Asset Quality of Indian Banks: Way Forward1
The Indian banks in general, and the Public Sector Banks (PSBs) in particular, are grappling
with the huge stock of stressed assets that has piled up in the system over the years. Any
amount of discussion on the whys and what of stressed assets would therefore never be
enough, if it enables us to discern what led to this phenomenal build-up of non-performing
assets (NPAs) in our system and determine what we should do to solve them, and identify
what could be done differently in future. I therefore compliment ASSOCHAM for organising
a national conference on this topical issue and thank them for giving me an opportunity to
share my views on the subject. I only hope this conference leaves us wiser about the problem
at hand and the solutions to deal with it. I realise that the issue is complex and believe it will
be naive to conclude that we go back with solutions that would work overnight.
Asset Quality
Gross NPAs and total stressed assets
Even if you have heard this many a time, let me put the issue in perspective in terms of the
Chart 1: Evolution of Gross NPAs (%)
Chart 2 : Evolution of Stressed Assets
(%)
16
14
12
12
10
10
8
8
6
6
4
4
2
2
0
0
2010 2011 2012 2013 2014 2015 2016
2010 2011 2012 2013 2014 2015 2016
Public Sector Banks Private Sector Banks
Public Sector Banks Private Sector Banks
Foreign Banks All Banks
Foreign Banks All Banks
magnitude and dimensions of the problem (Chart 1 and 2). The total stressed assets in the
Indian commercial banks have risen to 11.5% with the Public Sector Banks leading the strain
at 14.5% as at end-March 2016. They still contain some amount of restructured assets
indicating potential for some more pain, albeit of lesser intensity.
Incremental NPAs
Let us now look at the year- on- year accretion to the NPAs. One could see that incremental
accretion to NPAs is quite substantial (Chart 3). There was a big addition post-AQR exercise.
What we need to realise
100
Chart 3: Y-O-Y growth of Gross NPAs
is that, maybe, going
80
forward addition to
60
NPAs may moderate
cent
40
but the provisioning
Per
20
needs as the NPAs age
0
will put pressure on the
-20
Sep-12 Sep-13 Sep-14 Sep-15
Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
P&L.
PSBs PVBs FBs All SCBs
Sectoral distribution of NPAs
It would also be interesting to look at the sectoral distribution of NPAs and total stressed
Chart 4: Asset quality in major sectors - Gross NPAs (%)
25
19.4
20
11.9
15
cent
7.7
7.4
10
6.0 5.8
Per
2.1
5 1.8
0
Agriculture Industries Services Retail Agriculture Industries Services Retail
GNPA ratio Stressed advances ratio
Mar-12 Mar-13 Mar-14 Mar-15 Sep-15 Mar-16
assets (Chart 4). It shows the obvious - the maximum stress in industry and infrastructure
with the PSBs facing greatest strain across most sectors (Chart 5).
Chart 5: Sectoral Distribution of Gross NPAs across Banking
Groups as at end March 2016 (%)
18
15.7
16
14
12
9.0
10
6.7
8
6.3
6
4
2.2
2
0
Agriculture Industries Retail Services Infrastructure
Public Sector Banks Private Sector Banks Foreign Banks
Restructured assets
During the five years to March 2015, banks have resorted to restructuring of loans in many
cases to postpone recognition of non-performance, or what we now call 'extend and pretend',
rather than using it as a tool to preserve the economic value of the units as intended. As a
result, until 2016 the restructured assets constituted more than 50% of the stressed assets of
all scheduled commercial banks masking the actual extent of deterioration of the loan
portfolios (Charts 6).
Chart 6: Restrutured assets as percentage of total
stressed assets
80
70
60
50
40
30
20
10
0
2010 2011 2012 2013 2014 2015 2016
Public Sector Banks Private Sector Banks
Foreign Banks All Banks
Down the years, as the stress deepened, these assets had to be classified as NPAs as
work outs of non-viable units did not succeed. The Chart 6 shows that the proportion of these
assets was much higher in public sector banks. The outstanding balance of these assets
declined sharply in 2016 post-AQR, as a major portion of these assets has been classified as
NPA post-AQR reflecting their true quality (Chart 6).
