Everybody Loves Rajan: Perspectives or Real Life Impact of NPA targeting

To say that Dr. Rajan ’s policies were incorrect, is stupid. In fact, the manner of him being targeted by even Dr. Swamy is ridiculous. Our earlier article was a statistical take on the Inflation workings and why targeting CPI was bit out of place and there was case for further rate cut.

Post Dr. Rajan online resignation, everyone turned into economist. In fact, the folks at CNBC TV18, and other business channels were running around helter skelter all weekend predicting doomsday. Earlier Dr. Swaminathan (Swaminomics) had predicted a huge cash outflow from India, if Dr. Rajan goes. There was support from all quarters. We have put out an article, stating that this seems to be a media hit job. But, since we are independent authors, I wish to digress and move away from the hoopla around the resignation. Only one thing that bother me was that given Dr. Rajan is so well informed, he resigning or stating not interested in second term a week before BREXIT vote is disturbing. Having said, that I would leave the matter to rest.

Two of Dr. Rajan ’s policies for which he is applauded is a) inflation targeting and b) NPA targeting or cleaning up Bank Balance Sheet. I wish to give a rather realistic or a ground level perspective on NPA matter. While, I am not a very experienced banker, I wish to state that I have been working as active in Debt Syndication for the past 5 years. I speak on these aspects from my own experience with on dealing with banks for both project finances and debt restructuring.

With this background, I would like to touch upon the NPA case.

Dr. Rajan’s biggest success or let’s say, what people say about his biggest success or again better, the reason for his ouster was his NPA targeting. Dr. Rajan gave Crony Capitalists a run for their money and decided to clean all bank balance sheets. In fact, the praise has been to such an extent that had it not been for Dr. Rajan, probably banks would have been ruled by Crony Capitalists and Politicians. In fact, with his fierce approach to NPAs, lot of reporting has happened and banks were forced to recognize NPAs. This is evident from losses reported by banks.

We are completely on board with Dr. Rajan ’s NPA targeting. BUT or HOWEVER, I do not agree with the manner or the implementation methodology. The NPA targeting while led to a clean-up of bank balance sheets, is seen only from a single perspective. That perspective been BANK BALANCE SHEET.  The policy did not care to account for the aftermath it leaves behind in terms of jobs or entrepreneurial loss.

Before I delve into the nitty gritty of perspective on the NPAs; lets first understand the meaning of NPA.

NPA means Non Performing Assets.

Annually, RBI comes up with IRAC (Income Recognition and Asset Classification) norms, which tell banks how they should go about recognizing income in their financials and their loans & advances to borrowers NPAs or what methodology should be followed for restructuring a bad account.

A non ­performing asset (NPA) is a loan or an advance where;

(i) interest and/ or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan,

(ii) the account remains ‘out of order’ i.e. outstanding balance remains continuously in excess of the sanctioned limit/drawing power for 90 days, in respect of an Overdraft/Cash Credit (OD/CC)

There are norms for the other types of loans too, but I would mention only two.

Effectively, the above norms mean, that if you are defaulting for a period of 90 days, then you are in trouble and banks can recognize you as NPA.

Further, in the NPA there are various types like sub-standard assets, doubtful assets and loss assets. Even before recognizing NPA, RBI came up with norms which talked defined norms to identifying potential NPAs which led to classification into SMA 0, SMA 1 and SMA 2. I must say, the SMA 0, 1 and 2 was a brilliant move. I would not go more into details because it gets technical now. The link in the bottom, readers may click it and read the norms.

My intention here is to give the reader a real life impact of NPA Policy. Here I wish to state that this article is not talking about impacts on Japyee Groups, Videocon, Reliance, etc. My concluding para will talk how the big guy gets out easily from the mess. I am talking from all the other guys, who are part and parcel of India’s GDP growth.

