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The RBI’s new (potentially compromising) powers

The Indian government issued an ordinance at the end of last week laying out some new powers for the Reserve Bank of India, powers which are aimed at chipping away at the country’s mammoth and thoroughly discussed bad loan problem. Here’s CreditSights with a brief explanation:

In essence, two additional sections ­35AA and 35AB ­ were introduced into the Banking Regulation Act. 35AA will allow the government to authorize the RBI to issue directions to banks to initiate insolvency proceedings for specific accounts under the provisions of the Insolvency and Bankruptcy Code while 35AB will let the RBI specify one or more committees to advise banks on loan resolution.

The idea is apparently to concentrate on the 40-50 big ticket accounts that make up 70 per cent of Rs6trn of NPLs, according to BofAML.

Now, this is potentially a good thing for a number of reasons.

For one, it might provide banks with cover from charges of crony capitalism, which would make it easier to move on bad loan resolution. If the RBI is making decisions about insolvency then bankers might be protected from investigative agencies — the ‘C Trinity‘ — probing their decisions. From CreditSights again, with bonus mention of the King of Good Times who acted as part catalyst for this recent bad loan push:

The purpose of 35AB is not as immediately apparent but is partly meant as a solution to mitigate bankers’ fear of being accused for “undue vigilance”. This was sparked by the arrest of former IDBI bank officials for allegedly showing favor over loans made to Vijay Mallya’s Kingfisher Airlines. Setting up oversight committees to help banks monitor progress and make decisions will partly “absolve” bankers of their actions and ease fears over being investigated. Decisions regarding delinquent borrowers are fraught with risks for Indian bankers, especially those in the public sector. If they get tough on powerful borrowers, they may face lawsuits from the borrower or political pressure from his supporters. If they are too lax, they may be penalized for losing what is ultimately public money. The involvement of the RBI may help to depoliticize the banks, though it may further politicize the RBI.

For two, it might be able to push through decisions that would have been stymied by bank consortiums failing to reach agreements on shared projects, or backing out of agreements which had been made. As CreditSights say, a joint lender forum framework “was introduced back in 2014 to tackle stressed assets by identifying vulnerable accounts early and come up with a corrective action plan (CAP). However, disagreements between banks have caused delays.”

And now, from SocGen’s Kunal Kumar Kundu (with more detail from the RBI here):

… joint lender forums (JLFs), which are consortiums of bankers dealing with particular projects. They may also be able to decide on matters such as bank haircuts and intervene if JLFs reach deadlock. The framework will also enable JLFs to deal more effectively with NPLs by possibly tweaking the current guidelines and reducing the threshold in terms of exposure as well as the number of banks within a JLF for taking a decision on NPAs. Banks that are a part of a consortium face problems when disagreement arises among them on projects that have gone bad. There are promoters who have taken loans from one set of banks for their holding company, while they may have loans from another set for their operating company through pledged loans. In certain cases, banks opt to evergreen loans by giving fresh loans to borrowers to pay off old loans. Thus, a particular account that is an NPL for one set of banks could very well be regular/performing loan for another set. The current rule states that decisions regarding a bad loan or toxic assets are binding on all lenders in a JLF if they are approved by 75% in terms of exposure or 60% in terms of absolute numbers. The above examples clearly explain why it is difficult to arrive at a consensus given the high threshold, and hence the threshold has proved to be a deterrent against resolution in multiple cases. The amendment has brought down the threshold to 60% of creditors by value and 50% by number of lenders.

For three, and most simply, the RBI will now explicitly be able to push reluctant banks to move. That’s a good thing if it gets a gummed up system moving but you do have to pause and note the obvious risk of the RBI being politically comprised by decisions it makes or doesn’t make. There’s also the difficulties involved in the RBI trying to price assets that can be half-completed or held up due to pending government approvals. Oh, and also the RBI is the banks’ regulator, which is a bit awkward/compromising. As CreditSights put it, this “is significant in terms of its practical aspect but also because of the promulgation of a more intrusive central authority to oversee commercial decisions.”

But even if you overlook the politicisation of the RBI, there are other problems with this plan. Most basically, there is the question of who will buy the assets and the need for capital to be pumped in as haircuts are taken. From Nomura:

However, there are some issues… as most of the NPAs (~85%) are concentrated in public sector banks, there would be fiscal implications. According to our banking analysts, while large PSU banks have the capital to take 40-50% haircuts, smaller PSU banks will need capital infusions by the government.

There’s also the idea that this plan relies on an untested and overburdened bankruptcy court and an ordinance is rather far from the bad bank many had hoped was coming — in fact, it might be best seen as part of a series of efforts to increase the efficacy of the mechanisms already in place to deal with the bad loan problem. For example, there are those who argue the RBI already had broad powers that allowed it to inspect, caution and advise banks. But the answer to that seems to be… yes, but they were indeed broad and now have been rendered explicit.

As Praveen Chakravarty says, “it’s a leverage that was previously not explicitly available. This ordinance is also as much about signalling as it is about the technicalities, I think.” Which is fair but also means we have to wait to see what the RBI does with this signal and whether the government follows up and reins in the state-owned banks where the majority of the problem resides. As CreditSights argue, “given the scale of the problem and the fact that a substantial amount of bad loans are not recoverable, it will take more than a piece of new legislation to help revive banks.”

While one could easily argue that recent moves to push a farm-loan waiver might be seen as a signal of a different sort… As SocGen said to close:

The government needs to play a much more proactive role to ensure that cyclical bursts of burgeoning NPLs do not take the economy hostage. Rather than banking on hope as a strategy, a sincere effort at reforming SOBs should be visible in reality and not just in policy documents. Freeing SOBs from political influence and ensuring more professional bank boards remains essential. The Bank Boards Bureau (BBB) set up under the Indradhanush scheme has so far met with limited success in ensuring the professionalisation of the boards of various SOBs. However, apart from top-level appointments, many of its functions are quite vague. Even with regard to appointments, the BBB does not have the final say and quite often decisions are left in limbo as the finance ministry (which has representative on the BBB) may differ in opinion with the BBB. The BBB also doesn’t have any role in choosing the non-official directors at boards of SOBs, and such appointments typically remain political. BBBs need to be given wider power in this respect, and the government needs to maintain a hands-off approach. The government should also aim at bringing down its ownership in SOBs to less than 51%. Increasing the number of private shareholders could eventually force SOBs to act in a much more professional manner and take lending decisions purely on a commercial basis.

Finally, and more importantly, governments should show a greater sense of fiscal responsibility and eschew populist decisions that adversely impact bank balance sheets. The recent decision by the newly elected government in the state of Uttar Pradesh to waive farm loans is a case in point. A study by Niti Ayog (erstwhile Planning Commission) shows that if other states follow suit, the total of waived loans could amount to 2% of GDP. Another example is the policy of providing extremely cheap (even free in many cases) energy to the agriculture sector. Not only does this cause major stress in the finances of power distribution companies (c.90% of which are government owned), leading to periodic bailouts of these companies by the banks, but it also unintended consequence of depletion of the already stressed levels of groundwater in India, as the extraction of groundwater becomes cheap.

Related links:
What Makes a Good ‘Bad Bank’? The Irish, Spanish and German Experience – ECB
So you think you can bank? Indian public sector edition – FT Alphaville
Modi takes aim at India’s ailing public banks – FT

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