Raghuram Rajan’s Take on India's NPA Crisis

Note to Parliamentary Estimates Committee on Bank NPAs

1) Why did the NPAs occur?

I have not seen a study that has unearthed the precise weight of all the factors responsible, but
here is a list of the main ones.

Over-optimism:

A larger number of bad loans were originated in the period 2006-2008 when economic growth
was strong, and previous infrastructure projects such as power plants had been completed on
time and within budget. It is at such times that banks make mistakes. They extrapolate past
growth and performance to the future. So they are willing to accept higher leverage in projects,
and less promoter equity. Indeed, sometimes banks signed up to lend based on project reports
by the promoter’s investment bank, without doing their own due diligence. One promoter told me

about how he was pursued then by banks waving checkbooks, asking him to name the amount
he wanted. This is the historic phenomenon of irrational exuberance, common across countries
at such a phase in the cycle.

Slow Growth

Unfortunately, growth does not always take place as expected. The years of strong global growth
before the global financial crisis were followed by a slowdown, which extended even to India,
showing how much more integrated we had become with the world. Strong demand projections
for various projects were shown to be increasingly unrealistic as domestic demand slowed down.

Government Permissions and Foot-Dragging

A variety of governance problems such as the suspect allocation of coal mines coupled with the
fear of investigation slowed down government decision making in Delhi, both in the UPA and the
subsequent NDA governments. Project cost overruns escalated for stalled projects and
they became increasingly unable to service debt. The continuing travails of the stranded power
plants, even though India is short of power, suggests government decision making has not picked
up sufficient pace to date.

Loss of Promoter and Banker Interest

Once projects got delayed enough that the promoter had little equity left in the project, he lost
interest. Ideally, projects should be restructured at such times, with banks writing down bank debt
that is uncollectable, and promoters bringing in more equity, under the threat that they wou ld
otherwise lose their project. Unfortunately, until the Bankruptcy Code was enacted, bankers had
little ability to threaten promoters (see later), even incompetent or unscrupulous ones, with loss
of their project. Writing down the debt was then simply a gift to promoters, and no banker wanted
to take the risk of doing so and inviting the attention of the investigative agencies. Stalled projects
continued as “zombie” projects, neither dead nor alive (“zombie” is a technical term used in the
banking literature).

It was in everyone’s interest to extend the loan by making additional loans to enable the promoter
to pay interest and pretend it was performing. The promoter had no need to bring in equity, the
banker did not have to restructure and recognise losses or declare the loan NPA and spoil his
profitability, the government had no need to infuse capital. In reality though, because the loan
was actually non-performing, bank profitability was illusory, and the size of losses on its balance
sheet were ballooning because no interest was actually coming in. Unless the project
miraculously recovered on its own – and with only a few exceptions, no one was seriously trying
to put it back on track – this was deceptive accounting. It postponed the day of reckoning into the
future, but there would be such a day.

Malfeasance

How important was malfeasance and corruption in the NPA problem? Undoubtedly, there was
some, but it is hard to tell banker exuberance, incompetence, and corruption apart. Clearly,
bankers were overconfident and probably did too little due diligence for some of these loans.
Many did no independent analysis, and placed excessive reliance on SBI Caps and IDBI to do the
necessary due diligence. Such outsourcing of analysis is a weakness in the system, and multiplies
the possibilities for undue influence.

Banker performance after the initial loans were made were also not up to the mark. Unscrupulous
promoters who inflated the cost of capital equipment through over-invoicing were rarely checked.
Public sector bankers continued financing promoters even while private sector banks were getting
out, suggesting their monitoring of promoter and project health was inadequate. Too many
bankers put yet more money for additional “balancing” equipment, even though the initial project
was heavily underwater, and the promoter’s intent suspect. Finally, too many loans were made
to well-connected promoters who have a history of defaulting on their loans.

Yet, unless we can determine the unaccounted wealth of bankers, I hesitate to say a significant
element was corruption. Rather than attempting to hold bankers responsible for specific loans, I
think bank boards and investigative agencies must look for a pattern of bad loans that bank CEOs
were responsible for – some banks went from healthy to critically undercapitalized under the term
of a single CEO. Then they must look for unaccounted assets with that CEO. Only then should
there be a presumption that there was corruption.

