Viral V Acharya: Some ways to decisively resolve bank stressed
assets
Speech by Dr Viral V Acharya, Deputy Governor of the Reserve Bank of India, at the Indian
Banks' Association Banking Technology Conference, Mumbai, 21 February 2017.
* * *
I am grateful to my colleagues and teams at the Reserve Bank of India for many stimulating
discussions and insights, to many banking sector stalwarts of today and the past, and to several
practitioners and policy-makers in sectors and institutions related to the resolution of bank
stressed assets. All errors remain my own.
Thank you to organizers of Indian Banks' Association for inviting me today. To all the Award
winners, congratulations on your stellar achievements and the innovative spirit you have shown
to be today's worthy recipients. Technology, "Fin Tech" as you say, is taking banking and
intermediation into unchartered territories. I have yet to fathom the full import of these sweeping
changes. In the meantime, my subject matter today will be more prosaic and somewhat
sobering.
I wish to speak today, with a certain sense of urgency, about the need and possible ways to
decisively resolve Indian banks' stressed assets.
Since the Reserve Bank of India (RBI) initiated the Asset Quality Review of banks in the second
half of 2015, it appears that possibly up to a sixth of public sector banks' gross advances are
stressed (non-performing, restructured or written-off), and a significant majority of these are in
fact non-performing assets (NPAs). For banks in the worst shape, the share of assets under
stress has approached or exceeded 20%. This estimate of stressed assets has doubled from
2013 in terms of what had been recognized by banks. The doubling of stressed assets is the
case also for private sector banks, but their ratio of stressed assets to gross advances is far
lower and their capitalization levels far greater. There have been several hints - in the declining
price-to-book ratios of bank equity, as I had observed in an oped piece for the Mint in September
2013, and in the incisive research reports of banking sector analysts - that many assets "parked"
by banks under the Corporate Debt Restructuring cell were severely stressed. These assets
were deserving of advance capital provisioning against future recognition as NPAs.
The Asset Quality Review has taken a massive stride forward in bringing the scale of this
problem out in the open and stirring a public debate about it. However, relatively little has been
achieved in resolving the underlying assets to which banks had lent. Several resolution
mechanisms and frameworks have been offered by the RBI to banks to get this going, but the
progress has been painfully slow. Most of the assets remain laden with such high levels of bank
debt that their interest coverage ratio is lower than one; they have little or no capacity to raise
funding for working capital and capital expenditures, or to attract private investors to turn them
around. Original promoters - who rarely put in any financing and primarily provide sweat equity -
have had somewhat of a field day, facing limited dilution, if any, of their initial stakes nor much of
a threat of being outright replaced.
There is a connection between these two outcomes - the lack of a comprehensive recognition of
stressed assets by banks and the absence of any resolution. Both stem from the structure of
incentives at our banks and the fact that stressed assets have been an outcome of excessive
bank lending, en masse, in a relatively short period from 2009 to 2012, and to a concentrated set
of large firms in a number of sectors such as infrastructure, power, telecom, metals (iron and
steel, in particular), engineering-procurement-construction (EPC), and textiles.
Let me first discuss the bank incentives. Only a bank that fears losing its deposit base or
incurring the wrath of its shareholders is likely to recognize losses in a timely manner. In many of
our banks, such market discipline is simply not present at the moment. In others, even if some
such discipline is at work, banker horizon is excessively short until end of the CEO's term. Banks
lobby for regulatory forbearance; perhaps some loan prospects have turned sour due to bad luck,
but beyond a point, concessions in recognizing losses just ends up being a strategy of kicking
the can down the road and leaving them as legacy assets for the next management team to deal
with.
The sectoral concentration of losses substantially amplifies this problem. Given the scale of
assets that needs restructuring, it is natural that the turnaround capital at asset-restructuring
companies (ARCs) has been limited in comparison. Some capital is simply sitting on the fence
until serious asset restructuring picks up speed. In the meantime, any assets put up for sale can
raise financing only at steep discounts, implying significant haircuts for bank debt. The loss of
capital that would result on bank books and the fear of vigilance actions that such haircuts might
trigger have made it almost impossible to get banks to embrace restructuring.
Effectively, there is no right price at which the market for stressed assets clears if left alone to
private forces. Even with an orderly resolution mechanism such as the Insolvency and
Bankruptcy Code in place, why would banks rush to file cases? In the unlikely scenario that
assets are in fact being sold by banks to investors at steep discounts, ARCs may just asset-strip
rather than do the economic turnaround. After all, these investors have waited far too long and
now wish to generate quick returns to meet the expectations of their own investors.
All this is playing out to near perfection in our setting. Its consequences are pernicious.
