B Mahapatra: Highlights and rationale of the recommendations of the
working group to review the existing prudential guidelines on
restructuring of advances
Keynote address of Mr B Mahapatra, Executive Director of the Reserve Bank of India, at the
round table on the highlights and rationale of the working group to review the existing
prudential guidelines on restructuring of advances by bank/financial institutions, organised by
the Centre for Advanced Financial Research and Learning (CAFRAL), Mumbai,
13 September 2012.
* * *
The contributions made by S/Shri M. P. Baliga and M. K. Poddar are gratefully acknowledged.
I am indeed grateful to the CAFRAL for inviting me here to discuss the highlights and
rationale of the recommendations of the working group to review the existing prudential
guidelines on restructuring of advances by banks and financial institutions, which I chaired.
The working group was represented by eminent bankers, accountants, rating agency, Indian
Banks' Association (IBA) and the Reserve Bank of India (RBI). The working group submitted
its report to the RBI on July 18, 2012, which placed it in its website on July 20, 2012 for wider
comments. Comments have poured in from various sources - banks, IBA, industry
associations, individual professionals, etc.; the print media have also covered it extensively.
One group of commentors have expressed reservations on some of the recommendations of
the working group; the other commentors, particularly the print media, have generally
appreciated the recommendations. I, as the chairperson of the working group accept the
brickbats and bouquets with all humility. I am grateful to CAFRAL for organising this round
table and giving me an opportunity to explain the highlights and rationale of the
recommendations of the working group.
Approach of the working group
Let me at the outset admit that restructuring of loans and advances is a legitimate banking
practice. The need to set up the working group arose with a view to aligning our restructuring
guidelines with the best international practices and accounting standards. Another motivation
for setting up the working group was to clarify certain instructions which were perceived to be
ambiguous.
The working group approached the whole issue from societal point of view that restructuring
served a useful purpose as it protects the productive assets of the economy. It also helps the
borrowers to recover from temporary problems and provides incentives to banks to nurture
such borrowers by allowing them regulatory forbearance of keeping the account as
"standard" or unimpaired. It has been demonstrated that the relaxation given to banks in
August 2008 for restructuring of loans helped them and their borrowers to tide over the
impact of the global financial crisis.
However, the working group observed that there has been an extraordinary rise in the level
of restructured "standard" assets, even surpassing the quantum of gross NPAs of the
banking sector. As seen from an updated table below, standard restructured assets
continuously exceeded the gross NPAs since 2010:
On top of that a rating agency has estimated that restructured standard assets may increase
sharply to reach Rs. 3,25,000 crore by March 2013. Public sector banks bear a
disproportionate burden of the restructured loans.
Gross NPA ratio, which was hitherto the main financial ratio to gauge the level of impairment
in the banking sector assets, is now being complemented with the ratio of restructured
standard advances to gross advances as a measure of latent impairment of the banking
sector's financial assets. This is in view of the perception by some of the market players that
a significant portion of these standard advances are actually impaired or will turn
non-performing with passage of time. The credibility of the Indian banking system is at stake.
The Economist (London), in its August 18-24, 2012 issue has also commented that India's
public sector banks are sitting on something unpleasant (restructured loans). Our own Indian
economic daily, the Economic Times on September 9, 2012 commented that the present
practices are completely defeating restructuring.
Regulatory forbearance
The concept of standard restructured assets arose when the RBI allowed project loans to
retain their standard asset classification on extension of their repayment schedule in
May 1999. That is if in the opinion of the bank the bottleneck in achieving regular commercial
production was of a temporary nature not indicative of any long-term impairment of the unit's
economic viability and the unit was likely to achieve cash break-even if some time was
allowed. This was extended to treatment of restructured accounts in March 2001. With the
issue of comprehensive guidelines on restructuring in August 2008, this regulatory
forbearance was made available to all types of loan restructuring except commercial real
estate exposures, capital market exposures and personal and consumer loans.
