India: A Nation In Stress

INDIA A NATION IN STRESS Issue #1
INDIA
A nation in stress
The everlasting issue of rising
NPA’s
- Rayan Dalal
INTRODUCTION
Overview
The Indian economy is considered one
of the most rapidly growing economies
in the world. Contributing to its high
growth are many critical sectors,
amongst which the ‘financial services
sector’ unarguably plays an imperative
role. The role of financial sector in
shaping fortunes for the Indian
economy has been even more critical,
as India since independence lacked
prowess of a resilient industrial sector,
it prompted India to depend on other
sectors for its sustenance. These other
sectors constituted of mainly the
‘financial service sector and
‘agricultural sector’. Within this
financial service sector in India today,
the most dominant segment accounting
for over 80% of the funds is the banking
system.
A banking system generically performs
three Primary functions in an economy:
The operation and functionality of
payments, the mobilization of savings
and the allocation of savings to various
investment avenues. By allocating
capital to the highest value use while
limiting the risk and cost involved, the
banking sector can exert a positive
influence on the overall economy, and
thus is of broad macroeconomic
significance. The economic progress of
a nation and development of its
banking sector tends to be invariably
interrelated. It is an indispensable
financial service sector mechanism
supporting development plans through
channelizing funds for productive
purpose, intermediating flow of funds
from surplus to deficit units and
supporting financial and economic
policies of the government. In order to
create a strong competitive and vibrant
banking system, the country over the
years has allowed entry of new private
sector banks and foreign banks leading
to flexibility in operational work and
financial autonomy to public sector
banks in respect of fund mobilization
and credit management.
Maintaining asset quality and
profitability are critical for banks
survival and growth. In the process of
achieving such objectives, a major
roadblock to the banking sector is
prevalence of Non-Performing Assets
(NPA). In India, the problem of bad
debts was not taken seriously until it
was mandated by the Narasimhan and
Verma committee back in 1991. The
committee mandated the curbing of
the particular issue because NPA’s
directly affected the credit risk faced by
Banks and its efficiency in allocating
resources. The rising incidence of NPAs
has been generally attributed to the
domestic economic slowdown. It is
believed that with economic growth
slowing down and rate of interest going
up sharply, corporates have been
finding it difficult to repay loans, and it
has added up to rising NPAs. Today 25
years later NPAs stand as India’s most
imperative national issue, since the
financial crisis of 2008. The total value
of Non-Performing Assets in our
economy currently is over 8 lac crore
rupees of which a significant
component lies with Public Sector
Banks (PSB). 20 of the top PSB’s in India
have an NPA ratio of over 15%. How
and why did this high level of default
occur? Where did we go wrong? What
strategies is the government using to
curb it?

INDIA A NATION IN STRESS | Issue # 2
The Banking Industry & Non
Performing Assets (NPAs)
In India, the banking system has a very
long history evolving over many years
passing through different phases post-
independence. After financial sector
reforms as part of economic
liberalization, the Indian banking
system has undergone several
transformations. One such
transformation has been the adoption
and implementation of international
practices in regulating and monitoring
the money market in India. The banking
sector has to concentrate on the
effective management of funds, to
avoid the hindrance of rotation of
funds.
Further, the priority sector lending by
the public and private sector
commercial banks are constrained by
few inadequacies such as misuse of
funds by corporates. Moreover, there
are the problems of inadequacies on
behalf of commercial banks in the
administration and allocation of sector
wise advances coupled with the banks'
quality of supervision in the post
disbursement period is poor leading to
accumulation of overdues which in turn
has increased the level of Non-
performing Assets (NPAs). To recover
default loans, the banks traditionally
adopted three different measures:
seizure of property (collateral), action
and sending reminders to the
borrowers. Out of three measures,
sending reminders is the commonly
and most often adopted measure
followed by legal action and seizure of
property by banks.
Non-performing assets (NPAs) are a key
concern for banks in India. They are the
best indicator of health of the banking
industry. The increase in NPAs shows
the necessity of provisions, which bring
down the overall profitability of banks
as a result of limited credit creation.
Therefore to improve the efficiency and
profitability of banks, NPAs need to be
reduced and controlled. A high degree
of NPAs suggests high probability of a
large number of credit defaults
affecting the liquidity of banks. Under
the circumstances, the role of credit
rating agencies also needs to be
relooked at and brainstormed over. We
need to devise a way forward to ensure
that rating agencies implement a
mechanism to monitor the same.
Across the globe, the banking sector
acts as the catalyst for the country’s
economy. Banks play a vital role in
providing financial resources especially
to capital-intensive sectors such as
Infrastructure, automobiles, iron and
steel, industrials and high-growth
sectors such as pharmaceuticals,
healthcare and consumer discretionary.
In emerging economies, banks are
more than mere agents of financial
intermediation and carry the additional
responsibility of achieving the
government’s social agenda also.
Because of this close relationship
between banking and economic
development, the growth of the overall
economy is intrinsically correlated to
the health of the banking industry.
During the high growth phase of the
economy from 2002 to 2008, credit
growth in the Indian banking sector
was in excess of 22%. A slackening in
the economic growth rate has resulted
in both, a lower credit demand as well
as a receding appetite on the part of
the banking industry, to extend credit.
Stressed assets (SAs) in India have
almost doubled from 5.7% in FY08 to
10.2% in FY13. Today it stands at nearly
14% of total advances.
NEWS
Greece has the highest NPA of 36.4 in the
world. Its economy is in tatters with around
50 per cent of registered unemployed people
without a regular job for over one and half
year
- Business Today

