Stress in the Banking Sector

Recent Developments

Reserve Bank of India’s biannual Financial Stability Report has once again flagged the fact that risks to the banking sector remain worryingly “high”.

In the central bank’s assessment, risks have stayed elevated due to:

* Continuous deterioration in asset quality

* Low profitability

* Liquidity issues

Important Role of Commercial Lenders:

Given the central role commercial lenders have in the financial system — serving to harness public savings and direct the flow of crucial credit to the most productive industrial and infrastructure sectors — any systemic risk to the banking industry has the potential to ripple across the entire economy.

Risks faced by Lending Sector:

A systemic risk survey completed in October was itself rather downbeat. Out of 34 categories of risk, the survey rated only 11to be very low or low, leaving 23 to be rated as medium to high risk.

Cyber security, credit growth, asset quality, capital adequacy, infrastructure creation and corporate profitability were already considered high risk then. Demonetisation has only increased the risk.

Given the above scenario, we revisit the recommendations made by Standing Committee on Finance (Chair: Dr. M Veerappa Moily)

Standing Committee Report Summary: Non-Performing Assets of Financial Institutions

The Standing Committee on Finance (Chair: Dr. M Veerappa Moily) submitted its report on Non Performing Assets of Financial Institutions on February 24, 2016. The report makes recommendations to improve the management, and facilitate recovery of Non-Performing Assets.

* Non-Performing Assets: A non-performing asset (NPA) is a loan given by a financial institution, which ceases to generate income. NPAs include loans where payment has been overdue for more than 90 days. The Committee observed that despite the government and the Reserve Bank of India (RBI) taking several steps, NPAs continue to increase.

* Empowered Committees: It observed that banks do not have adequate capability to undertake credit appraisal. Credit appraisal involves evaluating capacity of the borrower, to ensure he is capable of repaying the loan. In this context, it recommended that specially empowered committees should be set up at three levels, namely (i) RBI, (ii) banks, and (iii) borrower, to continuously monitor large loan portfolios. Further, these committees may be mandated to submit periodical reports on their findings, to the central government and Parliament.

* Restructuring of loans: The Committee observed that currently banks restructure loans on the basis of classification of their assets, and other benefits related to provisioning. It suggested that banks should carry out such restructuring by taking into account the temporary inability of the borrower to repay the loan and to preserve the economic value of the assets. It further suggested that indicators should be developed for projects when a loan is sanctioned. The indicators would facilitate monitoring of loans, and pre-empt the possibility of an NPA.

* Wilful defaulters: Wilful default refers to a situation where a borrower defaults in making repayments, despite having sufficient resources. The Committee observed that wilful defaulters constituted 21% of the total NPAs of banks. In this context, it suggested that banks should make names of the top 30 wilful defaulters public. Such a step would act as a deterrent for others to default willingly on loan repayment. It suggested that necessary amendments should be made to the RBI Act, 1934, and any law or guideline in force, to allow for such public disclosure. Further, the Committee recommended that names of companies that have undergone restructuring of their loans, should also be made public.

* Timeline for Corporate Debt Restructuring: Corporate Debt Restructuring (CDR) is a voluntary mechanism, which involves restructuring of debt of entities which are facing problems in repaying loans. The Committee observed that currently deliberations among stakeholders to settle CDR cases continue for years. It recommended that a timeline of six months should be introduced to settle such cases.

* Strategic Debt Restructuring: Strategic Debt Restructuring (SDR) empowers banks to take control over the management of the defaulting company, by converting the loan into equity. The Committee recommended that a change in management of the company should be made mandatory, in cases involving wilful default, or where funds have been diverted and no recovery is possible.

* Absorbing written off NPAs: The Committee suggested that the RBI should consider allowing banks to absorb their written-off assets gradually, in a staggered manner. This would help the banks in restoring their balance sheets to normal health.