Covid-19: A Samudra Manthan Of Our Financial Sector

Delhi, we have a problem.

Our financial services ecosystem is in trouble.

Even before Covid-19, beyond the smokescreens, the true gross non-performing assets across banks and NBFCs probably stood at 12 percent of the Rs 140 lakh crore of advances. Covid-19 could well push this to 20 percent of advances. This fear is reflected in the current state of savings, lending, and credit markets.

Status quo and forbearance can at best keep the ecosystem undead. Instead, we need the ecosystem to be fit enough to fuel our growth aspirations with the adequate flow of credit.

China’s credit to the non-financial sector is at 259 percent of GDP. India’s is at 126 percent. When credit fuels jobs and output, it can trigger the virtuous cycle of supply, consumption, investment, and savings that India sorely needs.

Of course, this fuel alone is insufficient to ensure sustainable growth. Alongside this, we also need a strong real sector to serve as a reliable vehicle, and a healthy investment climate to make the growth path motorable. Prime Minister Narendra Modi’s vision of reforms, as articulated on Tuesday, should help address these aspects.

In this article, however, we will focus our attention on the revival of the financial sector.

Sizing The Problem And Possible Solution

With NPAs perhaps already at Rs 17 lakh crore, and maybe headed to Rs 28 lakh crore, we must start by acknowledging that a tumor of this scale requires surgery, not Band-Aid.

First, the system needs to be unburdened of its NPAs, and recovery has to be expedited.

Their resolution can be dealt with separately.

Second, to protect the taxpayer and to restore trust, this quarantining has to be done at fair market valuations, not at book value. The bright light of truth could expose weaknesses in some financial institutions. They will then need resolution or recapitalisation.

Third, to pivot towards sustainable lending going forward, we will need accountability and reforms to guard against a repeat of this age-old lend, pretend, and rescue cycle.

Quarantine and Recovery – ‘Neelkanth’

The suggestions below draw entirely from Malaysia’s experience with their institutions ‘Danaharta’ and ‘Danamodal’ after the Asian crisis.

The government should set up a bad bank (‘Neelkanth’) with say Rs 2 lakh crore of capital, self-funded by Rs 2 lakh crore of Government of India recapitalisation bonds. The fiscal implications would be no different from the substantial public sector bank recapitalisation that has already been undertaken over the past three years.

This capital of Rs 2 lakh crore would allow Neelkanth to acquire Rs 5 lakh crore of gross NPA, paid for in recap bonds, assuming an average fair value of 40 percent of notional.

The sheer size of the funds needed, the need for speed, and the need for flexibility in tweaking rules to aid speedy NPA resolution make the case for a fully government-owned bad bank. Bringing in external funds of reasonable scale on economically and politically acceptable terms may simply take too much time.

It should be manned by specialised distressed asset professionals, including international and sectoral experts. Recovery management is very different from regular commercial relationship banking.

Neelkanth would be given statutory powers to acquire, manage, and dispose of the NPAs. Financial institutions would be allowed to deal with Neelkanth without fear of prosecution.

Neelkanth would have a finite lifespan of five years to work with stakeholders and address the NPAs.

Neelkanth Operations

Let’s illustrate how Neelkanth would work.

To start with, it would arrive at a fair value for every large NPA beyond a threshold size of say Rs 1,000 crore.

In a specific example, assume that it bids Rs 400 crore (in GoI recap bonds) as assessed fair value for a Rs 1,000 crore loan on an NBFC’s books.

The NBFC could reject the bid as being too low. But it would then have to ensure provisions of at least Rs 600 crore against the loan so that the net NPA on its books would be at or below the bid price of Rs 400 crore.

Assume the NBFC did sell the asset to Neelkanth. On the upside, if Neelkanth actually recovered Rs 700 crore from the asset over time, then 80 percent of the additional Rs 300 crore recovered – Rs 240 crore – would be paid back to the NBFC. On the downside, any recovery below Rs 400 crore would be the sole liability of Neelkanth.

This approach could help address the concerns around asset valuation for both the NBFC and for Neelkanth.

The Price Of Fair Value

Transferring NPAs at an independently-assessed fair value would help ensure that taxpayers do not bail out any promoter or financial institution. However, it would severely expose financial institutions with inadequate loan loss provisions.

Over time, loan loss provisions for bank NPAs have improved. However, for some financial institutions, even NPA recognition may be incomplete. When they are forced to mark down their large NPAs to fair value, some of them may require capital. Once again, the taxpayer could be eyed.

In Malaysia, Danamodal was created precisely to provide equity to such strained financial institutions. Any such taxpayer equity infusion, however, would have to pass some litmus tests.

• First, it must only be considered if rescuing the institution is critical for overall financial stability.
• Second, such infusion cannot be a bailout for promoters and equity holders – they would first have to take an appropriate hit.

In the case of Malaysia, taxpayers did not face a loss from Danaharta and Danamodal. In fact, at 59 percent, their recovery against NPAs was quite creditable. The bad bank was also wound up in a time-bound manner, as envisaged.

Learnings From The Past

While the scale and import of the problem argue for putting taxpayer money at risk now, we cannot allow this cycle of ‘extend, pretend and bailout’ to continue.

Any intervention has to be accompanied by long-awaited reforms. Prime Minister Modi’s Tuesday speech is encouraging in this regard.

The recommendations of the 2014 PJ Nayak Committee must be implemented, if nothing else, to grant professional autonomy to public sector bankers, and to hold them truly accountable for their performance.

There is also the need for governance reform – across risk managers, auditors, boards, rating agencies, supervisors, regulators, and the bureaucracy.

We need reform of our debt markets, to improve their liquidity, depth, and functioning.

Finally, as argued earlier, real sector reforms and improvements in the overall investment climate will have to go hand in hand with any financial sector cleanup.

Murder On The Mumbai Express

There has to be accountability as well. Before casting the first stone, however, it is worth reflecting that few classes of stakeholders, if any, come out of this looking good.

Across commentators, analysts, investors, bankers, financiers, promoters, fund managers, regulators, rating agencies, auditors, the bureaucracy, politicians, and the government, we have all played our part in this ‘murder on the Mumbai Express’.

Alongside enforcing specific accountability, we also need a collective truth and reconciliation approach to introspect, learn, and correct for the future.

The Critical Challenge – Execution

Admittedly, the suggested solution set here—a bad bank, recapitalisation, and extensive reforms—will be anything but easy.

There will be no shortage of expert objections on legal, regulatory, moral and other grounds.

Perhaps there are alternative routes. But any alternative has to account for the scale of the problem and target the ultimate objective – making our financial services ecosystem fit to support our growth aspirations. Tinkering at the edges is simply not an option.

Ultimately, our political leadership will have to direct our legal experts, regulators, and bureaucrats to focus less on the objections, and instead find ways to make the chosen solution set work. Execution, as always, will be key.

Ananth Narayan is Associate Professor - Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.

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