What Is The Way Out Of India’s Bad Loans Crisis?

Government reports tend to be written in a dull, boring and emotionless manner. Sample this line from the latest annual report of the Reserve Bank of India (RBI), released in late August 2017: “The asset quality of the banking sector continued to be a concern during 2016-17.”

If you happen to be the kind who hasn’t followed what has been happening in the banking sector in India, you would read the sentence and feel, ah, there is some problem with banks, and it will soon be sorted out. The sentence gives no idea of the gravity of the situation.

Now only if things were as simple as that. Take a look at Chart 1, which plots the gross non-performing advances ratio or simply put, the bad loans ratio of banks, over the years. Bad loans are essentially those in which the repayment from a borrower has been due for 90 days or more.

Chart 1 tells us that nearly a tenth of loans given by banks has been defaulted on. It also tells us that the bad loans of Indian banks have jumped over the last two financial years. The question is, why.

Over the years, many Indian banks (and largely public sector banks) refused to acknowledge that there was a problem. They simply kicked the can down the road by restructuring many loans, which were bad ones.

One way of doing this is by allowing the borrower a moratorium during which he does not have to repay the principal amount of the loan. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased. In technical terms, this kicking the can down the road is referred to as “evergreening” the balance sheet.

After a crackdown by the RBI, the banks, over the last two financial years, started recognising bad loans as such. Take a look at Chart 2. It plots the gross non-performing advances ratio for the largely government-owned public sector banks.

In fact, Chart 2 tells us the same story as Chart 1. There has been a huge jump in bad loans of public sector banks over the last two years. And this has been primarily the case because these banks started recognising their bad loans as bad loans. The first step towards solving a problem is acknowledging that it exists. Indian banks took a long time to do that on the bad loans front, worsening the situation.

A primary reason for this huge jump in bad loans has been on account of lending to industry. Many of these loans have been defaulted on. Take a look at Chart 3.

What does Chart 3 tell us? The bad loans ratio of public sector banks in case of lending to industry is 22.3 per cent. This basically means that for every Rs 100 lent to industry by public sector banks, Rs 22.3 has been defaulted on, and is not being repaid.

Further, large borrowers account for 56 per cent of loans given by banks. At the same time, they account for 86.5 per cent of the bad loans. The RBI defines a large borrower as one who has an aggregate fund-based exposure and non-fund-based exposure of Rs 5 crore or more. Fund-based exposure is basically normal lending by a bank in various forms, which includes overdrafts, bill financing, term loans and so on. Non-fund-based exposure is a situation where the bank does not commit to any outflow of funds. A bank guarantee is a good example of this.

While lending to industry and large borrowers has turned out to be a huge problem for banks, retail lending (i.e., personal loans, home loans, vehicle loans, credit card outstanding, loans against fixed deposits and so on) has not been as risky. The bad loans ratio of banks on retail lending is just 2 per cent. This means that out of every Rs 100 given out as a retail loan by banks, only Rs 2 has been defaulted on.

What explains this dichotomy is a question worth exploring. Let’s take the example of State Bank of India (SBI), the largest public sector bank as well as the largest bank in the country. As on 31 March 2017, the bad loans ratio of the bank when it came to retail lending was 0.55 per cent. At the same time, the bad loans ratio when it came to corporate lending was 13.7 per cent.

This basically means that SBI does a terrific job at retail lending but really messes up when it comes to lending to industry. What is happening here? Thomas Sowell, an American economist-turned-political-philosopher, discusses the concept of separation of knowledge and power in his book Wealth, Power and Politics.

How does it apply in this context? In public sector banks, managers who have the knowledge to take the right decisions may not always have the power to do so. Take the case of retail lending. The manager looks at the ability of the borrower to repay a loan, and then decides to commission or not commission one. This explains why the bad loans ratio in case of retail lending is as low as 0.55 per cent. A proper process to give a loan is being followed in this case.

But when it comes to lending to corporates, there are people out there (or at least used to be) who are trying to influence the manager’s decision, from bureaucrats to ministers to politicians. In this scenario, the manager ends up giving out loans even to those corporates who do not have the wherewithal to repay it.

The separation between knowledge and power has led to a situation where loans were given to many crony capitalists, who have defaulted, and what we are seeing now is a fallout of that. In many cases, the corporates have simply siphoned off the loan amounts by over-declaring the cost of the projects they borrowed against.

Now let’s take a look at the bad loans ratio of new-generation private sector banks in Chart 4.

As can be seen from Chart 4, as on 31 March 2017, the bad loans ratio of new private sector banks stood at 4.2 per cent. In comparison, that of the public sector banks was at 12.3 per cent. This clearly tells us that when there is no separation of knowledge and power, as is the case at private banks, the quality of the lending carried out is much better.

This brings us back to the question as to why the government should continue to own 21 banks. What purpose do they serve for the government? When public sector banks make losses, these losses are adjusted against the shareholders’ equity of the bank. After this, the government as the owner has to bring in fresh capital into the bank. Since 2009, the government has already invested close to Rs 150,000 crore in these banks. Every additional rupee that the government invests in these banks gets taken away from some other form of spending, from education to health to agriculture.

The estimates on how much more capital these banks will require in the years to come are truly mind-boggling. These estimates also take into account the fact that banks will need to start following Basel-III norms, which come into force from 2019 onwards.

The government’s hope was that these banks would require Rs 180,000 crore between 2015-2016 and 2018-2019. Of this, the government plans to invest Rs 70,000 crore and expects the banks to raise the remaining Rs 110,000 crore on their own.