Fraud

The size of frauds in the public sector banking system have been increasing, though still small
relative to the overall volume of NPAs. Frauds are different from normal NPAs in that the loss is
because of a patently illegal action, by either the borrower or the banker. Unfortunately, the
system has been singularly ineffective in bringing even a single high profile fraudster to book. As
a result, fraud is not discouraged.

The investigative agencies blame the banks for labeling frauds much after the fraud has actually
taken place, the bankers are slow because they know that once they call a transaction a fraud,
they will be subject to harassment by the investigative agencies, without substantial progress in
catching the crooks. The RBI set up a fraud monitoring cell when I was Governor to coordinate
the early reporting of fraud cases to the investigative agencies. I also sent a list of high
profile cases to the PMO urging that we coordinate action to bring at least one or two to book. I
am not aware of progress on this front. This is a matter that should be addressed with urgency.

2) Why Recognize Bad Loans?

There are two polar approaches to loan stress. One is to apply band aids to keep the loan current,
and hope that time and growth will set the project back on track. Sometimes this works. But most
of the time, the low growth that precipitated the stress persists. Lending intended to ke
ep the original loan current (also called “ever-greening”) grows. Facing large and potentially
unpayable debt, the promoter loses interest, does little to fix existing problems, and the project
goes into further losses.

An alternative approach is to try to put the stressed project back on track rather than
simply applying band aids. This may require deep surgery. Existing loans may have to be written
down somewhat because of the changed circumstances since they were sanctioned. If loans are
written down, the promoter brings in more equity, and other stakeholders like the tariff authorities
or the local government chip in, the project may have a strong chance of revival, and the promoter
will be incentivized to try his utmost to put it back on track.

But to do deep surgery such as restructuring or writing down loans, the bank has to recognize it
has a problem – classify the asset as a Non Performing Asset (NPA). Think therefore of the NPA
classification as an anesthetic that allows the bank to perform extensive necessary surgery to set
the project back on its feet. If the bank wants to pretend that everything is all right with the loan,
it can only apply band aids – for any more drastic action would require NPA classification.

Loan classification is merely good accounting – it reflects what the true value of the loan might
be. It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely
losses. If the losses do not materialize, the bank can write back provisioning to profits. If the
losses do materialize, the bank does not have to suddenly declare a big loss, it can set the losses
against the prudential provisions it has made. Thus the bank balance sheet then represents a
true and fair picture of the bank’s health, as a bank balance sheet is meant to. Of course, we can
postpone the
day of reckoning with regulatory forbearance. But unless conditions in the industry impr
ove suddenly and dramatically, the bank balance sheets present a distorted picture of health, and
the eventual hole becomes bigger.

3) Why did the RBI set up various schemes to restructure debt and how effective were
they?

When I took office it was clear that bankers had very little power to recover from large promoters.
The Debts Recovery Tribunals (DRTs) were set up under the Recovery of Debts Due to Banks
and Financial Institutions (RDDBFI) Act, 1993 to help banks and financial institutions recover their
dues speedily without being subject to the lengthy procedures of usual civil courts. The
Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests
(SARFAESI) Act, 2002 went a step further by enabling banks and some financial institutions to
enforce their security interest and recover dues even without approaching the DRTs.

Yet the amount banks recover from defaulted debt was both meager and long delayed. The
amount recovered from cases decided in 2013-14 under DRTs was Rs. 30590 crores while the
outstanding value of debt sought to be recovered was a huge Rs 2,36,600 crores. Thus recovery
was only 13% of the amount at stake. Worse, even though the law indicated that cases before
the DRT should be disposed off in 6 months, only about a fourth of the cases pending at the
beginning of the year were disposed off during the year – suggesting a four year wait even if the
tribunals focused only on old cases. However, in 2013-14, the number of new cases filed during
the year were about one and a half times the cases disposed off during the year. Thus backlogs
and delays were growing, not coming down. A cautionary point as we welcome the NCLT’s efforts
is that the DRTs and SARFAESI were initially successful, before they became overburdened as
large promoters understood how to game them.

