The new government will assume office end-May. Several columns have been written advising the new government to pursue structural reforms. Needless to emphasise that a sound banking system is a sine qua non to carry forward structural reforms initiated during last five years, after policy paralysis in the previous five years. Despite several initiatives by the Centre and the Reserve Bank of India, the problem of non-performing assets (NPAs) in the Indian banking system remains an unfinished agenda.

The closing balance of NPAs of all scheduled commercial banks (SCBs), which was close to ₹8 trillion in 2016-17, rose to ₹10.4 trillion in 2017-18. Gross NPAs as per cent of gross advances of SCBs increased from 9.3 per cent (11.7 per cent for public sector banks) in 2016-17 to 11.2 per cent (14.6 per cent for PSBs) in 2017-18, notwithstanding recovery of ₹1.3 trillion and write-offs of ₹1.6 trillion during 2017-18. By September 2018, NPA ratios declined marginally. The RBI’s next Financial Stability Report, due in June 2019, will give the latest information on NPAs for 2018-19.

Corporate weakness

The NPA problem of the banking sector is essentially a reflection of weaknesses of corporate sector balance sheets. Many corporates were hand-in-glove with their bankers to roll-over their sticky advances as performing assets through the process of ever-greening year-after-year.

Had there been no Asset Quality Review (AQR) since 2015, weakness of balance sheets of both commercial banks and the corporate sector would have gone unnoticed for a longer period, thereby building up financial sector vulnerability. The Insolvency and Bankruptcy Code (IBC), enacted in May 2016 by the government, was a game changer to resolve the twin balance-sheet problem.

While cleaning of balance sheets of both banks and the corporate sector must be done in a time-bound manner, there is resistance emerging from the corporate sector. Firms have approached the Supreme Court for relief against liquidation under IBC. While the apex court has fully endorsed the IBC, the February 12, 2018, circular of the RBI on resolution of stressed assets has been declared ultra vires . Beaten by the Supreme Court, the RBI is in the process of revising its circular on NPA resolution. Any relaxation of AQR, resolution mechanism, or even prudential regulations may be a retrograde step, which should be avoided for a sound banking system in India.

It is true that there is a need to distinguish between wilful defaulters and defaulters due to adverse circumstances. Freedom given to banks earlier to restructure debts through several schemes did not yield desired result. Before the AQR, debt restructuring by banks was essentially a new form of ever-greening. Banks are not charitable organisations. Their activities for lending to genuine borrowers will be constrained by large accumulation of NPAs.

India’s growth scenario continues to be better than many other developing countries. What has gone wrong with the industries so that they could not service their debts? Have they diverted funds for unproductive purposes? Have they messed up corporate governance leading to fall in profit that is insufficient to service their debt? Is it a cash-flow problem or an insolvency problem? If it is an insolvency problem, there is no point in delaying insolvency proceedings under IBC. Delay in resolution under IBC would erode the value of collateral leading to bigger loss to the creditors.

NCDs, equities

In most cases of debt restructuring, it is observed that outstanding advances are converted into either non-convertible debentures (NCDs) or equities issued by debtors. If it is NCD, the creditor is assured of a fixed return in lieu of interest on outstanding loan. This may be debtor-friendly if yield on NCD is lower than interest rate on the outstanding loan. If it is equity, banks become the owner of the company. Bankers are anyway not good entrepreneurs. Moreover, creditors have regulatory limit for investment in non-SLR securities.

This model of restructuring is not ideal to the extent that the cash-flow problem of the borrower is not addressed. He may default in servicing NCDs as well. In order to service NCDs, many corporates have been issuing commercial papers and corporate debts on a private-placement basis. This can at the best delay the default rather than resolve the cash-flow problem of the borrower.

The burden of restructuring of debt should not entirely fall on banks. Borrowers may have to bring in their contributions for a credible resolution. If banks can offer a credible resolution plan, borrowers should accept it before the case is referred to the National Company Law Tribunal (NCLT). If debtors do not agree with the creditors for the resolution, there is no other way but to proceed for liquidation. Unless there is a threat of liquidation, credit discipline cannot be imparted on borrowers.

RBI’s excess capital

Bulk of the infrastructure loans can be securitised and sold to an asset reconstruction companies (ARCs) with appropriate haircut. If private sector ARCs are not equipped to buy large infrastructure loans, the government may consider setting up an ARC in the public sector. Pressure on the government to recapitalise banks may be reduced if a public sector ARC is prepared to take over sticky advances of banks, particularly those lent to the infrastructure sector.

The Committee on Economic Capital Framework of the RBI, headed by Bimal Jalan, is due to submit its report by June 2019. The appropriate level of capital for a central bank is a debatable issue. Nevertheless, there is a high probability that the Bimal Jalan Committee would estimate excess capital held by the RBI. Instead of transferring RBI’s excess capital to the government, this can be utilised for setting up of an ARC in the public sector, which can clean up the NPAs of PSBs.

The writer is a Visiting Fellow at IGIDR and former Principal Adviser of the Monetary Policy Department of RBI

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