Another estimate, made by Viral Acharya (who was at the Stern School of Business when he wrote the paper which had this estimate, and is now one of the deputy governors of the RBI), and Krishnamurthy V Subramanian of the Indian School of Business, in a research paper titled ‘State intervention in banking: The relative health of Indian public sector and private sector banks’, suggests higher numbers.

The professors come up with three scenarios. In what they call the extremely prudent scenario, they feel that the public sector banks would require around Rs 997,400 crore of capital. In the less prudent scenario, banks would need Rs 653,300 crore of capital. In the least prudent scenario, banks would need Rs 512,300 crore of capital.

These are huge numbers that we are talking about here. Clearly, the government is not in a position to fund the capital required by the public sector banks.

So, what is the way out for these banks? Is recovering loans that have gone bad possible through the sale of assets that were offered as collateral against these loans? On this front, the record of public sector banks, where the bulk of the problem lies, is quite unremarkable. Take a look at Table 1.

What this table tells us very clearly is that the ability of public sector banks to recover loans from defaulters is very weak.

In June 2017, the RBI identified 12 loan accounts which are responsible for around one-fourth of the bad loans of banks for immediate resolution under the Insolvency and Bankruptcy Code. As on 31 March 2017, the total bad loans of banks in India (including that of foreign banks) amount to Rs 791,995 crore. One-fourth of that amounts to Rs 197,999 crore, which is not a small amount of money by any stretch of the imagination.

Under the Insolvency and Bankruptcy Code, the bank whose loan has been defaulted on needs to approach the National Company Law Tribunal to appoint an insolvency resolution professional to manage the company which has defaulted on the loan.

Meanwhile, the existing board of the company is suspended. The professional has 180 days to come up with a workable solution for the company to be able to repay the loans it has defaulted on. This can be extended by another 90 days. At the end of 270 days, if no solution is in sight, a liquidator is appointed.

This is how the process is supposed to work. It is too early to comment on whether this will work or not. The actual evidence will emerge over the next one year.

The government’s other big plan to sort out the bad loans mess in public sector banks is to merge (relatively) strong banks with weak ones. As part of this, the five associate banks of SBI were merged with it. So was the Bharatiya Mahila Bank. And this has dramatically pulled down the performance of the bank, for the period from April to June 2017. Take a look at Table 2. It plots the bad loans ratios of various kinds of lending carried out by the country’s largest bank, before and after the merger.

As is clear from Table 2, the bad loans ratios of the different kinds of lending carried out by SBI has deteriorated majorly after the merger. The hope with such mergers is that the relatively strong balance sheet of the strong bank will pull the weak banks through. But what seems to have happened is exactly what a former deputy governor of the RBI, R Gandhi, had warned about in 2016, when he had said: “Merger of a weak bank with a strong bank may make the combined entity weak if the merger process is not handled properly. The problems of capital shortages and higher non-performing assets (or bad loans) may get transmitted to stronger bank due to undue haste or a mechanical merger process.”

Acharya said something similar recently: “Sometimes merging stronger entities with weaker entities leads to bringing down the stronger entity.”

Given this, the government needs to wait it out a little and see how the merger of associate banks and the Bharatiya Mahila Bank with SBI plays out. But it seems to be in a hurry to merge other banks with each other and that is not right. In August 2017, the union cabinet cleared an alternative mechanism to oversee proposals of amalgamation of public sector banks.

Let’s take a look at Table 3. It lists all the public sector banks which have a bad loans ratio of 10 per cent or higher.

Table 3 tells us that many public sector banks are in a big mess on the bad loans front. Banks like Indian Overseas Bank and IDBI with bad loans ratios of 24.99 per cent and 23.45 per cent, will pull down the performance of any big bank they are merged with.

Even big banks like Union Bank of India, Bank of Baroda, Punjab National Bank and Canara Bank have a bad loans ratio of 10 per cent or more. If and when weaker banks are merged with these banks, their performance will only deteriorate.

Also, there is enough research evidence that suggests that most mergers don’t work. As the Harvard Business Review article titled ‘The Big Idea: The new M&A playbook’ points out: “Companies spend more than $2 trillion on acquisitions every year. Yet study after study puts the failure rate of mergers and acquisitions at somewhere between 70 per cent and 90 per cent.”

When the failure rate is so high, why even attempt to merge, especially when even the initial signs suggest failure? Typically, most mergers get sold on the idea of so-called synergy between the companies, which is a term everybody uses but nobody defines. John Lanchester does define “synergy” in his book How to Speak Money. As he writes: “Synergy: Mainly BULLSHIT, but when it does mean anything it means merging two companies together and taking the opportunity to sack people… When two companies merge, the first thing that ANALYSTS look at when evaluating the deal is how many jobs have been lost: the higher the number, the better. That’s synergy.”

Of course, no public sector bank employee is going to get fired after any merger. So, the only reason why a merger might work is a non-starter in the Indian context.

Given this, where does that leave us?

Some of the worst-performing public sector banks aren’t really that big.

Take a look at Table 4.

There are six public sector banks which have high bad loans and, at the same time, are small. If we add up the total lending of the banks listed in the table, it is less than 8 per cent of the total lending carried out by banks in India (public sector banks + private sector banks + foreign banks). It is time that the government took some tough decisions on these banks by either selling them or simply shutting them down and then selling their assets piece by piece. The total lending carried out by these banks isn’t big enough to impact the overall bank lending scene in India.

If the government does this, then the number of banks it currently owns will come down from 21 to 15. And the happy teens are clearly a much better space to be in than the struggling twenties.

Of course, any such decision will be difficult to take, given the hungama (for the lack of a better word) that would happen and the political repercussions it would have. Given that, we can only hope and pray that the recovery process initiated under the Insolvency and Bankruptcy Code becomes some sort of a success.