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The RBI paper seems to treat all distressed assets largely as business model failures, which is not correct. Photo: Pradeep Gaur/Mint
The RBI paper seems to treat all distressed assets largely as business model failures, which is not correct. Photo: Pradeep Gaur/Mint

Seeking to end economic distress

Is the purpose of RBI's guidelines to make the Indian banking sector stronger or to make the corporate sector weaker?

The Reserve Bank of India (RBI) has recently released a discussion paper on the building of a framework for revitalizing distressed assets in the Indian economy.

The paper could have served as a launch pad for much-needed institutional innovation in the banking and financial sector. Instead, it has been reduced to an administrative exercise without any underlying analytical construct.

Its purpose is not entirely clear. Is it to make the Indian banking sector stronger or to make the private sector weaker? A vulnerable set of borrowers is not the best way to make lending institutions robust anywhere. Certainly not in India.

While there can be no disagreement with early detection of stressed assets and higher provisioning norms the RBI suggested, where the proposed guidelines fail is in not taking a holistic approach to the issue of asset quality.

The emphasis on provisioning is more than welcome. Indian banks have a non-performing assets (NPA) coverage that is the worst in the Asia-Pacific region and one of the worst globally.

This is largely because most banks have a profit versus provisioning trade-off and invariably it is the former that wins. This mindset needs to change and the guidelines will ensure that to compete globally, especially with the advent of global Basel III norms, NPA coverage will be raised as it needs to be to 100%. To do this is all the more important since capital adequacy of Indian banks is the lowest in the world except that of banks in Greece, Spain, Italy and France.

However, even as the provisioning policy will make banks more stable, it should not exacerbate the distress of the borrower. This is especially important during a period of exceptional macroeconomic stress. Today, a number of intrinsically viable projects are facing cash flow and liquidity management issues.

The situation on the ground is such that a temporary cash flow issue for a company can become a liquidity problem and if not supported, can escalate into a solvency issue.

As such, the prudential norms and provision policy has to be aligned not directly linked. For example, it is possible not to treat an account as restructured if there is no sacrifice involved on the part of the bank and the bank is satisfied about the realizable value of the collateral.

Another issue with the guidelines is that they emphasize early recognition of distress without paying adequate attention to the underlying causes and without incentivizing early revitalization. An academic insight must be converted into a policy guideline with caution.

The danger of such an undifferentiated one-size-fits-all approach in the current situation may lead to credit stagflation—making credit more expensive and making its availability more inequitable.

Similarly, given the size and structure of the banking industry, there can’t be one undifferentiated guideline for all banks. In India, as elsewhere, there are well-capitalized banks and also critically undercapitalized banks. The norms have to be different based on the risks, the tier-1 risk-based capital ratio and the leverage ratio.

In general, in the Indian case, stressed assets fall into one of the three buckets: intrinsic business model failures, regulatory and policy reversal and macroeconomic deterioration.

The RBI paper seems to treat all distressed assets largely as business model failures, which is not correct. Empirical evidence shows that existing NPAs and growing stress is highly concentrated in a few sectors with a relatively small number of companies.

Only five sectors—steel, infrastructure, power, textiles and telecom—account for two-thirds of the corporate debt restructuring book. The top 30 loan defaulters of public sector banks account for more than one-third of their NPAs. What is common between these sectors is an inconsistent policy environment.

What the paper also fails to recognize is that a large part of the banking system’s problems stem largely from the liability side, not the asset side. No domestic institution is capable of financing longer-term projects. Commercial banks—existing and new—cannot take exposures of this size and long duration on their books.

With their liability side, maximized at three to five years, this is bound to create a huge institutional asset-liability mismatch along with the burning of regulatory capital. Already the term loan to working capital ratio for banks is nearing 75:25—way above normal.

Writing about the US banking sector, RBI governor Raghuram Rajan had wisely pointed out, “Liquid markets will help banks offload risks they should not bear, such as interest rate or exchange risk. They will also allow banks to sell assets that they have no comparative advantage in holding, such as long-term loans to completed infrastructure projects, which are better held by infrastructure funds, pension funds, and insurance companies. Liquid markets will help promoters raise equity, which is sorely needed in the Indian economy to absorb the risks that banks otherwise end up absorbing."

That is the real issue.

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

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

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