9 min read.Updated: 11 Jun 2020, 04:02 AM ISTAnanth Narayan
Post covid-19, bad loans will rise sharply across the system. We must acknowledge the truth and act
If NPA projections post covid-19 are indeed as dire as a scenario indicates, that makes a case for a stronger set of pre-emptive relief measures to be weighed against the fiscal space available
As India’s already weak economy takes a body blow from covid-19, all eyes are on our financial services ecosystem —banks, non-banking financial companies (NBFCs) and debt capital markets.
For a while now, there have been clear symptoms indicating that all is not well with this ecosystem. There has been a trust deficit. Despite all the liquidity in the system, it has been unable to finance India’s growth aspirations. Moreover, we have avoided a full report and diagnosis, and dragged our feet on treating the core issues. Perhaps with the best of intentions, we have not acknowledged the full extent of our financial sector’s non-performing assets (NPAs) for close to a decade now.
Under this collective wilful blindness, India has kicked the can down the road on resolving chronically-stressed sectors such as real estate, power, and micro, small and medium enterprises (MSME). The country has dragged its feet on much-needed reforms of banking, governance and markets. Finally, India has lagged behind in enabling ease of investments, which has constricted credit growth as well as job and output creation.
That said, in every challenge lies an opportunity. It is never too late to acknowledge the truth and act.
Reliable estimates of possible NPAs post covid-19 could be an invaluable input in designing any economic relief and recovery package. Over the medium term, a credible financial sector health report can help us diagnose and treat the core issues that afflict our real economy, and help us achieve our immense economic potential.
Banking and NBFCs
To be fair, ever since RBI launched the Asset Quality Review (AQR) of banks in 2015, banking NPA disclosures have improved significantly. Reported gross banking NPAs rose from 4.5% of advances in March 2015 to 11.6% of advances in March 2018, before declining to 9.3% of advances in September 2019.
Even so, banking NPA recognition remains incomplete—even before covid-19. For a while now, RBI has allowed banks to postpone NPA recognition for some of the over ₹8 trillion of MSME, MUDRA and commercial real estate loans. Anecdotal reports suggest there could be significant stresses lurking there, and the true banking NPAs could already be over 11% of advances.
Likewise, while provisioning against NPAs has significantly improved over time, it remains incomplete. A cursory glance reveals that the extent of any particular bank’s loan loss provision has largely been determined by the capital available to absorb them, rather than by any objective assessment of the recoverable value from the NPAs.
There is even more trust deficit around NBFC NPAs. While RBI has strengthened reviews of NBFCs in recent times, unlike banks, they have not been subject to a rigorous, formal AQR. Officially, NBFC gross NPAs were at 6.3% of advances as of September 2019—lower than that of banks. This is simply not credible.A trust deficit is any financial ecosystem’s worst nightmare. It allows speculation and fear to take over.
Applying the banking sectoral NPA percentages to NBFC advances suggest that the actual gross NBFC NPA could already be as high as 11.5% of advances as of September 2019 (chart 1). In fact, TransUnion CIBIL reports suggest that NBFC delinquency in sectors such as auto, housing, loans against property, and personal loans are much higher than industry standards —so the 11.5% figure could actually be charitable to NBFCs.
Taking this into account, the true bank and NBFC NPAs could already be between 11% to 12% of advances as of September 2019, rather than the 8.7% suggested by official numbers. Concomitantly, the provisioning shortfall would be even higher.
Even assuming a rapid recovery from here, our FY21 GDP could contract by 5% to 6%. There is considerable economic distress among both households and businesses. All this will reflect in sharply higher financial sector NPAs.
RBI has rightly stepped in to provide temporary moratorium and forbearance relief to the ecosystem. After all, many businesses will recover as the economy recovers, and much of the NPA numbers in the interim could just be unhelpful noise. Thanks to this forbearance, official financial sector NPAs will show no additional stress over the next quarter.
But will all businesses and households recover? In the absence of any further economic packages, it appears that the true, durable NPA will rise sharply through covid-19. While considerable uncertainty makes any estimate hazardous, here’s a scenario for banking and NBFC NPAs put together by the Observatory Group (chart 2).
This scenario estimates that on the back of significant additional stresses in loans to MSME, industry, transport operators, tourism, hospitality, real estate, and unsecured retail among other sectors, collective bank and NBFC gross NPA could rise as high as 19.5% of advances.
The health check-up
NPAs—both actual as well as scenarios —can be an accurate pointer to the health of our economy, and importantly, help determine our economic policy imperatives.
Banks and NBFCs should have a sector-wise estimate of how NPAs could pan out post covid-19. This should be an invaluable metric for policy makers to help determine the extent and sectoral focus of any covid-19 relief and recovery package.
