing finance and asset-based finance, has emerged as an alternative to traditional bank finance. Unfortunately, the NBFC sector has also been under stress as witnessed in the recent NBFC crisis concerning ILF&S and Dewan Housing Finance.
The paper addresses how the PSB sector faces the systemic risk of inadequate loan disbursing standards and ineffective resolution processes of distressed sectors.
What is currently wrong with Banking in India?
The private undertaking of infrastructure projects has become a trend, which points to the long-term capital investment needs of such projects. The highest-quality borrowers have resorted to capital markets, such as equity and bond markets, for their borrowing needs. With such competition in place, the quality of lending for banks has come into question. Banks are typically left with risky infrastructure projects which may or may not turn cash-positive. Instead of lending down the credit curve, PSBs may stick to financing the Government instead of undertaking new loans. These PSBs are unable to strike a balance between ‘playing it safe’ and ‘betting on risky’. Essentially, public sector banking is unable to grow to its fullest potential being aversive to new business.
Catering to deposits has also become a costly affair for banks because households now have convenient access to financial markets. PSBs are also losing out on deposit share of retail lending and private banks are dominating the market. PSBs are torn between their sole purpose of existence to serve the public and the ability to sustain the increasing competition in the banking space.
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How to approach the problem of NPAs?
In case of a stressed loan, the bank typically resorts to either ever-greening (giving new loans to service old loans) or loan restructuring. Ever-greening involves extending the term of the loan and has an opportunity cost of missing out on deploying capital toward better quality borrowers. Restructuring, on the other hand, is a more comprehensive manner of treating stressed debt that involves a reduction of interest rate, conversion of a portion of the loan to equity, and even writing down the value of the loan.
A loan is eligible for restructuring only if it is classified as a non-performing loan. Once classified as NPA, the bank has to create provisions for such loans. Provisioning smoothens the effect of bad loans over a period on the bank’s balance sheet and the revenues of the bank do not experience a sudden event. However, provisioning for bad loans translates into low Government revenues or higher commitment to recapitalize banks. Provisioning makes the bank look good on paper, which overstates the bank’s capacity to disburse more loans. If the realization of bad loans is not as per estimations of recovery rates, the pressure falls on the taxpayers to recapitalize the bank.
- Out-of-court restructuring frameworks: In case of bankruptcy, National Company Law Tribunal (NCLT) assumes responsibility for the restructuring of stressed assets. Given the limited capacity of NCLT, the paper proposes a system of time-bound out-of-court restructuring between the creditor and borrower before taking the proceedings to NCLT.
- Development of an online platform for distressed loan sales: To reflect transparency in the sale of loans, a secondary market can be created for price discovery of bad loans. A secondary market for such transactions will also provide a price reference for selling bad loans and the banks will not fear unwarranted scrutiny over writing down loans.
- Asset management bad banks: Bad banks act as an aggregator of bad loans and assume ownership of the underlying assets. If these banks take over the borrower, the value of the loan realized will be higher. Bad banks can also engage in a turnaround strategy and be compensated for in equity. For example, bad banks may decide to carry forward an asset until demand revives instead of panic selling such assets or operating them at a sub-optimal capacity.
Numerous recommendations tend to make better loans, which stresses the importance of better project evaluation units within the internal framework of the bank. A shift from asset-based lending to cash-flow based lending is suggested by the ex-RBI officials. Cash-flow based lending is linking the covenants of loan agreements to leverage and liquidity performance of the borrowers. Such a method of lending is bound to lead to a proactive system of provisioning and proficiently automate risk management.
Making better loans also means minimizing fraud. RBI has set aggregate group lending limits and must impose them when the economy meets demand revival.
Should there be re-privatization or change in management structure for PSBs?
The paper deliberates on how the change in ownership structure for PSBs is not necessarily limited to re-privatization. The following is a summary of how the PSBs can bring a positive change in the management to better align operational efficiency with objectives:
- PSBs have to cater to certain mandates of financial inclusion and accessible finance across sectors. These mandates are non-commercial and hurt the profitability and asset quality of banks. An alternate approach, as proposed by the paper, maybe to reimburse the banks for these mandates. The Government can devise a scheme of compensating banks for servicing non-commercial causes, such as operating in remote areas.
- PSBs do not enjoy operational independence on how to function. The Government plays a key role in appointing the Board members PSBs to be able to ensure that the decisions taken by the Board are in line with the public agenda. A suggested reform is to form a holding company, owning a stake in PSBs, entrusted with the sole responsibility of appointing Government directors to bank’s Boards. Such a holding company calls for the elimination of the Department of Financial Services (DFS) in the Ministry of Finance.
- Ensuring incentive-based remuneration structure for public sector bankers to encourage decisions toward prudent undertaking and monitoring of projects. This will foster competition between the public and private sectors for expert personnel.
- The paper encourages the option of PSBs turning into state-linked banks instead of state-owned. The divestment shall be in phases so that the bank boards can maintain oversight while reducing their stake in PSBs. Re-privatization of banks will free PSBs from the public sector norms and reward operational freedom. However, re-privatization shall be avoided if the buyer is a corporate house to eliminate the possibility of self-dealing, where the corporate house will favorably disburse loans to their subsidiaries.
How to establish robust risk management in the banking system?
The ex-RBI officials urge the banking sector to manage the interest rate risk based on clearly outlined strategies. The paper underscores the importance of statutory liquidity requirements (SLR) in presence of liquidity of coverage ratios (LCR). Encouraging mark-to-market accounting on treasury securities will pass through the changes in the interest rate in economic value terms. The adoption of IFRS/Ind accounting standards will help better adapt to the changing scenario globally. Banks will resort to interest rate risk derivatives to hedge against variations in earnings attributed to mark-to-market accounting. Credit derivatives, such as credit default swaps and loan guarantees, can also be used to manage credit risk.
Another key issue discussed in the paper was concerned with the pass-through of RBI policy rate cuts to end consumers. To better offer the benefits of rate cuts, banks must decide to link the loan rates across sectors to the policy repo rate.
Long overdue reforms on better loan underwriting, monitoring, recovery, and robust risk management are the only ways to ease the pressure on the banking sector in India. For India to attain its GDP and development goals, the banking sector will act as a catalyst. Re-capitalization is not the only solution to provide relief due to the country’s mounting debt-to-GDP ratio and fiscal deficit entering double digits. The pandemic is a call to action for the Government on taking the reforms necessary to capitalize on the looming opportunities.