Let's step back from the NPA scare

Business Standard, 28 June 2021

An "NPA Scare" is afoot in India: An exaggerated fear of non-performing assets (NPAs) and about the losses experienced by lenders. Business failure, and credit losses, are integral to lending. If we shy away from all NPAs, or demonise default, this will harm economic growth. The focus on human interest stories, and on transactions that go wrong, tends to obscure the vast scale of successful lending that takes place. We need to relax a little about NPAs, and worry about the three things that are wrong with the Indian credit market: (a) Banking regulation, (b) The lack of a capable bond market, and (c) Bankruptcy reform.

Do you want to lend with no possibility of default? This can be done: You must buy US or German 90-day government bonds, which are AAA-rated. These yield roughly 0 per cent. If you buy an Indian government bond, you are displaying some risk appetite; this is rated Baa3 by Moody's. But then, you think that the higher risk is justified by the higher interest rate.

The ghost of default hovers over most lending. The only way to achieve zero defaults is to lend to the German or the US governments. The important question is: After suffering losses on a certain part of the portfolio, does the overall rate of return work out okay? As an example, suppose there are 10 per cent NPAs, which induce a loss of 50 per cent, and on the remaining 90 per cent there is a return of 20 per cent. The overall portfolio return works out to 13 per cent: In this case, a 10 per cent NPA rate worked out fine. To say that "10 per cent NPA is bad", in isolation, rarely makes sense.

If policy makers or board members demand extremely low NPA rates, this hampers rational financial strategies and hampers credit access. It is a bit like selling life insurance and demanding that customers don't die.

Business failure is a part of life, so credit defaults will always happen. At present, financial regulators and agencies are zealously guarding against future default and going after past defaulters. Business folk are responding to the NPA Scare by pulling back from borrowing. They are using more equity capital, and hence investing less, which is harming gross domestic product (GDP) growth.

Deaths faced by life insurance companies surge in a pandemic. In a similar fashion, business failures rise when growth declines. When Indian growth slowed in the last decade, defaults increased. This is the normal working of the market economy.

The modern media creates a spectacle out of human interest stories. Each plane crash receives vast coverage, while thousands of humdrum flights go by unnoticed. In a similar fashion, a huge volume of debt transactions goes through successfully all the time. As financial economist Harsh Vardhan recently pointed out, about Rs 12 trillion of new credit takes place every year. But in the modern media, there is a spotlight on a few big defaults, which fuels the NPA Scare. A large number of small defaults, which add up to Rs 1,000 crore, does not get the same spotlight as a Rs 1,000-crore default by a company led by a colourful personality. Excoriating the rich has become fashionable in these egalitarian times.

This is not to say that all is well in the Indian credit market. There are three important problems that require solving: Banking regulation, bond market, and bankruptcy process.

The first is the weaknesses of banking regulation. All too often, banks in India have given loans, suffered from default, and found themselves bankrupt after these defaults were paid for. But bank fragility should not fuel the NPA Scare; it should kick off improvements in banking regulation that solve this problem.

The job of banking regulation is to force market-based accounting upon lenders. In the past, this has not been done. Banks have systematically overvalued their portfolios, and regulators have supported this. Regulators must force banks to assess the market value of loans and mark their portfolios to market every quarter, thus showing losses on the P&L every quarter reflecting the net credit deterioration (if any) of their overall portfolio. Regulators must test the veracity of the valuation claims of banks by requiring an auction every year of a small random sample of assets, through which the market value obtained through the sale can be compared against the claims of the management.

The second problem is the bond market. Banks have short-dated deposits and are structurally unable to do long-term lending. Most infrastructure projects in India are highly risky and require commensurately low leverage. The right path to long-dated corporate debt lies in the bond market. There are, however, structural failures in financial regulation which have held back the emergence of the bond market. The losses in long-dated infrastructure and corporate lending should not fuel the NPA Scare; they should kick off the requisite bond market reforms. This is a work programme which was begun in the 2015 Finance Bill but withdrawn.

The third problem is the bankruptcy code. This is about reducing the losses suffered by lenders when default takes place. The defining aphorism of this field is "a defaulted company is a melting ice cube". As quickly as possible, the bankruptcy process needs to kick in, shift control to the committee of creditors, and find a value-maximising deal for lenders. As part of this, the bankruptcy code should force the discovery of theft by promoters, which would lead to commensurate actions against them.

When these things work well, there will be more restructuring. Regulators and agencies need to instil less fear in lenders, so that lenders are able to actively restructure debts when faced with incipient signs of distress. A small loss in restructuring is generally better than a large loss rein bankruptcy.

The Indian bankruptcy reform has been in play since 2016, but the elements described here have not fallen into place through the combination of regulators, courts, departments, and agencies. The problems of the bankruptcy process should not fuel the NPA Scare; they should generate the energy to come back into the bankruptcy reform with fresh energy and intellectual capacity.

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