As a basic premise it should be understood that the need for restructuring arises when a
standard account borrower faces difficulties in repayment and such an account should be
classified as impaired on restructuring. The working group studied the international best
practices in this regard and observed that restructured accounts are classified as impaired if
the restructuring (i) is on account of financial stress of the borrower or due to
delays / non-payment as per contractual terms by the borrower; and (ii) the modification of
terms is non-commercial, i.e., disadvantageous to the lenders.
The working group also observed that as per International Accounting Standards, loan
accounts are generally treated as impaired on restructuring. It also noted that "Definition of
Default" under the Internal Ratings Based (IRB) approach of Basel II for computation of
capital requirement for credit risk, identified restructuring as an event of default irrespective
of the asset classification. The working group also took note of the fact that the capital
market and the rating agencies viewed any restructuring of an account as an event of
impairment even if the regulators allowed the accounts to retain the "standard" asset
classification status. Therefore, the working group opined that for consistency, restructuring
should be treated as an event of impairment or default and hence the account should be
downgraded to sub-standard or NPA category.
The working group was conscious of the consequences of aligning our restructuring
guidelines with this best practice at this juncture when the impact of global financial crisis is
substantial and a new crisis in the form of European sovereign debt crisis is still unfolding.
Doing so immediately might act as a disincentive to banks to restructure viable accounts
which could lead to substantial distress to the borrowers and increase in the non-performing
assets and provision requirements for the banks.
The working group, therefore, recommended that the asset classification benefit available on
restructuring of advances be done away with, say, after a period of two years.
Banks are perhaps not happy with this recommendation, as observed from their comments.
However, other stakeholders like print media, rating agencies and certain individual
professionals have welcomed this recommendation. Some comments in the newspapers
have even advocated forthright implementation of this recommendation without waiting for
two years.
Provisioning buffer
The working group also estimated that a significant portion of restructured standard assets
turn into NPAs subsequently as some of these accounts were ab-initio weak and the
due-diligence carried out for viability studies were not proper. June 2012 Financial Stability
Report of the Reserve Bank estimated that 15% of such loans may turn into NPAs while the
working group took a more conservative view under a stressful scenario and estimated that
25-30% of such loans may slip into non-performing category. This assumption was based on
the fact that restructurings have taken place only in the recent past with long moratorium and
repayment holidays and the repayment behaviour of such borrowers is still not known.
In view of the above, the working group recommended a higher general provisioning
requirement on restructured standard assets i.e., from the existing 2% to 5%. This will ensure
the pre-existence of a buffer when such loans slip into non-performing category. However,
the working group felt that a forthright increase in such provisioning requirement will
adversely impact the balance sheets of the banks and therefore a calibrated approach was
adopted to coincide with the two-year transition period given for withdrawal of regulatory
forbearance on asset classification. For the present "stock" of restructured standard assets
the general provision was proposed to be increased from 2% to 3.5% in the first year and
from 3.5% to 5% in the second year. However, the new restructured standard assets ("flow")
will straightaway attract provision of 5%.
Infrastructure sector loan restructuring
While the working group recommended doing away with the asset classification benefit on
restructuring in a phased manner, it was sensitive to the current economic situations and the
importance of the infrastructure sector in the country's development. The working group was
also aware of the delays and uncertainties associated in obtaining clearances for
commencing commercial operations by the infrastructure entities.
The working group, therefore, felt that extant asset classification benefits to infrastructure
project loans due to change in date of commencement of commercial operations (DCCO)
may be allowed to continue for some more time in view of the delays/uncertainties
associated in obtaining clearances for such projects. However, the working group was of the
view that this limited forbearance should be used judiciously and it must have disincentives
to disallow misuse of the forbearance. Therefore, standard asset provision of 5% for such
infrastructure loans has been recommended.
The working group also observed that internationally regulatory forbearance was offered in
times of financial and economic crisis in order to alleviate their adverse impact on real and
financial sector. However, in India these have become a kind of standing instruction
applicable at all times. The working group, therefore, recommended that the Government
and the RBI should come out with a framework which will precisely and objectively define a
severe crisis (like the 2008 financial crisis) requiring both the Government and regulatory
intervention. The framework should also broadly indicate the fiscal and regulatory measures
to be taken under such conditions in the phases of (i) crisis containment and (ii) debt
restructuring. The rationale for this recommendation was that any regulatory forbearance
should be used as a special tool only in the times of crisis. Such phases were clearly seen in
India during the 2008 financial crisis, when Government and RBI both intervened in the real
and financial markets with incentives and regulatory forbearance.
