Assessing the new rules to solve the NPA problem

The government has empowered the Reserve Bank of India (RBI) to help resolve the issue of non-performing assets (NPAs). The RBI has also since directed the banks that the joint lenders’ forums (JLFs) should implement the corrective action plans (CAPs) within the prescribed timelines. So the big question is—will the bad loans now get resolved more efficiently than was the case until a few weeks ago? Let us look at the issue closely.

As per the RBI directive, banks will now have to agree to a common approach for restructuring or recovery of each non-performing loan (NPL). The common approach will be the one adopted by the lead bank, along with a few more banks so as to meet the thresholds of 60% of lenders by value and 50% by number. The desirability of this approach assumes that the interests of all banks need to be aligned with or subsumed within the interest of the lead bank. It is doubtful that the smaller banks would be happy with this measure for the simple reason that if the same was true, all the members of the JLF would have anyway agreed with the lead lender and a prescription by the RBI would not have been required in the first place. Having said that, this seems to be a fair approach to the extent that the JLF can now move forward with majority support.

However, we need to evaluate as to whether even after getting the JLF aligned, will we face some other critical bottlenecks? In my view, the real problem has been the absence of a reliable and coherent basis for JLF members to agree to a common plan. Let us try and understand this.

When a troubled asset, like a power project, underlying an NPL, is to be revived or transacted with an asset reconstruction company (ARC), the fundamental requirement for an optimal decision process is the data on the costs and benefits involved in the process. The parties involved would need to have reliable data to put their money on the table. The required data would include the operational, financial, and regulatory pay-offs from the power project, post-restructuring or recovery actions. While the data is more easily available for an operational project, it is not so for an under-construction project. For example, the projected operational and financial performance for a thermal project depends on multiple variables like the power purchase agreement (PPA), fuel supply agreement (FSA), environmental clearance status, timelines for construction, etc. Each of these variables is prone to uncertainties.

In the absence of reliable data regarding the elements of the pay-off to the banks, each bank would adopt a stance that is aligned with its risk appetite and preferences. It is known that the process of the bank getting back its dues through the legal recovery process is usually slow, uncertain, and value destructive. There is no market clearing mechanism to serve as a guide for the pricing decisions in the restructuring or recovery to be done by the banks. This leads to a widening of the bid-ask spreads, reflecting the uncertainty in the pricing of risk in the transaction. As a result, the transaction either does not get consummated or if forced to consummate, leads to a sub-optimal situation for certain stakeholders. Till now the absence of an agreement within the JLF reflected the former and in the revised circumstances, the forced agreement within the JLF will reflect the latter.

Now the same logic will get extended when a buyer of the NPL (or the underlying asset) is brought into the game. There is neither a junk bond market nor have there been any significant transactions of impaired businesses to serve as a guide for valuation. In the absence of any shadow pricing of the junk loans or the impaired underlying assets, the potential buyers of the same are expected to quote low prices to hedge their risk on account of high uncertainty, while buying the same from the banks. While we may hope to count on competition among the buyout funds, they would, in aggregate, be still expected to behave in their collective interest and not be truly competitive.

So, what can we expect from the new paradigm? While the timelines for recovery are expected to be more streamlined, there are caveats to the same.

For one, the banks will be under pressure to close the transactions soon and this could at times lead to under-pricing of the loans, to the advantage of the buyers.

Second, the provisions made by the banks till now could turn out to be inadequate. These provisions would, till now, have been based on expected losses from the NPLs. But now we are talking of losses based on potentially lower realizations than expected earlier. Third, it might turn out to be a case of missing the woods for the trees. While the NPLs would be off the books of the banks, some of them would still require significant recapitalization, as they would have lost a significant amount of capital and credit-making capacities as well.

As a final thought, even as the process of JLF is being streamlined and disciplined, it would be helpful if the government and the RBI can help create an improved market for distressed assets at the
earliest.

In the long term, this is of course an imperative for the banking system as well as the economy. In the short term, an increased flow of capital into the stressed assets transactions should be encouraged with specific policy and tax incentives for a limited time period. This will help in a more competitive market and better price discovery. We have begun the journey of correction and must take it to the most optimal conclusion.

Hemant Manuj is an associate professor of finance at SP Jain Institute of Management and Research.