Asset quality of banks is an important indicator of the efficiency of financial intermediation in an economy. Despite efforts to reform the legal system of loan recovery and build a responsible credit culture by educating borrowers, banks’ asset quality in India continues to deteriorate. To ramp up credit-monitoring systems in banks, the Reserve Bank of India (RBI) introduced a “Framework for Revitalising Distressed Assets in the Economy" in January 2014 with built-in, step-by-step monitoring after early identification of weaknesses in loan accounts, and suggested remedial measures for each stage of stress.

The RBI could not, however, check the tendency of banks to accommodate existing borrowers by giving them additional loans with the hope that the whole loan would not become non-performing asset (NPA) in their books. Easy restructuring of loans using forbearance on asset classification helped banks escape the correct classification of advances as NPAs. The RBI withdrew such forbearance from 1 April 2015, and required banks to disclose divergence between their data and RBI data on NPAs arising due to varying interpretations of prudential standards.

The RBI rolled out asset quality review (AQR) during 2015-16 to enforce correct classification of NPAs. This led to a sudden spike of gross NPAs from 4.62% in 2014-15 to 7.79% in 2015-16, reaching 10.41% by December 2017 (Rs8.41 trillion). Moreover, there were many delinquencies in the pipeline where the overdue was 60-90 days, amounting to Rs2.85 trillion.

Insolvency and Bankruptcy Code (IBC), 2016: The IBC was enacted in December 2016 to expedite resolution of stressed assets, and provide an exit route to failed entities. Subsequently, the first lot of 12 large delinquent corporate loan accounts constituting 25% of total NPAs was referred to the National Company Law Tribunal (NCLT). RBI required banks to make a provision of 50% (now reduced to 40%) for newly referred NPAs. The resolution process is at different stages with bidders often shifting stance and seeking legal recourse, alleging injustice in acceptance of bids.

Insolvency professionals (IP) and committee of creditors (CoC), the main anchors of the process, are struggling to find amicable solutions in the bidding. The code has already been amended twice to debar willful defaulters from regaining control of their assets through proxies. According to Edelweiss, banks will have to take a 52-60% haircut by the time stressed assets are resolved.

To fully leverage IBC, 2016, a simplified, generic mechanism has been developed by the RBI for resolution of stressed assets of Rs20 billion and above, effective from 1 March. It has discontinued debt- restructuring schemes and converged them into two options for NPAs: (a) Banks to design a restructuring plan (RP) for stressed loans duly vetted by external rating agencies, which should be able to revive the loan account and convert it into a performing loan within 180 days. If overdue persists, banks must invoke IBC within 15 days. Once action is taken under IBC, banks must make a provision of 40% of loan amount and file a resolution case with NCLT. The NCLT has to accept or reject the petition within 15 days. Within 180 days, the debt-resolution process should be completed. It can be extended by 90 days by NCLT depending on individual merits, failing which liquidation proceedings follow.

IPs and CoC seek guidance from the Insolvency and Bankruptcy Board of India (IBBI) set up in October 2016, but they may not be able to understand the dynamics of the various industries in which borrowers operate. Going by the experience of the first lot of stressed accounts where IBC was invoked, it appears that a lot of clarification is needed in the process, which involves calling of bids, verification of bidders’ fitness, going for rebids, approval of bids by CoC, transfer of ownership of units, etc. Such an integrated process requires coordination among stakeholders to avoid protracted judicial and administrative hassles, and capacity-building of involved individuals.

More delinquent borrowers may have to be moved to NCLT as banks’ RPs have a rigid time frame. Banks and borrowers may not be able to coordinate and make units fully functional and viable within 180 days. Besides, banks may like to bypass RPs and move to NCLT at the first sign of slippage as delinquent borrowers become defensive and rarely cooperate with lenders in resurrecting the unit, unless slippage is merely on technical grounds.

Learning from the resolution process: In view of the ongoing bidding processes and approach of CoCs, it cannot be estimated how long it would take for banks to recover dues and what the extent of haircuts would be. The journey seems to be tough with no visible signs of loan recovery even though many are now close to deadlines. It is important that the regulator and banks note the differences in incentives of bidders who want to gain control of units and lenders who want to optimize recovery. For IBC to serve as a seamless process of debt resolution, it is crucial to pick up operational nuances from the ongoing processes, spot critical points causing delay, and remove impediments via further amendments of the code and/or institutionalizing appropriate, well-defined legal and administrative solutions as standard operating procedures (SOP). If cognizance is not taken of hurdles in invocation of IBC, it can push banks into a pile of legal hassles with fear of perpetual loss of value of underlying assets.

The combination of efforts to improve recording and availability of credit history, pooling updated information under the Central Repository of Information on Large Credits on loans of Rs50 million and above, and quick invocation of IBC should be used as an opportunity to forge a cultural shift towards improving sanctity of debt contracts. Banks should consider this an opportunity to codify conduct, train employees in debt resolution, and improve quality of credit origination, follow-up, and recovery so that asset quality improves on a sustainable basis.

Published with permission from Ideas for India (Ideasforindia.in), an economics and policy portal.

K. Srinivasa Rao is director, National Institute of Banking Studies and Corporate Management.

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