Project Name

NPA IN BANKS

Submitted by:

PUNIT GANATRA

Guided by:

Prof. V.S.DATE

P.G.D.B.M Yr: 2007-2009 Finance

Institute: N. L. Dalmia Institute of Management Studies & Research

N. L. Dalmia Institute of Management Studies & Research Shristi, Sector -1, Mira Road (E), Mumbai 401 104.

NLDIMSR

N. L. Dalmia Institute of Management Studies & Research Shristi, Sector -1, Mira Road (E), Mumbai 401 104.

CERTIFICATE
This is to certify that the project titled

NPA IN BANKS

Submitted by: Mr. PUNIT GANATRA

To: N. L. Dalmia Institute of Management Studies and Research, Mumbai in the fulfillment of the course, P.G.D.B.M During academic year 2007-2009 this has been carried out by him under our supervision and guidance.

Prof. V.S.DATE (Project Guide)

Prof. P. L. ARYA (Director)

NLDIMSR

ACKNOWLEDGE MENT

First and foremost, I would like to thank Prof. V.S.DATE & Prof. P. L. Arya for their guidance on the topic. I would also like to thank all my friends & other classmates who have helped me with their support and corrected me with their criticisms. I would also like to thank other faculty & staff members whose teaching & guidance has helped me in accomplishing this difficult task in such a short time.

My acknowledgements remain incomplete without thanking my family members. I would like to thank my parents, sister & others for their wholehearted support in helping me complete this project.

At the end I would like to thank all those who have indirectly helped me achieving my target & those whom I may not have mentioned in this acknowledgement.

NLDIMSR

EXECUTIVE SUMMARY
The Non-Performing Assets (NPAs) problem is one of the foremost and the most formidable problems that have shaken the entire banking industry in India like an earthquake. Like a canker worm, it has been eating the banking system from within, since long. And like the dreaded disease AIDS, banks have not been able to find a reliable cure for this malady. It has grown like a cancer and has infected every limb of the banking system. At the macro level, NPAs have chocked off the supply line of credit to the potential borrowers, thereby having a deleterious effect on capital formation and arresting the economic activity in the country. At the micro level, the unsustainable level of NPAs has eroded the profitability of banks through reduced interest income and provisioning requirements, besides restricting the recycling of funds leading to serious asset-liability mismatches. It has inter alia lead to reduction in their competitiveness and erosion in their capital base as well. The problem of NPAs is not a matter of concern for the lenders alone. It is a matter of grave concern to the public as well, as bank credit is the catalyst to the economic growth of the country and any bottleneck in the smooth flow of credit, one cause for which is mounting NPAs, is bound to create adverse repercussions in the economy. Mounting menace of NPAs has raised the cost of credit, made banks more averse to risk and squeezed genuine small and medium enterprises from accessing competitive credit and has throttled their enterprising spirits as well. The spiraling and the devastating affect of NPAs on the economy have made the problem of NPAs an issue of public debate and of national priority. Therefore, any measure or reform on this front would be inadequate and incomprehensive, if it fails to make a dent in NPAs' reduction and stall their growth in future, as well.

NLDIMSR

TABLE OF CONTENTS

Sr. No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

NAME Introduction to NPAs NPA Classification Valuation of NPAs Factors responsible for NPAs Statistics Implication of NPAs Committee on Banking Sector Reforms Measures to Recover NPAs Securatisation Act Management of NPAs Conclusion Bibliography

PAGE No. 01 04 08 13 16 20 22 25 41 50 52 53

INTRODUCTION TO NPAs
Granting of credit facilities for economic activities is the main raison detre of banking. Apart from raising resources through fresh deposits, borrowings, etc. recycling of funds received back from borrowers constitutes a major part of funding credit dispensation activities. Non-recovery of installments as also interest on the loan portfolio negates the effectiveness of this process of the credit cycle. Non-recovery also affects the profitability of banks besides being required to maintain more owned funds by way of capital and creation of reserves and provisions to act as cushion for the loan losses. Avoidance of loan losses is one of the pre-occupations of management of banks. While complete elimination of such losses is not possible, bank managements aim to keep the losses at a low level. In fact, it is the level of non-performing advances, which, to a great extent, differentiates between a good and a bad bank. Mounting NPAs may also have more widespread repercussions. To avoid shock waves affecting the system, the salvaging exercise is done by the Government or by the industry on the behest of Government/ central bank of the country putting pressure on the exchequer. In India, the NPAs, which are considered to be at higher levels than those in other countries, have, of late, attracted the attention of public as also of international financial institutions. This has gained further prominence in the wake of transparency and disclosure measures initiated by the RBI during recent years. The Committee on Financial System, Capital Account Convertibility Committee on Non-Performing Assets of Public Sector Banks has dealt with the subject of NPAs of Indian banks.

NLDIMSR

What is an NPA? To begin with, it seems appropriate to define Non-Performing Advance popularly called NPA. Non-Performing Advance is defined as an advance where payment of interest or repayment of installment of principal (in case of Term Loans) or both remains unpaid for a period of two quarters or more. However with effect from March 2004, default status would be given to a borrower if dues were not paid for 90 days. If any advance or credit facilities granted by bank to a borrower becomes non-performing, then the bank will have to treat all the advances/credit facilities granted to that borrower as non-performing without having any regard to the fact that there may still exist certain advances / credit facilities having performing status. The magnitude The NPAs in the Indian banking system have assumed astronomical dimensions. NPAs of scheduled commercial banks totaled Rs.70,904 cr as on March 31, 2002, which form 10.40% of our gross bank credit, about 15.75% of our annual budget and 3% of our Gross Domestic Product. It is equivalent to our annual defense budget. In absolute terms, NPAs have been increasing at the rate of about 5 to 6% every year. The staggering magnitude of NPAs is costing the public sector banks alone, more than Rs. 5,000 cr annually, by way of loss of interest income, apart from servicing and litigation costs. The malady of high level of NPAs eroding the profitability of banks is not confined to public sector banks alone, it is equally hammering the bottom lines of old as well as new generation private sector banks and foreign banks. Segmentation of NPAs NPAs cover a cross-section of industries such as iron and steel and related units like Ferro Alloys; Manmade textiles; Real estate / Civil and Project

NLDIMSR

related construction; Pharmaceutical; Leather / goods export; Garment export; Fertilizers and Chemicals; Cement and Cotton (fibres / textiles); Tea / Coffee; Jute; Sugar; and Jewellery / Diamonds. NPA in Indian Banks Vis--Vis other countries Comparison of the problem loan levels in Indian banking system vis--vis those in other countries, particularly those in developed economies, is often made, more so in the context of the opening up of our financial sector. The data in respect of NPAs level of banking system available for countries USA, Japan, Hong Kong, Korea, Taiwan and Malaysia reveal that to ranges from 1% to 8.1% during 1993-94, 0.9% to 5.5% during 1994-95 and 0.85% to 3.9% during 1995-96 as against 23.6% 19.5% and 17.3% respectively for Indian banks during these years. Notwithstanding this, some features relating to the NPA

reporting/evaluation practices in other countries vis--vis those in our countries need, however, to be considered before reaching to any conclusion on the level of NPAs. In some countries, all or bulk of banks provisions are general provisions and identified losses are written off at an early stage. Banks in these countries carry very little NPAs in their balance sheets. The recovery measures are also very expeditious in view of stringent bankruptcy and foreclosure laws. The concept of gross NPA and Net NPA is not in vogue in these countries. In Indian banking, due to time lag involved in recovery process and the detailed safeguards/procedures involved before write-offs could be affected, banks even after making provisions for the advances considered irrecoverable, continue to hold such advances in their books which is termed as Gross NPA together with the provisions. The provision adjusted NPAs in Indian banking segment i.e. Net NPAs, constitute only 8.2% of the net advances of the banks as on 31 st March, 1998 which no doubt are high by international standard but are not so alarming as Gross NPAs project.

