Sunit Arora explains why the debate on non-performing bank assets is so highly charged and needs to lead to practical changes in the banking system.
A circular by the Reserve Bank of India (RBI) in July has sparked an important debate in India on the strength of bank balance-sheets and on their risk management practices.
The RBI says its missive — titled ‘Framework for compromise settlements and technical write-offs’ — is part of a continuing roadmap for banks and non-bank finance companies on how to deal with loan defaults. In India, a loan becomes a non-performing asset (NPA) if either the principal or interest has been overdue for more than 90 days.
The aim of the circular, the central bank said, is to rationalise existing regulation, tighten up some provisions and make the rules more transparent. What the central bank suggests involves two routes for dealing with defaults.
One is a compromise settlement when the bank agrees to a haircut, that is a reduction in the outstanding dues. The other is a technical write off, to close the loan account. Banks routinely make technical write-offs, where loans are written-off from the books for accounting purposes without foregoing rights to recovery.
Dealing with fraud and wilful default
What has raised eyebrows is RBI’s decision to allow compromise arrangements with wilful defaulters and fraud cases. It marks a shift by the RBI, which had till then clearly instructed banks that “borrowers who have committed frauds/malfeasance/wilful default will remain ineligible for restructuring”. It also introduced a ‘cooling period’, during which fresh lending to wilful and fraudulent defaulters is not allowed.
The political reaction was swift. Opposition parties questioned why the central bank would risk allowing wilful defaulters back into the lending market. Bank employee unions argued that negotiating settlements with firms involved in fraud cases would erode public trust in the banking system. And, commentators stressed, in many cases this was about writing off loans or taking a haircut at the taxpayer’s expense.
Write off regime
Though NPAs are a problem for India’s banking system, it has managed to lower their incidence over the past decade. The gross NPA rate is now at a ten-year low of 3.9%. This decrease is largely due to loan write-offs. According to the RBI, bad loans worth ₹2.09 trillion (£19.75 billion) were written off during the year ended March 2023.
The total loan write off by the banking sector is a significant Rs 10.57 trillion (£101.62 billion) in the past five years, it recently revealed in response to a Right To Information (RTI) query from the Indian Express. In all, banks have written off a staggering ₹15.31 trillion (£144.72 billion) since 2012-13.
As mentioned earlier, write-offs are routine. What is worrying is that the recoveries have been poor. RBI says banks recovered ₹1.09 trillion (£10.3 billion) from ₹5.87 trillion (£55.48 billion) written off in the last 3 years. That’s an 18.5% recovery rate. Going by this track-record, it’s difficult to imagine the banks are going to get more through a negotiated settlement with wilful defaulters and fraudsters.
The RBI’s reasoning
Seeing the feedback to its notification, the RBI furnished a detailed response later in July. It argued that locking lenders’ funds in an unproductive asset is not desirable, and that this has been its regulatory stance since 2007. As long as the legal cases (and penal measures) against wilful and fraudulent defaulters remain untouched, the bank argued, early recoveries by lenders should be a preferred option, subject to safeguards.
Further, because continuing credit relationships with borrowers classified as willful defaulters and frauds would be “fraught with moral hazard” for banks, a compromise settlement is desirable because it leads to “a complete detachment of the lender with the borrower”. In any case, the RBI stressed, such arrangements need bank board approval. So, the main goal behind the guidelines is to help clear up financial blockages in banks’ balance-sheets, it argued.
That said, the central bank did make one clarification: the “cooling period” of a minimum 12 months before a bank can make another loan to wilful defaulters and to those engaging in fraud is not an open invitation for bad actors to borrow fresh funds from lenders, the RBI said. It stressed that this is a “general prescription” for compromise deals. Just as well. Bankers privately admit they were not comfortable with this clause, because it could lead to certain wilful defaulters being given fresh loans.
On September 21, the RBI issued another clarification. It released draft guidelines for treatment of wilful defaulters and large defaulters. “Any account included in the list of wilful defaulters, where the lender has entered into a compromise settlement with the borrower, shall be removed from the list only when the borrower has fully paid the compromise amount,” the draft guidelines noted.
It also suggests that no credit facility shall be granted for floating of new ventures by any lender to a wilful defaulter for five years after it has been removed from the list of wilful defaulters. The draft guidelines will be codified into law after public feedback and consultations.
Loot and scoot
The relationship between wilful defaulters and nationalised banks is an emotive issue in India. Memories of the twin balance-sheet problem – that is overleveraged corporates and high levels of non-performing-assets at banks in the easy-money period after the 2008 crisis – have not faded.
It is widely believed that politically-connected corporations manage to secure loans from nationalised banks with the intention of defaulting later. PSU banks accounted for 75.9% of aggregate gross NPAs compared to 61.9% of advances, according to Care Ratings. In recent years, many of these NPAs have been written off.
The public perception that big borrowers may be playing fast and loose with the system stems from the fact that smaller firms and individuals face stricter repayment rules, collection agents, and lowering of credit scores if they fail to keep up payments.
While banks do not furnish the names of wilful defaulters, a few years ago the finance ministry released a list of the top wilful defaulters. Some of the promoters of these entities have fled the country, fuelling the feeling that the government needs to do more to hold loan defaulters accountable for their actions.
The government argues that measures like the Insolvency and Bankruptcy Code, setting up for the national asset reconstruction company, and streamlining NPA recognition norms have made an impact in cleaning up the banking system.
But, as bankers will affirm, bad loans are made in good times. Unless banks set up rigorous systems around giving loans, identify NPAs quickly and secure higher recoveries, bad loans will be back.
And there is reason to be wary. The amount of money in the wilful default category jumped by 39% to ₹3.40 trillion (£32.12 billion) in the two years to December 2022, according to Transunion Cibil. Watch this space.
Sunit Arora is an independent journalist and editor based in Delhi. His twitter handle is @sunitarora