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The Festering Twin Balance Sheet Problem

Introduction

  • Last Year, Banks reported that nonperforming assets had soared, to such an extent that provisioning had overwhelmed operating earnings. As a result, net income had plunged deeply into the red.
  • Normally, nonperforming assets (NPAs) soar when there is an economic crisis, triggering widespread bankruptcies. This is precisely what happened in East Asia during 1997-98 and the US and UK in 2008-09. But there was no economic crisis in India; to the contrary, GDP was growing at a world-beating pace. Nor had there been any major calamity in the corporate sector; no large firm had gone bankrupt
  • The explanation
    • The RBI had conducted an Asset Quality Review (AQR), following which banks cleaned up their books, sweeping away the debris that had accumulated over many years and mandated adjustments were completed in March.  But NPAs nonetheless continued to climb, reaching 9 percent of total advances by September 2016 double their year-ago level.
    • More than four-fifths of the non-performing assets were in the public sector banks, where the NPA ratio had reached almost 12 percent
    • on the corporate side, Credit Suisse reported that around 40 percent of the corporate debt it monitored was owed by companies which had an interest coverage ratio less than 1, meaning they did not earn enough to pay the interest obligations on their loans (What is Interest Coverage Ratio?)
  • It became clear that India was suffering from a “twin balance sheet problem” where both the banking and  corporate sectors were under stress Read about Twin Balance sheet Problem in CHAPTER 2 THE CHAKRAVYUHA CHALLENGE OF THE INDIAN ECONOMY also it was explained in detail in Economic survey of 2014-15
  • At its current level, India’s NPA ratio is higher than any other major emerging market (with the exception of Russia), higher even than the peak levels seen in Korea during the East Asian crisis
  • Typically, countries with a twin balance sheet (TBS) problem follow a standard path. This model, however, doesn’t seem to fit India’s case
  • Standard Case: Over-expansion during Boom– Defaulting in Crisis– Hampering Growth
  • India’s case
  •  India had boomed during the mid-2000s and sailed through the GFC largely unscathed, with only a brief interruption in growth before it resumed at a rapid rate. This happened because Indian companies and banks had avoided the boom period mistakes made by their counterparts abroad.
  • More precisely, in this view, they were prevented from accumulating too much leverage, because prudential restrictions kept bank credit from expanding excessively during the boom, while capital controls prevented an undue recourse to foreign loans.
  • In other TBS cases, growth was derailed because high NPA levels had triggered banking crises.
  • But this has not happened in India. In fact, there has not even been a hint of pressure on the banking system
  •  And all for a very good reason: because the bulk of the problem has been concentrated in the public sector banks, which not only hold their own capital but are ultimately backed by the government, whose resources are more than sufficient to deal with the NPA problem. As a result, creditors have retained complete confidence in the banking system
  • For some years, it seemed possible to regard TBS as a minor problem, but Growth will not solve the problems of the stressed firms; to the contrary, the problems of the stressed firms might actually imperil growth.
  • To avoid this outcome, a formal agency may be needed to resolve the large bad debt cases
    • the same solution the East Asian countries employed after they were hit by severe TBS problems in the 1990s.
    • time may have arrived to create a ‘Public Sector Asset Rehabilitation Agency’
    • Public Sector Asset Rehabilitation Agency NPA

What went wrong? (This is the story of NPA 😃 )

  • The origins of the NPA problem lie in decisions taken during the mid-2000s. During that period, economies all over the world were booming, almost no country more than India, where GDP growth had surged to 9-10 percent per annum.Firms made plans accordingly. They launched new projects worth lakhs of crores, particularly in infrastructure-related areas such as power generation, steel, and telecoms, setting off the biggest investment boom in the country’s history. Within the span of four short years, the investment-GDP ratio had soared by 11 percentage points, reaching over 38 percent by 2007-08 This investment was financed by an astonishing credit boom, also the largest in the nation’s history, one that was sizable even compared to other large credit booms internationally. There were also large inflows of funding from overseas, with capital inflows in 2007-08 reaching 9 percent of GDP. All of this added up to an extraordinary increase in the debt of non-financial corporations. But just as companies were taking on more risk, things started to go wrong. Costs soared far above budgeted levels, as securing land and environmental clearances proved much more difficult and time-consuming than expected. At the same time, forecast revenues collapsed after the GFC; projects that had been built around the assumption that growth would continue at double-digit levels were suddenly confronted with growth rates half that level and financing costs increased sharply
  • Firms that borrowed domestically suffered when the RBI increased interest rates to quell double-digit inflation
  • And firms that had borrowed abroad when the rupee was trading around Rs 40/dollar were hit hard when the rupee depreciated, forcing them to repay their debts at exchange rates closer to Rs 60-70/ dollar.
  • Higher costs, lower revenues, greater financing costs — all squeezed corporate cash flow, quickly leading to debt servicing problems
  • They lived happily ever after 😃 

What Explains the Twin Balance Sheet Syndrome with Indian Characteristics?

