BFMS Term Paper_Anirban

8/21/2019 BFMS Term Paper_Anirban

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BFMS TERM PAPER

ON

Non-Performing Assets in Indian banks: An analysis

Submitted to: Prof. P C Narayan

Submitted By:

Group-17

Anirban Chandra(122011)

Parul Srivastava(122059)

Barretto Maclean(122022)

On

August 19th

, 2013


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CONTENTS

Abstract ...................................................................................................................................................... 2

History of NPA in Indian Financial system .................................................................................................... 2

NPA- Feature and RBI guidelines ................................................................................................................. 3

Cycle .................................................................................................................................................................... 3

What is a NPA ..................................................................................................................................................... 3

NPA Identification ............................................................................................................................................... 3

Salient features of NPA-treatment according to RBI guidelines ........................................................................ 4

Classification of NPA’s ........................................................................................................................................ 4

Causes of NPA ............................................................................................................................................. 4

Analysis of GDP and loan advances on NPA: ................................................................................................ 5

Data Analysis: ...................................................................................................................................................... 5

Results and Interpretation: ................................................................................................................................. 6

Analysis for priority sector lending: ............................................................................................................. 7

Effect of Priority Sector lending-Data analysis .............................................................................................. 7

Results and interpretation ........................................................................................................................... 9

Management of NPAs ............................................................................................................................... 10

Preventive measures: ....................................................................................................................................... 10

Corrective measures ......................................................................................................................................... 10

How NPAs impact a financial institution?................................................................................................... 11

Steps taken to handle NPA problems in India through ARCs: ...................................................................... 12

Implementation issues in NPA recovery: .................................................................................................... 12

Issues faced by ARCs ......................................................................................................................................... 13

Critical analysis of ARCs in India in comparison to global models: ............................................................... 13

Performance of Indian ARCs and other recovery channels: ......................................................................... 14

NPA systems in Asian economies ............................................................................................................... 15

Japan: ................................................................................................................................................................ 15

China: ................................................................................................................................................................ 15

Future: ..................................................................................................................................................... 17

Conclusion: ............................................................................................................................................... 17

References ................................................................................................................................................ 19

Exhibits ..................................................................................................................................................... 20


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ABSTRACT

Non-Performing Assets (NPAs) or Non-Performing Loans (NPLs) have substantial impact on any

country’s financial system. So it is necessary to know the statistical significance of the reasons for

NPAs, specifically GDP, the total loan advances, and priority sector lending. Along with that, acomparison between Indian public sector banks and private sector banks on dealings in loan portfolio

shows the banks’ capability in handling NPAs. Though in India many safeguard mechanisms to

manage NPAs are in place like Asset Reconstruction Companies (ARCs), it is necessary to analyse

their performances and the issues faced by them. A global perspective on how other countries are

performing in handling NPAs would reflect India’s position. In future, given the possibilities of

corporate bond market and new banking licences, it is also important to analyse their effects on NPAs

for Indian financial institutions.

HISTORY OF NPA IN INDIAN FINANCIAL SYSTEM

The Indian financial system has matured a lot if we analyse it for the period of 1995-2013.

Exhibit 1 and Exhibit 2 denote the change in percentage of NPA’s its distribution across sectors as

well as public and private sector banks.

The 1991 crisis hampered the heath of entire financial system and left the banks undercapitalized with

high NPA’s. The restructuring of the NPA’s in banking sector was done on the basis of Narasimham

committee recommendations. The methods of Income recognition, asset classification and provisioning

laxity being used were the major reasons for failure.

A lot of reforms have one into the building of a robust system starting the Narasimham committee

recommendations to promulgation of SARFESI act. From being debtor friendly in terms of loan

recovery the regulations have over time given more teeth to the creditors. This has also resulted in

banks able to dole out more loans for sustainable development. A typical loan consists of three stages.

• Evaluation and assessment of proposal

•

Support during loan period

• Exit decision and modality

Earlier sometimes banks exhibited extremes of behaviour in exhibiting these stages. Loans were

disbursed based on promoter politician nexus. In the monitoring stages banks sometimes colluded with


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individuals to classify projects as sick. Such practices were prevalent due to improper monitoring at

each stage, lack of information centralization. With the setting up of agencies like CIBIL and CRISIL,

strict measures of RBI, changing focus of banks on profits, setting up of ARC’s, more information

being viable in public domain partly due to adoption of information technology the loan disbursement

process for the three steps mentioned had improved substantially .The SARFESI Act had given more

control to creditors which resulted in a change a mind-set.

The first effective step towards decreasing NPA’s was to improve the loan disbursement

process itself

The second was SARFESI ordinance which gave more control to the creditors in case of NPA

loans

The third was the implementation of BASEL norms added robustness to the financial structure and

indirectly incentivized banks with low NPAs.

NPA- FEATURE AND RBI GUIDELINES

CYCLE

WHAT IS A NPA

The asset side balance sheet of the bank has a substantial component in the form of loans given out.