NLDIMSR

NPA CLASSIFICATION
NPA Norms across the world: The details and classification standards of non-performance vary from country to country, as the countries put in place norms as per the peculiarities/requirements of their banking systems. The practices with regard to these securities also differ. In certain countries, an advance is considered un-collectible and classified as loss asset only after it remains as past due or doubtful for a certain length of time, whereas in India, an advance is considered to be classified as loss the moment it is considered un-collectible. In certain other countries, the available securities are deducted from the doubtful advance to arrive at the net doubtful portion, whereas in India provision is required to be made even on the secured portion. In India, the provision required to be made in respect of the portion not covered by the realizable value of securities in doubtful advance 100% whereas in some countries, its 75% or even 50%. The concept of collateral also differs in as much as security of standby nature like guarantee of promoter/third party, net worth of the promoter/guarantor are not considered as security in India. Historical Conceptualization of Problem Loans in Indian Banking: Health Code System: A critical analysis of a comprehensive and uniform credit monitoring was introduced in 1985-86 by RBI by way of the Health Code System in banks, which inter alia, provided information regarding the health of individual advances, the quality of credit portfolio and extent of advances causing in relation to total advances. It was considered that such information would be of immense use to bank managements for control purposes. The RBI advised all commercial banks

NLDIMSR

(excluding foreign banks, most of which had similar coding system in their organizations) on November 7, 1985 to introduce the Health Code classification indicating the quality (or health) of individual advances in the following eight categories, with a health code assigned to each borrowal account: 1.Satisfactory Conduct is satisfactory; all terms and conditions are complied with; all accounts are in order; and safety of 2.Irregular the account is not in doubt. The safety of the advance is not suspected, though there may be occasional irregularities which may be 3. Sick-viable considered to be as a short term phenomenon Advances to unit which are sick but viable under nursing and units in respect of which nursing/revival 4.Sick: non-viable/sticky programmes are taken up The irregularities continue to persist and there are no immediate prospects of regularization; the accounts could throw up some of the usual signs of incipient 5.Advances recalled sickness Accounts where the repayment is highly doubtful and nursing is not considered worthwhile; includes where 6.Suit filed accounts 7.Decreed debts 8. Bad and doubtful debts decisions have been taken to recall the advance Accounts where legal actions or recovery proceedings have been initiated Where decrees have been obtained Where the recoverability of the banks dues has become doubtful on account of short-fall in value of security; difficulty in enforcing and realizing the securities; or inability/unwillingness of the borrowers to repay the banks dues partly or wholly Under the above Health Code System, the RBI was classifying problem loans of each bank in three categories, which are as under: (a) Advances classified as bad and doubtful by the bank

(corresponding to Health Code No. 8)

NLDIMSR

10

(b) Advances (c)

where

suits

were

filed/decrees

obtained

(corresponding to Health Codes Nos. 6 & 7) and Those advances with major undesirable features (broadly corresponding to Health Codes Nos. 4 & 5) PRUDENTIAL NORMS In order to ensure greater transparency in the borrowal accounts and to reflect actual health of banks in their Balance Sheets, RBI introduced prudential regulations relating to Asset Classification An Asset is considered Non Performing in case if interest or installments of principal or both remain unpaid for more than two quarters and if it has become past due, i.e., 30 days after the due date. An Advance is to be classified as Sub-standard if it remains NPA upto a period of two years and will be classified as Doubtful if it remains NPA for more than eighteen months. An account will be classified as Loss, without any waiting period, where the dues are considered uncollectible or only marginally collectible.

BASIS OF NPAs The basis of treating a credit facility as NPA is as detailed below: ASSET In respect of which interest has remained past due for six months. TERM LOAN Inclusive of unpaid interest, when the installment is overdue for more than six months/on which interest amount remained past due for six months. BILL Which remains overdue for six months.

NLDIMSR

11

OTHER CURRENT ASSETS The interest in respect of a debt/income on a receivable in the nature of short-term loans/ advances, which remained overdue for a period of six months. SALE OF ASSETS/SERVICE RENDERED. Any dues on account of

these/reimbursement of expenses rendered which remained overdue for a period of six months. LEASE RENTAL/HIRE-PURCHASE INSTALMENT The installment which has become overdue for a period of more than twelve months. OTHER CREDIT FACILITIES The balance outstanding including interest accrued made available to the borrower/beneficiary in the same capacity when any of the credit facilities become NPA.

NLDIMSR

12

VALUATION OF NPAS: DIFFERING APPROACHES

NPAs are a by-product of most financial systems and the level of NPAs is an indicator of the health of the financial system of an economy. Valuation techniques should present the situation, which maximizes the overall interests of all the concerned parties. The broad objectives of the valuation Framework are essentially: To set a sound basis for the selling bank/ institution to finalize the sale of assets, To provide a basis for the fair market value of the assets, To promote transparency of the valuation processes, and, To comply with internationally accepted practices.

The valuation of an asset or the pool of assets is a precursor to any restructuring exercise. Any valuation exercise shall attempt to address the following issues: The fair market value of the asset should represent the price at which market participants would undertake a restructuring. The transaction value should reflect the potential for income generation and return of principal, balanced against the applicable risk profile and market lending margins. The valuation Framework should allow for valuation of specific assets as well as a portfolio of assets (i.e. portfolio of loans to be acquired from a bank). In most cases, a single value will apply to each loan acquired. For larger loans, however, an element of risk/return sharing with the selling bank may be considered. I shall now discuss here the valuation approach in two parts i.e. (i) traditional approaches and (ii) unconventional approaches. Traditional Schools of Valuation Processes

NLDIMSR

13

There are various methodologies used to value the companies or their debt. Typically cash flows, assets or replacement values, or a combination of these, are considered when determining the value of a company or its debt. The matrix shows the risk profile of the NPA based on its cash flows and collateral. As shown, stronger the cash flows and collateral, lower the risk profile of the asset. Some of the widely used approaches towards valuation of an NPA by the valuation firms are detailed as under: Discounted cash flows Liquidation / sale of assets Earnings model Case specific valuation models

Discounted cash flows One of the commonly used methods for estimating the value of the companys debt is the anticipated cash flows. The cash flow stream will represent the interest and principal payments expected to be received by the lender, primarily arising out of the internal cash flow generation from underlying business activities. Where the asset is a partly completed project, the cash flow stream will have to take into account whether the project will be completed and if so how it will be financed. If certain lenders decide to fund this through extended facility, this will be taken into account in the asset's cash flow stream. Essentially the decision on the projects financial viability will be determined by using an incremental cash flow analysis. Normally, the value of a healthy asset is computed as the discounted value of the expected future cash flows. However, a company in distress or an NPA may have negative earnings (profit before interest, depreciation and tax) and may be likely to incur operating losses for the next few years. For such companies, the estimation of future cash flows is not so easy, as there is a strong possibility of bankruptcy (Damodaran, 1994). Under such a scenario the asset valuation is also based on subjective parameters. A NLDIMSR 14

company under financial distress has some or all of the following characteristics: operating loss, inability to meet the debt obligations and high debt equity ratio. When dealing with such cases, the credit analysts need to evaluate the possibility and timing of positive financial performance of the company in future which may be dependent on the industrial scenario, possibility of infusion of additional funds and the overall macro economic environment. If the company is expected to improve its financial position in the future, the following discounted cash flow model may be used for the distress companies / NPAs. Liquidation value approach If the loan is in default with no or low expectation of it being serviced, the cash flow from liquidation of the asset and collateral will be the primary approach rather than the net present value of the cash flows. In this case, the take-out of the lender is primarily by way of exercise of their rights on the asset and attached collateral. The liquidation value of the company is the aggregate of the value of the assets of the company if sold at the market prices, net of transactions and legal costs. The estimation of the assets becomes quite complicated when the assets of the company cannot be easily separated like in a steel, textile or petrochemical plant. If such assets are sold individually, majority of the asset may not fetch a price closer to their book value (or when they are sold as a bundle). Further, when such sale is to take place at a quick pace, the value of the assets further fall down, as it is more or less equal to forced sale of these assets. As a result of this forced sale, the seller has to accept a discount on the fair market value of such assets. In most cases, such a realization is not able to cover even the secured debt fully and hence the valuation of the debt would be limited by this realizable value. This approach has been widely used in countries like Thailand where a significant number of loans were secured by real estate and other marketable securities of various kinds. Earning model

NLDIMSR

15

In performing companies, the P/E ratio of the industry or other similar companies may be used as a tool for determining the market value of the assets of company. If the debt of the company is more than its assets, then a proportionate discount may be applied to the debt. The above approach, however, cannot be used for most of the NPAs, as they would have negative EPS. In such cases, the cash earning per share of the company and cash P/E ratio of the similar companies may be used to arrive at a market value of the assets. This shall enable the analyst to arrive at a reasonable valuation of the NPA debt. Case specific valuation models Depending on case to case, various models have been evolved and used for specific requirements. I shall discuss here one of such models to provide an idea as to how varied the models can be from the conventional approaches. Segmentation into buckets For a huge portfolio of small loans, different kind of approach may be used for arriving at the realistic valuation. One of them is categorizing the loans in various buckets and then analyzing a sample picked from various buckets. Post currency crisis of late 1990s in Thailand, the price of real estate had declined to abysmally low levels and majority of the property-linked loans had become NPAs in the books of the local banks. One of the leading financial companies in the world was contemplating to purchase these loans totaling over 20,000 small loans. For arriving at the appropriate valuation, they had followed the following methodology: Segmentation of the assets in various buckets Selection of a sample out of each bucket Detailed analysis of each sample Statistical extrapolation of the sample to the entire bucket 16

NLDIMSR

Arriving at the final range of the valuation of the portfolio

NLDIMSR

17

FACTORS RESPONSIBLE FOR NPAs

The dues of the Banking sector are generally related to the performance of the unit / industrial segment. In a few cases, the cause of NPA has been due to internal factors (to the banks) such as weak appraisal or follow-up of loans but more often than not, it is due to factors such as management inefficiency of borrowal units, obsolescence, lack of demand, non-availability of inputs, environmental factors, etc. The main reasons for sickness and the factors leading to NPA are as under INTERNAL FACTORS: Diversion of Funds for expansion, modernization, setting up of new projects, helping or promoting sister concerns. Time / Cost overruns while implementing the project. Business failure like product failing to capture market, inefficient management, strike / strained labour relations, wrong technology, technical problems, product obsolescence, etc.