Net NPAs
High levels of NPAs have been progressively causing increasing stress on banks' earnings.
As a result, banks' provisioning capacity has also come under pressure leading to a spike in
the Net NPAs levels as well (Chart 7). Higher net NPAs indicate lower provision coverage
7
6.1
Chart 7: Evolution of Net NPAs (%)
6
4.6
5
4
3
2
1.3
0.8
1
0
Sep-15 Sep-15 Sep-15 Sep-15
Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
PSBs PVBs FBs All SCBs
NNPA to total net advances
ratio which should progressively improve as the strain on profitability eases.
Some contributory factors
The reasons for the growth in the NPAs are also not far to seek. Table 1 and the Chart below
show that the bank debt fuelled the rise in corporate leverage steadily from 2005 to 2011. It is
worth noting that despite the 'high leverage' being a well-established and most widely
known risk factor of corporate lending, bank lending to industrial sector continued at an
average elevated rate of over 20 percent. Do we call this irrational exuberance? Obviously, an
Table 1: High credit growth leading leverage
06- 07-08 2008- 2009- 2010- 2011- 2012- 2013- 2014- 2015-
07 09 10 11 12 13 14 15 16
GDP Growth (%) 9.6 9.3 6.7 8.6 8.9 6.7 5.6 6.6 7.2 7.6(P)
(Annual)
Credit Growth (%)
28.1 22.3 17.5 16.9 21.5 17.0 14.1 13.9 9.1 10.9
(annual- As reported on
the last Friday of the
financial year)
Credit growth 26.7 25.0 23.0 24.4 23.6 20.3 15.1 13.1 5.6 2.7
Industrial sector (%)
overly leveraged business is more sensitive to turbulence.
Portfolio diversification is key to managing idiosyncratic risk. The banks' credit
portfolio leaves scope for improving the diversification both in terms of single name and
Chart 9: Percentage change in the
Chart 8: Share of large borrowers in the
asset quality of large borrowers
gross advances and Gross NPAs
80
66.3
100
86.4
83.4
60
72.8
80
35.1
40
58.1 58.0
56.8
60
nt
sectoral concentrations. Charts 8 and 9 show that the stress is higher in large borrowers'
accounts. In the overall credit portfolio, share of industrial advances is around 40%. While
this is partly justified based on the relatively higher credit intensity of industrial sector, the
banks have to see the need for proper balance taking into account the risk return trade-off
especially in the larger loan segment.
Risk Management
The conference rightly highlights the key role of risk management in developing a less
stressed loan book. Let me therefore examine the elements of a good credit risk management,
look at the past and draw some lessons for the future.
Banks are in the business of taking risks. If they are not taking risks they are not doing
banking business. But, what does taking risk mean? Can it mean taking chances? When
would a measured risk taking be different from recklessness?
Essentially, risk management would involve knowing the risk, measuring it, and
controlling it within the risk appetite of the bank by using appropriate mitigants. Let us
therefore identify the various sources of credit risk.
The first risk from credit management emanates from the possibility that the business
does not take off as projected. It is likely that the project report based on which a credit
proposal is submitted is highly optimistic. There is therefore a need to evaluate a proposal for
how close the projections might be to reality. Even assuming that the projections were
reasonable, there is the possibility that external factors might render the projections
unachievable. The usual way to deal with this is to do a sensitivity analysis. The scenarios
tested should be adequately stressed and plausible. They need to factor in the possibilities that
arise on account of the fact that India is a lot more open economy now. Competition from
abroad apart from domestic competition should be visualised and therefore global capacities
and not just domestic capacity should be the criteria. Banks very often also undermine the
forex risk embedded in cases which involve liabilities denominated in foreign currency.
As referred to earlier, during the boom period, underwriting standards did get lowered
by what one may call irrational exuberance. What could be the right counterbalance in such
cases? A strong balance sheet of the promoter seems to be an answer. However, it appears
that there was no adequate effort to assess corporate leverage. We therefore had situations of
the promoters ending with much less skin in the game. What this does is to turn the problem
of corporate insolvency into a problem of the banks rather than that of the promoter.
