NPA Emerging Challenges

S. Khasnobis
Distressed debt strategies International experience in NPL management

NPAs Emerging Challenges in India

S. Khasnobis

The Indian banking sector has Genesis and historical a) Pre-liberalization era:
played a commendable role in perspective In the context of accretion to
fuelling and sustaining growth Non-Performing Assets (NPAs) NPAs in the banking system,
in the economy. In the recent have been plaguing the Indian fi- the contributory factors dur-
past a large part of the banking nancial sector for a long time, but ing this period were mainly the
sector’s growth has been on the were not in the public domain un- following:
back of financing consumption, til the early nineties. By that time,
as reflected in the growth of re- a significant number of loan as- i. Down-swings in agricultural
tail banking. While the progress sets involving uncertainty with sectors triggered by monsoon va-
on this front is likely to contin- respect to ultimate collection had garies, bringing about all-round
ue, sustaining this growth in the piled up, creating concerns with economic and demand recessions.
coming years may require fo- the opinion-makers about the
cus on the supply side – capacity- health of the Indian banking and ii. Industrial licensing: The
building. A growth driver in this financial sectors. scale of the economy in relation
phase would involve financing NPAs reflect natural waste in to international standards was
the emerging Small & Medium any economy. In advanced econ- compromised, leading to high
Enterprises (SMEs) sector of the omies, the financial markets are capital costs per unit of produc-
economy. As such, banks would well-developed and segmented, tion. This was often said to be off-
have to gear up for the challeng- with various players operating in set by lower labour costs. Howev-
es of managing growth and con- identified niches, catering to vari- er, in reality labour productivity,
sequent risks in the SME sector ous user/risk segments. This con- coupled with application of au-
financing. Addressing this issue stitutes an effective institutional tomation, outweighed the benefit
and putting in place a suitable mechanism for targeting risks to from lower labour costs in the In-
risk mitigation mechanism is go- players with an appetite for such dian context.
ing to be a fairly daunting chal- risks. Commercial banking is
lenge. One way of ensuring focus conducted in a highly risk-man- iii. Sector-wise reservation:
would be to free up capital – both aged and mitigated ambience, un- Reservation of major sectors for
financial and human – and make like its Indian counterparts who investment by the Government of
them available for sustaining the are often required to take unmiti- India (GoI) in the public sector
growth in assets and profitabili- gated risks as a part of business structure in post-independence
ty. Farming out the banks’ Non- policy. days became a necessity owing
Performing Assets (NPA) portfo- to various reasons, among others,
lio to asset-recovery companies, The origination of NPAs in the non-availability of private capital.
which specialize in this segment Indian banking landscape can be In later years many of these Pub-
of the financial sector, could be broadly discussed in two stages: lic Sector Units (PSUs) (though
an option worth evaluating. they might have served their so-
a) pre-liberalization era; and cio-economic objectives) became
b) post-liberalizing era. commercially unviable in the ab-
sence of a proper growth plan

