India’s Financial Services: Trust deficit, truth, and dare

The genesis of this trust deficit is that financial institutions have been slow to acknowledge and provide for the true extent of their stressed assets.

RBI’s Asset Quality Review (AQR) of banks, launched in 2015, forced banks to come clean on their asset quality. Consequently, the reported Gross Non-Performing Assets (GNPAs) of banks rose from 4.6 percent of advances in March 2015 to 11.6 percent of advances in March 2018, before recovering to 9.3 percent of advances in March 2019.

However, the worst is yet not over. Credit Suisse reckons that Rs 2.4 lakh crore of additional large bank debt — about half relating to NBFCs — could end up as fresh stressed assets. There is likely further bad news from loans to Micro, Small and Medium Enterprises (MSME), and under the MUDRA scheme. Stressed banking assets could settle at 12 percent of advances.

If banks are yet to complete NPA recognition and provisioning, NBFCs are far worse off. NBFCs reported GNPA of 6.6 percent of advances as of March 2019 — lower than the 9.3 percent reported by banks.

Bluntly, few analysts believe this reported NBFC GNPA.

NBFCs (and Housing Finance Corporations) have not yet undergone a full-fledged AQR. NBFCs also have more exposure to stressed sectors such as real estate and construction than banks. With large, back-ended bullet repayments, some NBFCs loans continue to show up as performing, even when the borrower has little ability to repay.

What is the “true” GNPA of NBFCs and HFCs?

When we don’t know what we don’t know, speculation takes over. NBFCs and HFCs had a balance sheet of Rs 36 lakh crore as of March 2019. If the extent of under-reporting is around 5 percent of advances, there could be Rs 1.8 lakh crore of more bad news yet to be recognised.

With banks, a bulk of the post-AQR NPA surfaced in Public Sector Banks (PSBs) with an implicit taxpayer guarantee — witness the Rs 3 lakh crore of additional capital that the government has helpfully supplied PSBs over the past three years.

With NBFCs and HFCs, there is no blank check underwriting their capital requirements.

The mistrust around asset quality has spilt over to doubts around governance as well.

Reported frauds relating to banking advances jumped up from Rs 22,500 crore in FY18 to Rs 64,500 crore in FY19. High profile financiers have had to move on, under a cloud of governance failures and in some cases, misconduct. Severe governance failures relating to the IL&FS default are still emerging. An excellent report by REDD in June 2019 highlighted how some NBFCs were possibly using “box structures” to mask their funding to their own promoters and related parties.

Beyond facts, water cooler whispers abound — about how financiers, promoters, politicians, bureaucrats, auditors, rating agencies and other stakeholders have engaged in severe misconduct to game the ecosystem.

Beyond a point, the truth does not matter. A trust deficit of this scale is any financial ecosystem’s worst nightmare and has to be addressed.

Most bankers resisted AQR and transparency. They repeatedly lobbied for “forbearance” — a euphemism for being allowed to extend, pretend, and sweep the dirt under the carpet.

We have heard several arguments in support of forbearance. That RBI/Basel norms for NPA recognition were unrealistic in the Indian context. That stresses were temporary, and that premature classification as NPA would come in the way of their resolution, creating economic distress and job losses. That capital is scarce, and India does not have the luxury of being overly conservative on banking capital.

We are seeing a déjà vu with NBFCs now.

No-one wants NBFCs to go through an AQR, fearing that we simply cannot handle the truth.

To be fair, a standalone NBFC AQR today would be akin to shouting “fire!” in a crowded hall. We are seeing a glimpse of this with the Yes Bank saga, where an attempt to bring in transparency spiraled into a panic sell-off.

How then do we address the trust deficit?

The answer is painfully obvious — along with truth around the problem, we need an honest, workable solution as well.

Alongside warning the people in the hall of the real fire hazard, they have to be shown how they can make an orderly exit.

What can be the honest, workable ways out for the issues around banks/NBFCs/HFCs?

First, we have to recognise that the overhang of large stressed assets needs a bespoke solution beyond the IBC process.

Second, we have to undertake deep structural reform of every part of the ecosystem.

Third, we have to bring in fresh capital into the ecosystem — but that would depend on us showing intent and delivery on the first two aspects.

The Insolvency and Bankruptcy Code (IBC) is a good legislation for resolution of our NPAs. However, the process has been delayed by litigation, process bottlenecks, and the sheer scale of the problem.

As I have argued earlier, we need a government-backed distressed asset manager to quarantine the large stressed assets of the ecosystem.

In this regard, the experience of Malaysia’s Danaharta is worth emulating.

After the Asian crisis, government-backed Danaharta bid for Malaysia’s large stressed assets at what they considered to be market price. Malaysia’s Financial Institutions (FIs) could decline to sell at the price but were then required to take penal provisions on the assets. On the flip side, if Danaharta recovered more than the original bid price through the resolution process, 80 percent of the surplus recovery was returned to the original FI.

This incentivised FIs to sell their stressed assets to Danaharta.

Danaharta was manned by professional sectoral experts (including international ones). With stressed assets effectively under state oversight, resolution could be sped, at times through legislative changes. Ultimately, Danaharta achieved a creditable 59 percent recovery rate in a time-bound manner.

We cannot stop at resolving the immediate NPAs alone and risk a repeat of this “lend — bail out — lend again” cycle over time.

We have to implement deep structural reforms alongside, to break this loop.

These would include banking reforms, along the lines of the PJ Nayak committee (May 2014) recommendations. Indian banks have to be corporatised, and we have to build a distance between North Block and banking.

Alongside, reform of capital markets, risk, and governance bodies (boards, auditors, regulators, credit rating agencies) needs to be undertaken as well.

Specific sectors of the economy such as real estate, construction, power also need deep-seated reforms.

There is no shortage of well thought out recommendations pertaining to each of these areas. We only await intent and execution.

Finally, if we show the way forward on addressing the overhang of NPAs and reforming the ecosystem, fresh private capital will follow.

There is tremendous goodwill for India’s prospects amongst investors – they only need to be convinced that we have a clear strategy in place and are focused on execution.

India’s financial sector ecosystem faces a deep trust deficit around its asset quality, disclosures and governance.

In the least, this crimps the ability of the sector to fund our much-needed growth. At worst, it is a lingering threat to our financial stability.

Ultimately, we need truth to remove the trust deficit. But to handle the truth, we need workable, realistic solutions to address the issues around asset quality and governance.

First, the overhang of NPAs requires a bespoke solution. A government-backed distressed asset manager along the lines of Malaysia’s Danaharta could be the answer.

Second, we have to undertake deep reform of all parts of the ecosystem – banks, capital markets, auditors, rating agencies, regulators and sectors such as real estate and power. There are ready, workable recommendations awaiting acceptance and implementation.

Finally, we need fresh capital. This will follow, provided we show intent and delivery on the NPA resolution and reforms as described above.

The current context is an excellent opportunity to truly strengthen the ecosystem and set up the next wave of growth and investments.

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