These assets have been classified a performing and non-performing. Any loan which is capable of

generating income for the bank is performing and when it ceases to generate that income it is declared

as non-performing. Managing NPA’s is important because they directly affect the financial

performance and profitability of a bank

NPA IDENTIFICATION

A loan can be classified to a NPA when

1. If there is more than 90 days interest or principal overdue the loan is considered to be a NPA.

Exception to this is case of agricultural advances they are considered NPA if payments on loans

for short duration crops become overdue for two crop seasons and long duration crops become

overdue for two crop seasons.

Payment default Declaring NPA NPA recovery


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2. For an overdraft or cash credit account if the account is out of order for more than 90 days

3. In case of bills if the account remains overdue for a period of more than 90 days

4. Identification of NPAs on an on-going basis and making provisions for such in each calendar

quarter.

SALIENT FEATURES OF NPA-TREATMENT ACCORDING TO RBI GUIDELINES

1. Treatment of NPAs should be done borrower wise and not facility wise in case the borrower has

More than one facility with the bank and the whole combination to be treated as NPA even if

one single facility shows irregularity. For consortium based advance involving multiple banking

arrangements, each bank can classify the account according to its own record of recovery.

2. Agricultural loans affected by natural calamities can have some relaxations (like converting to

term loan, rescheduling the repayment period, issuing fresh loans) though the modified loan

contract would have to follow the NPA norms for agricultural advances.

3. Loans backed by central government guarantee are not treated as NPA but it can’t be treated for

income recognition.4. Project financing: Banks need to fix the commencement date for commercial operations

(DCCO) and infra and Non-infra projects are treated differently according to the DCCO and

with industrial loans the moratorium of interest period is considered while determining NPAs.

5. Possibility of Any regulatory relaxation in certain situation for certain sectors: for example in

real estate sector special regulatory treatment in loan restructuring. (RBI, RBI master circulars,

2012)

6. RBI recognizes capital market, commodity and real estate as sensitive sector.in 2012 Real estate

accounted for almost 90% of banks’ exposure in this sensitive sector. RBI discourages banks for

speculative involvement in real estate sector.

7.

Temporary deficiencies in which the borrower is unable to repay due to certain factors like non

receipt of stock statement etc. (RBI, RBI notification, 2013)

Except these exemptions whenever a loan interest or principal overdue days exceed 90 days the loan is

classified as an NPA

CLASSIFICATION OF NPA’ S

Type Criteria Provisions

Standard Payment on time Zero

Substandard 0 to 90 days 10%Doubtful 90 to 365 days 50%

Loss >365 days 100%

CAUSES OF NPA

The main factors for explaining NPAs in financial institutions in India are as below

Internal reasons:

Inefficient management, inappropriate technology, marketing failure etc.


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Overestimation about the future

External reasons:

Recession in economy

Infrastructural problems

Price rise

Delay in sanctioned limit by banks Natural calamities

Other reasons:

During the three stages of lending process, the collusion within the promoter-politician-bank

circle

Regulation for compulsory loan advances of 40% which might be of high default risks.

ANALYSIS OF GDP AND LOAN ADVANCES ON NPA:

Table-1: India’s GDP and total loan advances by Indian SCBs

Year

India

GDP(*10^8)

(current US$)

Total Loan

AdvancesGDP*Loan(factor) NPA

2004 7210 664103.8462 4788188731 61881

2005 8340 884805.346 7379276585 56796

2006 9490 1265777.127 12012224937 49857

2007 12380 1650233.728 20429893559 48214

2008 12240 1751702.308 21440836252 52746

2009 13650 2102501.206 28699141468 60930

2010 17100 2545967.299 43536040818 74685

2011 18720 3024558.886 56619742338 89100

2012 18410 3766419.682 69339786352 130800

Source: Compiled from World Bank data and Reports on Trends in Banking in India, RBI (2003-2012)

The expectation of prosperous economy (which can be associated with GDP and GDP growth) is touted

as the reason for higher loan disbursal which in effect is expected to lead to higher level of NPAs for

Banks. From exhibit, it is evident that the GDP and Loan advances are highly correlated with R2 value

of 93.33%. Higher loan advances in expectation of higher GDP growth is expected to raise the levels of

NPAs. (Exhibit3)

DATA ANALYSIS:

We would test the dependence of NPA on GDP of India and the total loan advances made by the bank.

With their individual contribution to the gross NPA amount, as there is clear correlation between the

GDP and loan advances between themselves, we are also taking into consideration the linking effect


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between them by adding a third variable and we set up the hypothesis of NPA being explained by the

following linear equation.

