Can central bank stem NPA rot?

This was published in the DNA on the 29th of May 2017

Indian banking is often in the news — sometimes as entertainment (around high-profile failed airline promoters), but mostly serious. The government’s recent NPA Resolution Amendment to the Banking Regulation Act is a serious development, which comes not a day too soon. NPAs now, at nearly Rs 9.6 lakh crore, account for 15 per cent of all bank loans and constitute a serious bottleneck to growth. However, is it kosher for RBI, as does the Central Bank (CB), to get operationally involved in the resolution of NPAs? And, is it enough?

The short answer to the first question is, absolutely. The puritan argument is that it represents a conflict of interest for the CB. A regulator cannot be seen to be resolving what is essentially a commercial decision of a regulated entity. However, taken to its natural conclusion, this approach will result in the banking industry proving the old chestnut “operation successful, patient died”. Ergo, CBs often get involved. The Bank of Japan (BoJ) recapitaliSing Japanese banks in the late 1990’s, US Fed acting as a lead arranger of rescue finance for LTCM in 1998 and the US Fed (2008) buyback of $1.5 trillion of distressed mortgage securities — these are but a few recent instances of active CB involvement in bank bailouts. In short, this is par for the course.

Now, for the second (and real) question — is it enough? A basic background first.

What are the basic steps involved in resolving a bad loan (NPA) issue? It normally consists of three basic rules:

Firstly, recognising the bad loan. Secondly, estimating and affecting a haircut on the loan, either to make the underlying business viable or to sell off the loan, and thirdly, generating capital to absorb the haircut.

Over the last few years, RBI has done stellar work in recognising NPAs. However, it is in the resolution of these loans where the ball got stuck.

First, thanks to the scourge of the 3 Cs (CBI, CAG, CVC), PSB bankers have been loathe to structuring haircuts for any loan gone bad. Arrests of senior bankers (including an ex-chairman of IDBI Bank) have further queered the pitch. Second, a limited tenure of most PSB bankers have meant that they have found it easier to simply evergreen the loans. In simple parlance, leave the problem for their successors. As a result, a stressed loan of (say) 100, after unpaid interest, interest on interest, fines on delays, balloons up to 200 or more by the time someone starts taking action.

This is where the new Ordinance helps. With this, bankers have received RBI cover to take decisions. RBI has a high (and deserved) reputation of integrity and professionalism. Haircuts agreed to by bankers under the direction, supervision and operational monitoring of RBI are unlikely to invite allegations of personal corruption that they could otherwise. While the process is still complex, with relatively few cases accounting for the bulk of bad loans (the top 20 cases account for over half of stressed loans by value), decisions should now be happening at a faster clip.

This brings us to the last, and by no means the least, of the issues — capital. Once the bank has identified the bad loan and determined a fair haircut value for the asset — it needs capital to recognise the haircut on its balance sheet.

Unfortunately, bank recapitalisation has progressed inadequately. The total outlay in the Union Budget for bank recapitalisation is Rs 10,000 crore — perhaps 20 per cent of what the banks really need. Cute acronyms (like Indradhanush) and toothless governance structures (like Bank Boards Bureau) have been tried. If that seems Tughlakian, policymakers are talking about a bigger one — consolidation. The merger of associate banks with SBI is being touted as a precursor. Easy in theory, but has a rather simple tautological fallacy — the banking system simply does not have surplus capital to absorb the aggregate PSB capital gap. It’s a classic case of adding 2 and 2, repeatedly, hoping each time that the answer somehow will be 10! SBI quarterly results showed it up starkly — nearly Rs 3000 crore of standalone profits, but Rs 3000 crore of loss on a consolidated (with the subsidiaries) basis. In short, even a small amalgamation pulled the giant down. Clearly, consolidation is not a likely solution.

Unfortunately, the new ordinance does nothing on capital. The solution has to be about someone writing out a big cheque, which only the government can plausibly do so.

The new Ordinance covers two of the three steps required for a resolution. It’s a big, necessary step forward. But it is not sufficient to resolve the issue — till the government recapitalises PSBs.