Therefore a strong underwriting system that is properly steeped in understanding and
mitigating risks is the first element of credit risk management. But when would this happen?
Only when risk culture permeates across the bank. Spreading risk culture is the function of
the board and top management of the bank. In fact the Basel Committee states as under:
Banks should have an effective independent risk management function, under the
direction of a chief risk officer (CRO), with sufficient stature, independence, resources and
access to the board
An important element of underwriting from a risk perspective will be the portfolio
diversification. A credit portfolio which is exposed to concentration by counterparty,
geography, economic activity and the like is more prone to shocks. There must be proper
systems to monitor risks arising from concentration and systematically address them. We
have allowed banks to have an exposure up to 15 percent of their capital to a counter party
and 40 percent to a group. Banks must be wary of hitting these limits. Seven exposures of
15 percent each would make the bank's capital vulnerable to the fortunes of a few companies.
There is therefore a move to look at these limits differently. The linkages will not be through
ownership alone but also economic relationships.
An effective pre-disbursement control is a very important element of credit risk
management. Banks are quite liberal in waiving sanction terms without being mindful of the
risk mitigant they are letting off go in the process. Almost every condition of sanction is a
risk mitigant. Sometimes there may be more than one serving the same purpose. A proper
evaluation of the waivers, modifications and suggestion of alternate measures in substitution
of waived requirements would go a long way in reducing credit risk.
It is said that a poor underwriting can be made up by a strong post-sanction
supervision and an excellently appraised credit can be marred by poor monitoring. Let me
elaborate. Assume that the cost of setting up the plant was overestimated and passed off in
appraisal. Tight control on release of monies and strong on-site supervision can still mitigate
the risk. On the contrary, a lax post-sanction supervision can lead to the promoters not
bringing in their contribution in time, money being used for purposes not part of the project
cost, and the like.
An important part of the risk management is the manner in which a stressed asset is
dealt with. By definition one can say that a stressed asset is a loan in which anticipated and or
unanticipated risks have manifested. Again the entire gamut of activities surrounding a fresh
underwriting will have to be undertaken. But is that done? It is a matter of concern that the
exercise is many a time directed towards postponing the recognition of stress. Therefore,
restructuring of large loans became fashionable to a default that we had to finally put a stop
to it. We realise that in any part of the world a going concern is better than a gone concern
and it is more so in our country in the absence of a framework for dealing with insolvency.
Hopefully, this will be overcome shortly, now that the Insolvency and Bankruptcy Act has
been passed. But we are not clear why a bank cannot classify an account as NPA and still
provide need based credit. The system of restructuring to prevent a downgrade of an account
puts pressure on the banks because they are building further leverage in an already leveraged
entity. What it is does is that it takes risk management away from the whole process.
Theoretically, the "three lines of defence model" has been used traditionally to model
the interaction between corporate governance and internal control systems of banks in the
context of management of financial risks. I would explain it with the help of analogy to the
three lines of defence in football game.
In football, it is the front line forwards and mid-fielders who set the stage for winning
the match. If they play with caution and strength, the rest usually follows smoothly. In credit
risk management, the loan officers and the loan sanctioning authorities constitute the first line
of defence. Being responsible for operational management, they have ownership,
responsibility and accountability for assessing, controlling and mitigating risk in credit
exposures together with maintaining effective internal controls. (Figure 1). If they ignore the
basics while selecting a project for bank finance, the risk management, compliance and
internal audits would have to work really hard to see that the loan turns out to be profitable
for the bank.
The credit risk management function constituting the second line of defence facilitates
and monitors the implementation of effective risk management practices by operational
management. Coming back to our football metaphor, the second line of defence has multiple
roles. It has to keep a watch on how the forwards are progressing and whether they need to
call them to modify the strategy. At the same time they have to be in readiness to react should
the situation suddenly slip out of the forwards' control. But, it would never be advisable for
them to leave their place and join the forwards - this would expose the team to attack by the
opposite team. Thus, the second line should only reinforce what the first line is doing, not to
replace them. In credit risk management, the second line of defence should assist the risk
owners- the credit department- in defining the target risk exposure and reporting adequate
risk related information through the organisation. If this line of defence is to function
effectively, this function has to remain independent. The credit risk management officers
should not be part of the credit approval committees.
