Stakeholders responsible for the manifold growth of NPAs
Former RBI governor Urjit Patel writes that banks applied little risk analysis in sifting good from bad assets, lending without due diligence
The government is responsible for ensuring adequate capital for banks that are under its ambit on a durable/sustainable basis. The dominant owner pre-2014 didn’t question risk controls in government banks even as it received significant dividends. A number of government banks did not have senior management in place, and governance suffered. This is a perennial shortcoming on account of bureaucratic inertia and political meddling. Ditto for the banks’ board of directors; it is common knowledge that this has traditionally been a placeholder for sinecure to political supporters. Key committees of the board, like the audit committee, have suffered from both inadequate membership, as seats go unfilled, as well as paucity of talent/ domain knowledge to carry out fiduciary responsibilities to the level that is required and expected. The regulator fell short on several counts in the period leading up to 2014. It failed to challenge assumptions through, for example, more rigorous stress-test scenarios at bank level, as well as sensitivity analysis on (demand) assumptions, and sector (policy) risks. The scale of exposure – or risk build-up – was not appreciated enough and contested by the regulator to effectively slow down or tighten the lending norms, say, by increasing sector risk weights to ensure protection by increasing capital requirements. India’s credit practices have been informed, inter alia, by a confidence that income recognition and associated prudential parameters had scope for exceptions built in; lenders, led by the government, and large borrowers felt that the requisite leaning could lead to dilution. Implicitly, on balance, discretion is the default rather than the rule. An extenuating reality is that the regulator in our system does its work by constantly looking over its shoulder. High professional integrity notwithstanding, the RBI’s reputation has been that of a soft regulator – deterrence has been undermined. […] The regulator, prior to 2014, not only neglected to take away the ‘punch bowl’ from the credit-binge ‘party’ – thereby missing an opportunity to signal that it is cognizant of a potential risk to sector stability – but may have contributed to spiking the ‘punch bowl’ by reinforcing forbearance through perpetuating practices like designating NPAs as standard restructured assets, a non sequitur.
The supervisor’s role is to ensure that stringent risk-management processes and requirements are adhered to. There was a failure to acknowledge and rectify government banks’ inability to identify poor performing assets; and restructure and react quickly to improve recovery or cut losses (by way of illustration, iron and steel companies, airlines, generators, real estate, etc). The regulator’s inspection reports rarely cautioned banks to the extent required about the high credit growth, which was running well ahead of real growth.
The banks themselves applied little risk analysis in sifting good from bad assets; they kept lending without much (or the requisite) due diligence, scepticism, concern for exposure concentration, high leverage and, overall, dynamic assessment over the cycle (in other words, closed loop control was abjured). Inadequate risk management in banks didn’t allow them to identify poor performing assets, and they may also have been in denial that there was a severe problem of poor quality assets (a build-up possibly as early as 2011 onwards). Instead, they seemed to have continued with extending further credit to poorly performing loan cases; this was done without commensurate enhancement of collateral; borrowers seem to have proffered their name/personal net worth in the form of personal guarantees as substitute. Furthermore, some large borrowers, allegedly, may have taken equity out of the business (if investigations under way are anything to go by) or, at any rate, they did not inject more equity nor, it would seem, did the banks demand this as a precursor to further extension of credit. In other words, the scale, nature and complexity of these exposures were allowed to balloon out of hand. The banks were too big to fail because the individual entities that they had lent to were deemed as too big to close down or change ownership. On an average, board-level firewalls did not fulfil remit adequately. Assets ‘tucked away’ by banks under the cloak provided by the Corporate Debt Restructuring cell were seriously impaired; these loans should have been evaluated for what they were – those meriting advance capital provisioning against likely recognition as NPAs in due course. What about the fourth and fifth stakeholders? Not much to say here except for the deafening silence of otherwise voluble business associations on the subject of defaulting borrowers. There have hardly been any notable declarations supporting rulesbased resolution and liquidation, or urging members to honour debt-servicing obligations. The dereliction is baffling, as the top leadership of business associations comprise bankers, and carry cost of NPAs is driving up the margin on loans for all borrowers.
The financial media in the country routinely bestows banking awards on banks that have been fined, sometimes more than once, by sector regulators for transgressions. One would think that the rules for qualification would include, at a minimum, a transparent criterion that any bank that has been penalized by a regulator – since this has to be disclosed to the stock market, it makes for easy and costless verification – say, in the twelve months prior to the date of announcement of award, will not be considered. Further, there are instances of jury members affiliated to an institution that has been fined by a financial regulator. A reputation for abiding by regulations should matter. Is sponsorship of annual awards and banking conclaves worth the implicit condoning of wrongful actions?
As an example, consider the following. In July 2019, the regulator imposed fines on eleven banks for a wrongdoing. A few months later, in September 2019, one government bank in that list received an award from a financial publication. In October 2019, a private bank that had been punished in July won an award from another financial publication.