EXTERNAL FACTORS: Failure, non-payment / overdues in other countries, recession in other countries, externalization problems, adverse exchange rates, etc. Government policies like excise, import duty changes, deregulation, pollution control orders, etc.

NLDIMSR

18

Willful default, siphoning of funds, Fraud, misappropriation, promoters / management disputes, etc.

Deficiencies on the part of the Banks, viz., in credit appraisal, monitoring and follow-up, delay in release of limits, delay in settlement payments / subsidies by Government bodies, etc. External factors like raw material shortage, raw material / input

price escalation, power shortage, industrial recession, excess capacity, natural calamities like floods, accidents, etc.

Contribution to NPAs by factors like siphoning off funds thorough Fraud/misappropriation was less significant in comparison with other factors. Incidence of NPAs on account of deficiencies on the part of banks such as delay in sanction and disbursement of funds whereby borrowing units are starved of funds when in need, and delay in settlement of payments/subsidies by the Government bodies was on the low side in proportion to other factors. Lack of effective co-ordination between banks and financial institutions in respect of large value projects does contribute to the emergence of NPAs even at the implementation stage. RBI had, in February 2000,drawn up certain ground rules in this regard in consultation with banks, financial institutions and IBA and circulated the same among banks and financial institutions for implementation. Susceptibility of the sanctioning authorities to external pressure, failings of the CEOs and the ineffectiveness of the Board to check his ways also contributed in no small measure to the unusual build up of NPAs in some of the banks. One of the most prominent causes for NPAs, as often observed by RBI Inspectors, is the slackness on the part of the credit management staff in their follow up to detect and prevent diversion of funds in the post-disbursement stage.

NLDIMSR

19

Impact of Priority Sector Advances on NPAs There is a common perception that the prescription of 40% of the net bank credit to priority sectors have led to higher level of NPAs, because credit to these sectors become sticky. However, it has been observed that the proportion of NPAs in these sectors is lesser than the proportion of NPAs in the Non-Priority sector, although, the incidence of NPAs in the priority sectors is much higher. The gradual increase in the proportion of the NPAs in the Non-priority sectors indicates that NPAs are increasingly occurring on borrowal accounts of Industrial sector during the recent years.

NLDIMSR

20

STATISTICS PERTAINING TO NPAs

NPA OF INDIAN BANKS The Non Performing Assets (NPA) of 27 public sector banks shot up to Rs.56,608 crore in September 2001. NPA not only reduces the yield on advances but also reduces the profitability of banks. The huge NPA's of the bank is due to the debtor friendly foreclosure and bankrupt laws which allows customers to default with (Rs. In crores) Year 1993 1994 1995 .1996 1997 1998 1999 2000 2001 Gross NPA 39,253 41,041 38,385 41,661 47,300 50,815 58,722 53,066 56,608 Gross NPA as % of Gross advance 23.2% 24.8% 19.5% 18% 15.7% 14.4% 14.7% 13% 13% Net NPA as Net NPA NA NA 17,567 18,297 22,340 23,761 28,020 26,596 27,856 % of net advances NA NA 10.7% 8.9% 8.1% 7.3% 7.6% 7% 7%

It will be also interesting to have a look at the movement of NPAs (gross and net), as a percentage of advances, group-wise over the last four years. This will give an idea of where banks, as different groups, stand in regard to their NPAs.

Percentage of gross / net NPAs to total advances as at end March Bank Groups Public sector banks

1998 16.0 (8.2)

1999 15.9 (8.1)

2000 14.0 (7.4)

2001 12.4 (6.7) 21

NLDIMSR

All private sector banks

8.7 (5.3)

10.8 (7.4) 13.1 (9.0) 6.2 (4.5) 7.6 (2.9) 14.7 (7.6)

8.2 (5.4) 10.8 (7.1) 4.1 (2.9) 7.0 (2.4) 12.7 (6.8)

8.5 (5.4) 11.1 (7.3) 5.1 (3.1) 6.8 (1.9) 11.4 (6.2)

Old private sector banks

10.9 (6.5)

New private sector banks

3.5 (2.6)

Foreign banks

6.4 (2.2)

All commercial banks

14.4 (7.3)

Note: Figures in parenthesis denote percentage of net NPAs to net advances It may be observed that the malady of high level of NPAs eroding the profitability of banks is not confined to public sector banks alone, but it is equally present in the private sector banks too. While some of the foreign banks loan portfolio had been affected by a few large accounts turning NPA, it is a matter of concern that some of the new private sector banks, which started off, on a clean slate had acquired so quickly such a large level of NPAs.

Share of NPAs in Net Advances Bank Group Number of Number of Banks Number of Banks with Banks with Higher Share Lower Share in Assets

NLDIMSR

22

Public

Sector

27 24 8 36

in Assets 4 11 8 15

3 4 -2

4 8 -11

16 1 -1

Banks Old Private Sector Banks New Private

Sector Banks Foreign Banks

Total

95

38

23

18

In all forums of interactions the global multilateral institutions and rating agencies had with RBI and the Government, directed lending concept gets quoted as an important attribute and a contributory factor for the build up of NPAs in banks in India. It is a different matter that RBI and the Government are accused of soft attitude towards banks which do not fulfill the prescribed targets for priority sector lending, particularly agriculture and small scale sector. The figures in the following table as on March 31, 2001 reveals information regarding the contribution by various segments of borrowers to the NPA stock of public sector banks: -

Gross NPAs as on March 31, 2001 Borrowing wise segment- Amount distribution of (Rs. Percentage to total NPAs

NLDIMSR

23

gross NPAs Public sector units Large Industries Medium industries Other non priority sectors Agriculture Small scale industries Other priority sectors Total

crores) 1334.05 11498.10 8658.69 9516.62 7311.40 10284.97 6169.33 54773.16 2.44 20.99 15.81 17.37 13.35 18.78 11.26 100.00

It can be understood that recovery of NPAs under priority sector advances particularly to agriculture and small-scale industries is sometimes hampered by externalities. Further, such NPAs are also spread over a large number of accounts and for small amounts. However, one fails to understand the reluctance of large borrowers to honour their repayment obligations. In many cases, failure of banks to take effective action against some of the defaulting large corporate borrowers was also noticed.

NLDIMSR

24

IMPLICATIONS OF NPAs
Supervisory action that may arise on account of high level of NPAs One of the trigger points in the proposed Prompt Corrective Action (PCA) mechanism [which was widely circulated by RBI through the public domain] is the level of net NPAs. When the trigger point under the mechanism is activated by the performance of a bank, the mandatory actions would follow by way of restriction on expansion of risk-weighted assets, submission and implementation of capital restoration plan, prior approval of RBI for opening of new branches and new lines of business, paying off costly deposits and special drive to reduce the stock of NPAs, review of loan policy, etc. Provisioning for NPAs Based on the Asset classification, Banks are required to make provision against the NPAs at 100% for Loss Assets; 100% of the unsecured portion plus 20% to 50% of the secured portion, depending on the period for which the account has remained in doubtful category; and 10% general provision on the outstanding balance in respect of Sub-standard assets. Banks have been asked to make provision @ 0.25% on their standard advances. Other implications The most important business implication of the NPAs is that it leads to the credit risk management assuming priority over other aspects of bank's functioning. The banks whole machinery would thus be pre-occupied with recovery procedures rather than concentrating on expanding business. As already mentioned earlier, a bank with high level of NPAs would be forced to incur carrying costs on a non-income yielding assets. Other consequences would be reduction in interest income, high level of provisioning, stress on profitability and capital adequacy, gradual decline in ability to meet steady increase in cost, increased pressure on net interest margin (NIM) thereby reducing competitiveness, steady erosion of capital resources and increased difficulty in augmenting capital resources.

