Coronavirus And The Zombie Attack On Indian Banks

In 2018, two economists from the Bank for International Settlements, Niladri Banerjee and Boris Hofmann wrote a paper on the rise of zombie firms: leveraged corporates unable to service debt from current profits. Zombie movies are characterised by reanimated corpses devouring human flesh and spreading contagion. In the banking sector, zombie firms are unviable firms feeding off easy credit and dithering banks while adding to systemic risk. While recent steps by the Reserve Bank of India and the government are praiseworthy, more is required to prevent a zombie onslaught on the brittle banking sector. I am critiquing recent measures on insolvency laws and debt servicing to support the real economy and their unintended consequences on banks.

The State Of The Banking Sector

One reason for rise of zombie firms, as states in the BIS paper, is the tendency of weak banks to roll over loans to defunct firms rather than writing them off – a phenomenon which Dr Raghuram Rajan famously coined as the ‘extend and pretend regime’. The macabre analogy is only to underscore that banks were reeling under a zombie attack much before Covid-19.

The RBI in its December 2019 Financial Stability Report noted that in September 2019, the gross non performing asset ratio for scheduled commercial banks was 9.3 percent. RBI’s baseline stress testing showed it may increase to 9.9 percent by September 2020. That ‘baseline’ prediction is supported by assumptions which, with the hindsight of Covid-19, seem not just benign but cheerful.

Adverse scenarios over the baseline have been derived based on standard deviations in the historical values of macroeconomic variables. A serious shock, assuming a standard deviation of 2 from the baseline would mean that the system-level Capital to Risk (Weighted) Assets Ratio or CRAR would decline from 14.9 percent to 11.2 percent by September 2020. Almost as an afterthought, RBI also mentions that it would need a shock of 3.52 SDs from the historical baseline for the system-level CRAR to drop to 9 percent - the minimum regulatory capital mandatory for banks.

I am no statistician. But exogenous shocked caused by Covid - 19 would certainly be beyond 2 SDs from RBI’s baseline assumptions. The fear is how close the virus-induced slump will be to 3.52 SDs. What is evidently clear is that the slump is disproportionately harsh on the banking sector. Post Covid-19, the NSE’s Nifty Bank index has fallen about 41 percent compared to the 26 percent decimation of the broader Nifty 50 index.

Raising The Insolvency Filing Threshold

The freeze in the velocity of money and disruption of supply chains, on account of the virus and subsequent lockdown, means many companies could be defaulting on their payment obligations to banks and trade counterparties. In light of that the Insolvency and Bankruptcy Code filing trigger has been raised to Rs 1 crore to prevent any ‘hair trigger’ bankruptcies. This move will definitely let micro, small and medium enterprises, and small borrowers breathe easier but the understanding needs to be more nuanced.

Typically, creditors that file bankruptcy applications for sub-Rs 1 crore defaults are operational creditors. Data reveals that even though operational creditors receive little in bankruptcy payouts, they are prolific bankruptcy filers since IBC gives them greater negotiating leverage in an NCLT process against larger companies in the supply chain. In some ways, the amendment can block avenues for MSME creditors from taking on defaulting firms with deeper pockets. But on balance, the gains from preventing large scale bankruptcies for relatively small amounts would outweigh the losses suffered by small vendors, sole proprietorships and employees from being denied a legal right. This move is likely to reduce the scope for fire sales in potential liquidation proceedings and prevent banks from suffering deeper haircuts. However, the duration of this measure and its constitutional validity will need to be examined in the coming months.

Possible Suspension Of IBC Filings

Going by growth slowdown forecasts and the finance minister’s recent comments, it seems that IBC filings could also be put in abeyance. To put this in context, an IBC filing can be made by a financial creditor, operational creditor or by the distressed borrower itself. A bulk of the operational creditor filings will be stymied by raising the monetary threshold for filing. A temporary ban on all filings by operational creditors will certainly add more teeth and would be a welcome move.