The working group also observed that the requests for special dispensations and one-time
measures are frequently made to RBI for restructuring of a particular sector of economy or
industry on the basis that such sectors were facing extraordinary stress or unprecedented
adverse conditions. In view of such frequent requests, the one-time measures lose their
meaning and these also have adverse impact on the regulatory safeguards of the banking
system. In view of this the working group felt that the requests for such regulatory
forbearance should not be made a regular feature and any such forbearance should be
accompanied with fiscal incentives to ensure the viability of the sector after restructuring.
Up-gradation of restructured NPA accounts
The issue of up-gradation of an account downgraded on restructuring arises with the first
recommendation of the working group of withdrawal of regulatory forbearance in asset
classification. The extant RBI guidelines prescribe that all restructured accounts which have
been classified as non-performing assets upon restructuring, would be eligible for
up-gradation to the "standard" category after observation of "satisfactory performance" during
the "specified period". Further, "specified period" is defined as a period of one year from the
date when the first payment of interest or instalment of principal falls due under the terms of
restructuring package.
It was observed by the working group that in some cases of restructuring of multiple credit
facilities with moratorium on payment of principal as well as major portion of interest,
accounts were upgraded on the basis of payment of interest on a small portion of the debt,
say funded interest term loan (FITL), for the specified period. The working group further
noticed that the account may still have its inherent credit weakness as payment of a small
portion of interest does not show the "satisfactory performance". Therefore, it was felt that
the specified period should be redefined by taking this aspect into consideration.
The working group studied the international best practices in this regard. For instance to
upgrade a restructured account in Australia, a satisfactory performance is to be observed for
six months or three repayment cycles, whichever is longer whereas in Thailand satisfactory
performance over three consecutive months/three instalments is required. France, while
allowing restructured accounts to be upgraded on account of satisfactory performance,
requires that these accounts be reclassified into a specific sub-category of performing
accounts until they are paid in full.
The working group had two options. One option was that "specified period" may be redefined
in cases of multiple credit facilities on restructuring as "one year from the commencement of
the first payment of interest or principal, whichever is later, on the credit facility with longest
period of moratorium". Another option was that an objective criterion of repayment should be
used for deciding the satisfactory performance. For this purpose, it was suggested that a
minimum of 10% of debt repayment should be made mandatory for up-gradation of an
account classified as NPA to standard category.
The working group examined the above two options and concluded that the first option was
more prudent as it will ensure that all facilities of a restructured loan performed satisfactorily
before upgrading a restructured account to standard category. The working group, therefore,
recommended that for the purpose of upgrading restructured NPA account with multiple
credit facilities, "specified period" should be redefined as "one year from the commencement
of the first payment of interest or principal, whichever is later, on the credit facility with
longest period of moratorium provided other outstanding loans/facilities in the account also
perform satisfactorily.
It may be recalled here that RBI's first instructions on asset classification of restructured
accounts, issued in April 1992, specifically prescribed that an asset, where the terms of the
loan agreement regarding interest and principal have been renegotiated or rescheduled after
commencement of production, should be classified as sub-standard and should remain in
that category for at least two years of satisfactory performance under the renegotiated or
rescheduled terms. Our present recommendation in this regard is not too harsh or very new.
Distribution of losses
Now, I will explain the rationale behind the recommendations which are aimed at rationalising
the distribution of losses between the borrower and the lender. It was observed that an
excessively debtor-oriented approach has the aspects of moral hazard as it may encourage
the debtor to take excessive risks in the knowledge that the burden of any losses will fall
disproportionately on creditors. In India, while the banks make the provision for diminution in
fair value of advances as a result of restructuring and sometimes take a burden of
low-yielding preference shares, borrowers fulfil their obligation by bringing only 15% of the
bank's sacrifice and that too in two phases.