Figure 1: Three lines of defence model
Source: ECIIA/FERMA Guidance on the 8th EU Company Law Directive, Article 41
The internal audit function is the third line of defence and is expected to provide
assurance to the organisation's board and senior management on how effectively the
organisation assesses and manages its risks. They particularly look into the manner in which
the first and second lines of defence operate. The assurance task covers all elements of an
organisation's risk management framework, i.e. risk identification, risk assessment and
response to communication of risk related information. Comparing this with a football match,
one would not expect the goalkeeper to be running with the forwards past the midfield to hit a
goal. Also, a team cannot always rely only upon a strong goal keeper to win the match. In
other words, an internal audit cannot solve all the risk management problems that primarily
are the responsibility of the operational, risk management and compliance teams.
RBI has issued detailed instructions to banks on credit risk management including the
organizational and reporting structure of risk management and internal audit departments. If
all institutional mechanisms have to function, they must be put in place to play the expected
role and not just as a tick box compliance.
The multiple defence line model would not be effective in the following situations
•
Misaligned incentives for risk-takers in first line of defence, which primarily arise
from the emphasis on generating sufficient revenue and profits for the institution.
•
Lack of organisational independence of functions in second line of defence.
• Lack of skills and expertise in second line functions
•
Inadequate and subjective risk assessment performed by internal audit.
Let me complete discussion on the three lines of defence with the role of the board and
senior management. After all a big part of the game is won by strategising and mentoring.
The players should have an executable plan that has assessed the opponent's strengths and
weaknesses. The board and the senior management draw up the risk strategy for the bank, set
the risk appetite for the organisation and allocate roles to each player and group of players.
They are thus like the coach and the manager of a team. Mind you, if you look at famous
football leagues, the coach and the manager are an important part of the teams.
Consequences
If banks continue to remain saddled with huge NPAs for a long time, it would make them risk
averse and choke the lending for economic activities in general. Another consequence is the
likely shift by the PSBs to loan segments such as personal loans and housing loans where the
banks so far have had lowest NPAs. While this may help in rebalancing the loan portfolio in
favour of less volatile sectors, care would have to be taken not to overdo this and shift the
leverage from the corporate sector to household sector. Yet another possibility is the rise in
the market share of private sector banks in industrial loans. We are seeing this already. This
would help the viable businesses continuing to have access to bank finance the broader
banking sector is still under stress. However, these banks will have to manage the resultant
credit concentration risk well. Overall, dealing squarely with stressed assets is crucial for the
nation's economic growth, which is why the RBI and Government have taken several
measures in this direction.
The Government and RBI Tool Kit
Steps taken by Government
The consequences of default in loans are aggravated by poor recovery. In particular, the low
rate of recovery through legal recourse is a cause for concern - the annual recovery as
percentage of amount of cases filed under SARFAESI Act, with DRT and Lok Adalats fell
from 20% in 2013-14 to 9% in 2015-16. With the Government having notified the
amendments to the DRT and SARFAESI Act, we hope to see improvement in the recovery
process. The Insolvency and Bankruptcy Code is yet another major step taken by
Government in this direction. The Government has set up a Committee, with four sub-groups,
to formulate detailed regulations and rules to operationalise the code within a short time span.
The Government has also taken steps to improve the corporate governance of the
PSBs. The Indradhanush initiative - breaking up the post of Chairman and Managing
Director, strengthening board and management appointments through the Banks Board
Bureau, decentralizing more decisions to the professional board and finding ways to
incentivize management - would contribute to better performance of loan portfolio of banks.
The Government has also pumped in quite a bit of capital into the banks.
Regulatory measures
The phenomenal rise in non-performing assets of banks has engaged considerable attention of
RBI too. Starting from the framework for dealing with stressed assets in early 2014, we have
initiated a series of measures to empower banks to deal with stressed assets. Realising that
information asymmetry is a major bottleneck in sound credit appraisal and strong credit
monitoring, RBI has created a large loan database (CRILC) that covers all loans over Rs.5
crore. The data base is accessible to all the banks. That database allows banks to identify
incipient sickness that is reflected in repayment behaviour. Leveraging the CRILC database,
lenders could coordinate their planning for recovery and resolution of the affected unit
through a Joint Lenders' Forum (JLF) once early signals of sickness are noticed. Incentives
have been given to banks for reaching quick decisions. We have taken steps to ensure that
the forum performs efficiently.