So, once a borrower is recognized as a NPA then the impact is as under:

1. Immediate NPA:
   1. For a company, company and all its directors are NPA,
   2. For a partnership firm, all its partners are NPA
2. Second Impact
   1. All the associate or sister concerns in the group wherein the promoters or directors are partners or directors. All subsidiary and holding companies related to the promoter, partners and directors
3. Third impact
   1. All other companies wherein the promoters are directors or partner on the date of recognition of NPA.

Let’s take a simple example:

A Ltd. has two shareholder directors Mr. X and Mr. Y.

Mr. X and Mr. Y also have another company called B Ltd.

Mr. X and his friend Mr. Z are partner in a firm called XZ Firm

Mr. Z is partner with a third party Mr. A for a firm called ZA Firm.

Now, due to some issue A Ltd., is unable to repay its debt for 3 months, the bankers recognize the company as NPA. So, the following people shall now be NPA:

1. A Ltd. – NPA no financing
2. X – NPA no financing
3. Y – NPA no financing
4. B Ltd., (sister concern) – Not a NPA but fresh financing stops
5. XZ Firm (associate concern) – Not a NPA but fresh financing stops
6. Firm ZA, will not be an NPA, but will not get additional credit from banks as Mr. Z is partner of a firm which is now a NPA.

So, one account becomes NPA, all others get stuck. The direct accounts are NPA, while the indirect account stop getting any fresh financing. This leads stop in the credit growth for all related industries, even if they are not NPAs, but are associated with NPAs.

Under SARFAESI, banks can now directly, start the process of reclaiming these account and auctioning the assets. Directly, does not mean tomorrow, but there is process; which is bit lengthy but still better than the pre-SARFAESI era. Having established what is an NPA and who all impacted, I will mention most important point. Well, no bank or financial institution or even credit card company will touch you for at least 5 years. In fact, post restructuring as well, no bank will touch you for minimum three years.

One of the major fallout of the NPA recognition and drying up of finances is also the degree of job losses. Each time a NPA is recognized, forget the promoter, minimum 10 to 15 people lose their jobs. For a company with a debt of say Rs. 20 cr., may have even 50 people on their roll. The moment its NPA, all these people are in trouble. I am not saying, the banks should not recognize NPAs, but there is an adequate mechanism to address what happens post the NPA.

Now, did the banks not recognize earlier NPAs, yes they did. Probably their pace was slower; and some accounts cases for genuine restructuring. However, the restructuring norms are tightened to such an extent and the provisioning increased further, banks lost any incentive in restructuring loans. In fact, in the past one year, banks were unable to restructure many loans. One more reason for many restructured loans slipping into NPA (case in point ICICI Bank), is that any exposure given to NPA again attracts provisioning. So, for example a Rs. 100 cr loan is restructured by a bank and to get the unit running, the bank has to give additionally Rs. 10.0 cr., based on a collateral property of say Rs. 10.0 cr., yet it attracts provisioning. Hence, banks are hesitant to give additional finance as it entails loss. In fact, with the revised NPA policy the financing to certain NPAs, dried to such extent no one wants to fund them.

Now, you would say why to finance a NPA. Not all promoters are bad. We cannot make a scathing assumption that all loans from PSU banks are given to Looters India Limited promoted by Politicians. In fact, anyone with that assumption is really high.

Analyzing Dr. Rajan: What has saddened me most about NPA management is that there has been inadequate study or lets say a diagnostic review of the NPA crisis. In fact, there were no attempts made to differentiate between cases of genuine NPA or case where there is an issue with the intention of borrowers.

For example, many metal related companies like steel are in trouble because their selling price is at par with their cost price and some have sell even below the cost price. In this situation many accounts have gone bad. This is one of the example. One more example was the fallout of the Telecom scam when overnight many companies who were working on the telecom sector for the companies who were allotted new licenses were not paid on time for the work as the licenses got cancelled. In that scenario, many of service providers for such companies became NPA. I did a restructuring of a telecom service provider, over a span of one year the company’s employees lost the jobs, the promoters lost all their properties, despite the fact that bankers agreed that the sector is hit so badly, it cant be helped. Given, these two example, I was also party to an investigation conducted by for fraud its employees and promoters in multiple case of CGTMSME Loan. So, there are various cases like banks at fault, employees fraudulent, companies fraudulent, genuine difficulties, etc.