NLDIMSR

25

The lesser appreciated implications are reputational risks arising out of greater disclosures on quantum and movement of NPAs, provisions etc. The non-quantifiable implications can be psychological like play safe attitude and risk aversion, lower morale and disinclination to take decisions at all levels of staff in the bank.

NLDIMSR

26

COMMITTEE ON BANKING SECTOR REFORMS:

The Committee on Banking Sector Reforms (CBSR) report suggests remedies to recover the NPAs as well their subsequent transfer as assets through fund management. Some of the critical points are discussed here under: Where guarantees have been given by the central or state government and a demand thereunder has been raised by the banks, these demands should be honoured. Banks must put greater reliance upon the recommendations of the Settlement Advisory Committee (SAC) in order to make better use of compromises for reduction of NPAs in their books. The most effective way of removing NPAs from the books of the weak banks would be to move these out to a separate agency which will buy the loans and make its own efforts for their recovery. The proper financial vehicle through which non-performing loans can be transferred would be that of the FRA-owned (government) asset reconstruction (ARF) managed by the independent private sector Asset Management Company. The ownership of the assets will lie with the government and the management thereof with a separate private sector entity having the necessary expertise and organization. The ARFs operations will be profit oriented and its aim will be to recover from the acquired assets (NPA) more than the price paid for it.

NLDIMSR

27

The FRA and the ARF owned by it may be set up under a special act of the parliament which while protecting it against obstructive litigation from the borrowers could also provide for quick and effective enforcement of its rights against them.

The government will provide the fund needed for the ARF. The size of the fund needed will depend upon the size of business it handle. Presently it is proposed that the ARF may restrict its activities to the NPAs of the three identified weak banks.

The ARF should focus on comparatively larger NPAs. It would be desirable not to acquire assets value below Rs.50 lakh. The payment in respect of the assets purchased from the weak banks may be made by the ARF by issuing special bonds guaranteed by the government and bearing a suitable rate of interest.

The bonds issued by the ARF in payment of the assets acquired as also those which it will issue for raising funds against the security of the assets it has purchased and which are in the course of collection may have a maturity of five years.

The ARF should purchase from the banks loans, which are NPAs as on a certain date say, 31.3.2000. In view of the foregoing it will be adequate for the ARF to have a life of not more than seven years form the date of its commencing business, say beginning 1.4.2000.

To begin with, the ARF may buy NPAs of only the three identified weak banks. However buying NPAs from other banks need not be totally excluded.

NLDIMSR

28

If need arises, more funds could be set up later. Participation in these funds may be open to both public and private sector. These funds can facilitate growth of secondary market for loans in the country.

Price at which NPAs will be transferred should be arrived by mutual agreement and in a transparent manner.

In the ownership of the AMC while the government may have a share of upto 49 percent, majority shareholding should be non-government. Institutions like SBI, LIC, GIC, UTI and IFCI and parties form the private sector could be the other shareholders. The possibility of attracting participating of multilateral agencies like IFC or ADB should also be explored. The initial capital requirement of the AMC is not likely to be more than Rs. 15 crore.

Professionals such as bankers, chartered accountants, engineers, lawyers and valuers should man the AMC, which must have a lean structure, so that it has the desired expertise and is cost efficient.

NLDIMSR

29

MEASURES TO RECOVER NPAs

Life Line of Banking: New RBI Formula for NPA Recovery Over the last few years Indian banking in its attempt to integrate itself with the global banking has been facing lots of hurdles in its way due to its inherent weaknesses, despite its high sounding claims and lofty achievements. One of the major hurdles, the Indian banking is facing today, is its ever-growing size of nonperforming assets over which the top management of almost each bank is baffled. On account of the intricacies involved in handling the NPAs the ticklish task of asset management of the bank has become a tight rope walk affair for the controlling heads, because a little wavering this or that side may land the concern bank in trouble. The growing NPAs is a potent source of worry for the finance minister as well, because in a developing country like ours, banking is seen as an important instrument of development, while with the backbreaking NPAs, banks have become helpless burden on the economy. RBI has announced the modified guidelines under the settlement advisory committee (sac) scheme vide its letter no bp.bc.11.21.01 040/99-00 dated 27th July 2000. A specific time frame was also stipulated in the scheme, but due to various reasons the scheme could not make any sizeable dent into the problem. Therefore, realizing the obstacles in handling the NPAs and solving the issue in a meaningful, and realistic manner, RBI now have come out with a fresh set of guidelines under the modified sac schemes discussed hereunder. Laying stress on the timeframe, the scheme looks more definitive and decisive, as cut off dates have been fixed for the implementation of the scheme. Under the scheme, detailed guidelines have been issued by RBI to cover NPA with outstanding amount upto Rs.5 crore. However for outstanding amount above Rs. 5 crore, policy formulation for the settlement of the account is left with the concerned bank it is observed that majority of the NPA constitute accounts with outstanding amount below rupees five crores. Thus by following the provisions of NLDIMSR 30

the revised schemes, the size of the NPAs can be reduced to a level acceptable as per the international norms. As per the guidelines, the scheme covers NPAs, which have become doubtful or loss assets as on 31.3.1997. Further the scheme also covers NPA classified as sub-standard as on 31.3.1997, but later on becoming doubtful or loss assets. NPAs with outstanding upto Rs. 5 crore In case of doubtful and loss assets as of 31.3.1997, through the modified schemes, the banks have been directed to follow up a settlement formula under which the minimum amount to be recovered, amounts to be entire outstanding running ledger balance as on the date the account was identified as NPA i.e. the date from which the interest was not charged to the running ledger, an analysis of the given formula shows that RBI has been very much generous in granting huge relaxation to the borrowers who were not coming forward for setting their overdue loans due to one or other reason. The scheme is of high practical value as it protects the borrowers who were having genuine problems in clearing their dues because the interest component constituted a multiplied amount of principal outstanding. On the other hand, the concerned banks were also finding in difficult to sacrifice the entire interest component, but outstanding in the dummy ledger. Now as per the provision to he scheme, they will be ready to grant such relaxation in favour of the borrowers. These guidelines have come as a windfall for borrowers who after a lot of negotiations, were almost ready to repay back their principal as well as a part of the interest component to settle their accounts, as under the modified scheme, they would be able to save the interest component. To that extent the concerned bank stands to lose. In the case of sub-standard asset as of 31.3.1997, the settlement formula as given in the modified scheme states that the minimum sum to be recovered must contain the entire running ledger outstanding balance as on the date of the account was identified as NPA. i.e. the date from which interest was not charged to the running ledger + interest at the existing prime lending rate of the bank from

NLDIMSR

31

1.4.1997 till the date of final payment. As per the modified sac scheme, the terms suggested for the payment of settlement amount of NPA are simple and pragmatic. As per the terms of the scheme, the settlement amount should be paid in lump Sum by the borrower. However in case of the borrower is unable to repay back in a lump Sum, the scheme allows sufficient breathing period to enable him to arrange the funds and clear at least 25 percent of the settlement amount to be paid upfront and the remaining amount to be recovered in installments spread over a period of one year along with interest at the existing PLR from the date of settlement upto the date of final payment It is observed that each bank is having a system of delegation of authority for the clearance of NPAs, so there should not be any operational problem in the implementing of the scheme as per the modified guidelines.