NPA = A0 + A1*(X1) +A2*(X2) + A3 (X3)

X1=Loan advances made by the banks

X2=GDP of India

X3=combined linking effect of GDP and Loan Advances(X1*X2)

A0 is the intercept and A1, A2, A3 are the coefficients

RESULTS AND INTERPRETATION:

Table-2: Regression Analysis output

:

Regression analysis of data gives us the regression equation for gross NPA with98.15 %( adjusted R 2

value) of gross NPA can be explained by the equation hence the relation is statistically significant (F

value of 142.72 Significance almost zero).From the analysis it is also evident that the combined linking

effect of GDP and Loan advances(X3) has more impact (t value 8.14) on gross NPA than these factors

individually are. Hence we can say that though individually they might not show significant statistical

impact on NPA, but the combined interaction and linking effect between GDP and loan advances(X 3)

explains the NPA levels for Indian banks.

SUMMARY OUTPUT

Regression Statistics

Multiple R 0.994212

R Square 0.988457

Adjusted R Square 0.981531

Standard Error 3589.517

Observations 9

ANOVA

df SS MS F Significance F

Regression 3 5516807714 1.84E+09 142.7232 2.9041E-05

Residual 5 64423162.21 12884632

Total 8 5581230876

Coefficient Standard Error t Stat P-value ower 95%Upper 95%ower 95.0 Upper 95.0%

Intercept 125442.3 9467.161199 13.25026 4.38E-05 101106.2 149778.4 101106.2 149778.4421

India GDP(*10^8) (current US$) -9.84079 1.158167354 -8.49687 0.000371 -12.818 -6.86363 -12.818 -6.863629526

Total Loan Advances -0.01635 0.010149879 -1.61132 0.168027 -0.04245 0.009736 -0.04245 0.009736412GDP*Loan(factor) 3.56E-06 4.37433E-07 8.144973 0.000453 2.44E-06 4.69E-06 2.44E-06 4.68734E-06


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ANALYSIS FOR PRIORITY SECTOR LENDING:

In 1989-90 priority sector target for domestic commercial banks was 40% which comprised of 18% to

agriculture, 10%to weaker sections. For foreign banks this number was 32%.This has been changed

with effect from August 2007 where the targets are now decided as 40% of Adjusted Net Bank Credit

(ANBC) or Credit Equivalent of Off-Balance sheet Exposure (CEOBE), whichever is higher. All banksare mandated to lend 40% of their net credit to the priority sector (SSI, agriculture) at interest rate not

more than 4% above prime lending rate.

RBI has included those sectors as part of the priority sector, which impact large segments of population

& the weaker sections, and which are employment intensive.

Source: RBI reports

Priority sector lending (40% of total lending) has always been identified as the major reason of increase

in NPA in Indian banking system. This can be attributed to the direct lending system. The NPA’s of the

priority sector have increased year on year. More than 55% of the scheduled commercial banks NPA’s

are from priority sector. The public sector had been more adversely affected by this as compared to the

private sector. The government in pursuit of populist measures and benefit to small farmers and

enterprises encourages public banks to lend directly (Government is the majority stakeholder in public

sector banks).On the other hand the private sector even in private sector has been conservative in

lending and has lent indirectly to priority sector through institutions like NABARD where risk of

default is less.

EFFECT OF PRIORITY SECTOR LENDING-DATA ANALYSIS

Table-3: Sector wise NPA(Priority sector) and Loan Advances for public sector and private banks


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The NPAs in priority sector were more in public sector banks when compared to private and foreign banks.

To check the dependence of priority sector lending on bank’s NPA we hypothesized the Total NPA

value as dependent on the total lending to priority sector and NPA created within the priority sector.

We are comparing between the performance of public sector banks and private sector banks. Here the

regression equation is

NPA public = A0 +A1*Y1+A2*Y2

NPA private = B0+B1*Z1+B2*Z2

Y1=public sector lending to priority sector, Y2=NPA created within priority sector by public sector

banks

Z1=private sector lending to priority sector, Z2= NPA created within priority sector by private sector

banks.

Priority Sector NPA in Indian Banks

Year

Public

sector

Lending to

priority

NPA in

Priority sector

by Public

sector banks

Public

sector

Total NPA

Per cent of

ANBC/OBE

Private

sector

Lending to

priority

NPA in

Priority sector

by Private

sector banks

Private

sector

Total

NPA

Lending

Per cent of

ANBC/OBE

2012 1130700.00 562 1125 37.20 286400.00 51 183 39.40

2011 1028615.00 413 711 41.3 248828.00 48.23 180 46.6

2010 864564.00 308 573 41.6 214669.00 47.92 173 45.9

2009 724150.00 243 440 42.7 187849.00 36.41 168 46.2

2008 610450.00 252 397 44.7 164068.00 34.18 130 42.5

2007 521376.00 229 386 39.7 144549.00 28.8 92 42.9

2006 409748.00 223 413 40.3 106586.00 22.8 78 42.8

2005 310093.00 234 476 42.8 69886.00 21.8 87 43.6

2004 244456.00 238 501 43.6 48920.00 26 104 47.3


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RESULTS AND INTERPRETATION

Table 4: Analysis result For Public sector banks:

Regression analysis for public sector banks shows that the regression equation explains

97.3%(Adjusted R 2) of total NPAs in public sector banks by the total lending to priority sector and

NPAs created in priority sector. Hence we can conclude that effect of priority sector lending on public

sector banks’ NPA is statistically significant (with F value 144.8).

