No Restructuring, Please! Let’s Focus On ProvisioningBloombergQuintOpinion
Along with an off-schedule monetary policy action of cutting the repo rate, the Reserve Bank of India also made some important announcements relating to banking regulations on May 23. It extended the moratorium granted on loan and interest payments for another three months. However, it disappointed the banking sector by not announcing any specific restructuring scheme, which the sector widely expected. Disappointed, the stock market reacted and bank stocks fell sharply.
Companies and banks both continue to expect the RBI to announce some form of a debt restructuring scheme to help companies facing financial strain due to the disruption caused by the coronavirus pandemic. Companies have suffered a serious loss of revenue which has impaired their ability to service their debts.
We have a history of restructuring schemes. After the global financial crisis, a veritable alphabet soup of such schemes were offered to banks—CDR, 5/95 Scheme, S4A, and so on. They did not end well and the non-performing loans kept growing. In 2016, the regulator finally conducted asset quality reviews to determine the level of NPAs and put an end to all these schemes.
As an outcome of the AQRs, banks, especially the government-owned ones, were found to have a significant shortfall in capital. The government had to infuse over Rs 3.5 lakh crore of capital into public sector banks over the next few years.
Restructuring schemes did little to improve the NPA situation but did delay capital infusion.
Effectively, they allowed the banking system to run undercapitalised for some years.
With the pandemic and the growing clamour for another round of restructuring schemes, we have the prospect of repeating history. On the other hand, if we learn from the last round of restructuring, we could use this crisis to undertake reforms on the way we deal with bad loans in regulation. For this, we have to start from the basics.
Restructuring Breaks A Three-Part Process
With any loan, there are three main aspects that regulation deals with: loan classification, income recognition, and credit provisioning.
Loan classification is nothing but naming various categories of loans—standard assets, special mention accounts, non-performing assets, etc. By itself, loan classification is just a labeling activity with limited financial significance. Financially significant are the other two aspects of regulation—income recognition and credit provisioning. Income recognition norms determine how much income from a loan can a bank account for in its income statement, and when. Credit provisioning rules decide how much income a bank has to set aside to provide for the loans that have defaulted on their repayment obligations.
When a borrower defaults on any payment obligation, it ceases to remain a standard asset and begins its journey to the NPA classification through the SMA stage.
Not all defaulting loans eventually turn into NPAs; some may recover and become standard assets. The regulator prescribes a schedule of provisioning that depends on the days since the loan default and the nature of security provided by the borrower for the loan. Current regulations demand a loan that has been in default longer than 90 days is treated as an NPA where the bank has to provide up to 70% of the amount in default over a period of time.
In a restructuring scheme, of the kinds that were offered after the 2008 crisis, these provisioning norms were abandoned. Banks were permitted to restructure loans that qualified for the scheme; they could basically redraw the loan contract with the borrower with a new repayment schedule.
The old loan that was in default was reborn as a new one with its history wiped clean.
The loan had a new repayment schedule and the provisioning requirements as per the old timetable were abandoned. There was a small one-time provisioning (typically around 5%) that was required as a condition of restructuring (many banks recovered this, at least partly, by charging a ‘restructuring fee’ to the borrowers). Such restructuring schemes have several problems.
They take away any judgment and accountability on part of the bank’s management. The regulator prescribes the loans that qualify for restructuring and most, if not all, loans that qualify, get restructured. Bank leadership, especially close to retirement, has great incentive to restructure all troubled loans so that dealing with them can be effectively passed on to its successors. When the restructuring is done under a regulator-approved scheme, bank managements easily absolve themselves of any accountability on the implications of restructuring.
Regulatory intent behind restructuring schemes is to provide relief to borrowers that are facing short term cash flow challenges due to some external factors. Restructuring schemes are not meant to defer repayments for clients who face no such cash flow challenge, nor are they meant to bail out unviable borrowers. A restructuring scheme blessed by the regulator has a high propensity of being misused to help such non-deserving borrowers.
To be robust, credit provisioning norms must be based on data on loss given default, recoverability of security, time taken for recovery, etc. Both banks and the regulator have to build datasets from the experience of a large number of loan life cycles to arrive at the provisioning rules.
Restructuring schemes create a rupture and reset in the life cycle of loans thus losing the value of the data from the loan.
Consequently, provisioning schedules do not develop sharpness and accuracy that would make them effective.
Instead Of Restructuring...
So, what is the alternative to restructuring especially to deal with the challenge that most borrowers would face due to the pandemic and the lockdown?
We propose that the regulator works entirely through the provisioning schedule and does not permit rewriting of the loan contract, i.e. no restructuring. Here is how such a scheme would work:
- Defaults in repayment by borrowers—any qualifying conditions to be set by the regulators—would be treated as defaults unless specific moratorium has been given by the regulator.
- The provisioning schedule for these defaults would be easier i.e. extended over a longer period of time and at lower levels than normally is the case. Essentially, the provisioning schedule will be stretched over a longer period with a clear understanding that over a defined period (let’s say six quarters) the provisioning norms will come back to the normal levels.
- If the borrowers get back on the repayment schedule, then all the provisions would be written back.
- Banks could restructure loans but such loans would be treated as non-performing with an appropriate level of provisioning to be made immediately.
- Banks will have the choice to either accept the new stretched provisioning or to restructure with full provisioning.
Such a scheme would help banks deal with defaults of borrowers who are stressed due to the pandemic. Lower provisioning requirements would reduce the pressure on banks’ profitability and capital. At the same time, since loans are not restructured, banks will also have to focus on ensuring that the borrowers return to regular repayments within a reasonable time.
Bank managements will have to use their judgment carefully before restructuring a loan which will entail full provisioning like a non-performing loan, and that will reduce the likelihood of large scale, indiscriminate restructuring.
This would also encourage banks to use the bankruptcy law to resolve stressed and over-leveraged firms. Thus, such a provisioning-based approach would avoid some of the pitfalls of the earlier schemes (post-2008 crisis) and yet help borrowers deal with short-term cash flow challenges.
While the pandemic is a serious challenge to the banking system, it is also an opportunity to reform. At the very least we should avoid the mistakes we made in dealing with earlier crises.
Harsh Vardhan is an Executive-in-Residence at the Centre for Financial Studies of the SPJain Institute of Management & Research, Shishir Mankad is Head, Financial Services at Praxis Global Alliance. The authors thank MB Mahesh and Prof Rajeswari Sengupta for useful comments.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.