Beware The Risk In MSME Lending, Former RBI Governor Raghuram Rajan Tells Parliamentary Committee
The SIDBI run credit guarantee scheme for medium and small enterprises is a growing contingent liability and needs to be examined with urgency, former RBI Governor Raghuram Rajan said in a 17-page note to India’s Parliamentary Estimates Committee.
Rajan has expounded on the reasons that led to a large build up of non-performing assets in India’s banking system, the regulator’s actions and what needs to be done to prevent a recurrence. It is in detailing that last point that Rajan has raised the flag on current vulnerabilities.
Both MUDRA loans as well as the Kisan Credit Card, while popular, have to be examined more closely for potential credit risk. The Credit Guarantee Scheme for MSME (CGTMSE) run by SIDBI is a growing contingent liability and needs to be examined with urgencyRaghuram Rajan, Former RBI Governor
Launched in 2000 the CGTMSE, now known as UDAAN, has recorded over 25 lakh cumulative guarantee approvals in 2016-17 with an aggregate loan amount of over Rs 1.25 lakh crore, according to information on its website.
Suggesting that the government should refrain from setting ambitious credit targets or waiving loans, Rajan reiterated that loan waivers vitiate credit culture and stress state budgets.
Agriculture needs serious attention, but not through loan waivers. An all-party agreement to this effect would be in the nation’s interest, especially given the impending elections.Raghuram Rajan, Former RBI Governor
When discussing why NPAs continue to mount despite an extensive asset quality review conducted when he was governor of the Reserve Bank of India, Rajan said as NPAs age they need more provisioning and that “a fair amount of the increase in NPAs may be due to ageing rather than as a result of a fresh lot of NPAs”.
Risk averse bankers and governments that drag their feet are why projects have not yet revived Rajan said. He also observed that the bankruptcy process is being tested by the large promoters, with continuous and sometimes frivolous appeals. Pointing out the obvious, that the judicial system is not equipped to deal with every bad loan, Rajan said much loan renegotiation should be done under the shadow of the Bankruptcy Court, not in it.
Banks and promoters have to strike deals outside of bankruptcy, or if promoters prove uncooperative, bankers should have the ability to proceed without them.Raghuram Rajan, Former RBI Governor
Rajan has offered several suggestions on how such a NPA recurrence can be avoided. Among them, he urged the government to adopt a new approach to NPA resolution, cautioning against old ideas such as bad banks and mergers.
We need concentrated attention by a high level empowered and responsible group set up by government on cleaning up the banks. Otherwise the same non-solutions (bad bank, management teams to take over stressed assets, bank mergers, new infrastructure lending institution) keep coming up and nothing really moves.Raghuram Rajan, Former RBI Governor
The parliamentary panel, headed by BJP’s Murali Manohar Joshi, has been tasked with identifying the reasons behind India’s nearly Rs 9 lakh crore bad loan pile. The panel had invited Rajan to brief on the matter after former Chief Economic Adviser Arvind Subramanian praised him for his work on identifying the crisis and speeding up recognition of stressed assets.
Here are excerpts from Rajan’s response to the Parliamentary Committee.
Why Did NPAs Occur?
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.
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.
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.
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 would 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).
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.
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.
Why Do NPAs Continue Mounting Even After The Asset Quality Review (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.
We need concentrated attention by a high level empowered and responsible group set up by government on cleaning up the banks. Otherwise the same non-solutions (bad bank, management teams to take over stressed assets, bank mergers, new infrastructure lending institution) keep coming up and nothing really moves. Public sector banks are losing market share as non-bank finance companies, the private sector banks, and some of the newly licensed banks are expanding.
What Could The Regulator Have Done Better?
It is hard to offer an objective self-assessment. However, the RBI should probably have raised more flags about the quality of lending in the early days of banking exuberance. With the benefit of hindsight, we should probably not have agreed to forbearance, though without the tools to clean up, it is not clear what the banks would have done. Forbearance was a bet that growth would revive, and projects would come back on track. That it did not work out does not mean that it was not the right decision at the time it was initiated. Also, we should have initiated the new tools earlier, and pushed for a more rapid enactment of the Bankruptcy Code. If so, we could have started the AQR process earlier. Finally, the RBI could have been more decisive in enforcing penalties on non-compliant banks. Fortunately, this culture of leniency has been changing in recent years. Hindsight, of course, is 20/20.
