What ails India's financial system?

Image: Reuters

The past fortnight was a hectic one for India’s central bank. It first placed 93-year-old lender Lakshmi Vilas Bank (LVB) under moratorium and forced its merger with the India arm of Singapore-headquartered DBS Bank. Three days later it ordered a special audit of Srei Infrastructure Finance Ltd and its subsidiary Srei Equipment Finance Ltd; details of the audit are awaited.

Meanwhile, the Reserve Bank of India (RBI) is monitoring the top 50 non-banking financial companies (NBFCs), which it considers systemically important to the financial ecosystem. In March, the apex bank imposed a moratorium on the beleaguered Yes Bank, some nine months after it did the same with the Punjab and Maharashtra Cooperative Bank (PMC). According to a report in Moneycontrol in June 2020, 44 co-operative banks had been put under the RBI’s watch list in the first half of the calendar year.

“The RBI is keeping a close watch, but in my mind one should act faster,” says Ashvin Parekh, managing partner at consulting firm Ashvin Parekh Advisory.  For instance, LVB had been reporting widening losses for the past two years on account of bad loans and provisioning.

Parekh, who has been working in the financial ecosystem for the last four decades, is quick to point how the RBI’s asset quality review (AQR) opened the Pandora’s Box of non-performing assets (NPAs) that went unreported. 

In 2015, Raghuram Rajan, the then RBI governor, introduced the AQR policy which forced banks to stringently recognize NPAs, and stop evergreening of books. For example, as part of the first AQR, the RBI had found a large divergence of Rs4,176 crore in the reported GNPAs of Yes Bank for 2015-16.

“After the economy started slowing down in 2014-15, the banking system started facing problems and it could not support the NBFCs. The risk weightage ratio in terms of lending changed the whole dynamics for NBFCs because they were heavily dependent on banks for their survival,” Parekh adds.

Since the collapse of Infrastructure Leasing & Financial Services (IL&FS) in September 2018, multiple banks, cooperative banks and NBFCs have come under the regulator’s scanner. In the last three years, several massive banking frauds have been reported. Read here.

To start with the NBFC crisis, while only two have been taken to the bankruptcy process—IL&FS and DHFL Ltd—there are half a dozen substantial cases where creditors are trying to find a resolution to recover loans from the likes of Altico Capital, Reliance Capital, Religare Home Finance. The failure of shadow financier IL&FS broke the back of NBFCs in India, which were heavy lenders to real estate developers.

“It is no secret that NBFCs would keep passing loans to each other but overnight, nobody wanted to buy anything (loans from each other). Everyone was stuck. While the loans to developers have come down, what we have seen is that NBFCs are now charging more interest while refinancing each other and the tenures of such loans are becoming shorter,” says the head of an NBFC, who did not want to be identified.

According to data compiled by Propstack, a real estate data platform, during calendar year 2019, banks and NBFCs together lent Rs1.27 lakh crore to developers, the lowest in five years; lending had been on an upward curve since 2015. In his book Overdraft released recently, former RBI governor Urjit Patel mentions that one-third of banking loans to the realty sector are under moratorium.

“There are a few NBFCs that are under stress since the last year; they have found it difficult to raise capital from capital markets but have managed to do so from banks. What has clearly emerged through this entire financial crisis is that corporate governance and promoter issues are the biggest concerns in Indian financial institutions,” says a senior executive of a ratings agency, who did not wish to be named. 

Case in point: In February 2019, the central bank found no divergence in provisioning norms of Yes Bank for 2017-18. By March 2020, it had superseded the board of Yes Bank and also placed it under moratorium. In a long statement, RBI had cited the bank’s continuous inability to raise capital, a steady decline in financial position, corporate governance issues and practices in recent years to be some of the reasons for this decision. “They need to act faster, they can’t wait for years to take a call for a clean-up. Also, the moment you notice there is a question mark on credibility of promoters, you have to take tough decisions,” adds the rating executive.