RBI's regulations require banks to classify loans into special mention categories
based on days past due for better monitoring. While restructuring of loans per se is not a bad
thing, we have almost put an end to the restructuring of unviable projects by banks and keep
them classified as standard assets too. At the same time, 5/25 scheme has been designed with
the objective of allowing the borrowers to take the benefit of better alignment of their
repayment schedule to cash flows to service the debt for a long term project. We have been
constantly monitoring the performance of the scheme and tweaking it wherever necessary to
ensure that it is not misused to evergreen the weak loans and to iron out the wrinkles if any.
The SDR scheme has been designed to deal with problem loans where promoters need
to be replaced, whereas the 'Scheme for Sustainable Structuring of Stressed Assets'(S4A) is
an optional framework for the resolution of large stressed accounts without change of
promoters. The S4A envisages determination of the sustainable debt level for a stressed
borrower, and bifurcation of the outstanding debt into sustainable debt and equity/quasi-
equity instruments which are expected to provide upside to the lenders when the borrower
turns around. This provides an incentive to capable, but overleveraged promoters to perform
and banks to continue to lend as the project is not deemed an NPA, if adequately provided
for.
Indian banks got into stress before full implementation of Basel III and revised IFRS
which are designed to provide protection against system level stresses. In particular, the
countercyclical capital buffers and expected loss based provisions would strengthen the banks
and create sufficient cushions against systemic risk events. The essence of all the macro-
prudential and countercyclical elements of Basel III is that they encourage banks to save
capital in good times for use in bad times. For Indian banks, the stress has occurred before
full implementation of Basel III and to that extent they have not had the benefits of this
improved capital standard. Rather, as Basel III is being implemented during a stressed phase,
Indian banks are under double pressure - to survive the current stress and implement Basel
III. Hence, external capital support is essential.
Government of India has already provided the required capital support to the public
sector banks, although with some conditions regarding the performance. More capital will be
infused as part of Indhradhanush. But it is necessary that the stressed assets-build up is
contained and the banks get back to generating adequate internal accruals. We are hopeful
that, once the pain is over, banks would emerge much stronger.
Malfeasance
While the RBI believes that businesses can get into financial difficulties and genuine business
needs should be supported, malfeasance should be properly dealt with. We have, therefore,
put in place a detailed system for identifying wilful defaulters and non-cooperative borrowers
with attendant consequences to the borrowers who are so declared. We also believe that
frauds should be sternly dealt with and have created a fraud registry.
Exploring alternative sources of project finance
Bank loans continue to be a dominant source of project finance except in North America.
However, owing to the considerable risks for the bank's balance sheets that arise from such
long term financing, capital market funding of project finance is being explored and
consciously promoted in many other countries.
Chart 10: Trends in bank funding of projects in Europe
For example, the bond funding of
projects in Europe has increased
from 3% in 2008 to 23% in 2014.
(Chart 10). We have issued
guidelines to make large borrowers
to go to capital market for part of
their funding needs. The revised
draft on large exposure has been
issued. We have also increased
credit enhancement to be provided by banks for bond issuances to make them attractive for
long term investors.
Conclusion
Any bank which does not have a strong risk management is likely to build a highly
susceptible credit portfolio. Risk Management is not static. It evolves over a period of time.
It need not be the same for all. Its sophistication grows with the growth in the complexities of
a bank's functioning. In fact, if a bank's risk management function is not commensurate with
the complexity of its operations, it is prone to the risks manifesting and turning beyond its
risk appetite. Regulators have put in place a framework for risk management. How well to
operationalise it and how to ensure that the various lines of defence play their expected role
are in the hands of the board and senior management of a bank. There is no line of defence
stronger than a board and senior management committed to sound risk management in a
bank.
Thank you.
***