  • Contrary to conventional wisdom, India did indeed follow the standard path to the TBS problem: a surge of borrowing, leading to over leverage and debt servicing problems.
  • What distinguished India from other countries was the consequence of TBS?
    • Even as Indian balance sheets have suffered structural damage the impact on growth has been quite modest. TBS did not lead to economic stagnation
  • To the contrary, it co-existed with strong levels of aggregate domestic demand, as reflected in high levels of growth despite very weak exports and moderate, at times high, levels of inflation.
  • What could possibly explain India’s exceptional experience?
    • The unusual structure of its banking system which ensured there would be no financial crisis
    • other factors includes
      • India has long suffered from exceptionally severe supply constraints, as the lack of infrastructure has hindered the expansion of manufacturing and even some service activities. As a result, there was ample room for the economy to grow after the GFC
    • x Instead, the strategy was, as the saying goes, to “give time to time

Is the strategy sustainable?

  • The inherent dynamism of the Indian economy would carry the impaired companies and banks along until the rising tide finally lifted all boats or covered the rocky shoals
  • In “containment” scenario, the NPAs would merely need to be limited in nominal terms. Once this is done, they would swiftly shrink as a share of the economy and a proportion of bank balance sheets, since GDP is growing at a nominal rate of more than 10 percent.
  • Countries with TBS problems tend to have low investment, as stressed companies reduce their new investments to conserve cash flow, while stressed banks are unable to assume new lending risks
  • And this seems to be happening in India, as well. Private investment, which had been soaring at the height of the boom, slowed sharply to a 5 percent growth rate by 2010-11. By 2015-16, it had actually started to shrink, and in 2016-17 so far it seems to have contracted by more than 7 percent
  • To cushion the impact on the overall economy, public investment has been stepped up considerably, but this has still not been sufficient to arrest a fall in overall investment.
  • In the short run, the economy can continue to expand briskly on the back of consumption, with firms fulfilling demand by using the capacity that was built up during the boom years. But over the medium term, the downward trend in investment will need to be reversed.
  • Banks around the world typically strive for a return of assets (ROA) of 1.5 per cent or above But Indian public sector banks are much below this international norm. In fact, their ROA has turned negative over the past two years
    • And as a result, investors are no longer willing to pay “full price” for public sector bank shares: share prices have fallen to just two-thirds of their book value
    • Public sector banks have responded to their difficult financial situation in the standard way. They have tried to protect their capital positions by minimising the new risks they are taking, that is by scaling back their new lending
    • As a result, total credit to the corporate sector has been decelerating steadily. In real terms, such credit growth is now negative, the lowest it has been in 23 years
    • This gradual tightening of the credit constraint has been felt rather unevenly across the economy. Household credit, where default has been minimal and where private sector banks have a comparative lending advantage, has been expanding exceptionally rapidly, fueling the growth of consumption.
    • Agricultural loans have also continued at a good pace, as they have been protected by the priority sector lending requirements
  • But corporate and MSMEs have been hit several. Real loan growth to MSMEs slowed significantly in 2014-15 and actually turned negative during the past two fiscal years
  • Meanwhile, loans to corporates in the stressed sectors remained buoyant for some time, in line with the strategy of keeping them afloat, but even for this group loan growth turned sharply negative in real terms during 2016-17
  • Public sector banks have also responded to their stress in another standard way. They have tried to compensate for the lack of earnings from the non-performing part of their portfolio by widening their interest margins
  • Inevitably, the good borrowers are seeking funding elsewhere: from the commercial paper market for their short-term needs and the bond market for longer-term financing.
  • This could, in a way, be considered desirable, as it is helping develop the country’s capital markets. But if this trend of disintermediation continues, it will leave much of the “tax” burden on the MSMEs, who cannot decamp for the bond markets, since they require the knowledge intensive type of lending that is provided only by banks.
  • This could, in a way, be considered desirable, as it is helping develop the country’s capital markets. But if this trend of disintermediation continues, it will leave much of the “tax” burden on the MSMEs, who cannot decamp for the bond markets, since they require the knowledge intensive type of lending that is provided only by banks.

What needs to be done?