However, a blanket ban on IBC filings by financial creditors needs to be reconsidered before imposed. Covid-19 has caused economic disruption since March whereas the stress in large zombie firms has been prevailing for several quarters for reasons which are unconnected to the virus, albeit exacerbated by it. An important tool used by bankers is the threat of an insolvency filing, fearing which hundreds of distressed borrowers, especially wilful defaulters, have agreed to loan restructuring or resolution via one-time settlements. An advisory by the RBI and the Finance Ministry to banks to not initiate insolvency proceedings against fresh defaults due to Covid-19 may have sufficed – but a complete lockdown on IBC filings will delay recoveries from legacy cases, require further provisioning, and compromise capital adequacy.

Under the IBC, borrowers may voluntarily choose to file for insolvency, but that too may be up for suspension. There seems little merit in preventing companies reeling from the virus impact to continue bearing the pain if euthanasia through IBC is possible. In any event IBC discourages frivolous or indiscriminate voluntary filings. Each voluntary filing requires a special resolution of shareholders and the insolvency process exposes the incumbent management to charges of fraudulent trading and unfair practices. A rational promoter will file for insolvency resolution only for legitimate business reasons. Keeping such unwilling businesses forcibly open will not turn their fortunes and will contribute to further distress.

Case in point is the fate of large telecom companies reeling under the Supreme Court’s perverse order on AGR dues. Such companies could voluntary file for insolvency resolution, be able to write off the AGR dues as operational debts, and re-emerge with healthier balance sheets and a greater capacity to service debt. The government should let borrowers decide their own fate or else we will be faced with spiraling debt, and no resolution in sight. Further, banks must resolve to liquidate the borrower as soon as possible, instead of dragging the process for 270 days.

Need For Further Provisioning Benefits

The RBI recently announced that banks would be permitted to grant a three-month moratorium on payment of dues under term and working capital loans. Banks which exercise this option would not suffer from any adverse asset classification. This is a welcome step as it would increase cash in hand for businesses with scarce liquidity and banks can target the relief where it is most desperately needed.

However this ignores the spectre of adverse provisioning that banks would have to suffer due to zombie firms of earlier vintage. The RBI’s June 7, 2019 circular provided that defaulting borrowers with debt in excess of Rs 2,000 crore, must be resolved within 7 months i.e. by early Feb, 2020. Failing resolution, banks would have to make additional provisioning of 20 percent for such accounts which could only be reversed on insolvency filing and admission of IBC proceedings.

However, the track record for resolution under the June 7 circular has been woeful. Data from RBI, indicates that of defaulted debt worth at least Rs 1,25,000 crore, resolution has been completed for a total exposure of only Rs. 1,617 crore. This means banks have to account for an additional 20 percent provisioning for NPAs in excess of Rs 1,23,000 crore. If the government suspends IBC filings then banks would be forced to take the hit without having the means to reverse it. Even if IBC is not suspended, the NCLTs can take several weeks to admit cases. This is bound to affect banks’ performance and the RBI must additionally extend a provisioning holiday to banks for at least one quarter, even for the older NPAs.

Conclusion

The impact of Covid-19 on the real economy will be staggering. The distress caused to the banking sector will become evident only in a few months’ time. Tweaks to bankruptcy laws are a welcome step to ameliorate distress in the industry, but they should not be at the cost of compromising banks’ ability to recover their dues.

There is a dire need for a moratorium on ageing and provisioning for bad loans or else banks will be perilously close to breaching minimum regulatory capital requirements. Zombie firms are not only dragging the ability of banks to transform monetary stimulus into cheaper credit but are fundamentally chipping away at their viability. We will soon find that the central government is faced with a large hole in public sector banks’ balance sheets, needing another round of massive recapitalisation at a time when the fiscal arsenal is depleted.

Suharsh Sinha is partner, restructuring and insolvency at law firm AZB & Partners. Views expressed here are personal.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.