Private sector Banks:

Table 5: Analysis result For Private sector Banks:

SUMMARY OUTPUT


Multiple R 0.989799

R Square 0.979701



Observations 9

ANOVA


Regression 2 436506 218253 144.7937 8.36366E-06

Residual 6 9044.027 1507.338

Total 8 445550

Coefficient ndard Err t Stat P-value Lower 95% pper 95%ower 95.0 pper 95.0

Intercept -51.681 38.16752 -1.35406 0.224492 -145.0735291 41.71157 -145.074 41.71157

Public sector Lending to priority -0.00021 8.2E-05 -2.61951 0.039612 -0.000415352 -1.4E-05 -0.00042 -1.4E-05

NPA in Priority sector by Public sector

banks 2.495251 0.222432 11.21802 3E-05 1.950978227 3.039523 1.950978 3.039523

SUMMARY OUTPUT


Multiple R 0.951121R Square 0.904632



Observations 9

ANOVA


Regression 2 13755.43 6877.713 28.45698 0.000867387

Residual 6 1450.129 241.6881

Total 8 15205.56


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Regression analysis for private sector banks shows that the adjusted R 2

value of 87% with much lowerF value (28.45). Hence we can conclude that the effect of priority sector lending on private banks’ NPA

is not statistically significant.

At the same time it is evident from the table, the percentage of Loan to priority sector (ANBC/OBE) is

comparable (due to RBI guidelines) and thus we can conclude that NPAs in public sector banks are

more sensitive towards priority sector lending than NPAs in private banks are.

MANAGEMENT OF NPAS

PREVENTIVE MEASURES:

The credit appraisal skills need to be changed as a lot of bad loans are being given due to this

reason. Economic viability, technical feasibility, quality of management and financial position

of the borrower should be evaluated properly.

Pre – credit and post – credit appraisals

Close monitoring of borrower accounts, site visits, factory visits should be done

Consultancy and technical services must be provided to the borrower units wherever necessary.

CORRECTIVE MEASURES

The corrective measures are taken when the loan has become an NPA. In this case a legal recourse is

taken. If we see the NPA performance over the years earlier NPA’s were higher. (Exhibit1,2) The

performance over the years have increased due to setting up of systems which have ensured more

effective recovery of bank credit, putting a legal framework in place to give more teeth to creditors

when it comes to recoveries .The institutions and the mechanisms set up were the following

1. One time settlement / compromise scheme

2. Lok-adalat

3. Debt Recovery Tribunal

Coeff icient ndard Err t Stat P-value Lower 95% pper 95%ower 95.0 pper 95.0

Intercept 0.853539 22.57832 0.037803 0.971071 -54.39362539 56.1007 -54.3936 56.1007

Private sector Lending to priority -5.9E-05 0.000204 -0.28827 0.782837 -0.000556728 0.000439 -0.00056 0.000439

NPA in Priority sector by Private sector banks 4.016128 1.424778 2.818775 0.030403 0.529822478 7.502434 0.529822 7.502434


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4. Securitization and reconstruction of financial assets and enforcement of Security Interest Act 2002.

(SARFAISI Act)

5. Corporate Reconstruction Companies

6. Credit information on defaulters and role of credit information bureaus

HOW NPAS IMPACT A FINANCIAL INSTITUTION?

Moral hazard: Interest income can’t be recognized on advances identified as NPA affecting profit,

along with that, further losses is created by provisioning. For this, lenders might tend to roll over any

potential Non performing loan expecting (even though might not be possible) future repayments, hence

creating ‘ever greening’. Such ever greening and non-viability of the concerned project simply postpone the present problem and escalate it in future.

Adverse incentive: The higher percentage of NPA on balance sheet would press the lender to take risk

and exploit rest of the assets more aggressively to stay profitable as rest of the asset portfolio has to

cover the whole liabilities and earn enough amounts of profits for the quarterly targets. These risky

ventures automatically become potential NPAs for the future and a self-fulfilling cycle is created.

Opportunity cost and cost of capital for clients:

NPAs are basically lost opportunity, the money locked in as NPA could have used to increase the return

on assets for banks which could have been favourable for other potential borrowers as in that situation

they could avail lower interest rate and lower cost of capital. Also increasing num ber of NPA’s

decrease credit rating of the bank , and investors loss confidence in Bank’s future and banks’ cost of

borrowing increases. (saha)

Difficult to maintain CAR as NPA’s and hence RWA’s increase

As in most of the cases, the government is a principal shareholder for the public sector banks it can put

pressure on the government expenditure as with high NPA amounting on bank’s balance sheet; it might

frequently need to bail out banks if proper structure is not in place.