when faced with burgeoning em-
ployee costs during their lifecycle.
As a result, down-stream integra-
tion of SMEs with these PSUs led
them to a sticky situation with
their bankers owing to a longer
receivable cycle/non-realization
of receivables. In addition, res-
ervation in some of these sectors
led to setting up of uneconomical
facilities, and improper quality
and product pricing (price-qual-
ity matrix issues) despite subsidi-
zation by the GoI.
iv. Controlled interest rate: In
the controlled interest rate re-
gime, banks were not in a posi-
tion to price the risk premium.
This led to cross-subsidization
across the risk profile of the loan
assets. Although additional col-
laterals were taken for risky loan
assets, in the absence of a condu-
cive legal system, the banks were
not in a position to realize value
from these collaterals.
v. Tariff protection: In the ab-
sence of a long-term tariff policy,
it was difficult for the banking
system to appraise project viabil-
ity with any degree of certainty
during the loan pay-back period.
vi. Role of Developmental Fi-
nancial Institutions (DFIs): The
NPA Emerging Challenges in India S. Khasnobis 10 / 11
DFIs played a predominant role three decades. In fact, there was a
in the growth financing during mini-industrial boom in the early
the pre-liberalization era. This part of the seventh five-year plan
model became unsustainable as (1985-88). However, a growing
they started facing difficulties in fiscal deficit triggered a macro-
raising funds. In a way, the DFIs economic crisis in 1991.
in India played the role of Ven-
ture Capital (VC) funding with- With the commencement of re-
out capturing the possible upside form of the economy in 1991,
of the model. The success of DFIs banks were to follow the Basel
can, therefore, be compared only Capital Accord. Consequently,
with VC funding. However, be- the Reserve Bank of India (RBI)
cause of non-availability of a fa- issued the first set of comprehen-
vourable legal environment, cou- sive guidelines for Income Recog-
pled with various extraneous nition and Assets Classification
factors, they are often discredited (IRAC) in April 1992. The cen-
with the failures. tral bank, with a cautious move,
adopted a time-based provision-
ing method and averted a near-
b) Post-liberalizing era: crisis situation by not imposing
India’s macroeconomic poli- a write-off of the entire loan as-
cies were conservative until the set impairment amount based on
early eighties. Accompanied by present value of realizable cash
some liberalization in the form flow upon recognition of NPA.
of de-licensing of select indus-
tries, permitted changes in prod- With a stable political scenario
uct-mix within the overall capac- during post-commencement of re-
ity (broad-banding) and creeping forms, and against the back-drop
relaxation of imports during mid- of hyped-up demand projections
eighties, the Indian economy reg- endorsed by several leading strat-
istered an average growth rate of egists, the Indian economy once
5.3 percent per annum (sixth five- again experienced a quick capac-
year plan) and 5.8 percent per ity build-up during the mid-nine-
annum (seventh five-year plan), ties. On the face of a liquidity cri-
much higher than the Hindu rate sis, many of these projects had to
of average growth of 3.5 percent borrow at abnormally high rates
per annum during the previous of interest.
Distressed debt strategies
However, towards the end of the
decade, the mistake was realized
as those loan assets started show-
ing signs of impairment. The vol-
ume of NPAs in the system reached
a peak level, requiring focused at-
tention. Many banks set up task-
forces, special asset management
groups, etc. to deal with the situ-
ation in a focused manner by cre-
ating a type of bad bank within
the bank. By that time the entire
South-East Asian region was reel-
ing under an economic crisis trig-
gered by the high level of NPAs
in the banking system. Many spe-
cialists and experts were, by then,
seriously raising concerns about
the possibility of India heading
for a crisis.
The net upshot was that by the
mid-nineties the banking indus-
try became risk-averse towards
corporate lending activity. Many
banks took a strong position in
government securities. Propelled
by the growth in the retail sec-
tor, the banking sector regis-
tered a decent credit growth dur-
ing the subsequent period. In the
late-nineties, during a declining
interest rate regime, the banking
sector was sitting on a sizeable
capital gain. As such, in order to
tackle the NPA stock problem, the
banking sector generally adopted
a ‘provide and hold’ strategy. As
a result, net NPAs in the system
International experience in NPL management
declined significantly, which was
also due to setting up of a self-
help mechanism, namely Corpo-
rate Debt Restructuring (CDR),
under the aegis of the RBI. The
CDR forum has done a com-
mendable job during the period
since inception in 2002 to restrict
the flow of NPAs in the system.
Regulatory and other responses
creation of Arcil
Several measures were adopted
by the banks in the past, directed
mainly towards reconstruction
and recovery, without much suc-
cess. With a view of dealing with
the industrial sickness in an effec-
tive manner, the Sick Industrial
Companies (Special Provisions)
Act, 1985, was enacted along the
lines of chapter XI of the US
Bankruptcy Law. Consequently,
a specialist body, Board for In-
dustrial and Financial Recon-
struction (BIFR) was set up with
the objective of expeditious reviv-
al of sick industrial companies
and winding up of unviable units.
BIFR, being a quasi-judiciary
body, was legislated with overrid-
ing powers with respect to many
of the important provisions under
the Companies Act, 1956. The
principal purpose of BIFR was a
quick disposal by way of putting
back the productive assets in
the system to realize value from
the unviable units and to recycle
capital. However, the BIFR proc-
ess proved to be unwieldy, serv-
ing as a protective shield to the
defaulting companies and was
rather ungainly to the banking
system.
By the turn of the decade, the NPA
situation had worsened owing to
a number of factors, including a
precarious balance of payment
position, a delay in achieving fi-
nancial closure of the projects un-
der implementation, increasing
interest rates and a recessionary
trend in the economy.
By the late-nineties the balloon-
ing figures of NPAs sounded
alarm bells throughout the finan-
cial corridors across the country.
As a result, two committees were
set up in quick succession and re-
ports were submitted: one in
April 1998 (Committee on Bank-
ing Sector Reform - Narasimham
Committee) and another in Octo-
ber 1999 (Restructuring of Weak
Public Sector Banks - Verma
Committee). The recommenda-
tions of both the committees in
handling of NPAs in the banking
sector were along similar lines: a
separate vehicle, by creation of
Asset Management Companies
(AMCs) for resolution of NPAs,
was suggested. Finally, the Secu-
ritization and Reconstruction of
Financial Assets and Enforce-
ment of Security Interest Act,
2002, (»the Act«) was passed to
 NPA Emerging Challenges in India S. Khasnobis 12 / 13