If the bottom-up NPA projections are indeed as dire as chart 2 indicates, that makes a case for a stronger set of pre-emptive relief measures, to be weighed against the fiscal space available. Sustained economic hardship and NPAs are not inevitable. They can be addressed by policy initiatives. From a more medium-term perspective, NPAs also indicate the policy steps needed for both the financial sector as well as the broader economy.
Accurate data might tell us that our financial sector is near comatose and battling a tumour. Our ultimate objective is not just to keep the ecosystem alive. We need the sector to eventually support our considerable growth potential with strong credit growth. In other words, our financial sector needs to run a marathon. This acknowledgement will goad us into taking up the difficult but inevitable course of treatment.
First, much of the financial sector is currently agonizing over the NPA tumour now, rather than considering any fresh business. While the Insolvency and Bankruptcy Code (IBC) is an excellent reform, no bankruptcy framework is geared to handling even the pre-covid-19 NPA quantum in a timely manner, let alone any post-covid-19 scenarios.
We will likely need a one-time surgical solution of a Bad Bank or a programme fashioned after the US Troubled Asset Relief Program (TARP), to remove a chunk of at least the pre-covid-19 large NPA and resolve them separately as efficiently as possible. This surgery will likely have to be accompanied by another round of recapitalization and resolution of some financial institutions.
Second, we can no longer kick the can down the road on addressing the many issues that dog chronically stressed sectors such as real estate, power, MSME, telecom, airline, shipping and others. These are extremely difficult issues to resolve. Any steps here will likely ruffle many feathers—including that of promoters, consumers and financiers. But for the sake of the financial sector and the broader economy, playing the ostrich is no longer an option.
Third, the need to improve ease of fresh investments cannot be overstated. Banking credit must flow for India to invest and create jobs and output, and in turn, there is a need for sustainable investment opportunities. In this regard, Prime Minister Narendra Modi’s speech clearly listed all the ingredients for attracting investments —such as reform of land, labour, laws and drawing in of supply chains. Follow through and execution is now critical. Creating sustainable jobs and output clearly holds the key to our economic prosperity.
Finally, even as we treat the tumour and nurse the patient back to health, the financial sector ecosystem cannot be allowed to revert to its old unhealthy lifestyle. First, public sector banks ratcheted up enormous NPAs over the last decade, requiring over ₹3.6 trillion of taxpayer equity infusion so far. Reforms such as those suggested by the P. J. Nayak committee (May 2014) may be essential to grant public sector bankers a level playing field, professional autonomy, and then hold them truly accountable.
Second, there have been egregious governance issues across all entities—private and public—in the financial services ecosystem. We need an overhaul of governance across risk management, auditors, boards, rating agencies, regulators, legal framework and government policy. Third, significant debt market reforms are needed to support the financial ecosystem.
The economic consequences
Collectively, all of us have acquiesced in this wilful blindness towards NPAs, the powerful metric that reflects our economic health and progress.
There are some plausible uncharitable reasons for this, such as our natural preference for good news over bad, especially if our own accountability and well-being are at stake. Let’s be kind to ourselves and ignore these for now.
There are other better-intentioned reasons. Former regulators have argued that in the absence of a durable resolution framework pre-IBC, NPA recognition would have instilled panic without offering ways out. Other economic thinkers scoff at the notion of “honesty"—what about the credibility of Chinese data, they ask. Senior bankers aver that NPA recognition shuts the door on any fresh funding for impacted businesses, condemning them to a death spiral without giving them time to recover. Some believe there are no durable solutions to some of the underlying problems—the power sector, for instance, is beyond repair, they say. Finally, there are even those that quote national interest—what will happen to the country, they ask, if we were to come out with the real numbers? Personally, I see very little merit in these arguments.
Yes, closing our eyes to our health reports can help stave off an immediate panic. But as the last decade has demonstrated, this denial can lead us to procrastinate over the treatment and worsen our economic health substantially. Any comparison with China is frankly a waste of time, until we create the jobs and output that China has over the past three decades.
Next, I am all for providing reasonable time for businesses to recover from temporary shocks, and covid-19 forbearance is a great example. However, this past decade clearly indicates that we have to draw the line somewhere.
On resolving deep-seated issues, there are solutions to every problem before the country, subject only to our willingness to listen, explore and execute. Finally, on the question of national interest, has ignoring our true financial health really served our country and its economy well thus far? As they say, the path to hell is paved with good intentions. To conclude, by closing our eyes to the real health report of our financial ecosystem, we do the Indian economy a great disservice. Until at least policymakers at the cockpit acknowledge the truth, we could struggle to address the core and difficult issues that dog our financial sector and the real economy.
Estimates of how our NPAs could pan out can give us crucial inputs into the design, extent and focus of any relief and recovery package that we put together now. At a time when we have limited fiscal and financial stability space, these insights would be crucial.