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STEPS TAKEN TO HANDLE NPA PROBLEMS IN INDIA THROUGH ARCS:

Structural reforms in Indian credit market to recover NPAs-First was the securitization,

reconstruction of financial asset and enforcement of securities ordinance and subsequent

act(SARFAIESI Act) by president of India in 2002 by which lenders got the power to take management

control, sell assets to recover the debt, recover any receivable from the borrower, but within some legalrestrictions (like 75% of the lenders are required to agree upon the recovery process).The ordinance

also created options for the legal framework for the Asset reconstruction company(ARCs) with power

of enforcement of securities acquired by ARCs from the original lenders. ARCs were encouraged,

under some legal framework, for an open, efficient and fair auction of the assets to recover the best

possible value from the NPAs. Along with that Lenders and ARCs got the special power (with

restrictions) over the borrower regarding any appeal against the seizure of assets before court or DRT

(debt recovery tribunal).The ordinance and subsequent Act has made provisions and guidelines for

regulations and registrations of ARCs by RBI. It allows ARCs to raise funds through security receipts

to QIBs, though they can’t raise funds from the public. The regulations and guidelines deal with theminimum capital requirement, controlling interest of the sponsors (no single sponsor with 10% of the

equity capital), cap of foreign equity capital (49%), structure of board of directors (50% independent

directors).

IMPLEMENTATION ISSUES IN NPA RECOVERY:

1. Management control: Given the fact that banks will be incapable in handling the operations of

client’s business, taking over the management control would require industry doctors, specialized

services which might not be easily available.

2. Quality and saleability of the securities: the quality of the securities may ultimately fetch

ridiculously low price in the auctions or lack or buyers at expected value as the assets might lose all

practical value (usability) or sometimes promoters can influence the buyers. Along with that market

price for the asset may come down. For example, when mortgage clients defaulted on payment in UK

in 1990s, building societies faced oversupply of real estate keeping the prices down at ridiculously low

level and they preferred restructuring of those loans.

3. Moral Hazard: In India, when the NPA story is more of a flow problem (substantial accretion) than

stock problem (one time cleansing of balance sheet) revolving around inappropriate evaluation and

monitoring process, if the ARCs are expected to handle bad loans created due to bad judgment orcollusion during evaluation of loan process, there is potential moral hazard created. If banks know they

can pass the bad loans off their balance sheet to the ARCs, they might be less cautious during the loan

appraisal process and recovery.

4. Price discovery of NPAs: When bad loans are transferred from banks to ARCs, they can either be

on book value or market value. Book value sales would be favourable for original lenders (as they

could recover the whole historical value) but that will simply translate the loss from one entity (banks)

to others (ARCs) hence creating unnecessary burdens on the ARCs. Hence market value sales seem

logical but that would require the actual price discovery of the asset which would be possible only if


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strong efficient secondary market is present. In absence of any strong secondary market, sale of such

asset at so called market value might create problems for public sector banks as it might be questioned

by central audit and the central vigilance commission in future as there might be some collusion or

conflicts of interests for the involved parties. This possibility would make the public sector banks

reluctant to the process (sale of the NPAs.)

5. Problems for capital adequacy: If the sale of NPAs happens at market value, the ARCs would buy

the asset at huge discounted price. For example, Danharta bought the assets with average discount of

48-50%.Such high discount would lead to capital erosion resulting in capital adequacy problems for the

banks which would require some safeguard. (Neeraj) (saha)

ISSUES FACED BY ARCS

Size and number of NPAs:

Almost half of NPAs with PSUs in India are within priority sector where per borrower NPA is smallwhereas the total number of borrowers (volume) is huge, which can be evident from Exhibit4 with the

number of cases files in Lok adalats. These borrowers are present over a large geographical area and

are mainly concentrated in rural areas. Hence Banks with good branch network in rural areas are better

positioned to handle such loans as ARCs would be centralized in nature. Only large loans (approx. 50%

of the problem loans) above a certain threshold limit should be passed on to ARCs for proper

functioning of them. Among these loans, real estate constitutes small percentage. So the advantages for

ARCs in countries likes Sweden and USA won’t be possible here.

Debt aggregation and consortium system:

For meaningful resolution of inter-creditor issues, it is necessary to have debt aggregation which won’t

be always possible. Along with that the consortium based lending in India does not distinguish clearly

the first and second mortgages or the seniority of debts; hence it becomes difficult to structure the inter-

creditor agreements.

Underdeveloped NPA market with Funding problems and lack of Government backing:

We have an underdeveloped secondary market of NPAs, lack of domestic investors, and absence of

Government guarantee for the assets transferred to ARCs. Hence ARCs have to look for foreign capital

where obviously foreign investors will invest for relatively higher returns. Along with that there is a

cap on foreign institutional investors’ investment. As a form of investment in the ACT an SR is allowed

but FIIs are not eligible for that benefit. The global counterparts in China have no cap for FIIs in the

ownership of ARCs and along with that there is a tax incentive to encourage foreign participation.