Promoters' sacrifice
It was felt that any sacrifice on the part of the lenders due to restructuring should be
accompanied with increased stake of the borrower in the business. This becomes important
for instilling financial discipline in the borrower as he will be more concerned about
preserving the value of his stake in the business. It was observed that the regulatory
prescription of promoters' sacrifice at 15% of the lenders' sacrifice was not sufficient enough
and in some cases even this 15% was not properly accounted for. Therefore, the working
group recommended that this 15% was the bare minimum and banks may prescribe a higher
sacrifice by the promoters.
Further, it was also felt that the sacrifice by the promoters should also be linked with the
quantum of the restructured loan. Therefore, the recommendation in this regard is that
promoters' contribution should be prescribed at a minimum of 15% of the diminution in fair
value or 2% of the restructured debt, whichever is higher.
Banks and also other stakeholders have welcomed this recommendation in their comments.
Some have even suggested that if there is a case of diversion of the funds, then such
borrowers should be compelled to bring back the funds along with the amount of their
sacrifice. I will like to state that our instructions in this regard are not new and instructions
regarding promoters' contribution were first issued in November 1985 guidelines on
rehabilitation of sick industrial units.
Another related recommendation in this regard is making it mandatory for the promoters to
extend their personal guarantee in all cases of restructuring. At present, personal guarantee
by the promoter is one of the conditions for getting the asset classification benefit except
when the unit is affected by external factors pertaining to the economy and industry.
However, the working group observed that some promoters do not agree to extend personal
guarantee under any circumstances. It was also observed that the criteria, "external factors
pertaining to the economy and industry" was subjective and it made it difficult for the banks to
press for promoters' personal guarantee. Considering that the restructuring of debt by
lenders benefits the company and promoters and also leads to sacrifice by lenders, it was
important to ensure promoters' "skin in the game" or commitment by stipulating personal
guarantee.
The working group discussed that in case personal guarantee is made mandatory, promoters
will be ensuring that only viable packages are submitted for restructuring. In view of the
foregoing, the working group recommended that RBI may prescribe that the promoters'
personal guarantee as a mandatory requirement for all cases of restructuring, i.e., even if the
restructuring is necessitated on account of external factors pertaining to economy and
industry. The working group also recommended that RBI may prescribe that corporate
guarantee cannot be a substitute for the promoters' personal guarantee.
Provision for diminution in the fair value of restructured advances
Reduction in the rate of interest and/or reschedulement of the repayment of principal amount,
as part of the restructuring, results in diminution in the fair value of the advance. Such
diminution in value is an economic loss for the bank and will have impact on the bank's
market value of equity. Banks are, therefore, required to measure such diminution in the fair
value of the advance and make provisions for it by debit to Profit & Loss Account. Such
provision should be held in addition to the provisions as per existing provisioning norms for
advances. Our extant instructions are very clear in this regard.
The working group examined the present method of calculating erosion in the fair value of
the advance as the difference between the fair value of the loan before and after
restructuring, and found the same to be appropriate. However, it was felt that there are
certain ambiguities and inconsistencies across the banks and the same were required to be
removed. Accordingly, the working group recommended that RBI may provide some
illustrative examples on calculation of the fair value of accounts on restructuring.
The working group also recommended continuance of the existing instruction that if a bank
finds it difficult to compute diminution in fair value of advances extended at small/rural
branches, it will have the option of notionally computing the diminution amount at 5% of the
total exposure, in respect of restructured accounts where the total dues to the bank are less
than Rs. 1 crore.
Conversion of debt into shares/preference shares
The next major highlight of the report is regarding arresting the trend of the banks being
burdened with shares/preference shares of non-viable companies as a result of restructuring
of their debt. The working group observed that banks were adversely affected in cases of
conversion of a large portion of debt into equity and / or preference shares. The working
group noticed that the trend of such conversion has increased recently, especially in cases of
large exposures restructured under CDR mechanism. The working group observed that such
conversions were akin to writing off the debt as in many cases the preference shares carried
zero or low coupon, added with the fact that they had no market value as also they did not
carry voting rights unlike the equity shares.
