Bad Loans – What Exactly Is The Problem?

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Oil prices are low. India has managed to avoid the worst of the 2008 Economic Crisis. Consumer demand is increasing, and the demographic divide is touching unprecedented potential. But then why isn’t the Indian economy galloping to record-breaking levels of GDP growth? Why does economic growth remain sluggish?

 

Projected GDP Growth for US, India, and China
Source : PWC

The Indian financial system is held together by the strong private banking sector as well as public sector banks, and these entities have been hampered significantly by the presence of non-performing assets – essentially money loaned to investors by banks that they’re not expecting back. All banks account for NPAs in their monetary calculations, but over the last decade or so the problem of NPAs has hit striking levels – the current total stress on the Indian banking system is supposed to be about Rs. 14 lakh crore. Bad loans form 9% of all loans of all Indian banks, and a whopping 20% of PSB (public sector bank) loans. These NPAs or bad loans create a financial bottleneck – balance sheets are stressed, so banks are averse to extending loans.

Causes

 In 2004, the economy was looking strong, global headwinds were positive, and Indian banks were in a mood to invest. The 2004-08 lending boom allowed for fast domestic growth founded upon obliging banks eager to lend. But this lending boom came to an abrupt halt with the 2008 economic crisis, and the prolonged global slump did not allow Indian banks to grow their way out. Further, India’s public policy took time to arrive at the root cause of the problem – the changes suggested were from a governance perspective (appointment of the Bank Board Bureau, RBI reforms in the form of the Monetary Policy Committee), whereas the primary issue was an economic one.

Structure of the Bank Board Bureau
Source : Youtube screencap

Even today, Indian banks remain wary of deep haircuts – even a superficial appearance of impropriety in forgiving of loans could invite investigation by the CBI or the Central Vigilance Commission. But, much as our mothers always tell us, haircuts are necessary, even if we don’t want them.

How We’re Fixing It

Former RBI Governor Raghuram Rajan had famously made the resolution of bad loans his number one priority, conducting an Asset Quality Review to help banks identify their NPAs.

Former RBI Governor Raghuram Rajan made the handling of Bad Loans his main priority

The government has also introduced a new Bankruptcy Code to allow companies to easily file for bankruptcy and liquidate assets to pay off investors. RBI has issued a Prompt Corrective Action Framework (PCA), which are thresholds for banks that they must not breach. The Banking Regulation Act has been amended to give RBI more power to fast-track resolution of stressed assets in time-bound manner. Setting up of the Bank Board Bureau, recommended by the Nayak Committee, will help banks govern themselves more transparently.

What Else Can We Do? 

The 2015-16 Economic Survey recommended the Four Rs to solve the problem of bad loans – RECOGNITION of NPAs, RECAPITALIZATION of banks through infusion of equity, RESOLUTION of existing NPAs, and REFORM of regulations and the banking system to prevent a repeat of the existing issues. These changes are far-reaching and comprehensive, and may take upto a decade to implement properly in full.

Implementing of US-style stress tests to determine capital shortage in PSBs, providing an adequate capital infusion to banks to bring lending rates up, ending the delay in appointment of Chairpersons and MDs in PSBs (this will in part be solved by the Bank Board Bureau), and bringing in independent directors at PSBs will be important steps in the direction of resolving PSBs. But it must be remembered that the problem may arise out of economic issues, but has been exacerbated by governance issues. Those issues must be tackled on priority basis.

Author | Ayush Kumar