At one end, public sector banks are running balance-sheets that seem to be in a perennial need
of recapitalization from its principal owner, i.e., the government, and shying away from lending to
potentially healthier industrial credits. Bank credit growth has been steadily declining at the
stressed banks. Some private sector banks face such headwinds too.
At the other end, sectors with the most stressed assets have excess capacity relative to current
or near-term utilization and no sight of immediate pickup in economic prospects. Promoters have
continued to operate, staying afloat with rollovers from banks which only increase indebtedness,
partly disengaged, partly disgorging cash from the few assets that are running.
The end result has been a silent atrophy of the true potential of these assets.
This situation should be a cause for concern to all of us. It is reminiscent of weak banks and
stagnating growth witnessed by Japan in the 1990s, with repercussions to date, and by Italy
since 2010. Japan has experienced, and Italy, is in my opinion experiencing, a lost decade.
I believe we are at crossroads and have an important choice to make.
We can choose status quo, but this would be insanity, "doing the same thing over and over again
and expecting different results," as Albert Einstein put it. It would risk a Japanese or an Italian
style outcome.
Or we can choose to call a spade a spade as Scandinavia did to resolve its banking problems in
the early 90's and the United States did from October 2008 to June 2009, even if only after letting
a significant bank fail. Ireland and Spain, where the recoveries since the global financial crisis
have not been as salubrious as in the United States, have nevertheless fared better than Italy;
they too first adopted measures to pretend and extend troubled bank assets, but eventually
recognized the scale of the problem and dealt with them in a decisive manner.
With our healthy current level of growth and future potential, with our hard-fought macroeconomic
stability, with our youth climbing echelons of entrepreneurial success day after day, with our vast
expanses of rural India that need infrastructure and modernization, and with our levels of poverty
that have steadily declined but still need substantial reduction, we simply don't as a society have
any excuse or moral liberty to let the banking sector wounds fester and result in amputation of
healthier parts of the economy.
How do we embark on a better path? I have been thinking hard of ways to swiftly resolve bank
stressed assets. I have tried to draw on the analysis and documentation of similar episodes in
economic history that I just alluded to, which in some cases I have had the good fortune to
contribute to and learn from.
Let me mention the key principles to successful restructuring that I have managed to glean:
First, there has to be an incentive provided to banks to get on with it and restructure the stressed
assets at a price that clears the market for these assets. If they don't do it in a timely manner,
then the alternative should be costlier in terms of the price they receive.
Second, the ultimate focus of restructuring and of assessment as to whether the restructuring
package being offered to the bank is at the "right" price must be the efficiency and viability of the
restructured asset. Generating the best price for the bank at all costs may only result in cosmetic
changes and risk serial non-performance of the assets.
Third, not all of the resulting bank losses should simply be footed by the government. As a
majority shareholder of public sector banks, the government runs the risk of ending up paying for
it all. It should manage the process at the outset to avoid that outcome. Wherever possible,
private shareholders of banks should also be asked to chip in. Some surgical restructuring
should be undertaken to consolidate and strengthen bank balance-sheets so that private capital
will come in at better valuations. It might have to accept that it is best to let some banks shrink
over time. Divestments should also be on the table. Historically, significant restructuring of
stressed assets has almost always involved significant bank restructuring.
Let me now elaborate "a" plan that employs two different models for stressed assets resolution
and recognizes the concomitant need for bank resolution. I will provide the plan in detail to make
the point that it can be done. What I enunciate should be viewed as an attempt to address all
dimensions of the problem. Its individual parts are, however, not meant to be cherry-picked by or
for the constituency favored by it. That would not work well.
So here it is.
1. Model I: Private Asset Management Company (PAMC). This plan would be suitable for
sectors where the stress is such that assets are likely to have economic value in the short run,
with moderate levels of debt forgiveness. I conjecture based on anecdotal observations that
sectors such as Metals, EPC, Telecom, and Textiles, qualify for this.
1. In terms of timeline, the banking sector will be asked to resolve and restructure, say its 50
largest stressed exposures in these sectors, by December 31, 2017. The rest can follow a
similar plan in six months thereafter.
2. For each asset, turnaround specialists and private investors - other than affiliates of banks
exposed to the asset - will be called upon to propose several resolution plans. Each
resolution plan will lay out sustainable debt and debt-for-equity conversions for banks to
facilitate the issuance of new equity and possibly some new debt to fund the investment
needs. We may have to consider that the sustainable portion of bank debt does not have to
be greater than some minimum amount, so as to allow for a large haircut if necessary for
economic recovery of the asset. Each plan would lay out cash flow prospects, whether the
promoter stays or not, and if yes, with what stake.