THE NPA EFFECT
What is a Non- Performing Asset
(NPA)?
The concept of NPAs arises from the
provision of loans and advances. Loans
and advances are treated as
performing assets if they generate
income regularly whereas they are
treated as an NPA when they cease to
generate income (interest, fees and
commission) which result in losses to
banks (financial institutions). In other
words, a loan asset becomes NPA when
it is not recovered in the stipulated
time and not generating any income.
NPA is a term in accounting system of
banks / financial institutions for
classifying the loans that are in risk of
default. Banking businesses involves
borrowing money from the public in
the form deposits and lending them to
the needy persons and business at a
premium. Lending money involve a
credit risk because the loans and
advances made by banks or financial
institutions are likely to turnout as non
- productive, non-rewarding and non -
remunerative which are likely to
become NPA.
To understand the concept of how
NPAs affect the functionality of banking
processes, we can have a look at the
components of a bank’s balance sheet
in the table above.
Asset Liability Management is what
runs the daily operations and generates
consistent earnings for a bank. It is the
combination of receiving deposits and
providing advances using the available
deposits. The profit is made by charging
an interest on the advance over and
above the deposit rate. In simple terms
this is how a bank functions, now what
happens when the advances provided
tend to default? This means capital and
funds that were provided by the bank
are now locked down and hence it
creates a liquidity issue since deposits
need to be paid back. This results in the
limitation of credit creation for a bank
that in turn affects the economy. To
ensure such risks are controlled, banks
have CRR and SLR requirements.
However when loan defaults soar over
20% in a bank, there is no reserve that
could possibly compensate for the
same. It is money that has been leaked
out of the economy that would been
otherwise efficiently diversified.
FAST FACTS
20%Eight PSB s have a GNPA over 20%
9.5 lack Cr
GNPA may rise to Rs 9.5 lakh crore by March
INFORMATION
The finance ministry has approved a proposal
to infuse Rs7,577 crore in six weak public sector
banks (PSBs). They plan on infusing 2.11 lack
crore over the next 2 years.