pave the way for setting up Asset deals after issuance of guidelines poses, it certainly does not cap-
Reconst r uc t ion C ompa n ies by the RBI in July 2005. ture the shareholders’ perspec-
(ARCs) in India. Under the Act, it tive. In addition, fully written-off
was envisaged that ARCs shall be In November 2005, GoI approved accounts are not captured on the
registered with the RBI and the investment by FIIs in the SRs is- bank’s balance sheet. From the
RBI would issue necessary guide- sued by ARCs up to a cap of 49%, shareholders’ perspective, it is
lines to ARCs for conducting with a sub-cap of 10%, by indi- important to understand the to-
business. The RBI came out with vidual FIIs. Also, foreign inves- tal recovery amount against the
the guidelines in April 2003, and tors have been encouraged to set amount written off, including ful-
the first ARC was granted regis- up ARCs in India by holding eq- ly written-off accounts, as a large
tration in August 2003. The Act uity capital of ARCs up to a max- part of the profit of the banks
was, however, challenged by a imum of 49% through the foreign attributed to the shareholders
group of borrower companies led direct investment (FDI) route. is written-off to their detriment.
by Mardia Chemicals and Indus- GoI, the principal shareholder of
tries Limited. After prolonged lit- Relevant issues PSU banks, which occupy more
igation, the Act was upheld by Definitional issue: A borrower than 70% of the banking land-
the Supreme Court of India in account becomes non-perform- scape in India, should certainly
April 2004. ing with a bank when payment demand this statistic to be pre-
Asset Reconstruction Compa- default occurs with respect to sented by all the banks. Further,
ny (India) Limited (Arcil) com- that bank, which is not cured for proper incentive to the banking
menced business by acquiring a particular number of days. It system is necessary for achieving
the first tranche of financial as- is therefore commonplace that a a higher recovery percentage. It
sets on December 31, 2003. The borrower account is a NPA with may be pertinent to note, though,
structure of Arcil for acquisi- some banks while it is performing that some of the banks present
tion of financial assets contem- with the remainder of the banks recovery percentages from NPA;
plates issuance of paper - Securi- in the consortium. The NPAs in the same, however, is not ex-
ty Receipts (SRs) by the trust to the banking system are the cumu- pressed in present value terms.
the selling bank in lieu of finan- lative NPAs of all the banks. As The focus, therefore, should be
cial assets transferred to the trust. such, they fail to capture the loan on recovery from gross NPA, in-
This unique business model has outstanding to all the defaulting cluding fully written-off accounts
achieved a modicum of success, (NPA) borrowers in the system. in present value terms, using cost
though the pace of acquisition of This leads to understating the of carrying NPA as the discount-
financial assets by ARCs has been volume of NPAs in the system. ing factor at the very least, if not
slow on account of very gradual Emphasis on net NPA: The bank- the opportunity cost.
development of the market. ing system in India places signifi-
Recently, the RBI has issued cant importance on tracking net
guidelines for inter-bank transfers NPA as a percentage of gross
of NPAs. However, the market assets. While net NPA percentage
has experienced only a few small is important for regulatory pur-
Distressed debt strategies International experience in NPL management