3. Each resolution plan would then get vetted and rated by at least two credit rating agencies to
assess the financial health (interest coverage ratio, leverage, etc.), economic health (sector,
margins, etc.), and management quality (promoter or the new team). The rating would be for
the asset and not just for bank debt in case additional debt is issued under the plan.
4. Feasible plans would be those that improve the rating of the asset (presently likely to be "C"
or "D") such that minimum of the two credit ratings is at or above a threshold level, e.g., at
least just below the investment-grade level. The intention is that the asset should not have a
high likelihood of ending up in stress soon after restructuring. Therefore, bank debt
forgiveness may have to be high enough and its converted equity stake low enough so that
new investors can come in with a controlling stake and have incentives to turn the asset
around.
5. Banks can then choose among the feasible plans. Coordination problems can be reduced
by employing RBI's Central Repository for Information on Large Credits (CRLIC) and
requiring that all plans with 2/3rd approval by outstanding bank credit can proceed. The
selected plan would simply be crammed down on any dissenting creditors.
6. Haircuts taken by banks under a feasible plan would be required by government ruling as
being acceptable by the vigilance authorities. Sustainable debt would be upgraded to
standard status for all involved banks. The promoters, however, would have NO choice as to
what restructuring plan is accepted, and may potentially get replaced and/or diluted, as per
the preference of and depending on the price at which the new managing investors come in.
7. At expiration of the timeline, each exposure that is not resolved will be subject to a steep
sector-based haircut for the bank consortium, possibly close to 100%. The promoter will
automatically have to leave. These assets would be put into our new Insolvency and
Bankruptcy Code regime. Alternately, they could be put up for sale to ARCs and private
equity investors who can turn around the assets, levering them up with fresh finance, if
necessary. If designed right, only the worst assets should end up in this scenario. However,
the possibility of ending up here would serve as a credible off-equilibrium threat so that
banks, even the most exposed ones, cannot hold up the restructuring.
There are ways to arrange and concentrate the management of these assets into a single or few
private asset management companies (PAMCs), at the outset or right after restructuring plans
are approved. These companies would resemble a large private-equity fund run by a team of
professional asset managers. Besides bringing in their own capital, they could raise financing
from investors against equity stakes in individual assets or in the fund as a whole, i.e., in the
portfolio of assets. The portfolio approach might help investors diversify risks on individual
assets, improve valuations, and attract greater capital. Bank creditors can set up an oversight
committee to ensure cash flows are flowing in and out of the asset restructuring company as per
the security rights agreed in the restructuring plans.
Let me emphasize that under this model, the asset management company would be entirely
private, like the "Phoenix" structure set up in Spain after 2012 to deal with bank NPAs in
Machinery, Steel and Winery.
Let me now turn to
2. Model II: The National Asset Management Company (NAMC). This plan would be
necessary for sectors where the problem is not just one of excess capacity but possibly also of
economically unviable assets in the short- to medium-term. Take, for example, the Power sector,
where projects have been created to deliver aggregate capacity that is beyond the estimated
peak utilization anytime soon. Many of these are stalled as they have no fuel inputs and little or no
income realization due to lack of credible purchase agreements. Their scrap value is likely small
and the only efficient use is as an ongoing concern. If input and output requirements are sorted
out, and as power consumption needs rise, these projects could eventually provide value. For a
country with per-capita consumption of electricity that is only one-third of the world average, it is
reasonable to expect that a well-run power asset won't end up being a white elephant.
Unlike the first model (PAMC) where asset recovery is likely to be relatively quick, these assets
may require a long time to start generating cash flows. In addition, the government should have
incentives to clear approvals and purchase agreements to make them viable. For both these
reasons, such assets would be best quarantined into a national asset management company
(NAMC). The NAMC would perform several functions to get the ball rolling: raise debt, say
government-guaranteed in part, for its financing needs; possibly raise some more to pay off
banks at a haircut, likely steep but softened by payment in the form of security receipts against
the asset's cash flows; keep a minority equity stake for the government; and, bring in asset
managers such as ARCs and private equity to manage and turn around the assets, individually
or as a portfolio. Infrastructure assets that are also long-lived and create externalities
(development of townships, improvements in overall productivity, etc.) could be resolved in
similar way.
These two models of asset restructuring - one private and the other quasi-government - share
many common features with approaches that have been adopted for resolution of stressed
assets in history: Sweden ("Securum" and "Retriva") in the early 1990's; in the United States in
dealing with the Savings and Loans Crisis ("Resolution Trust Corporation"); in Japan (post-1998
via its Deposit Insurance Corporation); in Indonesia ("IBRA"), Malaysia ("Danaharta") and South
Korea ("KAMCO") to deal with the South East Asian crisis; and more recently, in Ireland
("NAMA"), Spain ("Sareb"), and again the United States ("TARP" along with Fannie Mae, Freddie
Mac and Federal Housing Administration). In fact, the European Banking Authority has proposed
a similar structure to deal with the NPAs of European banks.