NPAs with outstanding over Rs. Five crore For recovery of NPAs over Rs.5 crore, RBI has left the matter to the concerned banks and advised that the concerned banks may formulate policy guidelines regarding their settlement and recovery. The freedom, in such cases, is given to the banks, because the attending circumstances in each case may vary from the other. Therefore it was in the right direction that adopting a generalized approach was not thought appropriate. In cases, where the amount involved is above Rs.5 crore, RBI expects CMD of each bank to supervise the NPA personally. The CMDs of the concerned banks are advised to review all such cases within a given timeframe and decide the course of action in terms of rehabilitation/restructuring. OTS or filing of suits by 31st August 2000.It is also expected that in all such cases, the matter be placed before the boards of the concerned banks for finalising the course of action by 31.9.2000. Further it is also clarified that in cases where a legal suit is required to be filed, the same should be filed in all such cases by 31.10.2000 and

NLDIMSR

32

it should be vigorously followed up. RBI also desires the submission of a quarterly report of all NPAs above Rs.5 crore from the PSU banks. Thus by putting up the cut-off dates for the implementing of the scheme, RBI desires the banks to realize the seriousness of the issue and gear up to sweep away the NPAs in one go. For the commercial banks, it is a golden opportunity to clear the mess, consolidate and come out on a track leading to the path of global banking. The time given for weeding out the disastrous NPAs is neither too long nor too short and the banks, with proper planning and follow up can drastically reduce their NPAs, if they firmly resolve to do so. RBI expects the commercial banks to follow the guidelines in letter and spirit without any discrimination or discretion as a slight dilution may jeopardize their interest. A proper monitoring system is also desired to be evolved for monitoring the progress of the scheme. As this is a rare opportunity given to the defaulting borrowers, so that they can avail the chance given for the settlement of their loans. Without adequate publicity of the scheme, the response from the defaulting borrowers may not be there to the expected level. It is a matter of concern that out of 27 public sector banks only three or four are able to manage to restrict their NPA level to below 5 percent. The Narsimham committee had pointed out in its report of 1998 that we seek consolidation by looking at the problem of NPAs from a relative angle. We find it comfortable to read NPA as a percentage to total advances, which reduced from 23.2 percent at the end of March 1993 to 16 percent at the end of March 1998 and further down to 15.9 percent at the end of March 1999. While in absolute terms total NPA of public sector banks increased from Rs.39250 crore as on March 1993 to Rs.45653 crore as on march 1998 to Rs.58554 crore as on march 1999. The modified scheme announced by RBI has come at the right moment when it is badly needed. The banking industry is ready to take it in the right

NLDIMSR

33

prospective, but it is successful implementation depends upon a number of factors as enumerated below: The success of the scheme would be limited to the level of seriousness evinced by the concerned banks. If it is taken as a routine guideline from the RBI and disposed of without attaching the importance it deserves, it may end up as any other routine matter. Looking to the gravity of the issue, the rate of success of the scheme depends upon the publicity given to the golden opportunity available among the defaulting borrowers. It is felt that the scheme must reach every nook and corner of the country as the disease reflected in the form of NPA is not restricted to a particular area or pockets in the country. It is also required that the progress of the implementation of the scheme be assessed periodically by evolving an alert monitoring system by each bank. As the implementation of the scheme is going to decide the destiny of the concerned bank, it is absolutely necessary that an effective monitoring system is there to ensure successful implementation of the scheme. It is also essential that while settling the NPA as a dispassionate and unprejudiced approach is adopted without any discrimination failing which the banks will not be able to weed out NPAs. A multifrontal approach to the problem involving all the concerned staff members in the field as well as in the controlling points is another condition for proper implementation of the scheme. In the absence of teamwork involving a top management as well as everybody upto the grassroot level, the banks would not be able to root out the problem.

Measures initiated by Reserve Bank and Government of India for reduction of NPAs Compromise settlement schemes The RBI / Government of India have been constantly goading the banks to take steps for arresting the incidence of fresh NPAs and have also been creating legal NLDIMSR 34

and regulatory environment to facilitate the recovery of existing NPAs of banks. More significant of them, I would like to recapitulate at this stage.

The broad Framework for compromise or negotiated settlement of NPAs advised by RBI in July 1995 continues to be in place. Banks are free to design and implement their own policies for recovery and write-off incorporating compromise and negotiated settlements with the approval of their Boards, particularly for old and unresolved cases falling under the NPA category. The policy Framework suggested by RBI provides for setting up of an independent Settlement Advisory Committees headed by a retired Judge of the High Court to scrutinise and recommend compromise proposals.

Specific guidelines were issued in May 1999 to public sector banks for one time non-discretionary and non-discriminatory settlement of NPAs of small sector. The scheme was operative upto September 30, 2000. [Public sector banks recovered Rs. 668 crore through compromise settlement under this scheme.]

Guidelines were modified in July 2000 for recovery of the stock of NPAs of Rs. 5 crore and less as on 31 March 1997. [The above guidelines which were valid upto June 30, 2001 helped the public sector banks to recover Rs. 2600 crore by September 2001]

NLDIMSR

35

An OTS Scheme covering advances of Rs.25000 and below continues to be in operation and guidelines in pursuance to the budget announcement of the Honble Finance Minister providing for OTS for advances up to Rs.50, 000 in respect of NPAs of small/marginal farmers are being drawn up.

Measures for faster legal process Lok Adalats Lok Adalat institutions help banks to settle disputes involving accounts in "doubtful" and "loss" category, with outstanding balance of Rs.5 lakh for compromise settlement under Lok Adalats. Debt Recovery Tribunals have now been empowered to organize Lok Adalats to decide on cases of NPAs of Rs.10 lakhs and above. The public sector banks had recovered Rs.40.38 crore as on September 30, 2001, through the forum of Lok Adalat. The progress through this channel is expected to pick up in the coming years particularly looking at the recent initiatives taken by some of the public sector banks and DRTs in Mumbai. Debt Recovery Tribunals The Recovery of Debts due to Banks and Financial Institutions (amendment) Act, passed in March 2000 has helped in strengthening the functioning of DRTs. Provisions for placement of more than one Recovery Officer, power to attach defendants property/assets before judgment, penal provisions for disobedience of Tribunals order or for breach of any terms of the order and appointment of receiver with powers of realization, management, protection and preservation of property are expected to provide necessary teeth to the DRTs and speed up the recovery of NPAs in the times to come. Though there are 22 DRTs set up at major centers in the country with Appellate Tribunals located in five centers viz. Allahabad, Mumbai, Delhi, Calcutta and Chennai, they have not been able to deliver as expected as they got swamped under the huge volume of cases (41,243) filed with them, since inception, out of which 35,871 cases were still pending as on 31.3.2002. Banks NLDIMSR 36

could recover Rs. 2,947 cr only, which is less than 1% of the amount claimed through the DRT mechanism up to 31.3.2002. The banks should institute appropriate documentation system and render all possible assistance to the DRTs for speeding up decisions and recovery of some of the well-collateralized NPAs involving large amounts. I may add that familiarization programmes have been offered in NIBM at periodical intervals to the presiding officers of DRTs in understanding the complexities of documentation and operational features and other legalities applicable of Indian banking system. RBI on its part has suggested to the Government to consider enactment of appropriate penal provisions against obstruction by borrowers in possession of attached properties by DRT receivers, and notify borrowers who default to honour the decrees passed against them. Circulation of information on defaulters The RBI has put in place a system for periodical circulation of details of willful defaults of borrowers of banks and financial institutions. This serves as a caution list while considering requests for new or additional credit limits from defaulting borrowing units and also from the directors /proprietors / partners of these entities. RBI also publishes a list of borrowers (with outstanding aggregating Rs. 1 crore and above) against whom suits have been filed by banks and FIs for recovery of their funds, as on 31st March every year. It is our experience that these measures had not contributed to any perceptible recoveries from the defaulting entities. However, they serve as negative basket of steps shutting off fresh loans to these defaulters. A real breakthrough can come only if there is a change in the repayment psyche of the Indian borrowers. Recovery action against large NPAs After a review of tendency in regard to NPAs by the Honble Finance Minister, RBI had advised the public sector banks to examine all cases of willful default of Rs 1 crore and above and file suits in such cases, and file criminal cases in regard to willful defaults. Board of Directors are required to review NPA

NLDIMSR

37

accounts of Rs.1 crore and above with special reference to fixing of staff accountability. On their part RBI and the Government are contemplating several supporting measures including legal reforms, some of them I would like to highlight. Asset Reconstruction Company: An Asset Reconstruction Company with an authorised capital of Rs.2000 crore and initial paid up capital Rs.1400 crore is to be set up as a trust for undertaking activities relating to asset reconstruction. It would negotiate with banks and financial institutions for acquiring distressed assets and develop markets for such assets. Government of India proposes to go in for legal reforms to facilitate the functioning of ARC mechanism Corporate Debt Restructuring (CDR) Corporate Debt Restructuring mechanism has been institutionalised in 2001 to provide a timely and transparent system for restructuring of the corporate debts of Rs.20 crore and above with the banks and financial institutions. The CDR process would also enable viable corporate entities to restructure their dues outside the existing legal Framework and reduce the incidence of fresh NPAs. The CDR structure has been headquartered in IDBI, Mumbai and a Standing Forum and Core Group for administering the mechanism had already been put in place. The experiment however has not taken off at the desired pace though more than six months have lapsed since introduction. As announced by the Hon'ble Finance Minister in the Union Budget 2002-03, RBI has set up a high level Group under the Chairmanship of Shri. Vepa Kamesam, Deputy Governor, RBI to review the implementation procedures of CDR mechanism and to make it more effective. The Group will review the operation of the CDR Scheme, identify the operational difficulties, if any, in the smooth implementation of the scheme and suggest measures to make the operation of the scheme more efficient.

