By Srijoy Das* in Mumbai, November 11, 2017: Banks in India face a tough task to comply with BASEL III norms, which primarily aim to make the banking sector strong enough to withstand economic and financial stress; reduce risk in the system, and improve transparency in banks.

A recent report by Fitch (rating agency) estimates that the additional capital requirements for Indian banks in order to be compliant to Basel 3 regime (under certain conservatively chosen growth rate assumptions) would amount to approximately Rs 4-4.5 lakh crores.

Most experts and economists agree that Basel 3 implementation would have a positive impact on Indian banks as it would strengthen the regulation of Indian banking system and enhance the resilience of the banking system to withstand financial and economic shocks. Notwithstanding the positives there has been considerable debate on the choices around recapitalizing of Indian banks to meet the Basel III capital adequacy norms.

It is not an easy task for Indian banks, which have to increase capital, liquidity and also reduce leverage. This could affect profit margins for Indian banks. Plus, when banks keep aside more money as capital or liquidity, it reduces their capacity to lend money.

Clearly the choices will be determined based on following key factors but not limited to such as – Can individual banks (including PSUs, private) access the capital market to raise capital or use resources of the government? How does current ownership structure impact the bank’s capital raising proposals? How will this impact the profitability of banks in terms of pricing of loans, return on equity?

While in the context of stability and resilience of Indian banking system, the above questions are important, the real danger to it lurks somewhere else. The above debate cannot ignore the “elephant in the room” – current Non Performing Assets (“NPA”) problem and related crisis that plagues the Indian Banking system. Even before Indian banks gear up to meet the Basel 3 standards, they have to fight the NPA crisis that threatens to strike at its very heart.

Just as one may sympathise about the bad timing of the NPA crisis with the banks, government and regulator, so one may also argue against their previous policy failures in dealing with NPAs and their lack of anticipation of these problems while making preparations for transition to Basel 3. Now the cat is out of the bag!

We need to focus on four aspects related to the current NPA problem – the looming crisis, the impact on transition of Indian banks to Basel 3, the impact on economy (and banking system) and the resolution of NPAs.

NPAs – The looming crisis

Last year the Reserve Bank of India (“RBI”) conducted an asset quality review (“AQR”) with a view to assess the asset classification practices of regulated banks that differentiate good loans from bad loans. This resulted in shocking disclosure about the bank NPAs.

To quote the RBI notification (on 18 April, 2017) which says, “There have been instances of material divergences in banks’ asset classification and provisioning from the RBI norms, thereby leading to the published financial statements not depicting a true and fair view of the financial position of the bank.”

For example – as far as the net NPAs are concerned, among the leading private sector banks, there has been an astounding divergence of Rs 3319 crore for Yes Bank, Rs 5105 crore for ICICI bank, Rs 9478 crore for Axis Bank, as reported by Mint – an Indian daily business newspaper.

Post AQR, the entire banking sector was impacted and bad loans in the Indian banking system jumped 80 per cent in FY16, according to RBI data. Among the PSU banks, record losses were posted in Q4 of FY16 by many large lenders like Bank of Baroda (Rs.3230 crore), Punjab National Bank (Rs.5367 crore), IDBI Bank (Rs.1376 crore) – to name a few, as these lenders scampered to align their loss provisioning books with that of RBI’s findings.

Further, according to the RBI, just 12 companies (mainly Steel and Infrastructure companies) are estimated to account for 25% of the gross NPAs, and were identified for immediate bankruptcy proceedings. While there are 488 others that have been given six months time to restructure their debt.

The RBI’s audit has not only brought forth the irregularities within the asset classification practices of the Indian banks (under-reporting NPAs, use of techniques such as evergreening of loan books etc.) but also disclosed the severity of NPAs to the public eye and financial markets. I shall urge the reader to read about the technical details of reasons behind the AQR divergences in RBI’s disclosures (or other various research based articles on this topic).

The NPA problem and the transition of Indian banks to Basel 3

Firstly the linkage between NPAs and capital adequacy is clearly an inverse relationship. The NPAs or losses from defaulted loans are a huge drain on the bank’s capital and therefore threaten the bank’s capital adequacy or its solvency. This implies the banks have to raise additional capital to not only cover the losses from defaulted loans but also meet the more stringent capital adequacy norms of Basel 3.

