Lehman’s Ghosts: The NPA Problem in Indian Banks

Indian banks are in trouble, which means you and I are in trouble too. A reek of déjà vu grips the nation as it reels under the next financial crises conditions akin to the 2007-08 times. There are talks of bank bailouts becoming imminent though minced under the weight of the government running away from Lehman’s ghosts.

This article aims to make the NPA problem less abstruse and point to what lies ahead.

A bank’s assets are the loans it lends out. An NPA or a Non-Performing Asset is a loan that is on the verge of default by the borrower. As per Indian rules, if the repayment of a loan is delayed beyond 90 days, the loan must be recognized as a default and an NPA. The gross NPAs in India were 5.1% of total loans advanced (as per the RBI) as of September 2015 which is approximately ₹6 trillion to ₹7 trillion of non-preforming loans! Moreover, even this figure is alleged to be ridiculously underreported. The NPAs in public sector banks is much higher than in the private sector since the former has to mandatorily lend to the ‘priority sectors’ such as infrastructure and power- the sectors that have the highest value of NPAs.

Banks are required to set aside funds as provisions -once NPAs are detected- for potential losses arising out of these loans going bad. This is similar to the provisions for bad debts created by businesses. It is a prudent measure to prevent the bank itself from going bankrupt and thereby wiping out all the deposits made by its customers. Though, this necessary prudence comes at a cost: the setting aside of capital further restricts the banks ability to advance more loans. This does three things: 1) It hurts banks’ profits deeply, 2) it limits credit availability in the economy multifold due to the credit multiplier effect forgone and 3) due to lack of supply of loans, the cost of borrowing rises. We’re seeing the impacts of all three: “leading PSUs including Bank of Baroda, Bank of India and IDBI Bank, reported their highest ever quarterly losses aggregating to over Rs 12,000 crore”, “Sensex sheds 362 pts, Nifty ends below 7050; SBI falls 6%” and “..slowing growth of bank credit, which stands at a 20-year low in single digits”, “Despite rate cut by the RBI, banks aren’t lowering their interest rates” etc. are scattered all across newspapers. This has ultimately affected investment growth in India adversely.

It was because of this provisioning requirement that banks grossly underreported their amount of NPAs. Recently, the RBI (read Rajan) introduced the Asset Quality Review and made reporting of NPAs much more stringent. Further, even restructured loans have to now be termed as NPAs (restructured loans explained later). This has led to speculations that the NPAs will rise to 11% of total loan advances and also the reason for the sudden spike in interest in NPAs in India.

There are multiple reasons why NPAs are growing in India, some that are our own making and some as externalities:

First, global slowdown and tepid demand: Borrowers need loans for leverage and capital; but since earnings are slowing, customers have delayed their payables, profits are being squeezed, exports (dollar value) are on a decline due to weak global demand, these borrowers simply don’t have money to pay back. Case in point: one of the most leveraged industry is the steel industry in India. With steel prices going off the cliff due to dumping by China, Korea and Japan, steel makers are left with huge losses. Credit Suisse estimates that the $50 billion of debt in the books of the major steel companies is around 15 times their collective operating profit in fiscal year 2015. Yep, it’s pretty bad.

Second, it wasn’t just the US banks that had gone berserk pre-2008: The period before the sub-prime mortgage crises was a boom year for the world economy. Optimism was high and credit growth was at an all time high. Banks gave out loans without indiscriminately without checking for credit worthiness. This is what led to the housing bubble and it is what is leading to our mess too. Defaults were inevitable.

Third, crony capitalism: Surprise? The priority sector for the public sector includes PPP projects. As for the PPP projects, “contracts to the private partners were awarded without competitive bidding and as part of rent-seeking transactions, firms bid aggressively at commercially unviable terms, bidders did not have sufficient professional expertise, and so on.” as has been reported widely in the media. And that’s not it. The government holds considerable influence on all public banks. It appoints all the officials and boards of banks and in fact, the government itself is represented on their boards by senior officials of the Finance Ministry. Without the tacit agreement of the government, the large loans made out by these PSU banks couldn’t have been possible. There are numerous examples of loans been advanced where they shouldn’t have been: IDBI Bank’s Ex-MD arrested

Fourth, regulatory delays in the Infra Sector (perhaps the most important): As per the BOT (Build-Operate-Transfer) model of PPP Infrastructure development in India, private players create Special Purpose Vehicles that makes each project act as an individual entity. These projects are highly leveraged (on an average 70%) since the gestation period is long and uncertainty is high, equity funding isn’t attractive to investors. Therefore, promoters start with high debt and hope to raise equity nearer to the completion of the project to get higher valuations when uncertainty is lower and rewards are nearer for investors. But, as is painfully typical in India, projects are inevitably delayed due to delays in procuring permissions,  clearances and land acquisition. This leaves promoters with high risk leverage and no equity to bank upon. Further, interest costs shoot up drastically by this time and interest costs further erode profitability. Low cash flows lead to more delays and the vicious cycle goes on.

