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Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

RBI: Looking beyond the shock

It might be worthwhile to allow banks to give loans to entities such as vulture funds who are interested in the acquisition of financially troubled firms

From Tuesday the Reserve Bank of India’s (RBI) new system of identifying and monitoring stressed assets of the banking sector will come into operation. It is a much stricter regime that has been designed to identify and monitor incipient stress before matters get out of hand.

Banks will, from now on, classify accounts as special mention accounts (SMA), within which there will be three sub-categories. The first category is where there is principal or interest payment overdue for more than 30 days but the account is showing early signs of incipient stress in the form of delay in submission of a stock statement, devolvement of letters of credit or frequent recourse to overdraft. This category is more in the nature of an advance warning system.

The second class is SMA-1, where the principal or interest payment has been overdue for 31-60 days and the third one is SMA-2, where the principal or interest payment has been overdue for 61-90 days. Till now the banks have been following a simple 90 day cut-off norm for classification of non-performing assets (NPAs).

Further, if an account is SMA-2 for any lender, it will result in the formation of a joint lenders’ forum and formulation of a corrective action plan (CAP).

The first implication of the new regime will be a formal quantification of the stressed assets of the banking sector. Until now, what is in the public domain is that the NPAs of the banking sector are in the range of about 3 trillion, which is about 4.5% of the total advances.

If the existing restructured accounts of around 5 trillion are added to the NPAs, the magnitude of the total infected assets touches 8 trillion. This is about 12% to 13% of the total advances.

Given the fact that the mortality of the restructured accounts—slipping of restructured accounts into the NPA category—is not only as high at 33% but has been increasing, the expected impairment of assets in the near future will be high. Anecdotal evidence suggests that the stressed accounts of the SMA-2 type are in the range of 4.5 to 5 trillion. This means the extent of poor asset quality for the banking sector at the aggregate level is around 12.5 to 13 trillion. This is more than 20% of total outstanding credit.

This level, extent and spread of the problem, especially across mid-sized companies, is bound to threaten the stability of the financial sector. It is now a triad of stress: within the overall economic stress, there are overleveraged companies struggling to meet their servicing liabilities, and banks with asset quality issues causing capital concerns. Most public sector banks are now near the lower threshold of regulatory capital adequacy requirements.

With higher asset impairment comes a higher provisioning and consumption of capital, which will adversely impact lending and consequently the NPA to the total lending ratio. This is shrinking the system’s ability of to deal with distress both in terms of instruments as well as standards.

While the system of identification of stressed assets has been changed dramatically, the resolution system has not been altered correspondingly. The framework continues to be built on the three Rs: rectification, restructuring and refinancing.

The structural pressures that will drive the banks towards resolution of stress are twofold.

First, the opportunity cost of locked up capital in NPAs is very high for banks—a deterrent to further funding and concessions. These circumstances will force the banks to resolve, deleverage and clean up their balance sheets to meet new regulatory capital norms.

RBI is creating incentives for the sale of stressed assets. However, what has not being adequately recognized is that there isn’t a developed market for stressed assets.

Second, the fact of growth global secondary markets, falling asset prices and constrained liquidity will result in banks looking to trade distressed loans with well-capitalized buyers rather than pursue more traditional workout strategies. It is this that RBI needs to facilitate.

Now that the focus has moved away from NPA resolution to stress management, the policy must focus on creating an enabling environment for mergers and acquisitions (M&As). So far, the only resolution available was for stressed assets through the asset reconstruction companies’ route or direct monetization of the securities.

In the new scheme of things, M&As have to be the linchpin of the stressed assets resolution strategy. To an extent this has been provided for by allowing specialized entities to carry out leveraged buyouts of stressed companies.

This needs to be widened as a strategy to encourage a move from public debt markets to private debt, quasi-equity and private equity markets. It might be worthwhile to allow banks, even if for a short period, to give loans to entities such as vulture funds who are interested in the acquisition of financially troubled companies.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice.

To read Drabu’s earlier columns, go to www.livemint.com/methodandmanner-

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