Asset Quality in Banks: Looking Far beyond Bad Banks

The banking system continues to suffer with shocks of asset quality woes.  The collateral damage caused by such a high volume of toxic assets impinges upon the overall efficiency of banks. More so in public sector banks (PSBs) that have a larger share of bad loans. Whenever banks accumulate large toxic assets attracting the attention of stakeholders, the issue of hastening resolution comes to the centre stage of policy debate.

Coming down heavily, the Economic Survey 2021 rightly attributed inefficient bank boards, poor governance structure and the failure of auditors to understand the “ever-greening” problem that added to the bad-loan mess. Besides recapitalising banks, enhancing governance in banks is held essential to improve the stability of the banking system. Going by the past experience of ever-greening, the survey suggested another round of asset quality review (AQR) after the current COVID-19-induced forbearance is phased out to assess the correct state of asset quality. It also supported the idea of setting up a bad bank to rescue the banks in near term.

Besides many interconnected factors, the reasons for deterioration of asset quality of banks are a function of (i) quality of credit origination. It is linked to the autonomy in credit decisions, risk governance and effectiveness of systemic controls.  (ii) Intensity of post-sanction monitoring and follow up of credit, effectiveness of monitoring tools – ability to sense incipient sickness. (iii) Effective and speedy debt resolution ecosystem to hasten loan recovery and to dissuade loan defaults. Its demonstrated impact should be able to transform the credit culture in the society.   A deep dive into the state of these asset quality drivers can help identify the gaps.

Asset Quality Trends

Having seen several swings of bad loans - gross non-performing assets (GNPAs) in banks, the recent spike was to 11.2% in 2017-18. PSBs had more GNPAs at 14.58 percent. But private banks could however contain them at 4.62 percent.

Due to the consistent efforts of banks, GNPAs were down to 8.5 percent by March 2020 and to a further low of 7.5 percent by September 2020, partly due to regulatory forbearance and standstill clauses in the asset classification.

The Reserve Bank of India (RBI), in its Financial Stability Report,December 2020, clearly flagged its concern that once the standstill clause is lifted, the GNPAs can climb to 13.5 percent by September 2021 in baseline stress and to 14.8 percent if the stress is severe. They are expected to touch a high of 17.6 percent in PSBs.

As a result of such deterioration in asset quality, the capital to risk weighted assets ratio (CRAR) at 15.6 percent in September 2020 may drop down to 14 percent in baseline stress and to a low of 12.5 percent if the stress is severe. It is expected that four to fivebanks may even breach the minimum benchmark of CRAR of 11.5 percent in baseline and nine banks in severe stress situations.

The RBI has taken the probability of a zero gross domestic product (GDP) in 2021-22 as baseline stress and -7.6 percent GDP as severe stress. Incidentally, the latest views of the RBI, Economic Survey and International Monetary Fund (IMF) indicates that such a stress may not manifest looking to the green shoots in the economy unless a second wave of the new virus strain causes massive disruption.

Indicative Global Trends

The asset quality data of IMF indicates that though there is no official acceptable limit for level of GNPAs, it is considered manageable if the banking industry in any country has GNPAs below the 3% mark and net NPAs close to 1% of assets. In this context, India does not compare well even with Brazil, Russia, India, China, and South Africa (BRICS) members.

According to the IMF, India ranks at 33 among 137 nations in a global list of countries with bad debt ratio in a descending order based on data of September 2018. Out of 32 countries having more bad loans than India, 16 are in Africa and the rest are in Asia, Europe and Caribbean.  China’s GNPAs stand at 1.75%, Brazil’s at 3.69%, South Africa’s at 2.83% as against Indian GNPAs at approximately 9.85% in 2017. Only Russia is ahead with 10.7 percent.

The best asset quality in banks is maintained in Canada at 0.4 percent, Republic of Korea at 0.50 percent and Switzerland at 0.6 percent. Ukraine with 54.3 percent, Greece 44.1 percent and Cyprus at 36.4 percent are struggling with a high component of bad loans. The balance of power between debtors and lenders decides the tilt of bad loans. The ecosystem in India is gradually moving power from debtors to lenders that can set a better trend in future with potentiality to improve the asset quality.

Asset Quality Efforts

As part of credit risk management, banks improve the asset quality using various strategies, by (i) proactive prevention of slippage of assets; tackling borrowers to prevent accumulation of overdues, (ii) recover bad loans through persuasion and constant follow-up, and (iii) many times may enter into compromise for a one time settlement (OTS) of bad loans sacrificing a part of defaulted loans.