Reasons for the rise in the level of NPAs in recent years
Between the early 2000's and 2008
the Indian economy was in its boom
phase. During this period Public
sector banks extensively funded
and lent to corporates. However,
the profits of most of these
corporates dwindled as a result of
the slowdown and the inevitable
crisis across the global economy.
The ban on mining projects, delay in
environmental related permits
affecting the power, iron and steel
sector, volatility in prices and
shortage of raw material deeply
influenced the ability of corporates
to pay back loans. Ever since there
has been a gradual rise in NPA levels
in our economy which has been
over looked and never curbed.
One of the pivotal reasons of rising
NPA is the relaxed lending norms in
the 21st
century especially for
corporates, influenced by their
financial status and inefficient
credit rating agencies. Also in order
to face competition banks hugely
sold unsecured loans which
attributed to the level of NPAs.
Today sectors in the economy such
as textile, aviation, mining,
Infrastructure contribute to the
largest volume of NPAs and
defaulters. There is a myth that the
main reason for rise in NPA in Public
sector banks was Priority sector
lending, however according to the
findings of Standing Committee on
Finance, NPAs in the corporate
sector are far higher than those in
the priority or agriculture sector in
terms of volume as well as degree
of defaults.
The Lack of Bankruptcy code in India
and sluggish legal system made it
difficult for banks to recover these
loans from both corporate and non-
corporates even if the loans were
secured, it was the liquidity needed
rather than the assets to keep the
bank’s profitability stable.
In Q1 FY18, non-performing assets
(NPAs) of a sample of 38 banks
increased by a sharp 34.2% on a y-
o-y basis. Also the NPA ratio
increased to 10.21% in June 2017
from 8.42% in June 2016, which is
the highest in the last six quarters.
On a q-o-q basis, the increase in
NPAs have been the highest in Q1
FY18 witnessing an increase of
about 16.6% to reach Rs. 829,338
crore as of June 2017.
NEWS
The share of bank lending to real estate
sector has fallen sharply to 17 per cent
in 2016 from over 68 per cent in 2013 as
banks are reluctant to provide credit to
this industry due to rising NPAs
- Economic Times

An internal study conducted by RBI shows that the
following factors contribute to NPAs.
Liberalization of economy/removal of restriction/reduction of
tariffs: A large number of NPA borrowers were unable to
compete in a competitive market in which lower prices and
greater choices were available to consumers that resulted in
consolidation and speculative funding. Further, borrowers
operating in specific industries have suffered due to political,
fiscal and social compulsions, compounding pressures from
liberalization.
Lax monitoring of credit and failure to recognize Early
Warnings Signals: A loan proposal generally passes through
many levels before approval is granted. However, the
monitoring of sometimes complex credit files has not
received the attention it needed which meant that early
warning signals were not recognized and standard assets
slipped to NPA category without banks being able to take
proactive measures to prevent this. It is partly due to this
reason, adverse trends in borrower’s performance were not
noted and the position further deteriorated before action
was taken.
Over optimistic promoters: Promoters were often optimistic
in setting up large projects and in some cases were not fully
above board in their intentions screening procedures did not
always highlight these issues. Often projects were set up with
the expectation that part of the funding would be arranged
from the capital markets which were booming at the time of
the project appraisal. When the capital markets subsequently
crashed, the requisite funds could never be raised, promoter
often lost interest and lenders were left stranded with
incomplete/unviable projects.
Directed lending: Loans to particular segments were dictated
by Governments policies rather than commercial
imperatives.
Highly Leveraged borrowers: Some borrowers were
undercapitalized and over burdened with debt to absorb the
changing economic situation in the country. Operating within
a protected market resulted in low appreciation of
commercial/market risk.
Wilful Defaulters: There are a number of borrowers who have
strategically defaulted on their debt service obligation
realizing that the legal resource available to creditors is slow
in achieving results.
Impact of high level of NPA’s on the Indian
Economy
Higher NPA ratio trembles the confidence of investors,
depositors and lenders. It also causes poor recycling of funds,
which in turn will have a deleterious effect on the
deployment of credit. The non-recovery of loans effects not
only further availability of credit but also financial soundness
and liquidity of the banks.
Profitability: NPAs put detrimental impact on the profitability
as banks stop to earn income on one hand and attract higher
provisioning compared to standard assets on the other hand.
On an average, banks are providing around 25% to 30%
additional provision on incremental NPAs which has direct
bearing on the profitability of the banks.
Asset (Credit) contraction: The increased NPAs put pressure
on recycling of funds and reduces the ability of banks for
lending more and thus results in lesser interest income. It
contracts the money stock which may lead to economic
slowdown.
Liability Management: In the light of high NPAs, Banks tend to
lower the interest rates on deposits on one hand and likely to
levy higher interest rates on advances to sustain their Net
Interest Margins (NIM). This may interrupt a smooth financial
intermediation process and hampers economic growth.
Capital Adequacy: As per Basel norms, banks are required to
maintain adequate capital on risk-weighted assets on an
ongoing basis. Every increase in NPA level adds to risk
weighted assets which warrant the banks to shore up their
capital base further.
Shareholders’ confidence: Normally, shareholders are
interested to enhance value of their investments through
higher dividends and market capitalization which is possible
only when the bank posts significant profits through
improved business. The increased NPA level is likely to have
adverse impact on the bank business as well as profitability
thereby the shareholders do not receive a market return on
their capital and sometimes it may erode their value of
investments. As per extant guidelines, banks whose Net NPA
level is 5% & above are required to take prior permission from
RBI to declare dividend and also stipulate cap on dividend
payout.
Public confidence: Credibility of banking system is also
affected greatly due to higher level NPAs because it shakes
the confidence of general public in the soundness of the
banking system. The increased NPAs may pose liquidity issues
which is likely to lead run on bank by depositors. Thus, the
increased incidence of NPAs not only affects the performance
of the banks but also affect the economy as a whole. In a
nutshell, the high incidence of NPA has cascading impact on
all important financial ratios of the banks viz., Net Interest
Margin, Return on Assets, Profitability, Dividend Payout,
Provision coverage ratio, Credit contraction etc., which may
likely to erode the value of all stakeholders including
Shareholders, Depositors, Borrowers, Employees and public
at large.

