India’s commanding heights are being brought down by its own laxity. With the rate cut underway in savings schemes, India’s fiscal policy is beginning to come to grips with its bad loans conundrum. India’s economy remains bedevilled by bad debt-laden public sector banks (PSBs) — unable to recoup them given the economy’s state, and unable to write them off. Institutional concerns about non-performing assets (NPAs) repayment are rising, along with the rising risk of financial instability. The Reserve Bank of India, enunciating concerns about PSB balance sheets that are under significant stress, said, “Their gross non-performing asset (GNPA) ratio may go up to 6.3 per cent by September 2016,” while a severe stress scenario could push this to 8 per cent. Sectoral NPAs will rise, with construction (7 per cent of total advances), iron and steel (8 per cent) and engineering (9 per cent) all facing a financial crunch.

In comparison, capital provisioned for such NPAs in PSBs rarely cross 3.8 per cent, while severe economic stress leading to full loss of the NPA’s total capital would wipe out 13.1 per cent of total advances. Credit concentration risk has risen alarmingly — defaults by the RBI’s top 10 group-borrowers would wipe out 30 per cent of capital, affecting 27 banks. Loan restructuring continues, with stressed loans (gross NPAs and restructured advances) at 14.5 per cent for PSBs. Such restructuring can incentivise defaults — 40 per cent of restructured loans turned into bad loans between 2011 and 2014. The market capitalisation of such afflicted PSBs has dropped below their inherent book value.

Meanwhile, corporate balance sheets are highly stressed, with private investment remaining weak. According to Credit Suisse, the number of companies with unhealthy earnings before interest and taxes to interest expense ratio (<1.0) has remained consistently above 1,000, lying below investment grade. Indian industries have seemingly reached the “Ponzi” stage of financing wherein companies do not earn enough to pay the interest on outstanding loans. India’s upcoming financial instability could prove Minsky’s hypothesis right. Vijay Mallya’s shenanigans aside, the NPA rot lies far deeper. There are 5,275 other “willful defaulters” who owe Rs 56,521 crore to Indian banks — such loans having grown nine times over the last decade. This bank-defaulter nexus has influenced policy, with 85 per cent of all stressed assets coming from the industrial sector. Loans were made with little to no tangible collateral (the Kingfisher brand was valued at Rs 3,000 crore by Grant Thornton), while corporations utilised public money to engage in unrelated businesses (land acquisition in the US by Zoom Developers). A combination of worsening business conditions, wrong-headed business decisions and banking malpractice and inefficiency created this NPA conundrum. The RBI should be given credit for, howsoever late, identifying such systemic risks. It has undertaken a number of regulatory initiatives to strengthen credit risk management at banks, increase capital against such NPAs (5 per cent for “standard assets”) and enforce promoter payments. Governance reforms, under “Indradhanush”, have led to the creation of the Bank Board Bureau along with the introduction of key performance indicators to measure banking performance. The urgency of resolving stressed assets with capital infusion and the passage of the Insolvency and Bankruptcy Bill has become stark. We face a restructuring dilemma. Banking capital, tied up in stressed assets, needs to be freed given the burden of higher provisioning. Banks can typically recognise failed structural loans as either NPAs, Asset Reconstruction Company (ARC) sales or restructure them using the strategic debt restructuring (SDR) route. The sale of such assets, to specially constituted ARCs, similar to the famed Troubled Asset Relief Programme (TARP), can help localise this problem to a “bad bank”. However, the current ARC model is flawed — despite more than 15 private ARCs registered under Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, little has been achieved (less than 33 per cent resolution on assets acquired with combined net worth of just Rs 4,000 crore). We need to reform our current ARC model. Over the long term, we must encourage the development of an ARC market where price discovery is encouraged. Banking mergers should be encouraged, especially amongst banks with high net NPAs and low provisions, while others should merit greater lending scrutiny. State Bank of India, with its Rs 40,250 crore of NPAs, requires special treatment. Failing banks which cannot be salvaged through asset sales or recapitalisation through “Indradhanush” should be provided limited additional survival capital with future expansion constrained by internal accruals. Recapitalisation, a radical surgery, is urgently required. PSBs need to invest in long term projects to gain adequate returns for growth. However, identifying risks in such projects is an inexact science, with India’s banks still evolving. The P.J. Nayak Committee’s recommendations seeking a Banking Investment Company (BIC) owning all public sector banks and controlling director appointments should be implemented. This will require repeal of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970. Loan recognition remains immature with PSU banks having stressed loans at 230 per cent of their capital. Early warning systems, designed using bank’s internal and external data elements and integrating a borrower’s pre-default behaviour with analytics, can help lenders take necessary steps in good time. The creation of the Central Repository of Information on Large Credits in 2014, along with the Joint Lenders’ Forum (JLF), are encouraging steps. A vibrant bond market would prove to be the greatest deterrent. Stiff premiums would have been commanded in the wake of ill-financial health (evident in Kingfisher’s case when airports refused planes to land unless fees were paid upfront) instead of sweet deals from public banks to hide their worsening asset quality. As recently implemented, cuts in banking deposit rates will help banks boost their bond portfolios. Risk sharing between borrowers and lenders needs to be re-instituted with controls on “riskless capitalism”. Shaming campaigns should be continued, impugning the defaulting parties as freeloaders on taxpayer money. Additionally, crony capitalistic practices — promoters establishing shell companies to repurchase stressed assets at muted valuations — need to be heavily penalised. We need a balanced loan-asset management system, focused on equitable risk sharing and better loan structuring. Achieving this will require fundamental reformation.