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The bad loan problem in the banking sector is likely to linger for a long while. Among other things, it will affect the sector’s ability to finance productive sectors of the economy. The Reserve Bank of India (RBI), on its part, is trying different things to help the banking sector, but conditions at the aggregate level are not improving as desired. As a recent Credit Suisse report noted, on top of 12% impaired assets, another 4.5% of loans are estimated to be stressed—and expecting a turnaround in the asset quality cycle would be premature.

It is now being reported that the banking regulator under new governor Urjit Patel wants to give more flexibility to banks to deal with the issue of bad loans. It appears that the current bad loan problem is becoming a difficult learning experience for RBI and it is not very sure as to what exactly needs to be done. When one option doesn’t work, it comes up with another one or tweaks the existing one in order to make things easier for the banking system. But the problem is so deep at the aggregate level that RBI’s measures are not making much of a difference.

For instance, in 2014, RBI came up with a scheme that allowed banks to extend the maturity of loans given to companies in the infrastructure sector. In 2015, it gave banks the option of converting a part of the debt into equity and taking a controlling stake in stressed companies.

In June, the regulator introduced another option called the Scheme for Sustainable Structuring of Stressed Assets, or S4A. This allows lenders to determine the sustainable level of debt for a stressed company and split the outstanding debt into sustainable debt and equity with some caveats. The idea again is that as the company turns around, equity will provide an upside to the lenders. But these options are not easy to implement on the ground and there is no guarantee that banks will be able to recover the money.

A Mint report earlier this week showed that lenders had been left with some difficult choices after they failed to find a buyer for debt-laden Essar Steel. The options they have are to either take an equity stake in the company or auction bad loans worth Rs44,000 crore to asset reconstruction companies (ARCs).

Both are difficult choices. Selling loans to the ARCs will attract a significant amount of haircut and an equity stake comes with its own uncertainties. This is just an illustration of how difficult things have become for the banking sector that is sitting on toxic loans worth Rs6.3 trillion.

The basic issue is that a part of the corporate sector is excessively leveraged, and without writing off significant amount of debt, things may not change. It’s also not easy for these companies to raise equity capital as investors are unlikely to invest in companies that are not able to generate enough cash flow to repay loans. It is possible that lenders taking equity stakes in such companies will not be able to recover their money for a very long time.

In this context, one can recall how banks converted debt into equity in Kingfisher Airlines, hoping to capture the upside in the high-flying airline. But the story didn’t play out according to the script. This is not to suggest that every company that is stressed today will go bust, but equity by definition is more risky.

The possibility of banks aggressively selling bad loans to ARCs also has problems. The ARCs will value bad assets at much lower levels and lenders will have to take a considerable amount of haircut. Most of the bad debt is concentrated in the books of public sector banks and the management may have to do a lot of the explaining at different forums in the future.

Another problem is that the ARCs themselves may not have the capacity to buy assets in large quantities. Banks, particularly in the public sector, are in a difficult situation, and it remains to be seen to what extent regulatory changes are able to solve the problem.

It’s going to be a long and difficult road, both for RBI and the banking system. A lot will depend on the extent to which the government is able to infuse capital in public sector banks. A delay in recovery will also mean a loss of competitiveness for banks that are relatively more stressed, as they will lose market share and may find it difficult to compete with new age banks.

What can the Reserve Bank of India do to solve the bad loans problem? Tell us at views@livemint.com

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