The Banking Regulation Ordinance (Amendment) of 2017 which passed earlier this month empowered the Reserve Bank of India (RBI) to directly intervene in the bank’s non performing asset (NPA) resolution process to accelerate the process of removing bad loans and assets from the banks’ balance sheets and kick start credit growth.

The Indian banking sector is saddled with debts estimated to be over 10 lakh crore rupees where the borrower has defaulted – a large part of which was revealed after the RBI’s asset quality review (AQR) last year that pushed banks to finally recognise a large number of outstanding loans were no longer being serviced.

Yesterday, the RBI released a notification detailing specific rules around its involvement in the NPA resolution process under the ordinance. In the notification, the regulator increased the size of its oversight committee to handle the large number of cases; proposed constituting an advisory panel and announced that it will revise its restructuring rules to allow a “value optimising” resolution process.

A number of market participants and economists agree that the RBI’s involvement in what is essentially a commercial decision is not right. According to a former PSU banker who requested anonymity, the regulator’s involvement into the resolution process is not ideal since the regulator is not equipped to make decisions around the pricing and sale of distressed assets.

“They are used to thinking from a regulator’s perspective and I don’t know how they will equip their officials to make commercial decisions. It has nothing to do with regulation or rule framing,” he says.

A large part of the government’s argument is that the RBI needs to get involved because bankers are afraid to trigger bankruptcy or take any decision on the resolution bad loans out of fear of investigation by the Central Bureau of Investigation or the Central Vigilance Commission. A bottleneck in resolutions is in no one’s interests, except maybe the defaulting promoter who has no obligation to pay, even if they have the ability to.

Market participants agree and even those who are against this ordinance on principle believe it may kick start the loan resolution process. The former banker said that employees in state-owned banks have the least incentive to go after defaulters.

“As a PSU banker, you are paid a meager salary, so if the CBI and CVC start harassing public sector bankers they will not take a decision. They took the loan decision and now the people are facing the music. For NPA, if they take the decision, they will face the music three years down the line.. So why should they take it?” said the former banker.

The new norms will presumably allow the RBI to make quick decisions on triggering bankruptcy in the case of defaulters, on the behalf of the banks. This should help banks kick start the process of resolution. An executive working for a large asset reconstruction company said that this will be the extent of the RBI’s involvement in the process – pushing the bank to make decision without getting involved in the actual negotiation.

“The RBI is not involving in taking the decision, they are only saying that banks need to take the decisions fast, and if banks don’t take the decision then they will. So they are not getting involved in the commercial negotiation on price etc. As the apex body, they had already been monitoring the process.. with this they are involving themselves more directly,” he said.

Despite disagreements, everyone Newslaundry spoke to said the ordinance is better than the alternative, which is doing nothing. According to the restructuring executive, this ordinance is needed because the banks are in dire straits and the government needs to take emergency measures to deal with the crisis.

Solutions

Short to medium term

Recapitalisation 

Recapitalisation won’t resolve the underlying issue but banks will need to address this sooner or later. Credit growth cannot occur without capital and the government will have to inject a significant amount of cash into public sector banks. Banks can also raise capital by issuing shares or debt instruments in the domestic and international markets. Under its Indradhanush plan in 2015, the government announced that it will inject 70,000 crore rupees in public sector banks in the next four years. A second re-iteration of this plan is expected to be announced this year.

Asset reconstruction companies

Asset reconstruction companies can play a valuable role, not just in the current resolution but for future NPA’s. These firms raise capital from outside investors and then use this to buy stressed assets and non-performing loans from banks at a significant discount. The banks are able to get rid of bad assets from their balance sheet and get back to their core business, while the ARC can work on liquidating the assets and working with defaulting companies to restructure their loan payments. ARC’s can help companies raise cash to re-start their business and allow them to defer payments on loans until they are cash flow positive. However, banks can do neither. ARC’s currently purchased over 2 lakh crore rupees in bad loans till date, and the restructuring professional quoted above claimed that the industry can double this amount in the next two years.

Long-term

Bond market development

A big part of the underlying cause of the NPA crisis is the inability of most banks to evaluate large infrastructure projects for viability before extending financing to them. This makes it difficult for them conduct due diligence or hold the project accountable for delays in payments. For such projects, bonds are ideal for raising capital if a liquid market is available. Bonds are graded by ratings agencies that can analyse projects thoroughly and systematically.  However, because of a number of policy and structural issues, India has not been able to develop a robust and liquid corporate bond market. The RBI, SEBI and the Ministry of Finance need to make this a priority.

Regulatory change 

The challenge in Indian banking seems to be a challenge of checks and balances. The sector seems to engage in feedback loops in every business cycle. This leads to every stakeholder – from the banks to the Ministry of Finance – doubling down on a strategy of credit growth leading up to the 2008 financial crisis.

Despite the size of the issue, there is very little clarity on what the role of the RBI has been in this. Financial regulators in India are opaque entities and there is very little public scrutiny on the regulatory process. According to Pratik Datta, researcher at the National Institute of Public Finance and Policy, preventing a recurrence of this crisis in the long-run, requires a fundamental change in the way our regulator functions.

“Currently the internal functioning of the regulator is very opaque. We know this whole crisis has been slow to develop. We have to question why this didn’t become a concern earlier? Why was this not brought up and given adequate attention? How did evergreening of loans [loans that do not require the principal amount to be paid off within a specified period of time] really happen? Why is the underreporting coming out now?”

Datta added that the RBI’s claim to expertise and call for autonomy have meant that the RBI has had very little public accountability.

“The RBI needs independence from the government in monetary policy decisions but not in every aspect of its functions. The regulator is an un-elected agent of the our elected representatives in parliament. And it is the parliament needs to impose certain checks and balances on the regulator through a clear and transparent code created by them. Unfortunately in India, it is the other way round. We need to question this lack of accountability as far as certain functions of bank regulation go,” he said.

Datta said that the Indian Financial Code that was drafted by the Financial Sector Legislative Reform Commission chaired by retired Justice BN Srikrishna, provided a clear blueprint for reforming the financial sector. Although many parts of the code has been enacted by the current government, there is much resistance by the regulators for enacting key parts of regulatory reform envisioned by the code.

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As it always happens with the financial sector, banks tend to be exempt from the rules of regulation and governance. Its importance to the economy and the relative complex nature of the business, means that we are doubling down on growth while looking at band-aid solutions to big, systemically threatening crises. Most people in industry are lukewarm about the NPA ordinance; no-one is confident this will have the desired effect and many object to it on principle.

Yet, most people agree this is one of very few options left with the government and the RBI to help defeat the multi-headed hydra that the NPA crisis has become. We are looking at atleast 2 years of fire fighting that will consume heavy financial and human effort without any assurance that such a crisis won’t repeat itself. Every loan portfolio has bad loans but a systemic NPA crisis requires a massive institutional failure across stakeholders and across the value chain.

The underlying institutional issue is often lost in the web of directives and notifications and amendments and the taxpayer will eventually bail a number of the state-owned banks out through recapitalisation. Given the small number of active income tax payers in the country, this is unlikely to cause public outrage of any scale.