Kolkata: Indian banks should budget for a combined loan loss of at least Rs1.6 trillion from the steel sector alone, says president and member of the management board of M.N. Dastur and Co.

Having assessed over Rs1.3 trillion of stressed assets of the steel industry over the past two years, Atanu Mukherjee, president and member of the management board of M.N. Dastur and Co., says total stress in the sector stands at Rs2.5-3 trillion, of which only around Rs1.8 trillion has been declared as non-performing assets (NPA). Edited excerpts from an interview:

What are your key observations about the stress in the steel sector?

Many of these embattled projects are results of over-enthusiasm. In most cases, the stress is due to very heavy leverage without robustness of business models. There were significant deficiencies in risk assessment. On paper, the projects looked bankable, but the projections were too optimistic. Unbalanced plant designs and inefficient operating practices were also responsible.

In an economy chasing rapid growth without a functioning debt market, it is understandable that there would be pressure from policymakers on state-owned banks to fund large projects. This exposed banks to act jointly with promoters to build capacity as opposed to giving priority to loan recovery. Many of these plants are in trouble because they followed exuberant expansionary strategies resulting in investments which were not rational from the standpoint of sustained profitability.

Finally, anecdotal evidence suggests leakage and diversion of funds. It is very difficult to explain why plants would have $2,000 and more per tonne in debt whereas the total capex on similar assets have typically ranged between $700 and $800 per tonne.

What kind of loan losses are we staring at?

These stressed loans should be written down to fair market value at the earliest, and if you pool them, a write down of at least about 50% on their face value is required in most cases.

For the entire steel sector, banks will have to eventually write off around Rs1.6 trillion. The problem is Indian banks are currently not in a position to absorb this shock—they need to be recapitalized.

For years, state-owned banks have refused to clean up their books because there are built-in disincentives. If there was a way to avoid declaring a loan as NPA, why raise the red flag and draw the attention of the senior management, or worse still, of the investigating agencies?

In many cases, lenders have extended loans to companies already in trouble, ostensibly to rescue them, but this has mostly been a case of good money chasing bad. In one specific case, a steel company, which had an unbalanced plant and high operating inefficiencies, had asked for an additional loan of Rs1,000-1,300 crore for further expansion under strategic debt restructuring. Our assessment for the lenders showed only Rs200-300 crore was required to address the plant’s inherent problems.

What is the best way to resolve the problem?

Resolution through bankruptcy is the right way to restructure these assets. However, there are two key challenges: India’s nascent bankruptcy system does not yet have the infrastructure and ecosystem for handling large complex bankruptcies. This may lead to adverse outcomes, triggering avoidable liquidations and larger than manageable write-downs. Secondly, given the current down-cycle in steel, many of these assets may have to be sold at pennies to the dollar, compared with what they may fetch after an orderly restructuring.

An organization on the lines of the US government’s TARP (Troubled Asset Relief Program) merits serious consideration. TARP stabilized the auto and financials sectors during the global financial crisis. The Indian government, too, should create a professionally run interim holding agency. This agency pools and acquires controlling interest as the assets are taken through bankruptcy proceedings, and manages and restructures these assets in the interim.

Pooling of stressed assets minimizes risks by drawing on synergies from different units. Many of these assets can be combined and turned into viable operations. Eventually, this agency will exit these turned around assets. This is likely going to lead to recovery of a significant portion of the bank recapitalisation infusions as was the experience with TARP.

If done properly, recovery from these written down assets should happen in 3-4 years with results starting to show within 6-12 months.