Before discussing what all this would imply for bank balance-sheets, let me pose and answer the
question: Are these supposed to be "bad banks"? The answer is NO. While I have previously
used the phrase "bad bank" for such ideas, over time I have come to dislike the title. A "bad bank"
conveys the impression that this entity is to operate as a bank but has bad assets to start with. In
fact, the idea is not to operate these entities as banks at all. Resolution agencies set up as banks
that originate or guarantee lending have ended up being future reckless lenders, notably in the
case of Germany which has often aggregated stressed assets of its Landesbanken into bad
banks. I would argue this has also been the story of Fannie Mae and Freddie Mac with respect to
housing booms and busts in the United States. It would be better to limit the objective of these
asset management companies to orderly resolution of stressed assets with graceful exit
thereafter; in other words, no mission creep over time to do anything else such as raise deposits,
start a new lending portfolio, or help deliver social programs. It is essential to keep the business
model of these entities simple to make them attractive for private investors with expertise for the
main task on hand - asset restructuring.
A moment of reflection clarifies that under both models I proposed, bank balance-sheets would
be freed up from the overhang of stressed assets and allowed to focus on their healthier
activities. The catch is that given the haircuts involved, there will be also be a need for decisive
We keep hearing clarion calls for more and more government funding for
3. Bank resolution.
recapitalization of our public sector banks. Clearly, more recapitalization with government funds
is essential. But few have suggested that the government should adopt measures to economize
its total cost. It should ask in return from banks it recapitalizes significant corrective actions, and
wherever possible, injections of private capital for loss-sharing with the taxpayers. The
expectation of government dole outs might have been set by the past practice of throwing more
money after the bad. Take for instance our bank recapitalization plan of 2008-09 after the global
financial crisis: banks that experienced the worst outcomes received the most capital in a relative
sense to get back to the regulatory capital norms. We must not allocate capital so poorly,
recreate "Heads I Win, Tails the Taxpayer Loses" incentives, and sow the seeds of another
lending excess.
There are better ways to do it building upon some performance targets already set under the
ongoing recapitalization plan. Let me propose five options:
1. Private capital raising: The healthier public sector banks could have raised private capital
by issuing deep discount rights in 2013, and some can still do so now. They must be
required to do this to share the government's burden of recapitalizing banks. It might be a
good way to restore some market discipline and get their shareholders to more seriously
care about bank board and management decisions.
2. Asset sales: Some banks will have assets or loan portfolios that are in good enough shape
to be sold in the market. Assets could be collected across banks and securitized into
tranches that are credit-rated, potentially creating some investor demand for buying it at
different levels of risk profiles. Such asset sales can generate some of the needed
recapitalization.
3. Mergers: As many have pointed out, it is not clear we need so many public sector banks.
The system will be better off if they are consolidated into fewer but healthier banks. After all,
we do have cooperative banks and micro-finance institutions to provide community-level
banking. So some banks can be merged, as a quid pro quo for timely government capital
injection into the combined entity. It would offer the opportunity to rejig management
responsibility away from those who have under-performed or dragged their feet the most.
Synergies in lending activity and branch locations could be identified to economize on
intermediation costs, allowing sales of real estate where branches are redundant. Voluntary
retirement schemes (VRS) can be offered to manage headcount and usher in a younger,
digitally-savvy talent pool into these banks.
4. Tough prompt corrective action: Undercapitalized banks could be shown some tough
love and be subjected to corrective action. Such action should entail no further growth in
deposit base and lending. This will also restore some market discipline in deposit migration,
away from the weakest public sector banks that have price to book equity (P/B) ratios of
around 0.5 or lower, to healthier public sector banks (P/B ratios around 1) and private sector
banks (P/B ratios of 1.5 to 4.5). The market has given its verdict as to where the growth
potential in our banking sector lies and deposit growth should be allowed to reflect that.
5. Undertaking these measures would improve overall banking sector health
Divestments:
and market-to-book valuations, creating an opportune time for the government to divest
some of its ownership of the restructured banks. This would also reduce the overall amount
the government needs to inject.
There are many details to work out. But I hope this provides a start. It is going to require being
balanced and creative, holistic and uncompromising, in achieving the end goal. Piece by piece
approach with all discretion given to banks simply hasn't worked. Time is of the essence if we
are to restore corporate investment and job creation.
Sustainable progress in an economy cannot occur when a set of players is allowed to hold up
the efficient allocation of capital. Their owning a smaller share of assets can help unlock
economic value; their hogging of these assets will only lead to further value-erosion.
I hope we can work together and collectively make the right choice.
Thank you for your kind attention.