NLDIMSR

38

Credit Information Bureau Institutionalisation of information sharing arrangements through the newly formed Credit Information Bureau of India Ltd. (CIBIL) is under way. RBI is considering the recommendations of the S.R.Iyer Group (Chairman of CIBIL) to operationalise the scheme of information dissemination on defaults to the financial system. The main recommendations of the Group include dissemination of information relating to suit-filed accounts regardless of the amount claimed in the suit or amount of credit granted by a credit institution as also such irregular accounts where the borrower has given consent for disclosure. This, I hope, would prevent those who take advantage of lack of system of information sharing amongst lending institutions to borrow large amounts against same assets and property, which had in no small measure contributed to the incremental NPAs of banks. Proposed guidelines on willful defaults/diversion of funds RBI is examining the recommendation of Kohli Group on willful defaulters. It is working out a proper definition covering such classes of defaulters so that credit denials to this group of borrowers can be made effective and criminal prosecution can be made demonstrative against willful defaulters. Corporate Governance A Consultative Group under the chairmanship of Dr.A.Ganguly was set up by the Reserve Bank to review the supervisory role of Boards of banks and financial institutions and to obtain feedback on the functioning of the Boards vis-vis compliance, transparency, disclosures, audit committees etc. and make recommendations for making the role of Board of Directors more effective with a view to minimising risks and over-exposure. The Group is finalising its recommendations shortly and may come out with guidelines for effective control and supervision by bank boards over credit management and NPA prevention measures. OTHER MEASURES TO CURB NPA:

NLDIMSR

39

Banks need to have better credit appraisal so as to prevent NPAs from occurring. However once NPAs do come into existence, the problem can be solved only if there is enabling legal structure, since recovery of NPAs often requires litigation and court orders to recover stuck loans. With long-winded litigation in India, debt recovery takes a very long time. But according to the new union budget of 2001-02 this problem will soon cease to exist Banks will get the teeth to salvage their stucky loans. Bad loans, which have dropped from 14 percent of total assets to 7.4 in the past decade, may now come down to the internationally accepted 5 percent level if the proposed foreclosure laws are enacted. Besides bankers said the decision to form seven more debt recovery tribunals will improve loan recovery. The proposed repeal of the sick industrial companies act will also prevent defaulting companies form taking refuge in the board for industrial and financial reconstruction. The setting up of additional tribunals, repealing of SICA and amendment of foreclosure norms will go a long way in helping banks recover non performing assets said Janki Ballabh, chairman SBI. Under the current system, banks have to file a suit and obtain a court decree to attach the property that is mortgaged with them. The new foreclosure norms will allow lenders to directly take possession of property by giving a notice; said P S Shenoy, chairman Bank of Baroda. According to bankers, bad loans are one of the reasons why banks have not been in a position to bring down lending rates further. With an average of over 7 percent of total amount lent not coming back, banks have to build in the cost of such delinquencies into their lending rates. Although the Finance Minister has not announced any specific measures for the three weak banks, the new foreclosure norms if implemented will go a long way in getting the weak banks back on track.

NLDIMSR

40

The BIFR was constituted with the intention of providing an opportunity to sick companies to get back on the rails by keeping lenders at the bay until they restructured their operations. Corporate have, however been misusing these provisions by making an application to the BIFR as soon as banks sent them notices to recover the loans. Banks are now working on developing debt recovery tribunals to solve this problem. The government has also mooted the suggestion of an asset reconstruction company, which will be a specialized agency set up for rehabilitating revival NPAs and recovering funds out of unrevivable NPAs Experts have also suggested the concept of narrow banking, where only strong and efficient banks will be allowed to give commercial loans, while the weak banks will take positions in less risky assets such as government securities and inter bank lending. One way of curbing NPA is a massive one-time write off bad loans in its balance sheet. This could be aimed at bringing down the net non performing assets closer to the targeted 5 percent from the present level of around 7 percent of net advances. A classic example could be that of ICICI which have written off its bad loan in its balance sheet for the year 2000-01 ICICI net NPAs outstanding as on 31.12.2000 were Rs.4215 crore. The ratio of net NPA to net advances declined to 7.2 percent as on 31.12.2000 from 7.6 as on 31.3.2000. Bringing down the NPA below 5 percent will help the institution obtain a clearance from the reserve bank of India for setting up a nonlife insurance subsidiary. Bringing the NPAs down to 5 percent in one stroke will require provisioning of over Rs.1000 crore, going by the last figure. Last year (99-00)

NLDIMSR

41

ICICI had made enhanced provisions and write offs of Rs.690 crore (Rs.478 crore in 98-99) and had earned a profit after tax of Rs. 1206 crore. RBI had earlier said that non-banking finance companies would need to contain their NPAs at below 5 percent to be eligible to promote insurance companies. Resolution of NPAs in the Asian Context To understand better the way that can be used to resolve the issue of NPAs, case study of KOREA have been described below which show as to how this nation have tackled the issue through the setting up of Asset Management Companies.

Korea In resolving NPA problems, the Korean government relied on a centralized AMC approach. The government had in 1997, assigned the role of purchase of bad loans to the Korea Asset Management Corporation (KAMCO). Also bankbased AMCs were created for the sale of bad loans of two major banks. KAMCO was established in 1996 for the foreclosure and sale of assets attached to for tax arrears, the liquidation of corporations and the NPA Fund, KAMCOs role was expanded to include the purchase of NPAs to assist in the rehabilitation of the financial sector. KAMCO became a bad bank and a non-performing asset fund was created to finance the purchase of NPAs. The government of Korea, Korea Development Bank and 24 banks are joint shareholders of KAMCO. Most of its funds come from bonds, which are issued for a period of 3 years and yield a quarterly interest applicable to the Korean Development Bank. The balance comes from the central bank, financial institutions and Korea Development Bank. The main goal of the KAMCO was to speedily dispose off NPAs to better the liquidity and soundness of the financial institutions, and this is to be

NLDIMSR

42

accomplished by 2003. To begin with, KAMCO paid for the bad loans partly in cash and partly in bonds but from 1998 onwards it was done through KAMCO bonds (Cooke & Foley, 2000). In the past, KAMCO had purchased NPAs from financial institutions in batches at fixed amounts up front, based on the expected recovery value of the portfolio. KAMCO had then engaged in due diligence process on each NPA, adjusted the initial price and then resettled depending on the nature of each loan and asset. In September 1998, there was a change in the acquisition method to a fixed purchase rate. KAMCO purchases were exempt from acquisition and registration fees but this did not carry forward for subsequent purchasers of the assets from the investor. KAMCO had planned recoveries though asset-backed securitization schemes or outright sales or workout schemes. In a December 1998 auction, Texas based Lone Star Fund purchased W 565 bn for W201 bn (a 64% discount) from KAMCO. KAMCO had acquired the debts collateralized by 1500 houses, buildings and factories from financial institutions for W204 bn. This was KAMCOs first sale of assets using an international securitization vehicle under Koreas asset backed securities law. KAMCOs strategies for recovery were debt restructuring (partial debt forgiveness, amended terms and debt-equity swaps), outright sales (loans sold individually or packaged in portfolios and offered to investors), asset-backed and equity partnerships securities. These assets were transferred to a SPV trust, which in turn issued debentures and bonds to be sold to institutional investors. KAMCO also went in for foreclosure auctions where they could dispose off the assets through court auctions and asset restructuring. KAMCO had issued CLOs and MBSs using the assets bought from banks and properties obtained through exercising collateral rights. These CLOs were guaranteed by KAMCO and carried a put option to sell the loan assets back to the banks in case the loan fell into default. The use of securitization to resolve NPAs

NLDIMSR

43

In recent times, securitization has been used by banks and AMCs to dispose off their NPAs. The securitization market has hence, assumed a role of specific importance in the context of NPAs (Kendall, 1996). Asset securitization is the conversion of assets or cash flows into securities, which are typically rated and called Asset-Backed securities (ABS). This has become popular for the disposal of NPAs as it brings with it benefits to both the issuer and investor. For issuers, it offers cheaper and more efficient funding for operations combined with greater balance sheet flexibility. For investors, securitization provides a broad selection of fixed income investment alternatives, most with higher credit ratings, higher yields, less downgrade risk than corporate bonds and more stable and predictable cash flows than other fixed income securities. Variants that have been introduced include Mortgage backed securities (MBS) and Collateralized bond and loan obligations (CBOs and CLOs). A CBO is an asset-backed security supported by an underlying portfolio of high yield bonds (Albulescu). They are set up to capture the arbitrage sometimes available from the yield differential between the high yield and investment grade debt markets. They are created by issuing multiple debt tranches to investors to finance the purchase of the underlying portfolio. The most senior tranche receives investment grade status by virtue of priority call on the cash flows from the high yield debt portfolio. The other tranches have junior priority rights to this cash flow. The most junior tranche is considered equity, which receives income after all the income spread after commitments to the senior tranches and expenses are met. This process can be used in the disposition of NPAs where the asset can be sold in this manner such that the claims on the cash flows would follow a pre-determined pattern.