He reckons that there should be different norms of provisioning and capital adequacy ratios for NBFCs. “They cannot be straitjacketed; those who grew their book aggressively, especially in real estate, need different rules as compared to NBFCs which are more focused on gold loans, MFI loans etc.”

In the last one year, NBFCs became creative in how they sold loans to each other to try and clean their books. While on paper it doesn’t look that they have taken hair-cuts, many NBFCs had started offloading loans by offering structured payouts. Read here. 

While RBI is yet to crack the whip on NBFCs on a lot of their practices, this year it has set a few precedents when it comes to Tier 1 and Tier II bonds of banks. Earlier, it asked Yes Bank to write down Rs8,400 crore Additional Tier 1 (AT1) bonds; it has now asked LVB to write down Tier II bonds worth Rs 318.2 crore.

“The RBI has set a precedent with the proposed write-off as it is the first time a Tier II bond is being written off. Investors should factor in the risk in Basel III instruments as these instruments can be completely written off in case the bank gets into trouble,” says Anil Gupta, vice president for financial sector ratings at ICRA. Gupta added that they expect the risk premiums for such instruments to increase for weaker private banks.

While the recent past isn’t glorious, the future doesn’t look that great either. Due to the coronavirus pandemic, the RBI had asked banks to offer moratorium to its customers for loans up to Rs2 crore. The impact of this moratorium will have significant consequences, say experts. As per RBI’s financial stability report in July this year, nearly half of the customers accounting for around half of outstanding bank loans opted to avail moratorium on their loans.

It further said that the macro stress tests for credit risk indicate that the GNPA ratio of all scheduled commercial banks may increase from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 under the baseline scenario. The ratio may escalate to 14.7 per cent under a very severely stressed scenario.

“Repayments by borrowers were better in September than the month before but we expect actual stress to start reflecting in little way in Q3FY21 results and more pronounced by first two quarters of FY2022 results,” says Gupta.

“For NBFCs and HFCs, the asset quality ratio could weaken quite sharply with NPAs increasing by 120-300 basis points,” adds Gupta. ICRA expects NPAs to rise to 11.1-11.4 percent by March 2021 for public sector banks, up from 10.7 percent in March 2020; and to 5.7-6.4 percent from 4.2 percent  for private banks. 

While the RBI grapples with these financial institutions, Patel, in his book, mentions another elephant in the room, “What is cause for concern is that in October and December 2019 ten banks (of which nine were government banks) disclosed that for the previous financial year the regulator, upon inspection, had found their NPAs to be higher than reported a few months prior in the annual financial accounts. A back-of-the-envelope calculation implies that the GNPA ratio for public banks could be about 0.3 per cent higher than the estimate reported for end March 2019.”

These days, most experts in India are divided in their opinion on one of the topics of the recently-released report of an internal working group (IWG) to review bank ownership guideline, allowing Indian corporate houses into banking.

In an email response, Viral Acharya, previously deputy governor of RBI, cited the research paper that he and Rajan have authored on this topic. The paper questions why the RBI taking this step. “First, industrial houses need financing, and they can get it easily, with no questions asked, if they have an in-house bank. The history of such connected lending is invariably disastrous – how can the bank make good loans when it is owned by the borrower?” the paper cited. “Moreover, regulators can succumb to either political pressure or the urgency of the moment. The RBI recognised the risk of excessive exposures to specific houses in 2016 by announcing group exposure norms, which limit how much exposure the banking system can have to specific industrial houses. These norms have been relaxed recently.”

The duo further questions if this is being done to find more bidders when it finally plans to privatise some of the public sector banks. But they ascertain that it would be a mistake to do so. For now, the RBI may be bracing itself to contain a potential pandemic-induced NPA crisis. Allowing private corporations into the banking sector may have its advantages (as well as cons), but perhaps this may not be the best time to go ahead with such ‘reform’.