Fifth, wilful defaulters: These are persons who illegally and willingly refuse to pay the banks the amount of interest and principal. Case in point: PNB says 904 wilful defaulters owe it Rs 10,869 crore 

Sixth, unfriendly bankruptcy laws: It takes on an average 4 years to completely exit an insolvent company, which is extremely inefficient as per global standards. This delays the sale of company assets and clearing of debts to the creditors including banks.

Now, there are a number of ways through which the loans pending with NPAs are recovered. These are mentioned below:

  1. ASSET RECONSTRUCTION COMPANIES (ARC): These are like BPOs that specialise in recovering debt. The banks outsource the process of dealing with NPAs to these ARCs. They ‘sell’ the loan to the ARC at a discount on the value of the loan, suffer the loss equivalent to the discount, but get the risk off their hands. The ARC now has the liberty to collect payments, convert debt to equity (thereby acquire decision-making power in the NPA and take decisions to turn it to profitability), sell the mortgage security, restructure the terms of the loan which can include increasing the time for repayment, a haircut (forgiving a part of the loan), interest rate renegotiation etc. Eventually, ARCs hold many such NPAs and further sell them in tranches to investors (mostly HNIs), thus securitising the NPAs. Since most banks do not have the time or expertise to deal with NPAs themselves, ARCs serve a useful purpose.
  2. CORPORATE DEBT RESTRUCTURING (CDR): In this case, the bank does not use an ARC but restructures the NPA on its own as per the laid norms.
  3. STRATEGIC DEBT RESTRUCTURING (SDR): The banks convert their debt into majority equity in the company by diluting the other shareholders of the company. Since they now are the major shareholders, they will either change the existing management with someone they trust or take charge themselves in order to take decisions that will lead the company back to profitability. Under SDR, these banks have to thereafter sell this equity in the company within 18 months of the exercise of the SDR option. There have been very few takers of this scheme since the equity in an NPA is mostly worthless.
  4. BAD BANKS: The most commonly recommended solution to the mess. It is akin to an ARC. They may be created in different forms: 1) as a Special Purpose Vehicle created by the bank itself to clean its balance sheet and protect itself from risk 2) as a nodal institution for all public banks; commonly referred to as the National Asset Management Company. This helps clean up the bank balance sheets so that they can lend, raise capital etc without the weight of provisioning and risk.
  5. 5:25 SCHEME: To give an impetus to infrastructural projects and reduce the NPAs generated from there, a 5:25 scheme was announced by the government. This scheme allows banks to extend long-term credit for infra projects, for up to 25 years, with an option to refinance these every 5-7 years. Refinancing effectively means that banks have an option of rewriting the terms of the loan in light of the changes in the economy every 5-7 years. This makes lending for 25 years more comfortable for banks.
  6. S4A OR SCHEME FOR SUSTAINABLE STRUCTURING OF STRESSED ASSETS: Banks can bifurcate a bad loan into ‘sustainable’ and ‘unsustainable’ parts. The portion of the loan that can be serviced through the existing cash flow is defined as sustainable debt. The unsustainable part (not exceeding 50% of the loan amount) can be converted to equity which can be sold to a third party within no specific time. Therefore S4A improves upon SDR by allowing the bifurcation and not mandating a deadline for the sale of converted equity.
  7. JOINT LENDER’S FORUM: For very high-value loans sourced from multiple banks/creditors, a JLF will be formed where the different lenders can meet and consolidate their claims and calculate the realisable value of the borrower’s assets. They can then form an action plan on how to restructure their loans. This is generally done as a preemptive measure to prevent the loan becoming an NPA.

Also worth mentioning are the measure taken by the government to improve the system:

  1. Creation of ‘Bank Bureau’: An independent body headed by Vinod Rai to be responsible for appointments of executives in PSU Banks. This is to tackle the problem of crony capitalism as was discussed earlier
  2. The Insolvency and Bankruptcy Code, 2016: Creates an insolvency regulatory body, a license for ‘insolvency professionals’ and empowers the creditors to initiate an ‘insolvency resolution process (IRP)’ and fixes a time limit of 180 days for finishing up insolvency proceedings
  3. Recapitalisation of banks has begun. Budget 2017 announced a 10,000 cr package and Budget 2016 had announced 25,000 cr.

These measures may all be good and keep us going for a bit longer, but as for now, we are caught in a deep crisis. There is no way our PSU banks can survive without the government bailing them out i.e. injecting taxpayers’ money as capital into them. The government doesn’t have a choice, it can not let banks get insolvent since people will lose out their savings. More and more bad loans are being written off from the books of these banks. This is India’s 2008 moment. The ghosts of Lehman are back.

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14 thoughts on “Lehman’s Ghosts: The NPA Problem in Indian Banks

  1. You can also add the fact that NPAs are rising because banks are being pushed to recognise NPAs by the RBI, something that was not happening at first. An extremely informative article, thanks for doing this!


    1. “Recently, the RBI (read Rajan) introduced the Asset Quality Review and made reporting of NPAs much more stringent. Further, even restructured loans have to now be termed as NPAs..”

      I have in fact, look for the above lines in the article. And thank you so much Siddhant! 🙂


  2. A very good article. One question – isn’t securitizing the NPA and doing equity swaps same as credit default swaps done by US banks in 2008?


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