Banks go for technical write-off of aged bad loans against which 100 percent provision has already been built up. Such write-off can reduce its burden on a bad loan portfolio and conserves capital while keeping the recovery options from borrowers open. Banks are forced to completely write-off loans when (i) there are no realisable securities, (ii) borrowers are not traceable, (iii) loan recovery is not viable where administrative cost of enforcing recovery is more than the potential recovery, and (iv) fraud perpetrated by borrowers has made it impossible to recover and many such compelling internal reasons.

Recent RBI report on “Trend and progress of banking in India – 2019-20” indicates that banks have written off Rs 8,83,168 crore in the last 10years. The share of PSBs in the write-off is Rs 6,67,345 crore working out close to 75 percent. The government has infused Rs 3.5 crore into PSBs in the last five years. Effectively, the entire chunk of capital provided is drained out to cover the bad loan losses. Banks can also sell bad loans to ARCs, other financial institutions or can enforce recovery through DRTs or by invoking IBC 2016.

The continued erosion of asset quality reduces share of interest earning assets, increases provision requirements and brings down profitability of banks. The resultant impact truncated the capital adequacy ratio (CAR) of some of the PSBs. The overall deterioration in the performance of banks led to RBI imposing prompt corrective action (PCA) on 11 banks. It also led to hesitancy of banks to expand fresh credit that made bank-dependent borrowers at the bottom of the pyramid to suffer.

Asset Quality Ecosystem

The government and RBI in collaboration with other stakeholders have been building robust debt resolution frameworks to improve credit culture. Beginning with the enactment of the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act , 1993 Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs) were formed. It began with the formation of the first DRT at Kolkata on 27April 1994. There are at present 39 DRTs and five DRATs in India. DRTs while speeding up loan recovery have also enabled setting up of Lok Adalat, an informal forum for out of court recovery of bad loans of banks.

Later, the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002 enabled the banks to deal with non-performing assets (NPAs) without court intervention. It also paved the way for setting up Asset Reconstruction Companies (ARCs) that needed licences to operate and are regulated by the RBI. Since the promulgation of the SARFAESI Act, 2002, 29 ARCs have been registered. The RBI also permitted the sale of NPAs of banks to other banks, non-banks and financial institutions wherever possible to improve the asset quality. These supportive institutions have been playing a strategic role in accelerating debt resolution.

The promulgation of the Insolvency and Bankruptcy Code, 2016 and setting up the Insolvency and Bankruptcy Board (IBBI) hastened the debt resolution in some large borrower accounts. Going forward, the biggest impact of IBC stems from Section 29A that can develop a well-behaved “credit culture” in the corporate arena.

Every defaulter, by now, understands that if one does not pay what one has committed to pay, one will lose the reins of control over business forever. This eventually should lead to a new cult of healthy borrowing, where borrowers shun over-leveraging, over-capitalisation, and diversification. It should be able to address the chronic problem of rising willful defaulters in banks.

The new legislative tools are helping banks to recover loans faster. The bad loan recovery by invoking IBC worked out to 45.7 percent and 45.5 percent of total recovery made during the year, whereas it was 15 percent and 26 percent by invoking the SARFAESI Act, 2002 during 2018-19 and 2019-20. It shows that IBC is proving to be a more effective tool in resolving bad loans. But despite all efforts, the accretion of fresh bad loans has been higher than recovery of loans adding to the total stockpile of bad loans. Despite such legal tools and institutions dedicated for recovery of bank’s bad loans, the tendency of building stock pile of toxic assets did not abate significantly.

Despite improvement in internal credit administration needed to prevent deterioration of quality of assets in banks, asset quality woes continue to mar the bank’s capacity to recover bad loans and consequently unable to take up fresh lending. The fact that some of the delinquent, disgruntled large borrowers are still able to play around with legal framework to escape from the obligation to repay loans and cause mayhem in financial intermediation shows that credit quality filtration in banks needs to be sturdier. 

Reasons for Rise in Bad Loans

According to the RBI, a rapid bank credit growth during 2005-12 and massive build-up of restructuring of loans led to a spike in bad loans. The forbearance to restructure loans at a concessional provision of 5 percent might have led to ever-greening of loans. Hence, the RBI withdrew the restructuring facility at concessional provision in April 2015.

