Banking Ordinance – Final Resort to Resolving NPA Problem?

Published on July 28, 2017 by Prashant Gupta

On May 5, 2017, the President of India signed the non-performing asset (NPA) ordinance to tackle the problem of soaring bad loans in the country. This much-awaited step empowers the Reserve Bank of India (RBI) to directly intervene in the resolution process and allows necessary amendments to the Banking Regulation (BR) Act.

The banking sector has remained one of the most favored sectors in India, given consistent revenue growth and financial performance. However, financial metrics in recent years indicate rising stress, with the non-performing loans to total gross loans ratio at 9.55%, compared with 4% for Brazil, 3% for Indonesia, and 2% for China as of end-September 2016.

The significant increase in NPAs on banks’ balance sheets and deterioration in corporate debt service capacity have created fear among banks to lend further to corporates. This, in turn, has resulted in a sharp drop in private investment, especially corporate investment, thereby hurting credit growth and affecting overall growth of the economy.

History has shown that banking crises can end up costing significant amounts of money if prompt and robust actions are not taken. Some examples include the 2008-2012 Spanish financial crisis and the 2008-2011 Irish banking crisis. During the banking crisis in Ireland, a large number of financial institutions faced imminent collapse due to insolvency. Ultimately, the government had to take the International Monetary Fund’s (IMF) assistance to resolve the crisis. Similarly, the European banking system remains under considerable pressure, with concerns on Italy’s banking sector, among others. Banca Monte dei Paschi di Siena S.p.A, one of Italy’s biggest commercial banks, will receive EUR 5.4bn in state aid.

Both India’s government and the RBI have initiated many reforms in the past, including Corporate Debt Restructuring (CDR), Strategic Debt Restructuring (SDR), and Sustainable Structuring of Stressed Assets (S4A). However, none have been effective enough to control the soaring NPA situation so far. So what makes this ordinance different?

Key features of the NPA ordinance:

• RBI authorized to issue instructions to banks to start insolvency proceedings against defaulting companies under the insolvency and bankruptcy code (IBC). Banks would have preferred to stay away from initiating insolvency proceedings due to fears of being questioned by investigative agencies. Now, under RBI supervision, banks will be forced to initiate insolvency proceedings. 
• RBI, on its own consent, to issue directions to banks for resolution of NPAs. Earlier, the RBI could provide guidance or suggestions; now, the RBI can direct banks to initiate an action. This is expected to result in transparency in the whole process. 
• RBI to elect members and form oversight committeesto advice banks on the resolution of NPAs.

Does the government appear to be shifting its burden on to the RBI?

If one looks at past initiatives – which have mostly been ineffective – one may think the government is trying to shift this burden by empowering the regulator. However, one must admit that the role of the government is to provide good governance and not technical advice, which should be left to specialists and experts in that area. We believe the RBI – being the chief banking authority – has a bird’s-eye view of the entire banking system and, thus, should be able to handle the situation more effectively.

As expected, soon after gaining this power, the RBI started directing banks to start bankruptcy proceedings against 12 big defaulters, constituting about 25% of overall gross NPAs. The RBI has given banks around six months to finalize resolution plans for other NPAs, following which they will have to begin insolvency proceedings on those accounts too.

Conflict of Interest?

Some of the critics are questioning the direct involvement of RBI in the bad asset resolution process. According to them, resolving bad assets is not a regulatory decision, but a commercial one. Giving more powers to RBI in taking such decisions can be construed as a case of micromanagement, which is not the function of a regulator. Typically, regulators stay away from commercial decisions of the entities they regulate, in order to preserve systemic stability. Naturally, the question arises: Should the regulator do this? If this is done, what prevents the RBI from directing the banks where to lend and return to the directed lending regime?

Of course, it is worth debating such issues; however, we must remember that, this is an unusual situation that` requires extraordinary actions. This is just the beginning and further necessary actions may be required during the implementation phase.

What is more worrying is that the total capitalization of Indian PSBs remains very thin as of March 2017. If the RBI directs them to take haircuts on stressed loans, it may become difficult for these PSBs to absorb losses due to their limited profitability and capital availability. In such a scenario, the government would have to pitch in to infuse adequate capital, in order to keep the banking system up and running.

Nevertheless, it is appreciated that the government is trying hard to tackle the grave NPA situation. The ordinance marks the beginning of a new cleanup drive, which can be truly successful, if the government and the banks support the regulator. Also, the RBI needs to ensure that the banks continue to function in a viable manner, else this scheme may also end up falling in the list of the other unsuccessful government schemes.

Impact on global investors

A conventionally strong regulatory framework is a prerequisite for long-term investors, which, in turn, is essential for economic growth. The announcement of the NPA ordinance is a credit positive for Indian banks, as this will not only strengthen the banking system, but also increase transparency. Furthermore, this would boost investor sentiment once the resolution process is expedited.

Global investors can leverage Acuity Knowledge Partners on-the-ground credit research capabilities to look at investment opportunities in India and leverage thematic research expertise. To know more about Acuity Knowledge Partners research capabilities, please visit https://acuitykp.com/client-segments/.

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