NLDIMSR

44

SECURITISATION ACT
All the measures mentioned before have been able to help banks recover a small fraction of their NPAs. But slippages of advances from the performing to the non-performing category has outstripped the recoveries of NPAs, as such, the problem kept on aggravating year after year and reached such a level that government was left with no option except to take drastic measures and promulgate the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance in June 2002 and repromulgation thereof again in August 2002. This Ordinance was later replaced by the Securitization Act in December 2002. Securitization Act is a fine, comprehensive and an extraordinary piece of legislation. It is a giant leap forward in the realm of financial sector reforms. It is a most reassuring sign of government's commitment to reforms. It fully addresses all concerns with regard to lenders' interests and all attendant legal aspects. This Act is revolutionary in the Indian context, as it gives sweeping powers to banks and financial institutions to seize the assets charged to them without intervention of courts and sells them off to realize their loans, which have become NPAs. The Act provides a framework for securitization of stressed assets. It provides a window to banks and financial institutions to deal with illiquid assets and strengthens their right of foreclosure and enforcement of securities. Salient features of Securitization act The secured creditor has been vested with two options under the Act. It can either transfer the Security Interest to a Securitization or a Reconstruction Company or enforce the provisions of the Act on its own, without the intervention of the court. As per Section 35, the provisions of this Act override all other laws for the time being in force notwithstanding anything inconsistent therewith contained therein. Further as per Section 37, the provisions of this Act or the rules made thereunder are in addition to and not in derogation of the Companies Act, 1956, Securities Contract (Regulation) Act, 1956, the SEBI Act, 1992 (15 of

NLDIMSR

45

1992) and Recovery of Debts due to Banks and Financial Institutions, Act, 1993 (51 of 1993) or any other law for the time being in force. i.) The Secured Creditor, may require the borrower (whose debt has been classified as NPA by the Secured Creditor), by notice in writing to discharge his liabilities in full within 60 days from the date of the notice, failing which the Secured Creditor can exercise all or any of the following rights under sub-section 13(4) to recover his Secured Debt. a. Take possession of Secured Assets of the borrower including right to transfer by way of lease, assignment or sale for realizing the Secured Assets. b. Takeover the management of the Secured Assets of the Borrower including right to transfer by way of lease, assignment or sale for realizing the Secured Assets. c. Appoint any person as Manager to manage the Secured Assets, the possession of which has been taken over by the Secured Creditor. d. Require any person, who has acquired any of the Secured Asset from the Borrower from whom any money is due and payable to Borrower, to pay the same to the Secured Creditor, as is sufficient to repay the secured debt. ii.) In case a Financial Asset has been jointly financed by more than one secured Creditors, under Consortium or Multiple Banking Arrangement, no Secured Creditor will be entitled to any or all of the above-said rights conferred on him u/s 13(4) of the Act, unless it is agreed upon by the Secured Creditors representing not less than 3/4th in value of the amount outstanding as on record date and such actions will be binding on all Secured Creditors. iii.) Where dues of the Secured Creditor, are not fully satisfied, with the sale proceeds of the Secured Assets, the Secured Creditor can file an application with the Debt Recovery Tribunal having jurisdiction or a competent Court of Law for recovery of the balance amount from the Borrower.

NLDIMSR

46

iv.) Secured Creditor(s) can proceed against the guarantor(s) or sell the pledged Assets without first taking any of the measures specified in clause (a) to (d) of sub-section 13(4) in relation to the Secured Assets, under the Act. v.) Secured Creditors can take over the management of the business of the defaulting Borrowers and appoint Directors where the Borrower(s) is a company or Administrator of the business in any other case, by publishing a Notice in newspaper in English and any other Indian language of the area, in which principal office of the borrower is situated. vi.) Once a Notice preparatory to repossession is received, the borrower cannot alienate the Secured Asset(s) in question. vii.) Banks can package and sell Loans via Securitization. Loans can be traded among Banks, like Bonds or Shares. viii.) Transactions to which the Act is not applicable. The provision of the Act shall not, inter alia, apply to a. Any Security Interest created in the Agricultural Land. b. Any Debt where the amount due is less than 20% of the Principal amount and Interest thereon. c. Any Security Interest for securing repayment of any financial asset not exceeding Rs. 1 lakh. d. Pledge of Movable assets within the meaning of section 172 of Indian Contract Act 1872. e. Any conditional sale, hire purchase or lease or any other contract in which no Security Interest has been created. ix.) Right of Appeal though flat powers have been conferred on the Secured Creditors (Banks and Financial Institutions) for taking possession of assets, right to appeal is also given to the borrowers against the steps like possession of assets taken by the banks. The aggrieved borrower can file appeal u/s 17 before NLDIMSR 47

the DRT within 45 days from the date of initiation of steps, though 75% of the amount stated in Notice or such lower amount as DRT may direct, is required to be deposited with the DRT concerned. Similar right of appeal before DRAT within 30 days is given u/s 18 to any person aggrieved by the order of the DRT. Thus the Act restricts frivolous or dilatory appeals. The Act ousts the jurisdiction of the Civil Courts and mandates that no Injunction shall be granted in respect of any exercise of rights conferred by or under this Act. Action taken by banks Banks and financial institutions have already started taking action under this Act swiftly. Notices have since been flashed to thousands of borrowers involving several thousand crores of NPAs. Borrowers, who never responded to the calls of the banks earlier and have been playing hide and seek game with them, have now seen the writing on the wall and have started responding positively. They are coming forward to settle their dues with banks. Settlements are being reached as per RBI norms and banks' own recovery management policies. Cash recoveries have started pouring in. Where the borrowers have not responded to the 60-day notices, the banks have tightened the noose and have started procuring Seizure Orders from District Magistrates (DMs) or Chief Metropolitan Magistrates (CMMs). Secured Assets have since been seized in several cases, which has compelled even hard-core defaulters to pay their dues. Never before the banks have received such an overwhelming response to any recovery measure taken by them earlier. Print media too is playing its part in building up the euphoria by giving wide publicity to the steps taken/being taken by banks. Despite initial hiccups, recovery of NPAs is gathering momentum. A dream act for banks and financial institutions In my view, it is a dream Act for banks and financial institutions. It can bring cataclysmic change in the financial sector. Borrowers will no longer be able to take banks lightly and simply walk away with precious funds of the public. The threat of taking over of the collateral assets and enforcement of loan covenants has already begun to show positive results. So far NPA recoveries are estimated

NLDIMSR

48

to be in the region of 20%. During next 3-4 years, the banks hope to recover 50 to 60% of NPAs through such tough measures. Recovery of NPAs will substantially bring down weighted average cost of working funds. It will pave the way for lower lending rates and better bottom lines. This Act is an essential prerequisite for smooth operations. Banks have got a shot in the arm with this Act. This Act has created the much needed recovery climate. This has given major fillip to the banks to deal with defaulters and reduce their NPAs. It has instilled a sense of urgency in borrowers to settle their dues. This Act will not only help in improving the financial health of the country, but also our moral fiber as a society by enforcing the sanctity of the contracts. Indian economy has suffered immensely from the lack of legal machinery for contract enforcement and strong lenders' rights. Successful implementation of the Act will free massive misallocated resources, bring back into circulation the same funds that have been locked up in sick assets. They will simultaneously relieve the pressure for fresh investments and create an overall multiplier effect that would boost employment, industrial activity and asset build up, apart from more efficient use of new capital and loss of rent seeking. Banks got to declare total war on the NPAs as it warrants action, on a war-footing basis.

