Raghuram Rajan explains bank NPAs - Part II  

Did the RBI create the NPAs?

Bankers, promoters, or their backers in government sometimes turn around and accuse regulators of creating the bad loan problem. The truth is bankers, promoters, and circumstances create the bad loan problem. The regulator cannot substitute for the banker’s commercial decisions or micromanage them or even investigate them when they are being made. Instead, in most situations, the regulator can at best warn about poor lending practices when they are being undertaken, and demand banks hold adequate risk buffers. The RBI is primarily a referee, not a player in the process of commercial lending. Its nominees on bank boards have no commercial lending experience and can only try and make sure that processes are followed. They offer an illusion that the regulator is in control, which is why nearly every RBI Governor has asked the government for permission to withdraw them from bank boards.

The important duty of the regulator is to force timely recognition of NPAs and their disclosure when they happen, followed by requiring adequate bank capitalization. This is done through the RBI’s regular supervision of banks.

Why did RBI initiate the Asset Quality Review?

Once we had created enough ways for banks to recover, we decided to not prolong forbearance beyond when it was scheduled to end. Banks were simply not recognizing bad loans. They were not following uniform procedures – a loan that was non-performing in one bank was shown as performing in others.

They were not making adequate provisions for loans that had stayed NPA for a long time. Equally problematic, they were doing little to put projects back on track. They had also slowed credit growth.

What any student of banking history will tell you is that the sooner banks are cleaned up, the faster the banks will be able to resume credit. We proceeded to ensure in our bank inspections in 2015 that every bank followed the same norms on every stressed loan. We especially looked for signs of ever-greening. A dedicated team of supervisors ensured that the Asset Quality Review (AQR), completed in October 2015 and subsequently shared with banks, was fair and conducted without favour. The government was kept informed and consulted on every step of the way, after the initial supervision was done.

Did NPA recognition slow credit growth, and hence economic growth?

The RBI has been accused of slowing the economy by forcing NPA recognition. I actually gave a speech in July 2016 on this issue before I demitted office, knowing it was only a matter of time before vested interests who wanted to torpedo the clean-up started attacking the RBI on the growth issue. Simply eye-balling the evidence suggests the claim is ludicrous, and made by people who have not done their homework. Let us start by looking at public sector bank credit growth compared with the growth in credit by the new private banks. As the trend in non-food credit growth shows (Chart 1), public sector bank non-food credit growth was falling relative to credit growth from the new private sector banks (Axis, HDFC, ICICI, and IndusInd) since early 2014.

Whenever one sees a slowdown in lending, one could conclude there is no demand for credit – firms are not investing. But what we see here is a slowdown in lending by public sector banks vis a vis private sector banks. Interestingly, if we look at personal loan growth (Chart 5), and specifically housing loans (Chart 6), public sector bank loan growth approaches private sector bank growth. So the reality is that public sector banks slowed lending to the sectors where they were seeing large NPAs but not in sectors where NPAs were low.

The fact that the public sector bank credit slowdown to industry dates from early 2014 suggests that the bank cleanup, which started in earnest in the second half of fiscal year 2015, was not the cause. Indeed, the slowdown is best attributed to over-burdened public sector bank balance sheets and growing risk aversion in public sector bankers. Their aversion to increasing their activity can be seen in the rapid slowdown of their deposit growth also, relative to private sector banks

In sum, the Indian evidence, supported by the experiences from other parts of the world such as Europe and Japan, suggests that what we were seeing was classic behaviour by a banking system with balance sheet problems. We were able to identify the effects because parts of our banking system – the private banks -- did not suffer as much from such problems.

The obvious remedy to anyone with an open mind would be to tackle the source of the problem – to clean the balance sheets of public sector banks, a remedy that has worked well in other countries where it has been implemented. This is not a “foreign” solution, it is an economically sensible solution. It is something that has been repeatedly flagged by the government’s own Economic Survey, under the guidance of the respected Dr. Arvind Subramanian. Clean up was part of the solution, not the problem.

Why do NPAs continue mounting?

The AQR was meant to stop the ever-greening and concealment of bad loans, and force banks to revive stalled projects. The hope was that once the mass of bad loans were disclosed, the banks, with the aid of the government, would undertake the surgery that was necessary to put the projects back on track. Unfortunately, this process has not played out as well. As NPAs age, they require more provisioning, so projects that have not been revived simply add to the stock of gross NPAs.

A fair amount of the increase in NPAs may be due to ageing rather than as a result of a fresh lot of NPAs. Why have projects not been revived? Since the post-AQR process took place after I demitted office, I can only comment on this from press reports. Blame probably lies on all sides here.

a) Risk-averse bankers, seeing the arrests of some of their colleagues, are simply not willing to take the write-downs and push a restructuring to conclusion, without the process being blessed by the courts or eminent individuals. Taking every restructuring to an eminent persons group or court simply delays the process endlessly. b) Until the Bankruptcy Code was enacted, promoters never believed they were under serious threat of losing their firms. Even after it was enacted, some still are playing the process, hoping to regain control though a proxy bidder, at a much lower price. So many have not engaged seriously with the banks.

c) The government has dragged its feet on project revival – the continuing problems in the power sector are just one example. The steps on reforming governance of public sector banks, or on protecting bank commercial decisions from second guessing by the investigative agencies, have been limited and ineffective. Sometimes even basic steps such as appointing CEOs on time have been found wanting. Finally, the government has not recapitalized banks with the urgency that the matter needed (though without governance reform, recapitalization is also not like to be as useful).

d) The Bankruptcy Code is being tested by the large promoters, with continuous and sometimes frivolous appeals. It is very important that the integrity of the process be maintained, and bankruptcy resolution be speedy, without the promoter inserting a bid by an associate at the auction, and acquiring the firm at a bargain-basement price. Given our conditions, the promoter should have every chance of concluding a deal before the firm goes to auction, but not after. Higher courts must resist the temptation to intervene routinely in these cases, and appeals must be limited once points of law are settled.

That said, the judicial process is simply not equipped to handle every NPA through a bankruptcy process. Banks and promoters have to strike deals outside of bankruptcy, or if promoters prove uncooperative, bankers should have the ability to proceed without them.

Bankruptcy Court should be a final threat, and much loan renegotiation should be done under the shadow of the Bankruptcy Court, not in it. This requires fixing the factors mentioned in (a) that make bankers risk averse and in (b) that make promoters uncooperative. We need concentrated attention by a high level empowered and responsible group set up by government on cleaning up the banks. Otherwise the same non-solutions (bad bank, management teams to take over stressed assets, bank mergers, new infrastructure lending institution) keep coming up and nothing really moves. Public sector banks are losing market share as non-bank finance companies, the private sector banks, and some of the newly licensed banks are expanding.

This is the second part of the two part article.

The first part can be read here:

Raghuram Rajan: Explaining bank NPAs - Part I