“The failure of a loan usually represents miscalculations on both sides of the transaction or distortions in the lending process itself.”

— Radelet, Sachs, Cooper and Bosworth (1998)

In the recent times the newspapers have been filled with some or the other news, issues, policies, regulation or resolution of NPAs. The NPA ratio has come down to 9.3% in March, 2019 from 11.5% in March,2018 according to mention by RBI Governor Shaktikanda Das. 

According to RBI, the definition of NPA is: ‘An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank.’

A non-­performing asset (NPA) is a loan or an advance where the payment of principal/interest is due (in default) for 90 days or above.First, when there is a default of payment, till 90 days, the accounts are subsequently classified as Special Mention Accounts (SMA): SMA 0/1/2. Then after 90 days, these accounts are classified as NPAs.Further NPAs are classified into sub­standard,doubtful and loss assets.Any income for standard assets is recognized on accrual basis, but income from NPAs is recognized only when it is actually received.

Reasons for accumulation of NPAs:

Increasing cases of wilful defaults and frauds are often considered as the primary reason behind the accumulation of bad loans in the Indian banking system.

When an economy experiences healthy GDP growth, a substantial part of it is financed by the credit supplied by the banking system. As long as the GDP keeps growing, the repayment schedule does not get substantially affected. However, when the GDP growth slows down, the bad loans tend to increase due to macroeconomic factors, primarily among them are interest rate, inflation, unemployment and change in the exchange rates.Hence, bad loans accumulate as borrowers are unable to repay due to stalling/closure of the big development projects

Bank-related micro indicators such as capital adequacy, size of the bank, the history of NPA and return on financial assets also contribute to the accumulation of bad loans. NPAs, specifically in the Public Sector Banks (PSBs), have adverse effects on credit disbursement. Increasing amounts of bad loans prompt the banks to be extra cautious. This in turn has caused drying up of the credit channel to the economy, particularly industries, making economic revival more difficult.

Need for Solution

Reviving industrial credit is crucial for the health of the overall economy, because industry (particularly manufacturing) tends to create more employment.

Mounting bad loans suggests vulnerability in the system, wherein short-term deposit-taking banks have to extend credit for long-term big development projects. And this model is visibly failing. Hence NPAs put several small depositors of the banks, particularly in the PSB, at risk.

Also an improvement in the recovery rate and reduction in timeline for resolution for insolvent companies will increase investor confidence in Indian Bond Market.

Recognition of the problem and the solution:

NPAs story is not new in India and there have been several steps taken by the GOI on legal, financial and policy level reforms. In the year 1991, Narsimham committee recommended many reforms to tackle NPAs.

SICA Act, The Debt Recovery Tribunals (DRTs) – 1993, CIBIL: Credit Information Bureau (India) Limited-2000, LokAdalats – 2001, One-time settlement or OTS- compromise settlement-2001, SARFAESI Act- 2002, Asset Reconstruction Company (ARC), Corporate Debt Restructuring – 2008, 5:25 rule – 2014, Joint Lenders Forum – 2014, Mission Indradhanush – 2015, Strategic debt restructuring (SDR) – 2015, Asset Quality Review- 2015, Sustainable structuring of stressed assets (S4A)- 2016 were some of the techniques applied to tackle the problem by government and RBI.

Every method was entangled, rules were not that clear, there were lot of cases pending in front of DRTs owing to limited infrastructure, not enough field experts and hence, it took years for creditors to recover their money. India needed a structured process; thereby Insolvency and Bankruptcy Code (IBC) -2016 came into existence.

It sets a time limit of 180 days which can be extended by another 90 days to complete the entire process. Some of the features of the code include the allocation of a new forum to carryout insolvency proceedings, setting up a dedicated regulator, creating a new class of insolvency professionals and another new class of information utility providers.

The forum where corporate insolvency proceedings can be initiated is the National Company Law Tribunal (NCLT) and appeals against its decisions can be made in the (National company Law Appellate Tribunal) NCLAT. The IBC vests the NCLT with all the powers of the DRT.