Economic Reforms
& Restructuring
In the past year and a half, India as a country under the Modi government has
witnessed several major economic and financial regulatory changes. Some of these
changes include introduction of Goods & Service Tax (GST), The Real Estate
(Regulation & Development act), Demonetization and last but not the least the
Insolvency Bankruptcy Code (IBC’16). All these are major industrial economic
reforms and regulations passed to primarily encourage facilitation of 3 major
criteria’s.
1. Credit Creation within the economy
2. Centralization of Industrial structure
3. Ease of running business activities
The implementation of these policies has within two years successfully turned
around several concerns prevailing within the economy. It has shaped avenues for
investment allowing banks to create liquidity through increase in deposits; it has
created a uniform tax structure that can feasibly be tracked to its source, it has
mandated real estate developers to disclose project related details in order to
promote accountability, transparency & efficiency in the sector and lastly it has
brought in an Insolvency Act to deal with the imperative issue of rising NPAs.
Like mentioned earlier there are two key components or elements that determine a
bank’s asset liability management model. The first being deposits, with
demonetization the government of India was able to convert a large degree of cash
currency held by citizens into deposits. It made it mandatory for the general public
to open bank accounts and deposit their money in return for freshly issued currency.
This was not able to cure the problem of rising NPAs, however it was able to control
the impact of it and create liquidity for banks whose capital was locked up as a result
of defaults.
On the other hand the Insolvency & Bankruptcy Code is likely to play a pivotal role in
addressing the non-performing assets (NPA) of the banking sector. The banking
sector is facing issues due to the bad loans on its books, which has created a risk of
capital erosion. NPAs have constrained the banks' ability to lend and credit is an
important ingredient of economic growth, the lack of which could lead to economic
contraction.
So how does the new Insolvency & Bankruptcy Code prevent and control an
economic contraction like this from happening?
STRUCTURAL CHANGES
Goods & Service Tax
An indirect tax levied in India on the sale of goods and
services. It simplified a slew of indirect taxes with a
unified tax and is therefore expected to dramatically
reshape the country's 2 trillion dollar economy.
Demonetization
The act of stripping a currency unit of its status as
legal tender. It resulted in a significant degree of the
population of India to open bank accounts prior to
which stood at less than 50%. This act of eliminating
black money faciltated credit creation for capital
locked up with PSBs.