Similar is the case in Korea where international bidding is allowed during the auctions.

CRITICAL ANALYSIS OF ARCS IN INDIA IN COMPARISON TO GLOBAL MODELS:

Around the globe generally three models are used to handle NPLs, i.e., Bank based models, Market

based model and government supported model. In bank based model, the loan remains with the bank

but placed to a subsidiary or a specialized unit. This has problems in terms of slow resolution,


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requirement of special skill sets in work out teams and above all risk-return trade off remains within the

bank. Market based model comes into picture when substantial economic crisis is absent though the

size of NPAs hinders efficiency of the banks. Here specialized intermediation by ARCs is done and

value of the assets is recognized through market forces. Government supported models come into

picture in economic crisis and intended for a one time clean up while the government bears the cost of

such clean up by creating a central ARC. These nodal ARCs raise money from third party investors andthus the risk and reward trade-off is transferred. South eastern Asian countries followed these models

during crisis as part of their knee-jerk reactions. Indonesia (IBRA), Thailand (TAMC), Malaysia

(Danhartha), and Korea (KAMCO) have followed the government supported approach whereas

Philippines, China have encouraged private entities through fiscal incentives and laws to unload bad

loans. India has a mix of market and bank based model.

One Time solution with Sunset clause: If we compare Indian ARCs with their global counterparts, the

difference becomes evident in the crisis they are supposed to handle. ARCs are expected to deal with

the systemic crisis which creates the bad loans in the banking system. So the global counterparts acted

as a one-time remedy with a sunset clause. For example, Resolution Trust Corporation of USA in 1990s

which dealt with the problem of loans association, during south Asian crisis in late 90s, Danharta in

Malaysia dealt with the bad loans created due to systemic crisis. But In India, ARCs are formed as

some business model, as considered in the SARFAESI act, and in absence of any sunset clause, they

are unlikely to be a remedy for any systemic crisis functioning as a normal business model, and they

would be more concerned about future growth rather than a one-time solution.

PERFORMANCE OF INDIAN ARCS AND OTHER RECOVERY CHANNELS:

ARCs in India are given special powers (though regulated) and the objective of Maximization ofshareholders’ wealth (ARC shareholder s) by taking up and resolving bad loans through these special

power seems paradoxical as these loans occur due to lack of due diligence in the process. Along with

that, if power can corrupt, so can a special power. Though the assets’ sale of bad loans are not supposed

to have a borrower centric consideration but assets can be sold at not so fair price and in maximum of

the cases, borrowers are given only the minimum details which can raise transparency issue.

Along with that, Indian ARC model can buy NPAs in the name of a trust, in which ARC acts as a

trustee even though they can exercise the special power while acting as a trustee. This device can avoid

the RBI regulations regarding NPA treatment, capital adequacy, and income recognition whereas ARCs

on their own are subject to these regulations like NBFCs. when the assets are on the books of trustswith relaxed regulation, the special privilege to the trustee(ARC) is not logical.

The main rationale for a market based model in India was that government official’s involvement might

spark the public criticism and in future there might be auditory ramifications regarding the

determination of fair market value of the distressed assets. On the other hand, Private ARCs were

expected to find the lowest possible but appropriate price from the banks. With only profit driven

motive of private ARCs, obviously the more promising NPAs become the target of private ARCs

which is contrary to Government’s vision of ARCs as ‘nursing home’ for distressed companies and a

long term solution for the problems.


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Success of the recovery channels:

From Exhibit4, it is evident that Among all the recovery channels, through SARFAISE act majority of

NPA is recovered (as a percentage of total recovered) with a sudden spike after 2010.It shows

SARFAISI act is our best available channel but there is a downward trend in the SARFAESI channel y-

o-y basis comparing with the amount involved creating some concerns on its efficiency.

Proposed Change in SARFAISI act and its implications: in December 2012, Parliament approved

the bill the amend SARFAESI act giving ARCs and banks the right to convert any part of the Debt into

equity and a chance for the lenders to become an equity partner of the defaulting companies. The

underlying logic is that lenders can gain from any appreciation of the share prices in future. The

downside risk of such step is that share price of such stocks might fall further than the exercise price

and hence increasing the loss for the lenders. This amendment also allows banks to bid for the

immovable property of the defaulters themselves (in absence of any other bidders) to be sold to a new

bidder at any later date (expecting appreciation in values), but they can carry the property for maximum

of seven years (as per Banking Regulation Act, 1949.) (Express, 2012)

NPA SYSTEMS IN ASIAN ECONOMIES

The Asian countries had the advantage of taking cue from the western world when it came to the

restructuring and bankruptcy systems in terms of what are more effective. The challenge is to address

the problems in nature of their own economy dependent on the country social, political and cultural

intricacies

JAPAN:

Reforms in Japan the NPL area started in 1997 (though the foreign investors were keen to invest in the

market from 1993 onwards). In 1997 the amount of bad loans with Japanese banks had increased to a

point where banks had to sell the loans or go bankrupt. At this point the foreign investors bought very

aggressively .In the year 1998-99 an estimated $600 billion paper was sold. Now local players have

also entered this market. Barriers to entry in this market are high — many auctions are invitation-only

and the company needs to have a sound relationship with Japanese financial network to get the

invitations.