Secondly as RBI is bringing the loan exposure accounting and capital adequacy norms in line with International standards, the exercise has revealed a huge amount of NPAs on the books of PSU and private sector banks. Therefore the NPA problem has not only made the transition difficult but also jolted the reputation of Indian banks as they strive to gain international respectability.

Impact and resolution

The current NPA crisis poses significant threats and costs to the economy. Mainly it can lead to choking of credit supply to real economy leading to its slowdown, which is already happening. Further costs related to government bailout of PSUs – suffering from losses – can put a big strain on fiscal resources.

Further the banking industry faces an undesirable trade-off that is unique to Indian banking system. For example, unlike the private sector banks, the PSUs that suffer from NPA problems cannot raise a significant amount of capital – to meet the capital adequacy norms – in the market without diluting the government’s share below 51%. So either the government has to decide to lower its stake in these banks or use tax payers money to recapitalize them.

This typical scenario exemplifies the tradeoffs the Indian government faces between preserving the ownership structure in PSUs, managing NPAs and fiscal prudence. Further there also lingers the potential moral hazard issue for the loss-making PSU banks that have less incentive to set their houses in order because of most certain bailout by the government.

While RBI’s AQR exercise has revealed the portfolio of bad loans, the other key part – resolution of NPAs remains a big challenge. According to Fitch ratings agency, current average provision cover of Indian banks is quite low considering that the accounts in question have been NPAs for several years and the recoveries from distressed assets have been lower than expected.

For example a recent recovery from one of the insolvent accounts has been a mere 6% which was quite contrary to the expectations of the banks and the government. The RBI has already asked banks to refer 12 accounts for insolvency. It has given lenders time until December this year to resolve another 30-40 accounts before taking these accounts into insolvency as well.

Nevertheless with slump in growth rates of bank’s loan business and the imminent ask for recapitalization to meet Basel 3 norms, the banks must push for quicker resolution of large bad loan accounts to recover capital that can plug some of the shortfall.

Road Ahead

Clearly an early recognition of NPAs and action on resolution mitigates the damaging impact of a crisis. Importantly the country needs a strong legal and institutional framework for dealing with bankruptcies and insolvencies. A major step in right direction has already been taken with the enactment and implementation of the Insolvency and Bankruptcy Code (“IBC”), 2016.

The new law is designed to facilitate quick resolution of stressed corporate assets in a time bound manner. While implementation of IBC will remain a big challenge due to the scale and size of our country’s economy, the policy enforcing institutions like National Company Law Tribunal (NCLT) must focus on continuous build-up of right skills and professional expertise needed to expedite bankruptcy cases on distressed firms and decisions regarding restructuring or liquidation of the assets.

Going forward, the Indian banking system needs committed approach from all its key stakeholders: Regulator (RBI), Government and Banks – to introduce reforms, innovation and policy measures.

With RBI taking several steps to bring the regulatory norms in line with International standards (Basel 3), certain pro-active steps seem worthy of adoption such as – countercyclical capital buffer to curb indiscriminate lending by banks during credit boom times, enforcing best practices in asset clarification, provisioning and accounting of loan exposures, periodic stress-testing programs based on adverse macroeconomic scenarios to assess whether banks are sufficiently capitalized to withstand stressed economic conditions.

In the past RBI has been criticized by experts for its regulatory forbearance and concessions to PSU banks. For the future it needs to be more proactive and create incentives for banks that recognize NPAs as early as possible and punish those that fail to do by allowing them to go down.

The Government as a major stakeholder for PSU banks (with ownership of 70% of the banking sector) needs to consider whether it is worth while maintaining such control. The demerits of this current policy include huge undesirable fiscal costs for bailout of banks suffering from NPA crisis, conflict of interest arising from disbursement of loans driven by politically vested interests rather than by commercial logic etc.

While this warrants a public-policy debate, however the current situation demands that government should take appropriate steps to recapitalize the loss making PSUs, thereby bring stability to banking system and possibly consolidate existing PSUs into few to improve efficiency of operations and oversight.

Lastly, the banks themselves need to tighten their internal risk management policy and administrative procedures for scrutinizing new loans and monitoring existing loans especially when the NPAs start increasing. Further banks must be proactive and flexible in – re-adjusting their risk appetite during economic booms (and busts), putting internal controls and risk limits in place like certain sectoral caps for sectors that are overheated.

*(Srijoy Das is Vice President, Department of Chief Risk Officer, Credit Suisse and his opinions and views expressed in this article don’t necessarily reflect the position or views of Credit Suisse.)