  • The bigger problem is that the key elements needed for resolution are still not firmly in place including,
  • Loss recognition.
    • The AQR was meant to force banks to recognise the true state of their balance sheets. Banks nonetheless continue to evergreen loans,
  • Coordination.
    • The RBI has encouraged creditors to come together in Joint Lenders Forums, where decisions can be taken by 75 percent of creditors by value and 60 percent by number. But reaching agreement in these Forums has proved difficult
  • Proper incentives
    • The S4A scheme recognises that large debt reductions will be needed to restore viability in many cases. But public sector bankers are reluctant to grant write-downs because there are no rewards for doing so. To the contrary, Major write-downs can attract the attention of investigative agencies.
    • To address this problem, the Bank Board Bureau (BBB) has created an Oversight Committee which can vet and certify write-down proposals.
  • Capital.
    • The government has promised under the Indradhanush scheme to infuse Rs 70,000 crores of capital into the public sector banks by 2018-19. But this is far from sufficient, and inherently so, because there is a principal-agent problem, arising from the separation of the institution of financial responsibility (the government) from its decision-making agent (the state banks).
    • Stressed assets are concentrated in remarkably few borrowers, with a mere 50 companies accounting for 71 percent of the debt owed by IC1 debtors.
  • The large, over-indebted borrowers are particularly difficult to resolve, for several deep-seated reasons:
  • Severe viability issues.
    • large write-offs will be required to restore viability to the large IC1 companies.
  • Acute coordination failures.
    • Large debtors have many creditors, who need to agree on a strategy
  • Serious incentive problems.
  • Insufficient capital.
    • In some ways, going down the path of bankruptcy would make sense for cases where the write-down needs are particularly large, which makes them ill-suited for S4A and SDR in the first place.
  • One possible strategy would be to create a ‘Public Sector Asset Rehabilitation Agency’ (PARA), charged with working out the largest and most complex cases.
  • Such an approach could eliminate most of the obstacles currently plaguing loan resolution.
 From where would this funding come?
  • Part would need to come from government issues of securities
  •  The second source of funding could be the capital markets. if the PARA were to be structured in a way that would encourage the private sector to take up an equity share.
  • A third source of capital could be the RBI.
    • The RBI would (in effect) transfer some of the government securities it is currently holding to public sector banks and PARA.
    • As a result, the RBI’s capital would decrease, while that of the banks and PARA would increase but establishing a PARA is not a panacea
    • First, there needs to be a readiness to confront the losses that have already occurred in the banking system, and accept the political consequences of dealing with with the problem.
    • Second, the PARA needs to follow commercial rather than political principles
    • It would also need a clear mandate of maximising recoveries within a specified, reasonable short time period
    •  The third issue is pricing. If loans are transferred at inflated prices, banks would be transferring losses to the Rehabilitation Agency. As a result, private sector banks could not be allowed to participate – and then co-ordination issues would remain – while private capital would not want to invest in the Agency since PARA would make losses.

Conclusion

  • Start with the area where the least amount of progress has occurred: the first R, Reform.
    • Indeed, once the Twin Balance Sheet problem is resolved, there could be significant moral hazard problems. Newly cleaned up balance sheets may simply encourage bank managers to lend freely, ignoring the lessons of the past.
    • The structural reform aimed at preventing this can take many forms but serious consideration must also be given to the issue of government majority ownership in the public sector banks.
  • The second R, Recognition.
    • banks have realised that the financial position of the debtors has deteriorated to such an extent that many will not be able to recover.
    • With higher NPAs has come higher provisioning, which has eaten into banks’ capital base. As a result, banks will need to be recapitalised – the third R –– much of which will need to be funded by the government, at least for the public sector banks
    • Rather, the key issue is the fourth R: Resolution. For even if the public sector banks are recapitalised, they are unlikely to increase their lending until they truly know the losses they will suffer on their bad loans. Nor will the largely stressed borrowers be able to increase their investment until their financial positions have been rectified.

Case of East Asian Countries

  • After the 1990s crisis, East Asian countries were able to resolve most of the large cases within two years.
  • One reason, of course, was that the East Asian countries were under much more pressure: they were in crisis, whereas India has continued to grow rapidly.
  • But a second reason why East Asia was able to clean up its problem debts so quickly was that it had more efficient mechanisms.
  • India has been pursuing a decentralised approach, under which individual banks have been taking restructuring decisions, subject to considerable constraint and distorted incentive
  • In contrast, East Asia adopted a centralised strategy, which allowed debt problems to be worked out quickly using the vehicle of public asset rehabilitation companies. Perhaps it is time for India to consider the same approach.

RBI’s Major Steps

  • The 5/25 Refinancing of Infrastructure Scheme:
    • Under this scheme, lenders were allowed to extend amortisation periods to 25 years with interest rates adjusted every 5 years, so as to match the funding period with the long gestation and productive life of these projects.
    • The scheme thus aimed to improve the credit profile and liquidity position of borrowers, while allowing banks to treat these loans as standard in their balance sheets, reducing provisioning costs.
  • Private Asset Reconstruction Companies (ARCs):
    • ARCs were introduced to India under the SARFAESI Act (2002), with the notion that as specialists in the task of resolving problem loans, they could relieve banks of this burden.
    • ARCs have found it difficult to resolve the assets they have purchased, so they are only willing to purchase loans at low prices.
    • As a result, banks have been unwilling to sell them loans on a large scale.
  • Strategic Debt Restructuring (SDR):
    •  provide an opportunity to banks to convert debt of companies
    • to 51 percent equity and sell them to the highest bidders, subject to authorization by existing shareholders.
    • An 18-month period was envisaged for these transactions, during which the loans could be classified as performing.
    • But as of end-December 2016, only two sales had materialised, in part because many firms remained financially unviable,
  • Asset Quality Review (AQR)
    •  the RBI emphasised AQR, to verify that banks were
    • assessing loans in line with RBI loan classification rules. Any deviations from such rules were to be rectified by March 2016.
    • Sustainable Structuring of Stressed Assets (S4A)
    • Under this arrangement, introduced in June 2016, an independent agency hired by the banks will decide on how much of the stressed debt of a company is ‘sustainable
  • .