Japan’s NPL market will grow both in the short term and in the long term. The Financial Services

Agency, which regulates and supervises all financial institutions especially regional banks, creditunions and credit associations, is pushing for banks to improve their balance sheets. This may lead toincreased selling of NPLs as well as a strengthening of their collection systems.

CHINA:

Four AMCs were established in 1999 when their banking system underwent an overhaul. Banks could

sell their NPA’s only to 4 AMC companies. The NPLs they acquired from the big four state-owned

banks in 1999 were transferred at their full face value of approximately US$171 billion in exchange for

10-year bonds. As the underlying value of the NPLs transferred was clearly significantly less than the

face amount of the loans acquired, it was never clear how the AMCs would have the funds to repay the


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notes upon maturity. However, When the big four banks began going public in 2005 the Ministry of

Finance in its notification made clear that would, if necessary, “provide support” with respect to the

AMCs’ repayment o bligations.

Process:

The AMC’s can sell the bad loans to the investors. They act as an intermediary only. But over these

years foreign in China investors have faced difficulties in acquiring control of assets from AMC’s due

to predominantly two factors: a nearly impossible-to-overcome bid/ask spread (the AMCs focus on

their acquisition cost of the loans while investors focus on their recovery value) and an unpredictable

approval process. Some investors including Goldman Sachs have left China. Even investors who have

been able to acquire the assets are facing difficulties since there is no proper legal system or collection.

Since late 2007, courts across China have invoked a self-imposed “three suspension policy” – the

suspension of filing of new NPL – related cases, obtaining judgments on existing cases and execution of

decisions made pending due to the supreme court judgment. This has also turned negative for the

investors who cannot now approach the courts.

The Chinese system has always been reluctant in handing over the NPA’s to the foreign investors

particularly when it comes to state owned enterprises. The supreme court guidance which came out in

2009 also dis-incentivized the state owned or state controlled enterprises by saying that if any

organization(which has NPA’s) undergoing reorganization the court should not accept cases for it even

if it has been sold to the distributor. The Supreme Court guidance invalidated the NPA sale for number

of reasons like the debtor or Guarantor being a government body, auction formats not being properly

followed, necessary approvals not being obtained, and the all-inclusive “any other situations involving

national or public interest. (PWC, 2012)

Graph-1:NPA Across all countries:

Source: World Bank data Indicator


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The graph shows the comparisons of NPA across all countries. India showed substantial improvement

after 2003 with the SARFAISI act and also due to higher GDP growth. Along with that, it shows steady

increase of NPLs in USA around the financial crisis of 2008.

FUTURE:

Even when the ARCs are envisaged totally in the private sector, it is necessary for them to have

complete operational independence. As Banks and financial institutions, through SRs, are their major

shareholders, arms-length transaction is necessary to avoid any window-dressing of the NPA problem.

With corporate bond market picking up in future with possible stable credit rating agencies, good

players will go directly to the bond market. That might cause the bad players concentration to go high

in loan market to banks resulting in potential increase in NPAs. Banks and FIs can mitigate the risk by

investing in those bonds.

CONCLUSION:

1. Recapitalization strategy if the banks recognize losses due to NPAs and end up having lower

capital levels, the recapitalization strategy from RBI will encourage banks not to roll over the

potential NPA to the future.

2. Foreign capital in ARCs: for capital requirement of private ARCs, more foreign capital

should be encouraged with some incentives (tax) like the ARCs in China.

3. Threshold level for ARCs: ARC’s are not equipped to handle priority sector loans. Since these

loans which are given to small farmers are small loans which are large is number it is very

difficult for ARC’s to follow up. It increases the workload of the ARC to handle numeroussmall ARC loans. At the same time penetration is a major factor with large parts of rural India

still grappling with the problem of connectivity .In this regard a central bank which has access

to these remote locations is better equipped to handle the NPA’s. Thus ARC’s should be given

only loans above a particular size.

4. Securitization: Development of a security market in India for the loan products through which

actual price discoveries of loans and NPAs will be possible.

5. Bond Market and its impact: Though Corporate bond market is not developed in India, a

developed corporate bond market will change the scenario for financial institutions. With bond

market with proper rating agencies and regulations in place, large and creditworthy players

(with good credit ratings) will shun the loan market and will raise funds at much lower cost

(low coupon rate with higher ratings).Hence Banks will have to either accommodate either the

small players with questionable creditworthiness or Banks can invest in the corporate bond

market but the interest income will be less than the income possible from the loan market.