In view of the above, the working group felt that there should be a ceiling/restriction on
conversion of debt into zero / very low interest preference shares. Another view was that
RBI should prescribe a minimum coupon (say yield on 364 days TBs) on such preference
shares.
The working group also observed that in some cases of restructuring, unreasonable losses
were allocated to the lenders as a result of conversion of debt into equity shares at a very
high premium over the current market price. It was also observed that the lenders suffered
heavy losses due to further decline in the market prices of such shares. In view of this, the
working group felt that RBI may prescribe that conversion of debt into equity shares on
restructuring cannot take place at off market rates, i.e., at a price which is higher than the
latest available market price. The working group felt that the conversion into unlisted shares
should be restricted due to the limited exit options available to banks for unlisted shares. The
working group recommended that any conversion of debt into equity should be done only in
the case of listed companies. There are suggestions to take up the issue with SEBI for
rationalising the norms on conversion price of debt into equity in cases of restructuring by
banks. The working group recommended that conversion of debt into equity/preference
shares should, in any case, be restricted to a cap (say 10% of the restructured debt).
We have received very favourable comments in this regard. Some have suggested that
conversion of debt into preference shares should not be permitted at all.
Exit option
Another important recommendation of the report arose from the observation that banks were
stuck with accounts which were restructured on being found viable, but later turned to be
slow in achieving the projected viability ratios. In some cases promoters did not bring the
funds as promised and the required equity could not be raised due to depressed market
conditions or due to the company's deteriorating financial health. The working group
observed that although the extant guidelines on restructuring provided the banks freedom to
decide, especially, in cases of CDR accounts, to either proceed legally under SARFAESI or
DRT or take up the account for restructuring, if found viable. However, once restructured, the
unviable accounts became a real burden, as with increased stakes the banks found it difficult
to abandon them and initiate recovery because the collaterals deteriorated in value with
passage of time.
The working group discussed the need for faster exit options in light of the international
resolution mechanism and recommended that exit options to banks in cases of non-viable
accounts should be made more comprehensive. The working group observed that in such
cases, banks should be advised to assess the situation early and use the exit option with a
view to minimise the losses. The working group also agreed that the terms and conditions of
restructuring should inherently contain the principle of "carrot and stick", i.e., it should also
have disincentives for non-adherence to the terms of restructuring and under-performance.
Right of recompense
The working group also stressed the importance that banks should recover the sacrifices
made by them once the account under restructuring turns around and starts making profit. It
was observed that banks generally waived the benefits accruing to them from right of
recompense at a later stage or the borrower contested the amount of recompense. RBI
guidelines make the "right of recompense" clause mandatory in cases of CDR restructuring
and CDR Cell has framed their own guidelines in this regard in terms of the powers
delegated to them.
It was noticed by the working group that due to the current guidelines issued by the CDR Cell
that recompense be calculated on compounding basis and that 100% of recompense so
calculated is payable, exit of companies from CDR system was not happening. In view of
this, the working group while recommending that recompense clause be made mandatory
also felt that CDR Standing Forum/Core Group may take a view as to whether this clause
may be made somewhat flexible in order to facilitate the exit of the borrowers from CDR Cell.
However, it also felt that in any case 75% of the amount so calculated should be recovered
from the borrowers and in cases of restructuring where a facility has been granted below
base rate, 100% of the recompense amount should be recovered.
The working group also recommended that the present recommendatory nature of
"recompense" clause should be made mandatory even in cases of non-CDR cases.
Assessing the viability for restructuring of accounts
Viability is the most important and prime criteria for an account to be taken up for
restructuring. It has been observed that many unviable accounts were projected as viable on
the basis of over optimistic financial projections and some kind of financial engineering. Our
extant guidelines allow the banks to examine the viability of accounts for restructuring on the
basis of broad parameters prescribed by RBI and benchmarks decided by the banks
themselves.
The working group observed that while restructuring of advances on solo basis, banks,
particularly at branch or controlling office level where sufficient skill is not available, generally
do not establish the viability of the account as rigorously as being done under CDR. Also, the
working group observed that in case of solo restructuring, while proper and intensive viability
study might be done for medium and large accounts, for small accounts viability study is
generally very limited.