THE INSOLVENCY & BANKRUPTCY
CODE 2016
The Insolvency and Bankruptcy Code (IBC), 2016 has been
enacted to merge the existing laws related to insolvency and
bankruptcy. Insolvency is a state in which financial difficulties
of a company are such it is unable to run its business at its
current pace. Bankruptcy is the status of a person who is
legally declared as incapable of paying their dues and
obligations The Code aims to smoothen this process to make it
clear and certain. The IBC involves standard steps which is
viable and understandable. So, everyone, be it creditors,
debtors, companies, or shareholders etc. shall have a standard
perform for any matters relating to insolvency.
India was in desperate need of an appropriate bankruptcy law
to help tackle the NPA problem in a more meaningful way. Our
corporate insolvency resolution framework prior to 2016 fared
poorly in terms of both timeliness and cost of proceedings.
Problem is, longer the time taken, greater is the probability of
erosion in realizable value of assets and, hence, lower the
recovery rate. In terms of resolving insolvencies, India ranked a
poor 136 out of 189 countries and the last among the BRICS
countries (Brazil, Russia, India, China and South Africa). The
average time taken for insolvency proceedings in India is about
4.3 years, while it is only 1.7 years in the high-income member
countries of the Organization for Economic Co-operation and
Development. More importantly, lenders tend to recover just
about 20% of their loans when businesses go bust compared to
the over 70% recovery in developed countries.
Reforms in bankruptcy laws can play a crucial role in economic
growth and financial stability. An effective insolvency
framework can offer huge economic benefits like ensuring
maximization of value of creditor’s claim by rehabilitating the
ailing debtor company or through an effective liquidation
framework if rehabilitation is not achievable. Absence of a
rational and efficient process of corporate insolvency has
inhibited development of a vibrant corporate bond market.
Large amounts of capital and assets have been locked up in
enterprises that have gone under with little prospect of revival.
Unfortunately till 2016 there was no comprehensive and
integrated policy on corporate bankruptcy in India. Multiple
agencies were involved in the process, whose jurisdictions
often overlapped that created systemic delays and
complexities. Keeping this in mind, the Bankruptcy Law Reform
Committee (BLRC) was set up, which submitted the draft of its
proposed Insolvency and Bankruptcy Code. Among other
issues, this draft addressed the timeline issue by stipulating a
strict timeline of 180 days for insolvency resolution and limiting
judicial determination at the trigger stage.
Enter Insolvency and Bankruptcy Code (IBC).

The Corporate Insolvency Resolution
Process

A step in the right
direction
This newly implemented Code will not only improve the
ease of doing business in India, but also facilitate a better
and faster debt recovery mechanism. It is widely believed
that this legislation will change the negative perception of
NPAs, recovery and litigation associated with India.
The new bankruptcy law is already proving to be a useful
tool for international creditors and investors from the
perspective of PE funds continuing to grow their
investments in India. Its stringent guidelines has also
facilitated several debt restructuring mechanisms from
entering the economy. It facilitated consolidation in the
economy by transferring wealth and assets from inefficient
capital utilizers to efficient capital allocators. The Code in its
own justice way aims to punish dilution in businesses by
discouraging existing promoters from bidding against their
own company’s assets. On the other hand it provides an
opportunity for efficiently run enterprises to take over these
sick assets at a discount and enables inorganic growth at a
low opportunity cost.
Currently the number of companies facing liquidation under
the Insolvency and Bankruptcy Code (IBC) is thrice that of
companies where a resolution plan has been approved, the
Economic Survey said. According to the Economic Survey, of
the 525 insolvency petitions filed in the National Company
Law Tribunal (NCLT), 30 companies have been ordered to be
liquidated, 10 companies have got their resolution plans
approved, 34 have been closed by appeal or review and 451
companies are still undergoing the process. In terms of the
quantum of loans involved for companies under the
insolvency process, the steel sector tops the list with Rs
57,000 crore of debt, followed by retail at Rs 12,719 crore.
The total loans to be resolved through the bankruptcy court, it
said, is Rs 1.28 lakh crore.
It is the first time that the government and Reserve Bank of
India are on the same page for effective resolution of the
problem of bad debt and improving overall financial discipline
in the way business is conducted in India. A number of
features of the IBC and the pronouncements of various high
courts and Supreme Court motivate us to look at this latest
effort in a positive manner. The coming months will show us
the early trends in actual resolutions under the code.
Hopefully, it will prove to be a game changer in the interest of
the Indian economy’s health and long-term growth. As Nelson
Mandela said, “I never lose; I either win or I learn.” The jury is
still out on the IBC even though the World Bank has
acknowledged the effort. Let’s hope all involved entities
implement the lessons they learn along the way for cracking
this debilitating problem of non-performing assets and
financial indiscipline facing the country.

India: A Nation In Stress

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