NPAs – Isn’t Prevention better than Cure!

The large and increasing levels of Non Performing Assets of the Indian banking industry has been hogging headlines for quite some time now, and there seems to be no end to the saga. To manage and contain this problem academicians, policy makers, RBI, and the Government have come up with various solutions with the insolvency code being the latest kid in the block. 

The proximate reasons for phenomenal increase in reported non-performing assets (NPAs) over the last three years, is not change in economic conditions or wilful defaults. It is simply because we had a strong regulator who insisted that banks follow the laid down, internationally accepted norms for recognizing NPAs – the so called Asset Quality Review. Otherwise, it would have been business as usual till one fine day the banking system would have simply collapsed and taken the real economy (and all of us too) along with it!

Any solution to a problem needs to first look at the reasons as to why the problem has arisen. Let us do the same for our “NPA” problem!

A manufacturing organisation makes physical products – say cars, or detergent, or steel utensils etc. To ensure consistent production of goods of high or at least acceptable quality they set up quality control systems which encompass design of appropriate manufacturing processes, quality control of their raw material or sub-assembly suppliers, correct operation and control at each stage of the manufacturing process till production of the finished product. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

Similarly, one of the key functions of banks is to continuously produce good quality loans & advances. By good quality, it means loans which are remunerative and have low probability of default. From this perspective, the incidence of high and growing levels of NPAs in the Indian banking system is akin to a manufacturing organisation making a larger than acceptable level of defective products.

The production process used by banks to ensure that consistently good quality loans are made consists of making a series of appropriate judgments or decisions for which banks need to have, inter alia, an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and suitable training, understanding how or why credit risks arise and having clear laid down credit risk  management policy, having a suit of loan products which are in line with the requirements of the potential borrowers and the risk capabilities of the bank, a not too cumbersome loan documentation process (this is extremely tricky since workable debt contracts are far from complete contracts!), monitoring the loans once it is made, and taking corrective action as and when required, entrapping the cash flows etc. All these taken together would ensure a high probability that the loans & advances made are repaid on time and on the terms agreed at the outset.  Failing which, banks have to have sound processes for recovering loans which go bad inspite of taking all possible measures earlier.

Now for banks to be able to take sound decisions it is essential to create a governance framework which encourages and nurtures independence and professionalism. Something which is just not engendered by having RBI, GOI, vigilance departments, criminal investigations, and courts micro-managing how banks perform their work and breathing down the necks of bankers 24 by 7. One result of such micro-management is the extremely voluminous loan appraisal notes prepared by banks. This detracts focus on the nature, quality and key risks of the credit while protecting all the people involved in the decision making process from any adverse outcome. The consequence is extreme delays in decision making and no clear cut indicators on accountability. In practice, ultimately the most helpless lowest level official, who has no support of the union or political support of any kind who ends up facing the music. This in turns leads to decisions being based on all kinds of extraneous reasoning which have little to do with the borrower and the credit risk. Appraisal notes running into 100 – 150 pages is the norm. I really wonder as to what kind of reasoned decision taking can take place under such circumstances. 

I would like to give another small (and totally unrelated to present discussion on NPA management) example of micro-management by RBI. For anyone doing any kind of business, the base level understanding is that they should know their customer. Even a doctor evaluates his patients on parameters others than strictly medical, say on socio-economic parameters, before prescribing any line of treatment. Now banks have to follow a strict and detailed KYC norms prescribed by RBI (which is also extremely difficult to comprehend). Are our banks and bankers so incompetent that they are unable to properly and correctly evaluate their customer?

Having nearly 70% of our banking system in the public sector has had another extremely adverse effect – the virtually complete absence of creativity and innovation. The closed, one size fits all framework for recruitment, promotions, pay-scales, to the extremely outdated and dysfunctional conceptual system under which most lending and monitoring is done, and the identical Core Banking System has left little room for experimentation and innovation, or growth. After all only open systems can hope to achieve negative entropy! Public sector does not automatically mean lack of professionalism and accountability, provided governance systems enable and nurture it. In this regard the continued interference of DOB, MOF with its natural consequence of politicization of decision making at all levels is a key factor and needs to be addressed forthwith. Any change for the better would have to start from here.

On the conceptual framework of lending in India, a couple of issues are extremely critical. First, the dichotomy on working capital versus term lending is not only artificial but also misleading. For the lender there should be only one focus, the debt servicing ability (both quantum as well as volatility) of the borrower and mechanisms for entrapping cash flows. No borrower can service its debt (which is the same as no lender can expect recovery) by recourse of foreclosing just either the working capital assets or the long term assets – or even both. For debt to be serviced the sine quo non, which is invariably missed out, is a functional borrower which can be expected to continue indefinitely as a going concern and create economic surpluses. Second, the single minded focus on security in lending misses on the nature of risk – whether the risk being assumed is in the nature of a debt risk or an equity risk – resulting in mispricing of the risk. An experience through which all of us have lived for more than 30 years are our DFIs. They were taking exposures on a portfolio of assets where their risk was essentially equity / quasi-equity in nature while their returns were wholly debt related. It is natural that the returns from such a portfolio would be sub-optimal. The main culprit here was equity risk premium, not sloppy appraisal or monitoring or the biggest bug-bear of all of us – corruption.       

The idea of having a “bad bank” is very much workable, if and only if, the reasons for proclivity of Indian banks to continuously create NPAs is first sorted out. The capital requirements can be fairly easily be met even for transferring entire reported NPA level of Rs.10 lakh crores. First, the bad bank need not take over the entire NPAs at book value. They can very well take it at a discount of say 10% of the book value with agreement to share any surpluses in recovery over a certain minimum. That would reduce the total capital requirement to Rs.1 lakh crore. Second, banks typically function at a Capital Adequacy Level of about 12%. As such the equity required to fund holding Rs.1 lakh crores of assets would only be around Rs.12,000 crores, with the balance funded through debt. This equity be funded on 50:50 ratio with GOI picking up Rs.6000 crores and the banking industry taking over the balance Rs.6000 crores. The balance capital requirement could be met through debt from the banking industry itself specially if such debt were guaranteed by GOI and qualify as SLR investment.

Keeping NPAs low for banks is critical for various reasons. First, NPAs deliver a double whammy to the bottom line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans. Second, banks being highly leveraged entities have much lower room to manoeuvre fall in operating margins, something rising NPAs result in. As such, it is important that actual NPA levels be monitored regularly and closely, otherwise they start making losses. Third, by affecting ability of banks to provide loans as well as liquidity services to the real economy (since the quantum of lending / funds available to grease the economic system with banks is exponentially inversely proportional to rising NPA levels) the income and employment opportunities in the real economy start getting curtailed (rather drastically) with rising NPAs in the banking industry. Finally, banks maintain the institutional memory of credit history of all the actors in the real economy in their records. It is very hard and expensive to recreate this information once lost. When NPAs become so high that a bank becomes bankrupt and has to be closed down, this memory is as good as lost forever. This in turn leads to a break in the payment cycle to and from the various players in the real economy, which in turn hits the real economy hard by drastically reducing both income and employment opportunities in the economy. These are the primary reasons that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones and making managing NPA critical for our collective well-being.