Reality bites The scope of the Act is limited. The provisions of the Act do not cover small loans up to Rs. 1,00,000 and the unsecured loans. Security interest of the banks in agricultural lands is also not covered. The secured loans are estimated to be just 30-35% of total NPAs of the banking industry. There are several limitations, weaknesses and shortcomings in the Act. The following issues need to be addressed at the earliest: 1. Issues with regard to Stamp Duty chargeable for transfer of assets from the originators to Asset Reconstruction Company (ARC), has not been addressed in the Act. The Stamp Duty is a state subject; it would require NLDIMSR 49

initiatives from the respective state governments. As a matter of fact, these banking assets should be exempted from the levy of Stamp Duty.

2. The issue of pricing or fixing a realizable value on the assets is another question not addressed in the Act so far.

3. Who will pay statutory dues like overdue sales tax, excise duty, income tax, electricity charges and other local tax arrears after the management takeover option is exercised by the Secured Creditor. Legal position in this regard need to be defined very clearly.

4. The appointment of a manager for the management of the acquired assets, in consultation with the borrowers, whose assets have been seized by the banks, seems to be an utopian idea.

5. The Act provides for appeal and for appeal over appeal, again a lengthy judicial process that may delay execution proceedings.

6. In case of gone concerns i.e., concerns which have been closed down, the banks will have to go through the same rigmarole for disposal of security in possession of an official liquidator.

7. The Act provides for concurrence of Secured Creditors representing threefourths in value of the amount outstanding where there are more than one Secured Creditors. This concurrence especially in cases of going concerns may not come through.

8. It is not clear whether the banks can use powers conferred under the Act to enforce the Security Interest simultaneously in cases pending with BIFR and or DRT or the Doctrine of Election will come to play.

NLDIMSR

50

9. Section 13(4) provides for management of Secured Assets only. Where a company has hundreds of assets, the management of isolated assets is how far feasible is difficult to decide and the Act is silent on this point.

10. In law, one cannot do indirectly what is prohibited directly. In case of sale of seized assets, the seller and the beneficiary will be the same. The sale of Secured Assets by banks at value enough to cover their dues would be adequately self-serving, but may appear to be unfair to the stakeholders.

11. In case of management control over the business of the defaulter(s), the Secured Creditor will have effective control over unsecured assets of the borrower as well, which contravenes the stipulated intent of the Act.

12. It will be difficult for banks to sell distressed assets, as there will be few takers for such assets. The corporate(s) may gang up to prevent sale of assets by banks. Auctions may turn out to be farce.

13. The Act empowers the banks to takeover the management of defaulting companies. Banks are not business tycoons, or jacks of all trades who can run any business activity with guaranteed success. Banks are not even custodians or merchants of commodities.

14. The Act does not address the problem of lack of infrastructure and practical problems involved in sale of distressed assets.

15. In case of certain specific industries where an industrial license, specific government approval or permission or special rights like mining lease etc., is issued in the name of the borrowing company, will such license/approval/permission be automatically transferred to the name of buyer/bank/concerned or not?

NLDIMSR

51

16. Will intangible assets like patents, brands, goodwill be deemed to be automatically transferred to the banks/buyers and defaulter won't have any right, title, or interest in such assets, once he has been divested of the secured assets charged to the bank.

17. The reason(s) behind exempting borrowers u/s 31 of the Act from the application of the Act, when amount due is less than 20% of principal and interest due thereon, is not understandable.

18. Valuation of assets and bidding process can trigger legal cases. There can be lack of unanimity among lenders also, as all lenders holding at least 75% stake in outstanding dues are required to agree to sell the assets of defaulters.

19. Borrowers might prefer objection on several issues before magistrates authorized to issue Seizer Orders and can transform into a potential enquiry into nature of Secured Assets, proper status, nature of liability and so on and so forth.

20. Lenders are vulnerable to prosecution by compliance authorities on many issues, despite the indemnity given under the Act to persons exercising the rights of Secured Creditors.

21. The Act provides for creating a Central Registry to record the particulars of transactions related to Securitization and Reconstruction of Financial Assets and Creation of Security Interest including electronic record of the same. It has not been clarified whether this registration would exempt ARCs and securitization companies from filing particulars with the State Registry simultaneously.

NLDIMSR

52

22. Last, but not the least, the extent to which a Secured Creditor can proceed against a third party acquirer of Secured Assets from the borrower has not been adequately addressed in the Act. It may open a Pandora's box of Legal proceedings with third parties for the Secured Creditors.

With the enactment of this landmark Act, though a giant leap forward has been taken, yet there is a long way to go. NPAs are not a one-time phenomena. It is a continuous process. Until the root cause of NPAs is eliminated, they will continue to generate with a vengeance. It is important to know the extent of malady and the question of how large a hole has been created in our Indian financial system by the NPAs? With the euphoria and the media hype that has been created, it may appear that banks are having a party time, as they have got the so called sweeping powers to rein in the recalcitrant borrowers. The Act is not a financial TADA. It is a tool and not a weapon in the hands of the banks to shoot the defaulters. It is an enabling provision, an extra right, which will be used by banks very sparingly, as a last resort to nail the hardcore defaulters only. Bankers have never been and they will never be capricious. They have always been considerate and will remain so in future as well. Much of the initial delight expressed by banks on the positives of the Ordinance is nothing, but a good old brouhaha or an irrational exuberance. This unbridled optimism is also reinforced by unbridled upward swing in Bank stocks in the bourses. The falling interest rates, the banks' embracing state-of-the-art technology for anywhere, any time and anyhow banking, the VRS in bank etc., could not create such a favorable impact as much as this Act has done.

NLDIMSR

53

MANAGEMENT OF NPAS
The quality and performance of advances have a direct bearing on the profitability and viability of banks. Despite an efficient credit appraisal and disbursement mechanism, problems can still arise due to various factors. The essential component of a sound NPA management system is quick identification of non-performing advances, their containment at minimum levels and ensuring that their impingement on the financials is minimum. The approach to NPA management has to be multi-pronged, calling for different strategies at different stages a credit facility passes through. RBI's guidelines to banks (issued in 1999) on Risk Management Systems outline the strategies to be followed for efficient management of credit portfolio. I would like to touch upon a few essential aspects of NPA management in this paper. Excessive reliance on collateral has led Indian banks nowhere except to long drawn out litigation and hence it should not be sole criterion for sanction. Sanctions above certain limits should be through Committee which can assume the status of an 'Approval Grid'. It is common to find banks running after the same borrower/borrower groups as we see from the spate of requests for considering proposals to lend beyond the prescribed exposure limits. It is necessary that running after niche segment may be fine in the short run but is equally fraught with risk. Banks should rather manage within the appropriate exposure limits. A linkage to net owned funds also needs to be developed to control high leverages at borrower level. Exchange of credit information among banks would be of immense help to them to avoid possible NPAs. There is no substitute for critical management information system and market intelligence. We have come across cases of excellent appraisal and compliance with sanction procedures but no control at disbursement stage over compliance with NLDIMSR 54

the terms of sanction. To overcome this problem a mechanism for independent review of compliance with terms of sanction has to be put in place. Close monitoring of the account particularly the larger ones is the primary solution. Emerging weakness in profitability and liquidity, recessionary trends, recovery of installments / interest with time lag, etc., should put the banks on caution. The objective should be to assess the liquidity of the borrower, both present and future prospects. Loan review mechanism is a tool to bring about qualitative improvement in credit administration. Banks should follow risk-rating system to reveal the risk of lending. The risk-rating process should be different from regular loan renewal exercise and the exercise should be carried out at regular intervals. It is not enough for banks to aspire to become big players without being backed by development of internal rating models. This is going to be a pre-requisite under the New Capital Adequacy Framework and if a bank wants to be an international player, it shall have to go for such a system. Banks should ensure that sanctioning of further credit facilities is done only at higher levels. A quick review of all documents originally obtained and their validity should be made. A phased programme of exit from the account should also be considered.

NLDIMSR

55

CONCLUSION
I am of the opinion that NPAs are better avoided at the initial stage of credit consideration by putting in place rigorous and appropriate credit appraisal mechanism. In the changing scenario banks cannot behave imprudently while sanctioning credit and later run to supervisors / regulators for regulatory forbearance and owners or strategic partners to bail them out. Secondly, the mindset of the borrowers needs to change so that a culture of proper utilisation of credit facilities and timely repayment is developed. One of the main reasons for corporate default is on account of diversion of funds and corporate entities should come forward to avoid this practice in the interest of strong and sound financial system. Finally, extending credit involves lenders and borrowers and both should realise their role and responsibilities. They should appreciate the difficulties of each other and should endeavour to work towards contributing to a healthy financial system. I do hope that corporate entities would put their best foot forward in creating an environment where a healthy, vibrant and sound financial system can be built-up and sustained.

NLDIMSR

56

NLDIMSR

57