It led to sizeable divergence in the asset quality data of banks and the RBI. Concerned over the inconsistency in the classification of GNPAs, tendency to shield impairment by restructuring assets, sporadic ever- greening of loans and such unhealthy practices made RBI to introduce AQR during 2015-16.

As a consequence, banks began to reclassify the assets and many restructured loans classified as standard loans slipped into GNPAs exacerbating the asset quality woes. The RBI highlighted, among others, the absence of strong credit appraisal and monitoring standards that have led to steep deterioration in asset quality in banks. Coming from the regulators, the comments have to be taken up by the banking system with seriousness.

Toning up credit administration and internal credit risk management is vital to the sustainability of the business model of banks. With technology able to support augmentation of market and economic intelligence, banks may have to revisit their internal credit-handling processes, procedures and systemic controls related to quality of credit origination.

The Bank for International Settlement (BIS) in its document on credit risk management outlined sound practices: (i) appropriate credit risk environment, (ii) sound credit-granting process, (iii) maintaining appropriate credit administration, and finally (iv) ensuring adequate controls over credit risk.  If the cue of BIS is implemented and lending infrastructure is strengthened, the quality of credit origination will improve significantly when the loan recovery tools developed thus far will be enough to manage the credit risk.

Forward Outlook on Asset Quality

Banks already loaded with high levels of bad debts are further stressed due to the impact of pandemic induced challenges. The potential large-scale rise in GNPAs in the coming fiscal year, 2021-22, needs to be tackled well with a multipronged strategy. Granting additional loans and restructuring of the existing loan facilities will provide borrowers enough time to recoup from the ongoing stress.  While the RBI in its recent Financial Stability Reportacknowledged that when the standstill clause in asset classification is lifted, banks will witness a rise in GNPAs to 13.5% by September 2021 in baseline stress that can slip to 14.8% in a severe stress situation.

Looking at the extraordinariness of the ongoing crisis, while it is necessary to focus on near-term challenges, at the same time, banks should not lose sight of the long-term systemic approach to improve the asset quality. While all the stakeholders are working together to tackle near-term challenges, additional capital infusion and even setting up of a bad bank could be a possibility.

Long-Term Approach

Working out process reengineering of credit origination, monitoring and quick debt resolution can be an integrated long-term approach to improve the quality of assets in banks. Going by the size of bank borrowers, collateralised loans: farm loans, retail loans, MSME loans, many of them having an add-on cover of collateral securities, are large in numbers and low in value. Whereas large loans and corporate sector loans, mostly secured by primary securities built with loan funds, are low in number of borrowers but high in value.

According to the size-wise distribution of borrowers, out of 27.25 crore bank borrowers in March 2020, only 6,79,034, much less than one crore borrowers have borrowed Rs 1 crore or more from banks sharing 56.3 % of total outstanding bank loans of Rs 105 trillion. Loans of Rs 47.38 trillion are spread among 89,473 borrowers who have borrowed more than Rs 10 crore. 95.7% of borrowers have loan limits up to Rs 10 lakh. 77 % borrowers have loans below Rs 5 lakh.

The crux of the problem may be due to the engagement of banks in handling large numbers of loans of small value – less than Rs 10 lakh. In an effort for equitable distribution of resources, banks may not be able to balance the interest of a few large size loan accounts. If the proportionality of focus on few large loan accounts is ensured, the quality of loan portfolio can improve.

While improving credit appraisal and follow-up techniques, it may be necessary to earmark certain bank branches for small value loans while loans of Rs 1 crore and above to be handled by a few branches where the compatible talent pool can be parked. Even alliances with non-banks for small size loans can be worked out so that more time can be devoted to large size loans.

Post-sanction scrutiny of borrowers conduct and account operations need more attention. Technology can be better used to follow up loan accounts of Rs 1 crore and above with enhanced oversight to prevent the downgrade of loan accounts. If due to any external or internal cause the account goes out of order, quick action to retrieve it can be planned.

However best, the external legal ecosystem is improved, unless the credit origination and internal follow-up methodology of credit is improved, the asset quality standards cannot sync with best practices. Unless credit quality improves, banks will not have enough latitude to compete in terms of risk-based pricing and market share. Any temporary solution like formation of a bad bank/alternate investment fund can be a band-aid and not a panacea against the ills of the present state of credit risk management in banks.