Point, I want to drive home is the impact of NPA real, its not a Balance Sheet entry or hitting on Profit & Loss account; and things move to normal after an accounting entry. Before I get to what happens next, I want to point something:

Most of NPAs are in PSU banks and in fact, like I said earlier, everyone is of the opinion that PSU banks been politically controlled gives loans on phone calls and private banks are better. Look at bank like HDFC BANK they are doing so good and why can’t private banks do so. See, your private banks wont lend unless you are very very good borrower. Very good borrower means you come with huge collateral, have huge profits, have minimum three year financials, and promoters have huge net worth. Should PSU also follow this; everyone will say YES. But, who lend to greenfield project, what about entrepreneurs who has less collateral but can take a huge projects. In fact, at the first sign of trouble Private Banks demand their money back, they will show maturity in understanding the problems of business and try to restructure.

Post NPA one of the following things happen:

1. Borrowers raises arms and says do what you want
2. Borrower tries to rescue
3. Too big account or loan, too many bankers
4. Bring in an ARC into picture

Let’s take point 1 and 2 together. Borrower raises arms happens in very less cases. Borrowers are first generation entrepreneurs or family businesses who don’t raise up their arms. Except cases of frauds, promoters are always available to banker. But given the restructuring norms, sometimes banks are adamant at helping or some issues always crop up, such as additional collateral, or clear the account then we will see, etc. etc.

Point 3, in this case generally the exposure of banks is very high so they try to give some money restructure it and see if it works. However, the increasing in provisioning norms banks have literally stopped giving money. So chances of revival are gone.

Point 4: ARC (Asset Reconstruction Companies) comes into play. Without been boring, all I will say is that ARCs ask for anywhere between ~15% to 20% IRR and 2x collateral cover their monies invested. Secondly, ARCs don’t pay to bank they issue bonds which attracts provisions and fluctuation in value of bonds, leads to further provisioning.

Even the cases pending at the Debt Recovery Tribunal are way too many; and it takes anywhere between year or two to get the judgements. So, once an asset is recognized as an NPA, the bank and borrowers are now married either forever, if there is case of revival or if there is a case of sale / auction.

Why am I mentioning all this. The point I want to drive home here is that we cannot just say everything is a crony capitalist lending. A machine gun joe approach at NPA targeting has led to heavy stress. Without an adequate mechanism to deal with “Life Post NPA”, the approach of fast recognition in an atmosphere of global uncertainty has led to catastrophic challenges. While, Dr. Rajan has decided to go to academics, these aspects have not been tackled. You may say, that this is not his problem. But, I disagree; Reserve Bank is a Bankers Banker. So, problem of Banks is a problem of the RBI. RBI cannot be like just an auditor, it needs to create a mechanism to even address the problem. Today, with NPA recognition, we have created huge NPA accounts, led to wiping out of profits of banks, destroying their capital adequacy ratio and also killing their ability to raise further capital. This is evident from the fall in their stock prices.

If the reader has reached to reading upto here, please spare some more time to read how things could been better.

One of the best example of saving from a crisis is Mr. Piyush Goyal’s UDAY scheme. Under the UDAY scheme Piyush Goyal transferred all the stressed debt of banks to DISCOMs to State Government and made them issue bonds to banks. This led to clean up of bank’s balance sheet at it removed the NPAs; banks are receiving sovereign guarantee bonds which are good for their capital and Discoms can get additional monies either from banks or anyone else. If the DISCOM performs well, these bonds of state government can be sold to PE funds, etc. and there are many nice things that can happen. This UDAY bonds initiative worked in favor of everyone, banks, RBI, discoms, state governments.

