Raghuram Rajan: Explaining bank NPAs - Part I

I have not seen a study that has unearthed the precise weight of all the factors responsible, but here is a list of the main ones.

Over-optimism: A larger number of bad loans were originated in the period 2006-2008 when economic growth was strong, and previous infrastructure projects such as power plants had been completed on time and within budget. It is at such times that banks make mistakes. They extrapolate past growth and performance to the future. So, they are willing to accept higher leverage in projects, and less promoter equity. Indeed, sometimes banks signed up to lend based on project reports by the promoter’s investment bank, without doing their own due diligence. One promoter told me about how he was pursued then by banks waving check books, asking him to name the amount he wanted. This is the historic phenomenon of irrational exuberance, common across countries at such a phase in the cycle.

Slow Growth: Unfortunately, growth does not always take place as expected. The years of strong global growth before the global financial crisis were followed by a slowdown, which extended even to India, showing how much more integrated we had become with the world. Strong demand projections for various projects were shown to be increasingly unrealistic as domestic demand slowed down.

Government Permissions and Foot-Dragging: A variety of governance problems such as the suspect allocation of coal mines coupled with the fear of investigation slowed down government decision making in Delhi, both in the UPA and the subsequent NDA governments. Project cost overruns escalated for stalled projects and they became increasingly unable to service debt. The continuing travails of the stranded power plants, even though India is short of power, suggests government decision-making has not picked up sufficient pace to date.

Loss of Promoter and Banker Interest: Once projects got delayed enough that the promoter had little equity left in the project, he lost interest. Ideally, projects should be restructured at such times, with banks writing down bank debt that is uncollectable, and promoters bringing in more equity, under the threat that they would otherwise lose their project. Unfortunately, until the Bankruptcy Code was enacted, bankers had little ability to threaten promoters (see later), even incompetent or unscrupulous ones, with loss of their project. Writing down the debt was then simply a gift to promoters, and no banker wanted to take the risk of doing so and inviting the attention of the investigative agencies. Stalled projects continued as “zombie” projects, neither dead nor alive (“zombie” is a technical term used in the banking literature).

It was in everyone’s interest to extend the loan by making additional loans to enable the promoter to pay interest and pretend it was performing. The promoter had no need to bring in equity, the banker did not have to restructure and recognize losses or declare the loan NPA and spoil his profitability, the government had no need to infuse capital. In reality though, because the loan was actually non-performing, bank profitability was illusory, and the size of losses on its balance sheet were ballooning because no interest was actually coming in. Unless the project miraculously recovered on its own – and with only a few exceptions, no one was seriously trying to put it back on track – this was deceptive accounting. It postponed the day of reckoning into the future, but there would be such a day.

Malfeasance: How important was malfeasance and corruption in the NPA problem? Undoubtedly, there was some, but it is hard to tell banker exuberance, incompetence, and corruption apart. Clearly, bankers were overconfident and probably did too little due diligence for some of these loans. Many did no independent analysis, and placed excessive reliance on SBI Caps and IDBI to do the necessary due diligence.

Such outsourcing of analysis is a weakness in the system, and multiplies the possibilities for undue influence. Banker performance after the initial loans were made were also not up to the mark. Unscrupulous promoters who inflated the cost of capital equipment through over-invoicing were rarely checked. Public sector bankers continued financing promoters even while private sector banks were getting out, suggesting their monitoring of promoter and project health was inadequate.

Too many bankers put yet more money for additional “balancing” equipment, even though the initial project was heavily underwater, and the promoter’s intent suspect. Finally, too many loans were made to well-connected promoters who have a history of defaulting on their loans.

Yet, unless we can determine the unaccounted wealth of bankers, I hesitate to say a significant element was corruption. Rather than attempting to hold bankers responsible for specific loans, I think bank boards and investigative agencies must look for a pattern of bad loans that bank CEOs were responsible for – some banks went from healthy to critically undercapitalised under the term of a single CEO. Then they must look for unaccounted assets with that CEO. Only then should there be a presumption that there was corruption.

Fraud: The size of frauds in the public sector banking system have been increasing, though still small relative to the overall volume of NPAs.

Frauds are different from normal NPAs in that the loss is because of a patently illegal action, by either the borrower or the banker. Unfortunately, the system has been singularly ineffective in bringing even a single high profile fraudster to book. As a result, fraud is not discouraged.

The investigative agencies blame the banks for labeling frauds much after the fraud has actually taken place, the bankers are slow because they know that once they call a transaction a fraud, they will be subject to harassment by the investigative agencies, without substantial progress in catching the crooks. The RBI set up a fraud monitoring cell when I was Governor to coordinate the early reporting of fraud cases to the investigative agencies. I also sent a list of high profile cases to the PMO urging that we coordinate action to bring at least one or two to book. I am not aware of progress on this front. This is a matter that should be addressed with urgency.

Why Recognise Bad Loans?

There are two polar approaches to loan stress. One is to apply band aids to keep the loan current, and hope that time and growth will set the project back on track. Sometimes this works. But most of the time, the low growth that precipitated the stress persists. Lending intended to keep the original loan current (also called “ever-greening”) grows. Facing large and potentially unpayable debt, the promoter loses interest, does little to fix existing problems, and the project goes into further losses.

An alternative approach is to try to put the stressed project back on track rather than simply applying band aids. This may require deep surgery. Existing loans may have to be written down somewhat because of the changed circumstances since they were sanctioned. If loans are written down, the promoter brings in more equity, and other stakeholders like the tariff authorities or the local government chip in, the project may have a strong chance of revival, and the promoter will be incentivized to try his utmost to put it back on track.

But to do deep surgery such as restructuring or writing down loans, the bank has to recognise it has a problem – classify the asset as a Non Performing Asset (NPA). Think therefore of the NPA classification as an anesthetic that allows the bank to perform extensive necessary surgery to set the project back on its feet. If the bank wants to pretend that everything is all right with the loan, it can only apply band aids – for any more drastic action would require NPA classification.

Loan classification is merely good accounting – it reflects what the true value of the loan might be. It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely losses. If the losses do not materialise, the bank can write back provisioning to profits. If the losses do materialize, the bank does not have to suddenly declare a big loss, it can set the losses against the prudential provisions it has made. Thus the bank balance sheet then represents a true and fair picture of the bank’s health, as a bank balance sheet is meant to. Of course, we can postpone the day of reckoning with regulatory forbearance. But unless conditions in the industry improve suddenly and dramatically, the bank balance sheets present a distorted picture of health, and the eventual hole becomes bigger.

This is the first part of a two-part article.