Complex lending landscape: Restructured assets in banking a part of the restructured book in
In the Indian context, capital as- system - CDR: the banking system of the country
set financing in the past was gen- Restructuring addresses long- as only a proxy for future NPAs.
erally done by term lenders (DFIs) term financial problems of a bor-
having a first charge on the fixed rower company by changing the Road ahead
assets of the company while the leverage structure. It has been The present definition of NPA
working capital financing was experienced that in most cases, is restrictive and keeps beyond
mostly done by the banks with a bank-based restructuring merely its ambit a very large number of
first charge on the current assets addresses the financial structure NPAs presently sitting on the
of the borrower company. In ad- of the company. The restructur- books of other important players
dition, a number of banks and fi- ing in the hands of the banks re- in the economy, namely Co-oper-
nancial institutions were involved duces to deferment of loan repay- ative Banks, State Financial and
in financing consortia which ap- ment and alignment of interest Investment Institutions, Mutual
parently was flagged out to miti- rate (graded scale structure of in- Funds, Insurance Companies and
gate risk of concentration (expo- terest) to suit the cash flow of the NBFCs. Obviously, an inclusive
sure limit) to industry/borrower. company, premised on the stabil- and macro view has to be taken
On the face of substantial cross- ity of the business model of the on the issue, which in turn would
holding amongst banks and fi- borrower company. In short, the give an idea of the much larger
nancial institutions in India, it is banks are not willing to take a role that the ARCs would require
really a matter subject to further large write-off at the initial stage. to play if they have to make a true
examination as to how far this As such, the shareholders’ per- and lasting impact. This would
concentration of risk to a borrow- spective of the borrower compa- entail bringing the impaired as-
er or a group could have been mit- ny in bank-based restructuring is sets of the other equally impor-
igated by following the exposure completely ignored. tant players within the ambit of
norms, particularly when GoI re- functioning as ARCs.
mains the significant stakeholder This syndrome has been observed
of the banking system. However, in CDR restructuring, in particu- The handling of impaired finan-
the pattern of financing in the In- lar. The success rate of such re- cial assets is a specialized subject.
dian context culminated in varie- structuring is questionable. The For one, resolution of impaired
gated interest amongst the lenders experience to date shows that the assets and unlocking values em-
in terms of security profile. This cases with better potential for bedded therein would need multi-
often leads to involved intricate turn-around (restructured un- disciplinary skill-sets covering
inter-creditor issues to the advan- der CDR) are going through fur- technology, business model vali-
tage of some class of borrowers. ther modification and settlement, dation, investment banking -
including by way of take-out fi- merger & acquisition and law,
nancing by the private equity virtually rendering them into a
funds, who walk away with eq- knowledge and execution hub of
uity upside. In light of the above, a different genre. It is rather unre-
one might like to consider at least alistic to assume these diverse
 NPA Emerging Challenges in India S. Khasnobis 14 / 15

skill-sets to be part of the domain Conclusions

knowledge for banks whose busi- The distribution of NPAs in the
ness focus is completely different. system follows the 80-20 rule
For another, the history of NPAs whereby 20% by number of bor-
in India would reveal that per- rowers are responsible for 80% of
sons in charge of handling NPA value of impaired assets and vice
portfolio more often than not de- versa. The large impaired assets
velop a strong attachment to comprise industrial assets hav-
these borrower accounts, perpet- ing good restructuring potential.
uating the sitting of these assets The Arcil experience shows in
on the books of the lender. In value terms that more than 60%
view of this, the strategy to be en- of the impaired assets are amena-
couraged by management/policy ble to be restructured or sold as
makers is to ensure severance of going concerns. The small assets,
these assets from the lenders’ however, have to be put through
books by way of a clean exit. a recovery process, where the col-
lateral-based financing practice
The exit from these assets, in followed by the banking system
turn, has to be at an early stage in the past offers a fair recovery
of evolution. In other words, an potential.
attempt should be made to dis-
cern incipient difficulties in an as- The seed of success of managing
set brewing at an early stage and the impaired assets in any econo-
to make attempts and transfer it my lies in the speed of recycling
to ARCs at that stage itself. This these assets and their realization
will ensure a much higher realiza- into cash. In achieving this ob-
tion and a better chance for busi- jective, it is important to have a
ness turn-around and resolution. conducive legal environment, an
Once the canker mires the bor- adequately empowered system
rowing entity in increasing dif- and structure, support from the
ficulties on all fronts, resolution government and finally, access to
of the NPAs becomes that much new domestic and foreign capital.
more complex and involved. The Only then shall the Indian bank-
obvious outcome is erosion in re- ing system be at full throttle to
coverable value. take up the challenge to de-stress
the system and prepare for fuel-
ling the SMEs and retail financ-
ing, the growth engine for the In-
dian economy in the future era.