How Should We Prevent Recurrence?
Improve governance of public sector banks and distance them from the government.
- Public sector bank boards are still not adequately professionalized, and the government rather than a more independent body still decides board appointments, with the inevitable politicization. The government could follow the PJ Naik Committee report more carefully. Eventually strong boards should be entrusted with all decisions but held responsible for them.
- Pending the change above, there is absolutely no excuse for banks to be left leaderless for long periods of time as has been the case in recent years. The date of retirement of CEOs is well known and government should be prepared well in advance with succession. Indeed, it would be good for the old CEO and the successor to overlap for a few months while they exchange notes. All the more reason to delegate appointments entirely to an entity like the Bank Board Bureau, and not retain it in government.
- Outside talent has been brought in very limited ways into top management in Public Sector Banks. There is already a talent deficit in internal PSB candidates in coming years because of a hiatus in recruitment in the past. This needs to be taken up urgently. Compensation structures in PSBs also need rethinking, especially for high level outside hires. Internal parity will need to be maintained. There will be internal resistance, but lakhs of crores of national assets cannot be held hostage to the career concerns of a few.
- Risk management processes still need substantial improvement in PSBs. Compliance is still not adequate, and cyber risk needs greater attention
Improve the process of project evaluation and monitoring to lower the risk of project NPAs
- Significantly more in-house expertise can be brought to project evaluation, including understanding demand projections for the project’s output, likely competition, and the expertise and reliability of the promoter. Bankers will have to develop industry knowledge in key areas since consultants can be biased.
- Real risks have to be mitigated where possible, and shared where not. Real risk mitigation requires ensuring that key permissions for land acquisition and construction are in place up front, while key inputs and customers are tied up through purchase agreements. Where these risks cannot be mitigated, they should be shared contractually between the promoter and financiers, or a transparent arbitration system agreed upon. So, for instance, if demand falls below projections, perhaps an agreement among promoters and financier can indicate when new equity will be brought in and by whom.
- An appropriately flexible capital structure should be in place. The capital structure has to be related to residual risks of the project. The more the risks, the more the equity component should be (genuine promoter equity, not borrowed equity, of course), and the greater the flexibility in the debt structure. Promoters should be incentivized to deliver, with significant rewards for on-time execution and debt repayment. Where possible, corporate debt markets, either through direct issues or securitized project loan portfolios, should be used to absorb some of the initial project risk. More such arm’s length debt should typically refinance bank debt when construction is over.
- Financiers should put in a robust system of project monitoring and appraisal, including where possible, careful real-time monitoring of costs. For example, can project input costs be monitored and compared with comparable inputs elsewhere using IT, so that suspicious transactions suggesting over-invoicing are flagged? Projects that are going off track should be restructured quickly, before they become unviable.
- And finally, the incentive structure for bankers should be worked out so that they evaluate, design, and monitor projects carefully, and get significant rewards if these work out. This means that even while committees may take the final loan decision, some senior banker ought to put her name on the proposal, taking responsibility for recommending the loan. IT systems within banks should be able to pull up overall performance records of loans recommended by individual bankers easily, and this should be an input into their promotion and pay
Strengthen the recovery process further
Both the out of court restructuring process and the bankruptcy process need to be strengthened and made speedy. The former requires protecting the ability of bankers to make commercial decisions without subjecting them to inquiry. The latter requires steady modifications where necessary to the bankruptcy code so that it is effective, transparent, and not gamed by unscrupulous promoters.
Government should focus on sources of the next crisis, not just the last one. In particular, government should refrain from setting ambitious credit targets or waiving loans.
- Credit targets are sometimes achieved by abandoning appropriate due diligence, creating the environment for future NPAs. Both MUDRA loans as well as the Kisan Credit Card, while popular, have to be examined more closely for potential credit risk. The Credit Guarantee Scheme for MSME (CGTMSE) run by SIDBI is a growing contingent liability and needs to be examined with urgency.
- Loan waivers, as RBI has repeatedly argued, vitiate the credit culture, and stress the budgets of the waiving state or central government. They are poorly targeted, and eventually reduce the flow of credit. Agriculture needs serious attention, but not through loan waivers. An all-party agreement to this effect would be in the nation’s interest, especially given the impending elections.
The full note can be downloaded here.