Presently, the RBI has prescribed certain very broad illustrative viability criteria - the
parameters may include the Return on Capital Employed, Debt Service Coverage Ratio, Gap
between the Internal Rate of Return and Cost of Funds and the amount of provision required
in lieu of the diminution in the fair value of the restructured advance. The working group
discussed the need for prescribing certain objective criteria and indicative benchmarks by
RBI, like those adopted by the CDR Cell, for restructuring of accounts by banks so as to
ensure that accounts where the viability is in doubt do not get restructured. It was also felt
that any benchmarks prescribed by RBI will bring uniformity and objectivity while assessing
the viability for restructuring the accounts.
The working group recommended prescription of suitable benchmarks by RBI for the
restructuring carried out by individual banks.
The working group also felt that the prescribed time span of seven years for
non-infrastructure accounts and ten years for infrastructure accounts becoming viable on
restructuring was too long and banks should take it as an outer limit. It was felt that in times
when there is no general downturn in the economy, the viability time span should not be
more than five years in non-infrastructure cases and not more than eight years in
infrastructure cases. We have received several comments in this regard. While some have
welcomed this step, a few have advocated that RBI should leave such matters to the banks.
Disclosures
At present banks are required to disclose in their published Annual Balance Sheets, under
"Notes on Accounts", information relating to number and amount of advances restructured,
and the amount of diminution in the fair value of the restructured advances under the
following categories:
(i) Standard Advances Restructured,
(ii) Sub-Standard Advances Restructured, and
(iii) Doubtful Advances Restructured.
Under each of the category above, advances restructured under CDR Mechanism,
SME Debt Restructuring Mechanism and other categories are required to be shown
separately.
The disclosures made by the banks in their balance sheets as regards restructured accounts
are used by market players and analysts for assessing the financial condition of the banks. In
terms of present guidelines banks are required to disclose annually all accounts restructured
in their books on a cumulative basis even though many of them would have subsequently
shown satisfactory performance over a sufficiently long period. As such the present position
of disclosures are quite stringent and do not take into account the fact that in many of these
accounts the inherent weaknesses in the accounts have disappeared and the accounts are
in fact standard in all respects.
However, it has been observed that some banks do not disclose the restructured accounts
on a cumulative basis. This may be because of the fact that our August 2008 guidelines have
not explicitly stated that such disclosures should be on a cumulative basis and our previous
instruction was about disclosing "accounts restructured during the year". In view of such
ambiguities prevailing and in order to maintain uniformity in disclosure of accounts, it was felt
necessary to clearly prescribe the disclosure requirements.
It was decided to take into account the presence of inherent credit weakness in a
restructured account as a criterion for disclosure. However, deciding the presence of inherent
credit weakness itself required some kind of objective criteria. It was felt that satisfactory
performance of a restructured account for a sufficient period of time should be taken as an
indication that the account has overcome its inherent credit weakness.
Our May 2011 circular prescribed higher provisioning for restructured accounts classified as
standard either ab-initio or on up-gradation from NPA category. Simultaneously, our
instructions on capital adequacy prescribed additional risk weights for restructured accounts
of certain types of loans. These higher provisioning and additional risk weight cease to be
applicable after periods prescribed in this regard. The working group felt that once the higher
provisioning and additional risk weights cease to be applicable for these accounts, they may
be treated on par with normal standard accounts.
Therefore, the working group recommended that once the higher provisions and risk weights
(if applicable) on restructured advances (classified as standard either ab-initio or on
upgradation from NPA category) revert back to the normal level on account of satisfactory
performance during the prescribed period, such advances should no longer be required to be
disclosed by banks as restructured accounts in the "Notes on Accounts" in their Annual
Balance Sheets. Accordingly, the working group also suggested a format for the disclosures
of restructured accounts.
Roll-over of short term loans
Another important recommendation of the working group was that RBI should clarify that the
cases of roll-over of short term loan, where proper pre-sanction assessment has been done
and no concession has been provided due to weakness of the borrower, should not be
considered as restructured account. The need for this recommendation arose as the banks
felt such short term loans (STLs) were like any other need based working capital facility and
their roll-over