The inefficient loan recovery system gave promoters tremendous power over lenders. Not only
could they play one lender off against another by threatening to divert payments to the favored
bank, they could also refuse to pay unless the lender brought in more money, especially if the
lender feared the loan becoming an NPA. Sometimes promoters offered low one-time settlements
(OTS) knowing that the system would allow the banks to collect even secured loans only after
years. Effectively, bank loans in such a system become equity, with a tough promoter enjoying
the upside in good times, and forcing banks to absorb losses in bad times, even while he holds
on to his equity.

The RBI decided we needed to empower the banks and improve on the ineffective CDR system
then in place. Our first task was to make sure that all banks had information on who had lent to a
borrower. So we created a large loan database (CRILC) that included all loans over Rs. 5 cro re,
which we shared with all the banks. The CRILC data included the status of each loan – reflecting
whether it was performing, already an NPA or going towards NPA. That database allowed banks
to identify early warning signs of distress in a borrower such as habitual late payments to a
segment of lenders.

The next step was to coordinate the lenders through a Joint Lenders’ Forum (JLF) once such
early signals were seen. The JLF was tasked with deciding on an approach for resolution, much
as a bankruptcy forum does. Incentives were given to banks for reaching quick decisions. We
also tried to make the forum more effective by reducing the need for everyone to agree, even
while giving those who were unconvinced by the joint decision the opportunity to exit.

We also wanted to stop ever-greening of projects by banks who want to avoid recognizing losses
– so we ended forbearance, the ability of banks to restructure projects without calling them NPA
in April 2015. At the same time, a number of long duration projects such as roads had been
structured with overly rapid required repayments, even though cash flows continued to be
available decades from now. So we allowed such project payments to be restructured through
the 5/25 scheme provided the long dated future cash flows could be reliably established. Of
course, there was always the possibility of banks using this scheme to evergreen, so we
monitored how it worked in practice, and continued tweaking the scheme where necessary so
that it achieved its objectives.

Because promoters were often unable to bring in new funds, and because the judicial system
often protected those with equity ownership, together with SEBI we introduced the Strategic Debt
Restructuring (SDR) scheme so as to enable banks to displace weak promoters by converting
debt to equity. We did not want banks to own projects indefinitely, so we indicated a time -line by
which they had to find a new promoter.
We adjusted the schemes with experience. Each scheme’s effectiveness, while seemingly
obvious when designing, had to be monitored in light of the distorted incentives in the system. As
we learnt, we adapted regulation. Our objective was not to be theoretical but to be pragmatic,
even while subjecting the system to increasing discipline and transparency.

All these new tools (including some I do not have the space to describe) effectively created a
resolution system that replicated an out-of-court bankruptcy. Banks now had the power to resolve
distress, so we could push them to exercise these powers by requiring recognition. The schemes
were a step forward, and enabled some resolution and recovery, but far less than we thought was
possible. Incentives to conclude deals were unfortunately too weak.

4) Did NPA recognition slow credit growth, and hence economic growth?

The RBI has been accused of slowing the economy by forcing NPA recognition. I actually gave a
speech in July 2016 on this issue before I demitted office, knowing it was only a matter of time
before vested interests who wanted to torpedo the clean-up started attacking the RBI on the
growth issue.

Simply eye-balling the evidence suggests the claim is ludicrous, and made by people who have
not done their homework. Let us start by looking at public sector bank credit growth compared
with the growth in credit by the new private banks. As the trend in non-food credit growth shows
(Chart 1), public sector bank non-food credit growth was falling relative to credit growth from the
new private sector banks (Axis, HDFC, ICICI, and IndusInd) since early 2014.

This is reflected not only in credit to industry (Chart 2), but also in credit to micro and small
enterprise credit (Chart 3).
The relative slowdown in credit growth, albeit not so dramatic, is also seen in agriculture (Chart
4), though public sector bank credit growth picked up once again in October 2015.
Whenever one sees a slowdown in lending, one could conclude there is no demand for credit –
firms are not investing. But what we see here is a slowdown in lending by public sector banks vis
a vis private sector banks.