Though that might hamper the interest rate margin for banks (as they would be raising capital

through same deposit rate).To compensate for the reduced margin, Banks might have to carry

riskier loan portfolios in the loan market with potential increase in NPAs. At the same time,

proportion of NPAs from bonds of established players would decrease with a developed bond

market and price discovery in the secondary market, thus having a positive effect on banks’


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NPA. To avoid the riskier loans in the loan market and to avoid the risk of NPAs, lowering of

savings deposit rate along with a developed bond market is necessary.

6. New Banking licenses: With new banking licenses being proposed targeting all inclusive

growth, specifically in rural India, maximum of the branches of the new banks may turn out to

be potential loss centres for the new banks, at least in short term, as the restrictions of number

branches will be imposed on the new banks. To meet the profit targets, these banks might endup having riskier loans on their books in those rural areas given the fact that priority sector

lending has more impact in NPAs of banks. Hence, new banking licenses should be provided to

those companies who will have sound financial strength and sound credit appraisal process.


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REFERENCES

bank, w. (2013, August). world bank . Retrieved from data-world bank:

http://data.worldbank.org/indicator/FB.AST.NPER.ZS/countries/1W-IN-CN-US-BR?display=graph

BOYAZNY, M. (n.d.). Taming the Asian Tiger-Revival of Non-Performing Assets. Euromoney Institutional Investor .

Express, I. (2012, december). Retrieved from Indian express: http://www.indianexpress.com/news/parliament-approves-

changes-in-sarfaesi-act/1043247/

Finnacle, I. (2012). NON performing assets-An Indian perspective.

Kalra, R. (2012). Non-Performing Assets-of Commercial Banks: A Case Study. The IUP Journal of Monetary Economics.

Kothari, V. (2011). Asset Reconstruction Companies.

Mahapatra, D. M. (2012). Impact of NPAs on profitablity of commercial banks. Aveshkar .

Neeraj, T. (n.d.). Resolution of NPA in India:. PRATT’S JOURNAL OF BANKRUPTCY LAW .

Patidar, D. (n.d.). ANANALYSIS OF NPA IN PRIORITY SECTOR LENDING: A.

PWC. (2012). PWC newsletter . Retrieved from http://www.pwc.com/gx/en/non-performing-loan-news/index.jhtml

RBI. (2012, july). RBI master circulars. Retrieved from RBI:

http://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=7370

RBI. (2012-13). RBI. Retrieved from RBI-Pririty Sector: http://rbi.org.in/scripts/FAQView.aspx?Id=87%20-priority

RBI. (2013, July). RBI notification. Retrieved from http://rbidocs.rbi.org.in/rdocs/notification/PDFs/62MCIRAC290613.pdf

saha, K. (n.d.). Can the ordinance recover NPAs. IIMB-Management Review .

times, e. (2011, july). New paper . Retrieved from economic times: http://articles.economictimes.indiatimes.com/2011-07-

18/news/29787351_1_arcil-bad-loans-idbi-bank

Veerakumar, K. (2012). Non-Performing Assets in Priority Sector: A Threat to Indian Scheduled Commercial Banks.

International Research Journal of Finance and Economics.


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EXHIBITS

Exhibit-1

Exhibit2


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P 21

Exhibit-3

Exhibit-4

Source: compiled from banking trend reports, RBI

y = 227.86x - 1E+06

R² = 0.9333

0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

0 5000 10000 15000 20000

Loan Advances

India GDP(*10^8)

GDP vs Loan Advances by Indian Banks

Series1

Linear (Series1)

Recovery Channel Particulars 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

Lok Adalat No. of cases referred 160,368 186,535 5,48,308 7,78,833 6,16,018 4,76,073

Amount involved (a) 758 2,142 4,023 7,235 53 17

Amount recovered (b) 106 176 196 112 2 2

% (b) / (a) 13.98% 8.22% 4.87% 1.55% 3.77% 11.76%

DRTs No. of cases referred 4,028 3,728 2004 6,019 12,872 13,365

Amount involved (a) 9,156 5,819 4,130 9,797 141 241

Amount recovered (b) 3,463 3,020 3,348 3,133 39 41

% (b) / (a) 37.82% 51.90% 81.07% 31.98% 27.66% 17.01%

SARFAESI ACT No. of cases referred 60,178 83,942 61,760 78,366 118,642 1,40,991

Amount involved (a') 9,058 7,263 12,067 14,249 30,600 35,300

Amount recovered (b) 3,749 4,429 3,982 4,269 11,600 10,100

% (b) / (a) 41.39% 60.98% 33.00% 29.96% 37.91% 28.61%

Total Amount involved (c) 18,972 15,224 20,220 31,281 30,794 35,558

Amount recovered (d) 7,318 7,625 7,526 7,514 11,641 10,143

% (b) / (a) 38.57% 50.09% 37.22% 24.02% 37.80% 28.53%

SARFAESI ACT/

TOTAL(recovered) % a'/d 51.23% 58.09% 52.91% 56.81% 99.65% 99.58%

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