Given that Dr. Rajan is the Banker to all Banks why has is not come up such an idea. Since past 3 years, every one is shouting to create a BAD BANK, which shall deal with the NPA menace. So, all the bad loans can be transferred to this BAD BANK, and they shall deal with the NPA problem. Cases of genuineness or otherwise, shold be explored by this bank. This bank may be backed by a mix of owners such as central government, banks (public or private), PE funds, etc. This banks shall be armed with specialist who can help in both revival or otherwise of such cases and ensure that there are stress situation on the system. This could the largest revival initiative which shall be headed or overlooked directly by RBI and PMO. I failed to understand, why this step or thoughts of this steps were not initiated by Dr. Rajan.

Now, coming to a shocker. Has anyone read the Chicago Booth Paper by Dr. Rajan on NPA or impact of NPA on asset prices leading to possibility of collapse on overall banking system. Dr. Rajan argues that with many NPAs, and banks trying to sell the assets to recover their monies, the prices of assets or properties start falling. This leads to stress in all banks as they are now required to ask their borrowers to make good loss of asset value. If this stress happens in a fast way, the entire banking system comes to risk. Having this knowledge and written an economic paper on this, I fail to understand why adequate back-stops were not created.

Annexure 1:

I am purposely excluding the Jaypees, Mallya, etc., for now; and talking of everyone else, who make up chunk of Indian bank lending. The Jaypees, Mallyas, Reliance with their huge assets have many PE funds or wealthy people lining up to buy their assets

Annexure 2: Those who can’t do, teach

I will borrow the start for this article from the opening lines of Dr. Rajan’s speech:

“Good morning. Let me state at the outset that these are my personal views. The topic for this session covers an enormous landscape. I simply could not do justice to it if I tried to be comprehensive – that would require a few volumes. At the same time, this conference deserves a view from 30,000 feet rather than a view from the trenches. So I will be selective in what I focus on, emphasizing what I believe to be a broad and important trend. Ultimately, though, the job of many of us in this room is to recognize the broad trend, and then get down to the nitty gritty of figuring out how to deal with it. I confess that the nitty gritty is far more difficult, so I will only speculate on what, if anything, ought to be done. My intention is to provoke discussion rather than to attempt to end it.” These were the opening lines of Dr. Rajan ’s presentation on August 27, 2005, Jackson Hole, Wyoming.

Predicting the crisis

Praise or critique should be taken naturally and in good stride given that Dr. Rajan is the King of Critiquing; someone who went against the tide. Cut back to 2005 Jackson Hole Meet, where Economists were lauding Greenspan over his economic policies, Dr. Rajan presented a critique on Greenspan’s policy further stating that some of his policies have inherently increased risk in the banking system. Dr. Rajan’s speech concluded that with excessive financial instruments are turning riskier (word risk is used 59 times in the article while the word Crisis is mentioned 4 times primarily in the context of Russian Economic Crisis). In his concluding remark Dr. Rajan mentions “In conclusion, financial markets are, at present, in extremely healthy shape. Yet it is at such times that excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe. While the techniques and instruments to absorb fluctuations have improved, there is uncertainty about how they will perform in a serious downturn”.

Cut to: “The Big Short” or the movie “The Big Short”, the name Dr. Michael Burry would ring bells.  Dr. Michael Burry, a hedge fund manager at Scion Capital LLC, US was one of the first to discover the impending housing crisis in 2005. In fact, he not only researched it or just presented a paper on it, he bet his entire fund’s assets in the CDS predicting a crash in 2007. Yes, you read it right, he even predicted the timing and not just that. he made Goldman Sachs sell him CDS for housing crisis. This is unlike an Economic Paper pointing to the risk or a prediction of crash. Now, Dr. Burry bet his funds assets on this was paying Margin for his position for literally a year and then when markets crashed he netted $700 mn for his clients; this despite his clients going against him threatening a lawsuit, among others. The reason, I shared Dr. Burry’s story is because he bet his money where his mouth is; rather than “those who can’t do, teach”.