Interestingly, if we look at personal loan growth (Chart 5), and specifically housing loans (Chart
6), public sector bank loan growth approaches private sector bank growth. So the reality is that
public sector banks slowed lending to the sectors where they were seeing large NPAs but not in
sectors where NPAs were low.
The fact that the public sector bank credit slowdown to industry dates from early 2014 suggests
that the bank cleanup, which started in earnest in the second half of fiscal year 2015, was not the
cause. Indeed, the slowdown is best attributed to over-burdened public sector bank balance
sheets and growing risk aversion in public sector bankers. Their aversion to increasing their
activity can be seen in the rapid slowdown of their deposit growth also, relative to private sector
banks (see Chart 7). After all, why would public sector banks raise deposits aggressively if they
are unwilling to lend?

In sum, the Indian evidence, supported by the experiences from other parts of the world such as
Europe and Japan, suggests that what we were seeing was classic behavior by a banking system
with balance sheet problems. We were able to identify the effects because parts of our banking
system – the private banks — did not suffer as much from such problems. The obvious remedy
to anyone with an open mind would be to tackle the source of the problem – to clean the balance
sheets of public sector banks, a remedy that has worked well in other countries where it has been
implemented. This is not a “foreign” solution, it is an economically sensible solution. It is
something that has been repeatedly flagged by the government’s own Economic Survey, under
the guidance of the respected Dr. Arvind Subramanian. Clean up was part of the solution, not the
problem.

5) Why do NPAs continue mounting even after the AQR is over?

The AQR was meant to stop the ever-greening and concealment of bad loans, and force banks
to revive stalled projects. The hope was that once the mass of bad loans were disclosed, the
banks, with the aid of the government, would undertake the surgery that was necessary to put
the projects back on track. Unfortunately, this process has not played out as well. As NPAs age,
they require more provisioning, so projects that have not been revived simply add to the stock of
gross NPAs. A fair amount of the increase in NPAs may be due to ageing rather than as a result
of a fresh lot of NPAs.

Why have projects not been revived? Since the post-AQR process took place after I demitted
office, I can only comment on this from press reports. Blame probably lies on all sides here.

a. Risk-averse bankers, seeing the arrests of some of their colleagues, are simply not willing
to take the write-downs and push a restructuring to conclusion, without the process being
blessed by the courts or eminent individuals. Taking every restructuring to an eminent
persons group or court simply delays the process endlessly.
b. Until the Bankruptcy Code was enacted, promoters never believed they were under serious
threat of losing their firms. Even after it was enacted, some still are playing the process,
hoping to regain control though a proxy bidder, at a much lower price. So many have not
engaged seriously with the banks.
c. The government has dragged its feet on project revival – the continuing problems in the
power sector are just one example. The steps on reforming governance of public sector
banks, or on protecting bank commercial decisions from second guessing by the
investigative agencies, have been limited and ineffective. Sometimes even basic steps
such as appointing CEOs on time have been found wanting. Finally, the government has
not recapitalized banks with the urgency that the matter needed (though without
governance reform, recapitalization is also not like to be as useful).
d. The Bankruptcy Code is being tested by the large promoters, with continuous and
sometimes frivolous appeals. It is very important that the integrity of the process be
maintained, and bankruptcy resolution be speedy, without the promoter inserting a bid by
an associate at the auction, and acquiring the firm at a bargain-basement price. Given our
conditions, the promoter should have every chance of concluding a deal before the firm
goes to auction, but not after. Higher courts must resist the temptation to intervene
routinely in these cases, and appeals must be limited once points of law are settled.

That said, the judicial process is simply not equipped to handle every NPA through a bankruptcy
process. Banks and promoters have to strike deals outside of bankruptcy, or if promoters prove
uncooperative, bankers should have the ability to proceed without them.

Bankruptcy Court should be a final threat, and much loan renegotiation should be done under the
shadow of the Bankruptcy Court, not in it. This requires fixing the factors mentioned in (a) that
make bankers risk averse and in (b) that make promoters uncooperative.