Insolvency professionals will have the task of monitoring and managing the business so that neither the creditors nor the debtor need worry about economic value being eroded by the other.On acceptance of the application by NCLT for proceeding for Corporate Insolvency Resolution Process (CIRP), Board of Directors of the company has to step down and Insolvency Professional takes the charge and the plan for revival or liquidation of the company, approved by majority of creditors is put in the action according to the IBC rules and timeframe.

It is predicted that the NCLT is focused on the legal process while the insolvency professional is focused on business matters.RBI listed out the 12 major accounts in India, which has the largest share of NPAs in the country.

Some great results have fared in: Ranking for ‘Resolving Insolvency’ But still there is a long way to go: Suggestions

As mentioned above, there is a mismatch of assets and liability for the banks. Banks’ assets are long term loans, whereas banks liabilities are short term deposits, which have landed banks in failures. Hence, it makes sense to say that commercial banks should be focusing on short term assets to match their short term liabilities. And for Long term projects, special purpose vehicles (SPV) should be created to fund a particular sector project and financial institution should be created to fund these SPVs and should be given incentives and proper regulation from the government.

Also, as recapitalization of PSBs is going on, a bank should first divide its assets into good and bad, meaning viable and unviable asset. Banks should be recapitalized according to viable assets to revive with its positive core rather than just giving out public money. By this, banks can also focus on their core business rather than managing NPAs and not contribute to slowing of the economic growth.

SICA Act in India was a ‘Debtor in Possession’ (DIP) Model just like U.S. Chapter 11. But there were flaws in the act compared to the U.S.model. There was also a problem in the assessment of viability of the company as only a few accounts were revived. ‘Another relevant fact is the definition of insolvency or ‘sickness’ under the SICA. The N.L. Mitra committee criticized the definition provided by SICA i.e. ‘at the end of any financial year, accumulated losses equal or exceed its entire net worth’ stating that this is the end rather than the initial point where the company’s problems begin.’

Time has changed, India made a comeback with ‘Creditor in Possession’ (CIP) Model of IBC inspired by U.K. owing to similarities in the judicial process and SMEs culture, but there is one problem. In SICA, debtors were made liable to take the proceeding to court if it is identified by them that company is in trouble. Under IBC there is no such amendment and hence there is a ‘problem of initiation’ which was clearly seen in the case of Jet Airways. Just because directors didn’t want to step down, they dragged the process, rejected lot of revival bids in early insolvency phase. And be it any reason, even the financial or operational creditor did not initiate the process.

Australia also followed CIP model, but faced the same problem and added the amendment to make directors liable for any default under their directorship, directors became scared to default and didn’t take any risky decision to grow the company making them stagnant. This also should not happen with India. But then Australia laid ‘Safe Harbor’ provision to ease out the rules. Hence still amendment in the IBC is required to make directors take help from outside professional for the revival of their company in the early insolvency stage itself.

On June 7,2019, RBI laid provision pertaining to rules for creditors to enter into a ‘review period’ in the first 30 days of default by the debtor account, and make a resolution plan for the concerned account and apply the plan in next 180 days to revive it. If the plan is not put into implementation, provision for this account is required to be increased more and more as days pass. This might lead the banks to initiate the CIRP of the account under IBC and may overcome the ‘Initiation Problem’ from the side of creditors. According to this new frame work for stressed assets, the above mentioned rule is now applicable to Small Finance Banks and NBFCs, as they have become an integral part of the economy and needs to be properly regulated to retain the trust of investors.

There can be a solution to mitigate the problem of NPA by forming a‘Bad bank’. But this is a very risky model as it requires extensive research and cross-country analysis as the taxpayers’ money is on table.

In India Secondary Market for Corporate Loans, particularly distressed loan is in the making, taking inspiration from U.S. and European market. But there is a problem of transfer pricing of these distressed assets. India will have to design a proper mechanism, a platform and regulation of valuation techniques using DCF method, so that there isn’t much of a gap between the bid and the ask price of the assets and so the market remains active and transparent.

India and the banking system requires a major turn around and all the financial professional will have to put in the work.